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Executives

Cole Lannum - Investor Relations

Joe Almeida - Chairman, President and CEO

Chuck Dockendorff - Chief Financial Officer

Analysts

Kristen Stewart - Deutsche Bank

David Roman - Goldman Sachs

David Lewis - Morgan Stanley

Mike Weinstein - JP Morgan

Bob Hopkins - Bank of America

Matthew Dodds - Citigroup

Glenn Novarro - RBC Capital Markets

Larry Keusch - Raymond James

Matthew Taylor - Barclays

Joanne Wuensch - BMO Capital Markets

Matthew O'Brien - William Blair

Brooks West - Piper Jaffray

Jason Wittes - Brean Capital

Richard Newitter - Leerink

Mike Matson - Needham

Anthony Petrone - Jefferies

Dave Turkaly - JMP Securities

Covidien Plc (COV) F2Q 2014 Results Earnings Conference Call April 25, 2014 8:30 AM ET

Operator

Good morning ladies and gentlemen, and welcome to the Q2 2014 Covidien Plc Earnings Conference Call hosted by Cole Lannum, Investor Relations Officer. My name is Benny and I’ll be your event manager this morning. (Operator Instructions). [I would note the parties] that this conference is being recorded for replay purposes.

And now I like to hand to Cole. Please go ahead.

Cole Lannum

Thanks, Benny and good morning, everyone. With me today are Joe Almeida, Covidien's Chairman, President and CEO; and Chuck Dockendorff, our Chief Financial Officer. We'll be making some brief introductory comments and then spend most of the time this morning as usual answering your questions.

During the call today, we may make some forward-looking statements, and it's possible that actual results could differ materially from our current expectations. Please refer to the cautionary statements contained in our SEC filings, including Form 10-K, for additional information about factors that could cause actual results to differ from those anticipated in such forward-looking statements.

We will also discuss today some non-GAAP financial measures with respect to our performance. A reconciliation of non-GAAP to GAAP measures can be found in our press release and its related financial tables, as well as in the Investor Relations section of our website, covidien.com.

For the second fiscal quarter, we reported GAAP diluted earnings per share of $0.97. After adjusting for certain specified items, our non-GAAP earnings came in at $0.96 per share. The after-tax impact of the amortization both this quarter and in the second quarter of last year was $0.09 per share.

Now I'll turn it over to Joe, who'll go into more detail on the second quarter results. Joe?

Joe Almeida

Thanks Cole. Let me begin by saying that overall, we were pleased with our results this quarter. Sales were on plan up 4% operationally and up 3% as reported. Our results are in line with our year-to-date expectations and our outlook for the rest of the year remains unchanged.

In the emerging markets, we're pleased with our overall performance as we once again post operational sales growth of 14%. In the BRIC countries we continue to grow very well with the growth in high teens. In addition, we made good investments in the BRIC countries this quarter including an acquisition in Brazil and joint venture in China, which we will capitalize on in the near term.

Turning to the U.S. and other developed markets conditions remained stable to improved, although sales growth this quarter was not as strong as it was in the first quarter due to the timing of customer orders between the first and second quarter.

Let me now turn to our second quarter performance in individual product sales categories. As usual I will discuss our growth on an operational basis excluding the negative impact of foreign exchange. Within Surgical Solutions, our Advanced Surgical business, had another excellent quarter posting 9% growth and once again we saw a double digit gain for vessel sealing which continued to benefit from prior year product launches including LigaSure impact and Blunt Tip as well as Sonicision.

In addition we were extremely pleased with the performance of our GI and interventional lung business both of which grew well over 20% organically this quarter. The results of our GI business were further aided by the acquisition of Given Imaging which closed at the end of February. Following this acquisition we now have one of our industry’s broadest portfolios for diagnose and treating GI disorder.

Sales of stapling were above those of prior year and primarily by the demand for Tri-Staple reloads outside the U.S. as we continue to benefit from the conversion our procedures from open to MIS. In addition during the quarter we announced a relaunch of our Reinforced Reload which integrates buttress material with Tri-Staple. We are excited about this unique proprietary stapling system and believe this is one of the many products that will help us continue our technological leadership in this category.

Finally we were again pleased with our results in the hernia category which posted another double digit gain in synthetic mesh. We continue to make target investments in this space and are very pleased with our new product pipeline over the coming years. Most recently we bolstered our product portfolio with a launch of Symbotex Composite Mesh in the U.S.

Within General Surgical, sales of electrosurgery products and [Sonicision] were boss that of the prior year. Once again the increase in [Sonicision] was driven by sizable gains in the emerging markets. However, these sales increases were more than offset by the impact of the Confluent biosurgery divestiture in mid January and somewhat lower sales of surgical instrumentation.

Moving to Vascular Therapies, we delivered low single-digit growth in Peripheral while Neurovascular was unchanged within Peripheral Vascular sales of chronic venous insufficiency products increased this quarter so it was a much more modest gain than in the past primarily due to customer purchase timing. Going forward we expect the Peripheral Vascular business to return to mid single-digit growth over the next several quarters.

In Neurovascular sales were flat with prior year while we had very good growth for Neurovascular in the U.S. it was offset by pressure in the European market tough comparisons in emerging markets and partially resulted from timing of customer orders and the recall of a certain loss of our Pipeline Embolization and Alligator Retrieval devices.

Regarding this recall as always patient safety remains at our top priority, we have identified a prosper solution and have actively worked with the FDA. While the timing of obtaining regulatory approval to get back in the markets uncertain to recall we negatively impact Neurovascular sales in the short term we expect this business to return to mid to high single-digit growth in the first part 2015 as we have a diversified portfolio [in occurring] launch of our next generation Embolization Device in Europe.

Turning to Respiratory and Patient Care. Just by the weak flu season Patient Monitoring sales were above a year ago led by capnography growth well in excess of 30% and growth in advanced parameter sensors in the mid teens. Once again we’re extremely pleased with the performance of the capnog business which continues to grow substantially.

In the Airway & Ventilation category the modest increase in sales of ventilators which rebounced from last quarter even sooner than expected more than offset the slight sales decline of airway products. In addition, we believe the recent approval and launch for our next generation PB 980 ventilator will help drive our vent business for the foreseeable future.

In Nursing Care, sales of incontinence products in the U.S. were well above prior year as we recover some market share and benefit from a new product launched in the second half of last year. Higher sales of enteral feeding products also contribute to the growth rate. In addition, our Kangaroo Feeding Tube with IRIS visualization technology recently received regulatory approval. We think this is one of the most exciting new products we launched into our enteral feeding markets several years.

Finally, growth in Patient Care was driven by considerable increase in SharpSafety sales in the U.S. this increase primarily resulted from favorable pricing and a competitive shortage of pre-filled syringes.

This quarter we continued to execute on our customer focus portfolio investment initiative in emerging markets growth strategy we’re pleased with our execution of several new product launches across our portfolio in addition we completed the acquisition of Given Imaging and the previously announced transactions in Brazil and China. We also opened our first center for innovation training and education in India. We believe our new products recent acquisitions and emerging markets investment continue to drive growth.

I will now pass the call over to Chuck, who will discuss the second quarter financials in more detail. Chuck?

Chuck Dockendorff

Thanks Joe. As Joe mentioned, sales came in on plan. Sales rose 2% in the United States and 7% outside the U.S. on operational basis. As you may recall, our first quarter performance was exceptionally strong. We now believe that during the first quarter, we benefited somewhat from the timing of customer purchases as the distributors bought more products than expected in advance of January price increases.

We believe this impacted our second quarter results. Adjusted gross margin decreased 180 basis points this quarter. This decline was primarily due to foreign exchange, which was more unfavorable than anticipated. While we extended our track record of driving positive volume and mix, it was somewhat less positive this quarter due to weaker vascular sales and the unusual sales trend of our lower margin supplies products.

Despite continued investments in emerging markets, adjusted SG&A as a percentage of sales declined 110 basis points this quarter, as we continue to gain operational leverage from productivity improvements. The acquisitions we completed this quarter will put some upward pressure on SG&A in the second half of the year.

Maintaining our commitment to invest in product development to expand our product offerings and accelerate future growth, we also continue to make incremental investments in research and development. R&D grew almost 11% this quarter to $135 million or 5.2% of sales. This represents a 40 basis point increase over a year ago and is our highest quarterly spend on R&D to-date, on an adjusted basis.

Our second quarter adjusted operating margin of 21.6% was in line with our annual guidance range. This amount includes a headwind of approximately a 140 basis points from the impact of unfavorable foreign exchange compared with the prior year.

Net interest expense for the second quarter was relatively unchanged from prior year. Looking forward, we expect net interest expense to be lower compared to prior periods. The adjusted tax rate was in line with the guidance we provided last quarter and we delivered adjusted EPS of $0.96 for the quarter, a 3% increase over the prior year.

Despite significant acquisition activity during the quarter, we still repurchased about $80 million of stock. In the last 12 months, we have returned more than $2 billion to shareholders in the form of dividends and share repurchases, representing over 100% of our free cash flow.

We believe some of the extraordinary strength in the first quarter was due to timing of purchases. However, we remain confident in our ability to achieve our expectations on both the top and bottom line. With the impact of the med device tax annualized and the majority of negative FX comparisons now behind us, we are increasingly comfortable that we can return to double-digit EPS growth, while still investing in our strategic bets. In fact there is even a possibility, we may get there as soon as the third quarter.

I’ll now turn the call back to Cole for Q&A.

Cole Lannum

Thanks Chuck. Hopefully, most of you’ve got the email that I sent out last night trying to streamline this process. For Q&A, we’re going to strictly limit you to one question and then you can get back in the queue, if needed. If there is a need for a follow up question for clarity, feel free to add, but we’re going to try to quickly do these things very quickly.

We’re beginning the call promptly at 9.30, so please be considered of others on the call, when asking your brief questions. Operator, can you go directly to the first question please?

Question-and-Answer Session

Operator

Thank you. First question comes from Kristen Stewart from Deutsche Bank. Please go ahead.

Kristen Stewart - Deutsche Bank

Hi, thank you. I was really disappointed by the one question rule. I’ve got a multipart question on the weather. So I guess I’ll just stick with the question on peripheral instead. I was wondering if you could just kind of us walk through just the trends that you’ve been seeing within the peripheral vascular business and just kind of what gets you comfortable in terms of the growth trajectory going forward?

Joe Almeida

Kristen, I was disappointed that you are not able to ask the question about the weather because I was ready to speak about weather and selling days. But I will go directly to your very relevant question, peripheral vascular. We see a tremendous amount of competition. We see that some of our tactical initiatives in the marketplace by having a basket of products are offered at a certain fixed price to physician owned labs and sometimes hospitals works not all the time but works well.

We see that the success of our DCB which we think is pretty much on track will be key for Covidien. And we remain on track to deliver on the commitments for the future. We don’t see the competitive market changing at all. It’s very competitive out there. We have 6, 7, 8 suppliers of products. We are encountering some competitive headwinds in atherectomy which we’re working very hard to come back with a commercial model that allows us to have our product in most procedures.

I just want to remind everyone that the use of atherectomy is very limited in peripheral vascular. So I am very confident that our team has, between product launches, some inorganic opportunities that we have ahead of us. We will be on track to deliver on our commitments.

Kristen Stewart - Deutsche Bank

Thank you.

Operator

Thank you. Next question comes from David Roman from Goldman Sachs. Please go ahead.

David Roman - Goldman Sachs

Thank you. Good morning. I wanted just to come back to some of Chuck’s comments around the fluctuations in growth over the first two quarters of the year. And I know you guys are very, very explicit about just right in Q1 potentially being somewhat above normalized rates. But maybe given that you have much more visibility into how inventory moves across your different segments; if you could give us some better sense just on volume trends across maybe different categories or different geographies in Q1 and Q2 just to help us sort of gauge what’s going on in the underlying business?

Chuck Dockendorff

Yes. David, I think clearly as we ended Q1, we saw, we actually came in a little ahead of plan. And it is hard to determine; I think at that point in time, we said we weren’t quite sure whether this was the strength in the economies in the U.S. and Europe or whether could have been just timing of orders. And as you know, in our surgical products, and that’s primarily the product that probably had the most impact from this, we do put through a price increase on January 1st on a lot of our products there and the dealers do tend to buy in ahead of that. That’s a hard thing to predict.

We didn’t really see any significant swings in inventory at our dealers or where we saw extra days or anything like that. But as we got into the second quarter, we did see a slowdown in the revenue in January mostly. So, we felt that some of that was the timing that came in into the first quarter. I think though and we look at it year-to-date, we are little ahead of plan, so we are right on track. And we did see that swing in the first quarter. But I would say for the most part the biggest impact from that was in surgical and the advanced surgical products that got impacted from that swing and the timing; we also saw a little bit in Europe as well.

David Roman - Goldman Sachs

Okay, that’s helpful. Maybe just a follow-up to that, and Joe in your prepared remarks I think you made passing reference that conditions remain stable to modestly improved and so in developed markets. So is it fair to say that the underlying trends across your business with the exception of the recall in neurovascular are pretty stable over the course of what you’ve seen in fiscal 2014?

Joe Almeida

Absolutely yes, absolutely yes.

David Roman - Goldman Sachs

Okay. Thank you.

Cole Lannum

Thanks David. Next question please?

Operator

Thank you. Next question comes from David Lewis from Morgan Stanley. Please go ahead.

David Lewis - Morgan Stanley

Good morning. Joe, I want to come back to the statement for a second here. I wondered if you could kind of just update us on what you expect the growth rate for this business to be over the coming quarters and years and specifically you were coming off the multiyear launch, obviously of Tri-Staple. And then just help us understand Duet. In the end, what impact did Duet have on the business and what positive impact should we expect now that Duet is theoretically back on the U.S. market? Thank you.

Joe Almeida

David, we find that franchise to be going meet to 5% to 7% probably the growth across the globe. If you peel the onion and you go into the endo stapling part of stapling that is near double-digits, so 9% to 10%. So we feel very comfortable with this franchise. I’ll tell you, we’re very happy to have the (inaudible) back in the market. When the product, former product called Duet, which we moved from the market, we did an extraordinary job of replacing that technology with our Tri-Staple. So going back in the market, we see some really nice tailwinds. But we should not expect the same kind of performance the Duet had because the Duet, when it was launched, there were no Tri-Staple.

So we see that as a great opportunity to go back into our accounts, they’re proprietary to our competitors and just go in with the proprietary provision product and break into that account. So I think that our technologies is so good in these area, we feel very comfortable with that, that provides us with even more comfort to be close to the upper range of the number I give at the beginning of my answer.

Cole Lannum

Thank you, next question please.

Operator

Thank you. Next question comes from Mike Weinstein from JP Morgan. Please go ahead.

Mike Weinstein - JP Morgan

Great. Joe could you talk just a little bit about given, we're not going to see given quarterly results, given the timing when the acquisition close. So could you talk about how its performance was going into the close and where you are with your integration plans?

Joe Almeida

Mike we are doing pretty well with the integration and let me take that about integration first and then tell you about the performance sales. We are actually on plan. I just had a chance to review, we review every two weeks the status of the acquisition with (inaudible) Brian now who runs that business and on a global basis, this was probably one of the best integration programs that we have put in place.

We had a coordinated effort to the integrations going extremely well and we should expect $40 million to $50 million in sales a quarter. I tell you that the first month everything is on track, actually better than we thought. So everything is green on our dashboards regarding to Given.

Chuck Dockendorff

Mike put that perspective, when we closed that deal, we had it for about a month in the quarter. So I think $40 million to $50 million a quarter, divide that by three give you an idea of the impact on the positive side to the Advanced Surgical business and there was almost exactly the negative impact from the sale of BioSurgery to the general surgery line as well in the second quarter.

Next question please? (Inaudible).

Mike Weinstein - JP Morgan

Just could you give the impact of price across the company this quarter?

Chuck Dockendorff

The impact of price. Pretty much where it's been historically no change in that. And (inaudible) will of that 50 to 100 basis points.

Joe Almeida

Well said Chuck.

Mike Weinstein - JP Morgan

Yes, understood.

Cole Lannum

Thanks Mike. Next question please?

Operator

Thank you. The next question comes from Bob Hopkins from Bank of America. Please go ahead.

Bob Hopkins - Bank of America

Thanks and good morning. I want to ask a follow up question on the pipeline stand. Joe or Chuck, can you just give us a sense as to what needs to happen to be able to start manufacturing again? Any kind of specifics would be helpful. And how confident are you that those things can happen in Q3 and you can start manufacturing again in the third quarter?

Joe Almeida

Bob, we're doing everything we can. We, this is a supplier issue that we had. So everybody knows it's not a pipeline issue, but it is a supplier issue on the capital that delivers the product and it's coding to it. And we found there was some issue with the coding. We are working with the supplier and we hope in another couple of, two or three weeks will be finished where the process validation. Once we finished the process validation, then we're going to be able to go to the FDA and file with the FDA a change in process.

There is two pathways to where there is a 31 days and 135 days. And we hope we can get to the 31 days. We are doing everything we can and we are. But there is a possibility it is a 135 days. We don’t think that that probability is high, but it's still there. So we're doing everything we can. We know and we are conversed with the FDA about the fact that this product is unique in the market and it's a life saving product, so as soon as we can get back in the market we would be able to get back and it is a 31 days of disruption to the supply chain is not great, is small. It is a 135, the disruption would enhance our conversation with the FDA. We are too confident in terms of process would be in good shape in terms of getting this product validated and ready for prime time.

Bob Hopkins - Bank of America

And Joe just one quick follow up on the topic of consolidation given the big orthopedic merger announced yesterday, I realized that’s a different sector but its goes to the question around critical mass generally across businesses in the way the healthcare environment is changing. Wonder if you could just give some quick comments, you have the critical mass that you think you needed across most of our businesses and just any thoughts on M&A broadly would be appreciated?

Joe Almeida

Well, scale is of great importance going forward. And we think that in most products that Covidien participates today. We are number one and number two so we have that scale. I don’t believe the scale across a multitude of specialties and procedures this will get to in the door. But I believe you need to be a very strong player in each procedure and specialties. So you should continue to see Covidien very active on the M&A front to strength its position in the specialty and procedures.

I do think size matters. And as we continue to move forward, the company continue to look at opportunities of all sizes in this arena.

Bob Hopkins - Bank of America

Thank you.

Cole Lannum

Thanks, Bob. Next question please.

Operator

Thank you. Next question comes from Matthew Dodds from Citigroup. Please go ahead.

Matthew Dodds - Citigroup

Hey good morning. Joe whether the northeast wasn’t an issue can you at least comment on close attendance during the last three months?

Joe Almeida

On what, I didn’t catch that?

Matthew Dodds - Citigroup

Attendance in the office the last (inaudible).

Joe Almeida

I don’t know. We have a committee here at Covidien that we work very hard on how to determine if there is a snow there or not. And we tend to be very strict about that but we also tend to put our customer service people in hotel so they can come to work the next day.

Matthew Dodds - Citigroup

I hope I get one more question on the gross margin for Chuck. It looks like the FX was a really big hit this quarter and I know you are saying it improves next quarter can you give any idea how much of less of a delta it will be and does it turn positive at some point do the hedges actually start work in your favor as its been negative for a long time.

Chuck Dockendorff

Yes. I think as you look at this quarter particularly the FX hedge was clearly the biggest piece of that when you compare to prior year. We still had favorable mix but it wasn’t as big as it has been in the past because of you’ve saw the kind of lower sales in Surgical and the strength we have in our suppliers business so that mix drove that piece of it down a little bit. But going forward we expect that to be back to normal because we expect those growth rates to return in our higher margin products and clearly the FX will begin to turn favorable in the back half of the year. So we see it definitely improving from where it is in the second quarter up to the third quarter and fourth quarter no question about it.

Matthew Dodds - Citigroup

All right. Thanks Chuck.

Cole Lannum

Thanks Matt, next question please.

Operator

Thank you. Our next question comes from Glenn Novarro from RBC Capital Markets. Please go ahead.

Glenn Novarro - RBC Capital Markets

Thanks, good morning. Joe a question on the acquisitions you mentioned in Brazil and China. Wonder if you can elaborate a little bit more on these deals? Did they bring you any revenues or are these businesses that you’re buying just a stable of presence in Brazil and China and overtime you’ll drive revenues through those businesses, continuing revenues through those businesses that you acquired. So just help us think about Brazil and China in these acquisitions?

Joe Almeida

Glen, we do have a very good presence in Brazil and China. China for Covidien is a pretty sizable sales country and Brazil doesn’t come much far behind. So we have structure there. The reasons for these acquisitions are different in nature. For China it’s a joint venture could be the maturity of that company and it’s an avenue for Covidien to continue to go after the second tier market, but also to achieve quick manufacturing ability in some of the open stapling products.

Okay. In Brazil it is less of a second tier opportunity despite the fact that company sales to the second tier market that in Brazil was different than China. Brazil is the public market, it’s the SUS, the S, You, S, the government health care system. And they have a good presence there but is also a place for Covidien can quickly establish a (inaudible) and start assembling products like such as ventilators and other products that in Brazil will be more advantages for our company. As you know there is a 25% price allowance differential between an imported product and a made in Brazil product. So Covidien will take advantage of that there too.

So there are two different types of objectives here and in terms of revenues for both of them very small. They have revenues but they are in a couple of million bucks per quarter so immature at this time to comment at this moment.

Glenn Novarro - RBC Capital Markets

Okay. Thanks Joe.

Cole Lannum

Hey, thanks Glenn. Next question please?

Operator

Thank you. Next question comes from Larry Keusch from Raymond James. Please go ahead.

Larry Keusch - Raymond James

Thanks and good morning. Joe, on the topic of M&A, I guess two things. Number one, I’m hoping you can talk a little bit about some of the deals that you’ve already completed. You mentioned in your prepared comments about BÂRRX and superDimension and strong sales growth. I just would love to get any sort of operational updates, so we can understand where those businesses are going. I think that’s going to be pretty important for you guys going forward.

And then also on the same topic, given your access to cash to your domicile outside of the U.S., I’m just curious how you are thinking about M&A geographically. You’ve done a couple of things overseas now. But I guess specifically I’m wondering if you believe there are still targets in the U.S. that you guys can go after?

Joe Almeida

Larry, just comment on superD and BÂRRX, those are great acquisitions. We put them under different management group within Covidien to be able to incubate as we call those emerging technologies.

BÂRRX, we are completely paid for in terms of the procedure in for Medicare as well as for insurance. The biggest barrier for BÂRRX was actually market development and making people aware of that someone having GERD may lead to esophageal cancer. And there is a way to prevent that by detecting Barrett's esophagus and having that figure. That’s a great story.

It took a little longer for us to get the momentum going, was not on the paying side; we got all the people paying for it. That was not an issue; it was more getting people behind primary care physicians who understand the disease. And I have to say that today, we are really doing well and we see this acquisition really start to significantly contribute to Covidien. As they start to leverage the top-line, we’re going to have less of an expense burden.

When it comes to superDimension, completely different situation, where we took a diagnostic technology and we expanded the therapy. So we're going to be launching some ablation products that will initially go for lung to complement our current liver product and then we're going to go through the trachea into the lung to deliver this energy therapy.

So, we're very excited about those two. And that is a phenomenon. I was talking to a physician here the other day who said this business of superD is ready to explode. We can start to see demand and that has also great penetration capability outside the U.S. We just sold some of equipment in China. So, we're feeling very comfortable with these two technologies and we're going to continue to invest in them.

In terms of using cash outside the U.S. we've been doing this all along. There is not a lack of targets in U.S. As I said, Covidien looks at all size of target, very large or very small. And having the ability to access cash outside the U.S. is a big plus for us.

Larry Keusch - Raymond James

Okay, terrific. Thanks very much.

Cole Lannum

Thanks. Next question please?

Operator

Thank you. The next question comes from Matthew Taylor from Barclays. Please go ahead.

Matthew Taylor - Barclays

Hi, good morning. Thanks for taking the question. I guess, I wanted to ask about your comment on the third quarter earnings growth, you said you may get the double-digit next quarter. In your mind, what are the key variables? I mean obviously you never know how revenue margins are going to shake out. But why you think you may get the next quarter versus you will and what helps you get there?

Chuck Dockendorff

The big thing here is as we look into the back of the year, the things have been hitting us prior to this have been foreign exchange and the device tax, not so much in second quarter but foreign exchange through Q2. And that really has changed around, when you do a year-over-year compare, it’s actually slightly favorable as we look at both the third quarter and the fourth quarter. And along with the productivity we’re driving because you’ve seen the productivity would enable to drive on the SG&A in second quarter despite continuing to make investments in emerging markets and some other areas.

And we see continued sales strength and growth in that third quarter as well. We think that’s what’s going to be the drivers and the better gross margin also going to be the drivers that bring us up to the double digit growth in Q3. The only thing that’s out there that could switch it would be, if there is a major change in the FX rates that we can overcome within the quarter because won’t like that as we look at it today. But that’s an unpredictable event that we see.

Matthew Taylor - Barclays

Thank you very much.

Joe Almeida

Just to complement on Chuck’s saying, we are working very hard on restructuring programs and confident with the SG&A, we’ve been very hard going away with cost restructures in the company. So, we have a lot of work going on right now that’s why we think that that’s a possibility for the third quarter, clearly for the fourth quarter will be there. And we are working hard to make sure that we have really double-digit growth in our EPS for 2015.

Chuck Dockendorff

I think even if you look at Q2, we made -- we are up by $0.03, the deal was close to $0.08 and that makes impact negative within that Q2 along. So we are achieving the double-digit growth excluding the FX. That was a big hit in Q2.

Cole Lannum

Thanks Matt. Next question please?

Operator

Thank you. Next question comes from Joanne Wuensch from BMO Capital Markets. Please go ahead.

Joanne Wuensch - BMO Capital Markets

Good morning. Thanks for taking the questions. Can we just pause on emerging markets please? Part of what you have been doing is hiring individuals in those areas. Can you give us an update on where those hires stand and remind us what percentage of your revenue is generated there? Thank you.

Joe Almeida

Good morning, Joanne. I will start with the revenue. About 15% of our revenue is derived from emerging markets from about sub 8% about three or four years ago. So we had huge growth there. We have hiring plans across all regions. And I would say that we are coming to a point where we are getting satisfied with the number of people that we hired in parts of Asia. We still have a bit more to hire in Brazil and we still have couple areas in the Middle East and Eastern Europe that we maybe hiring. But the big wave of hiring that we had last two years is 80% to 90% completed, not 100% in some other countries. And our growth in BRIC countries where we probably put most of our hiring has been now 18% to 20%. So we are very, very happy with the results. And now it’s time to explore two things in emerging markets, one is the second tier or tier 2 markets; the second one is places in Latin America and Asia other than the BRICs that we think that are good opportunity to make a small investment and have some good benefit.

Joanne Wuensch - BMO Capital Markets

Thank you.

Cole Lannum

Thanks Joanne. Next question please?

Operator

Next question comes from Matthew O'Brien from William Blair. Please go ahead.

Matthew O'Brien - William Blair

Good morning. Thanks for taking the question. I was hoping to talk about the advanced surgical business a little bit coming out of stages and there is a couple of new robotic systems now that are available from Intuitive. And I was just curious there was a lot of commentary during that meeting about their focus on some of the instruments where you guys are both going to compete going forward. I am just curious given those two new systems and their commentary, if there is anything you see now that makes you change your view on the impact of robotics and those products on advanced surgical over the next couple of years, maybe two, three years given how important that business is to the growth profile of Covidien?

Joe Almeida

Yes, Matt. So, let me just speak about our innovation pathway here. We have about 12 products that were launched between May of ‘13 and October of ‘14. I see these come out of innovation going into energy, continue some in stapling. And as I look at our growth in our advanced surgical products, we are at a rate of twice as fast as our nearest competitor. We think that robotic technology continues to be a niche. I think we need to understand that every time robotic technology is promoted is an opportunity for Covidien to participate as we are leaders in MIS instrumentation. So stapling, MIS stapling continues number one in the world.

So I would tell you that that’s a plus for us. But Covidien is also looking at ways of bringing new technology to the OR that will make operating patients safer with no incremental cost. So we’re now ready for primetime, but when we are probably about year and half, we will be talking to you guys about how our system to bring more precision into surgery with an economical impact that is neutral. I’m very comfortable with the pathway of technology (inaudible). We have R&D centers in North Haven Connecticut; Cambridge, Massachusetts; Munich, Germany; as well as Shanghai, China. They are working very hard to bring the new wave of technology for the next 24 months to the market and I think we're going to continue to lead at path.

Matthew O'Brien - William Blair

Very helpful thank you.

Cole Lannum

Next question please.

Operator

Thank you. Next question comes from Brooks West from Piper Jaffray. Please go ahead.

Brooks West - Piper Jaffray

Thanks for taking the question. Chuck I wanted to circle back on SG&A leverage, you guys have talked about that a lot. I understand there is maybe some pressure in the second half of this year, but longer term, can you quantify the opportunity in SG&A as a percentage of sales and when should we really look for that starting to fall meaningfully to the bottom line?

Chuck Dockendorff

I think you are seeing some of that kick-in now, I mean we're down 110 basis points in SG&A from the prior year. And a big piece of that is the productivity that we're driving through and what we call the leverage by containing the cost. But we have significant productivity going on today.

In Europe, we really regionalized that structure last year, it driving to a significant savings. We are making some major changes and how we into market in the U.S. So these are growth areas and have slowed down and the business has a done a great job taking cost out without really missing anything on the topline. So they’ve done a phenomenal job.

You are going to see continued leverage on SG&A going forward. We have plans in place to drive more of this through outsourcing or off-shoring driving more into our product operation within Europe, taking those things out of country. We should do this the face of it as we do add deal, that puts a little positive pressure on the SG&A, but we still see net the SG&A leverage coming through. So, we would expect that to decline when you compare it to the prior years when we expect that productivity to continue.

So, we feel real comfortable about that. Remember we're driving down a 110 basis points on the SG&A line from the prior year. And this is why we are continuing to make investments in emerging markets and other areas what we call a strategic bet. So we're still making those investments as well.

So, it really is truly pretty significant decline in productivity or improvement in productivity we're seeing on the SG&A.

Brooks West - Piper Jaffray

So, is it couple of 100 points left or I mean could we see this in a longer term model, kind of get to 20s as a percentage of sales is that the way we should think about it?

Chuck Dockendorff

I mean long-term, we clearly know we need to bring it down. And so, I don't want to give out any specifics on what we go to. But again, I just bring it back to what we're committed to is driving this double-digit EPS growth. And the only way we're going to get there, we're going to continue to improve gross margins through mix and all of that. But more importantly, we know we need to drive the leverage within the SG&A going forward in order to drive that over the long-term. So, we do see a couple of points of opportunity there on the SG&A line to drive to further growth in the future.

Brooks West - Piper Jaffray

Thanks so much.

Cole Lannum

Thanks Brooks. Next question please?

Operator

Okay. Your next question comes from Jason Wittes from Brean Capital. Please go ahead.

Jason Wittes - Brean Capital

Hi, thanks for taking the question. Maybe if I could follow up on last question on margins. My understanding was that, quite a bit of your margin upside was reinvested into emerging markets. But that seems to be sort of going into the second, I guess the second stage here. So when you think about the margin improving you discussed; a, are we are going to see slightly less reinvestment in emerging markets and b, I also know the lot of those emerging market investments are front end loaded, and also do you expect to see just higher margins in those regions?

Chuck Dockendorff

No, we are not going to stop investing in emerging markets. That’s still good opportunity for us. We are going to continue to do that. So we are going to drive the leverage and invest in both our strategic bets that we have in emerging markets.

So one thing about emerging market is we have a higher than normal SG&A ratio there. Part of that is because we are putting the investments a little ahead of the sales when you get into salesforce and some of the new training institutes that we have built launching this year.

But also our infrastructure over there is probably not set up in the most efficient way. We went into those countries relatively quickly. We are able to capture the market and we are able to get good returns on it, but from back office and G&A structure we have a lot of opportunity to streamline that and bring that out. So we think that, we can bring the G&A in that areas down by about half and drive that productivity through, we are still investing in our opportunities around selling and marketing.

So it’s not a question of driving this productivity or more SG&A by stopping the investments. Like I said we continue this quarter to continue to invest in emerging markets and we will continue in the future and that’s part of the thing that we layout.

Jason Wittes - Brean Capital

Okay, thank you.

Operator

Thank you. Next question comes from Richard Newitter from Leerink. Please go ahead.

Richard Newitter - Leerink

Hi, thanks and thanks for taking the questions. Good morning. Just a follow up on the question about your kind of minimally invasive R&D efforts. Joe it sounds like you were kind of describing a timeframe of 12, 24 months or something project in development, can you just maybe give us a little bit more color on that, should we be thinking of you guys as kind of having an initiatives in the works and this could potentially, well I am not going to say a robotics platform, a minimally invasive kind of next generation maybe something a little bit more paradigm shifting and revolutionary versus evolutionary development is that kind of what that 12 to 24 month comment was geared towards?

Joe Almeida

I am not going to give you more color on that because I think that is sufficient for now. We tend not to launch products like Apple, so I would not be on stage launching stuff, we just kind of launch like we always do and we have more interest in making sure that patients are really benefited and the system will benefit from our lower cost system.

If you think about MIS for computing this an evolution, we have the statement, we have prior statement first generation, we revised that with a lighter, we have a third one coming out with a very light and very potent battery. And from that we are going to go into other systems that have better visualization, better access as well as gives more freedom to the surgeon. And this is what I am saying to you is probably in the next 12 to 36 months you are going to see more launches in this area. So I am not going to make a commitment. We don’t use a word robotic here because it’s not what we are talking about, we are talking advancements in MIS. So think about a progression of providing better economics with equal or better clinical outcomes.

Cole Lannum

Thanks Rich. Next question please.

Operator

Thank you. Next question comes from Mike Matson from Needham. Please go ahead.

Mike Matson - Needham

Thanks I was wondering if you could maybe comment on the impact of the upcoming drug-coated balloon launches on your peripheral vascular business. I guess particularly from the perspective of the both the balloons and stents products, but also your other acme products? And then maybe you can just give us an update on your DCB program in terms of where you stand with your U.S. trial?

Joe Almeida

Yes. We have spoken about that that Europe we’re probably going to be able to see this product late ‘15 and the U.S. would be about ‘17. Our trials in the U.S. overall are going well. And we should have the products everything goes well, approved and ready for market in 2017 in the U.S.

That product is key for us, because the way we see their early data is a good product and will be essential for us to add to the portfolio, not having a product is not an option. So we’re very focused on how the trial was designed, how the trial was powered and we’re happy with the process that we’re undergoing, right now. I was about two weeks ago in Minneapolis, I visited the duplicate production line that we have there. And it looks like we’re making tremendous progress in how we make the product and also that we’re going to be ready for production.

Remember we’re going to have a preview of this product, how it works with our portfolio in Europe in 2015. So, it would be a really good indicator for Covidien, about the power of our technology. The [attractive] piece is more of an American technology is now used in Europe very [certainly], we see there. We’re going to have the attractive new product launch in Japan which we’re very optimistic that it’s going to make a huge difference in our business in Japan, but it’s not for all markets.

So, the ability to have those two products and nice to have thing is not an essential thing.

And just the impact of the balloon, so on your existing business, I guess in the two year interim before your products launched in the U.S. then?

Joe Almeida

Yes. I think that’s going to be if everything goes to plan, we’re going to have a year to two years, depends upon who launches first of an impact in the U.S. And we’re going to work hard to be able to lock our accounts and have our technology in place. But we're going to have to hold this to our market share as much as we can during that period. And then when we launch the product, we're going to probably go back at whatever was lost if any was lost during that period.

Mike Matson - Needham

All right thanks.

Cole Lannum

Thanks Mike. Next question please?

Operator

Thank you. Next one comes from Anthony Petrone from Jefferies. Please go ahead.

Anthony Petrone - Jefferies

Thanks and good morning. Maybe to stay on vascular a bit, Joe, and just switch over to neurovascular; a big focus at the Analyst Day last year was on stroke, you have Solitaire and focused on stroke in several programs, one at SWIFT PRIME. So maybe can you give an update on your stroke program and maybe an update on what other products outside of Solitaire we could expect specifically addressing stroke? Thanks.

Joe Almeida

Sure. First of all, I just want to make sure that there is an understanding that our ability to read through this pipeline we call that we have is very temporary, speaking to the management (inaudible) and talking to (inaudible) as early or as latest yesterday, we’re very confident in our ability to bring this business to 7% to 9% growth going into 2015 without a problem. We have very robust pipeline or products going across. And the Solitaire is doing well.

We have a huge amount of products being developing for the next 24 months. We have a couple of technology acquisitions that we made that will be available in two or three years. And we're looking at couple of opportunities right now in terms of acquisitions that will make a very good difference in the next 12 months to 18 months. So, we're very excited about the franchise.

So, the stroke portion of it, it is [diving along]. We had the paper that came out with very mixed results which did not represent the use of our product, with the IMS III.

And I tell you we start to recover from that and to taking all the strength to be accepted. And we are very, very optimistic about stroke to deploy, to have new products being developed to be complimented to the current Solitaire. So, no sparing any efforts.

Some comments were made before about SG&A spending. We are very, very focused in spending money in our strategic bet. Neurovascular is one of our largest ones and we're going to continue to spend money there. As I said, there is flatness that we had this quarter and was driven mostly by pipeline and some operational issues in Europe there being taking care. As we speak, don't have any resemblance or any pack to what we think what the business going to do in 2015.

Anthony Petrone - Jefferies

Thank you.

Cole Lannum

Next question please?

Operator

Okay. Next question comes from Dave Turkaly from JMP Securities. Please go ahead.

Dave Turkaly - JMP Securities

Thanks. I think you mentioned competitive pressure in Europe in neurovascular as well and I was wondering if we get a little more color on what that was specifically and if we think it should continue. Thanks.

Joe Almeida

In Europe, remember the products are launched little faster and our pipeline product has been there for a long time. We have a new pipeline being launched in Europe which is coming out in the next couple of months. That’s going to be a huge help for us in Europe. We also had some execution issues in Europe which is being taken -- the acquisition issues have been taken care as we speak. But I am very excited about the new pipeline, the pipeline flex that is being launched in Europe in the next couple of months that is something will be phenomenal.

So as I spoke to Christian who runs our European business, we were able to really get from him the commitment of that business going back to really healthy growth.

Dave Turkaly - JMP Securities

Thank you.

Cole Lannum

Operator, I believe now we are coming along the people in the queue that are dialing into, we ask questions, so ladies and gentlemen thank you for your patience as you’ve got – we've gotten through the first part of the queue. I would like to open it up to anyone that has any follow up questions. And operator, could you go to the next question please?

Operator

Thank you. Next question comes from Kristen Stewart. Please go ahead.

Kristen Stewart - Deutsche Bank

Hi. Thanks for taking the follow up. I was wondering, Chuck I think you mentioned that interest expenses going to be going lower. I was wondering if you could just extend upon that and maybe touch on just the IRS tax liabilities that you have outstanding; any better visibility on when those maybe paid.

Chuck Dockendorff

Yes. On the interest, like I said the cash flow remains pretty strong. And we think that along with may look at doing some different changes we are going to our debt structure, looking at some rate reductions there. We think that we can modestly improve some of the interest going forward in Q3 and Q4. So that will be a slight improvement, nothing dramatic.

As far as the IRS situation, we are sitting here. We expect to make maybe a couple of hundred million in payments sometime in the second half of the year related to some Tyco tax liabilities. Again, we are not in the process of controlling that. So we kind of get updates from them on that. And historically the timing has always been further out than what they projected. But right now, we’ve kind of got that built into our cash flow projections looking out to the second half of the year.

Kristen Stewart - Deutsche Bank

How do we just think about the total liability potential and just how to balance that I guess across whether it would be doing buybacks or dividends or anything like that constraining….

Chuck Dockendorff

I don’t think it will have any impact at all. If you look at the total liability, take everything Kristen and you look at what we have and you know the components of our balance sheet because we have our legal liabilities on our own subsidiaries and then we’ve got due to certain people and from other people, the other Tyco people, the total net is about 1.6 billion is what we owe. And these would be our liabilities as convenient as well. When you break out that 1.6 billion about 300 million of it is post spend and 1.3 billion is the pre spend with Tyco. So that 1.3 billion will be paid out we think over the next couple of years, like I said in my comments of $200 million maybe $300 million as we set all these issues with the IRS. And this was true about three periods of audits with Tyco prior to the spend.

So that kind of level of payment we feel this is conservative and fully reserved. And a lot of these issues are resolved now. It’s just that you can’t resolve the entire period until all the issues are resolved. And so, we think this will be a relatively modest payment going out that won’t impact anything we do for acquisitions or dividends or share repurchases going forward.

Kristen Stewart - Deutsche Bank

Thank you.

Cole Lannum

Thanks Kristen. Next follow-up question please?

Operator

Thank you. Next question comes from Anthony Petrone from Jefferies. Please go ahead.

Anthony Petrone - Jefferies

Maybe just an update on at a high level your sort of hurdle rates for M&A. I know you mentioned that M&A could be of all sizes. Just wondering if you’re thinking bigger sizes, does that sort of change the outlook of what the hurdle rates are for M&A? Thanks.

Chuck Dockendorff

We’ve maintained these hurdle rates for a while, both we have strict strategic hurdle rates and financial metrics as well, which we adhere to. And so they are distinguished a little bit around the risk of whatever acquisition we’re doing. So when we look at a product line that we’re tucking around the world which we’re familiar with, the risk is relatively low. Our hurdle rate certainly is lower than on that. And it would be on a new technology that may take 3 or 4 years in R&D to launch and there is other competitors out there.

So, I would tell you that all the hurdle rates are well above our cost of capital. The other component we look at is return on invested capital and we look at that typically on a bigger deal as well as internal rates of return when we look on return on invested capital 5 years out of what that return is coming in to.

So, all of these are going to be accretive. We want to be accretive to shareholder value. So those returns that we’re looking for are greater than our cost of capital in all these cases. And we usually -- I’m not trying to say specifically what they are but they are really much higher than our cost of capital, so we build in a risk factor in there.

Anthony Petrone - Jefferies

Thanks.

Cole Lannum

Thanks Anthony. We’re coming up on the bottom of the hour. So I am going to wrap things up right now. I just want to say for a moment thank you very much from my standpoint for moving things so quickly today. I was thrilled we were able to get everyone and have a couple of follow-up questions as well. Starting a new Eastern Time today, a replay of the call will be available. This replay will also be available on our corporate website covidien.com. From members of the media, who’ve listened to the call and have additional questions, please contact Jacqueline Strayer or Lisa Clemence in our corporate communications department.

For anyone else on the analyst side having more detailed questions involving non-material information, both Todd and I will be available all day today and all weekend to take your calls. Thank you and have a great afternoon.

Operator

Ladies and gentlemen, that concludes the conference today. You may now disconnect.

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