Covidien Ltd. F3Q10 (Qtr End 6/30/10 Earnings Call Transcript

| About: Medtronic plc (MDT)

Covidien Ltd. (COV) F3Q10 (Qtr End 6/30/10) Earnings Call July 29, 2010 8:30 AM ET


Rich Meelia - Chairman, President and CEO

Chuck Dockendorff - EVP and CFO

Cole Lannum - VP of IR


Kim – JPMorgan

Mike Weinstein – JP Morgan

Bob Hopkins - Banc of America

Rick Wise – Swanson

David Lewis - Morgan Stanley

Matthew Dodds – Citigroup

Adam Feinstein - Barclays Capital

Sam Gunderson – Piper Jeffrey

David Roman - Goldman Sachs

Michael Matson – Wells Fargo Securities

Joanne Wuensch - BMO Capital Markets

Christian Store – Deutsche Bank

Josh Jennings – Jeffries & Co.

Jason Bedford - Raymond James

Larry Keusch - Morgan Keegan

Thomas Kouchoukos – Stifel Nicolaus


Good day, Ladies and Gentlemen, and welcome to the Third Quarter 2010 Covidien Earnings Conference Call. My name is Janada and I will be your operator for today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer question. (Operator Instructions)

I would know like to turn the conference over to your host for today, Mr. Cole Lannum, Vice President, Investor Relations. Please proceed.

Cole Lannum

Thanks, Janada. And good morning, everyone. With me today are Rich Meelia, Covidien’s Chairman, President and CEO; and Chuck Dockendorff, our Chief Financial Officer.

The press release with details of our third quarter results is issued earlier this morning and is available on our website and on the news wires.

During today’s call, we’ll make some forward-looking statements and it’s possible that actual results could differ materially from our current expectations. Please refer to the precautionary statements contained in our SEC filings for a more detailed explanation of the inherent limitations of such forward-looking statements.

We’ll also discuss some non-GAAP financial measures with respect to our performance, including in particular, operational growth, which is net sales growth, excluding the affect of foreign exchange.

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 invest relations section of our website

For the third quarter, we reported GAAP diluted earnings per share of $0.70. After adjusting for certain onetime items, our non-GAAP earnings for the second quarter came in at $0.85 per share.

Now, I’d like to turn it over to Rich, who will go to more details on the Third Quarter results, Rich.

Rich Meelia

Thank you, Cole. Before I discuss the Third Quarter, I’d like to make a few brief comments.

As you all know, it has been almost exactly three years since we’ve spun off and became an independent company. At our first investor day, immediately appreciating spin, we highlighted five key strategic initiatives. They were focused on growth, commitment to innovation leveraging structure, driving up operational excellence and enhanced portfolio management.

Three years later, these key initiatives, as well as our overall company strategy, remain unchanged. The objectives we highlighted to achieve our strategy at that time, included accelerating growth and higher margin franchises, continue improvement in gross margins, focusing R&D and business development on new technology, and managing the portfolio for growth.

We successfully delivered against all of these objectives over the last three years. We markedly accelerated the pace of new product launches, significantly increased selling marketing and R&D investments, improved gross margins, reshaped the portfolio by divesting or deemphasizing lower-growth lower-margin businesses, and inquiring new businesses that will accelerate growth, expand our product line and deliver higher margins.

Looking at operating margins for example, we committed to making the investments necessary to expand our selling organization, implement R&D investments to drive innovation and create the cooperate structure necessary for a standalone global company.

We knew these investments would put a damper on our operating margins, but I’m pleased to say that we’ve now brought our margins back to the 2007 pre-spin level.

So, our strategy is not changed. Our objectives to achieve that strategy are being met, and we are very pleased with the progress we’ve made.

However, in our conversations and meetings over the last month or so, we’ve heard that some of you believe we’ve changed our principles and modified the criteria we are using to make investments.

Let me be perfectly clear, we have not changed our principles or investment criteria. We continue our rigorous financial evaluation process before we make any investment, large or small.

Our investment criteria have not changed. Our capital allocation strategy has not changed. We continue with our disciplined approach to capital and are making investments that we expect will benefit the business over the long-term. We remain committed to maintaining our strong investment-grade rating, to use our balance sheet flexibility and significant free cash flow to make investments necessary to grow the business, and to be prudent in our allocation of capital.

Specifically addressing the EV3 acquisition, the business provides significant scale to our existing vascular platform gives us a strong position in both the peripheral vascular and neurovascular categories is consistent with our growth strategy and will benefit from our global footprint and establish capabilities.

EV3 has an outstanding product lineup and a robust pipeline of new offerings. We believe that it will accelerate our top-line growth rate, and be additive to our gross margins.

On a cash basis, the acquisition will be accretive in the first full year, post close. EV3 is an excellent addition to the Covidien portfolio, and we are highly confident it will drive increase shareholder value. While their results will not be consolidated with ours until the fourth quarter, EV3 registered strong sales growth in their Fiscal Second Quarter ending in June; again exceeding the expectations.

Now turning to the quarter. Overall, we had another good quarter from a margin and profitability perspective, delivering a 6% increase in adjusted operating income, a 90 basis point increase in adjusted operating margin, and a 15% gain in adjusted EPS.

We introduced several key new products, including EXALGO, PENNSAID, Tri-Staple, SILS hand instruments and hemorrhoid stapler. These launches reflect the success of our established strategy to focus on growth and innovation, accelerate new product launches and bring market leading technology to our customers.

In our large medical devices segment, yet another solid quarter with broad-based growth led by our oximetry monitoring, vascular and energy products.

Third Quarter results were aided by a good performance for the VNUS and Aspect businesses, partially offset by the divestitures of sleep and oxygen.

In Endomechanical, we registered good growth for our stapling products. In the soft-tissue repair category, sales were even with a year ago as increases for mesh and biosurgery were offset by lower fixation device sales as a competitor reentered the market, slowing our growth.

We did learn just late last week that we received a preliminary injunction in Germany, allowing enforcement of our patens for hernia fixation devices.

One of our key competitors will be required to move their offending devices from the German market immediately. We will continue to take the necessary steps to protect our intellectual property in all our markets.

In our capital related businesses, including energy hardware and imaging delivery systems, we’re still seeing constrained spending by hospitals, though we did register sales gains off the very low base of a year ago.

Also, we saw little impact in the quarter from additional pricing pressures as a result of the austerity efforts in Europe.

Turning to the pharmaceutical segment, we were again disappointed with our top-line results in the Third Quarter. While the initial performance of both EXALGO and PENNSAID is meeting our expectations, our older brands are facing expanded generic competition.

In radiopharmaceuticals, the sale of U.S. nuclear pharmacies during the quarter drove a sales decline. Excluding the impact of this divestiture, radiopharmaceutical sales would have been above those of prior year.

In the generic pharmaceutical category, we faced intense competition, primarily focused on price, coupled with some distributor inventory contractions. We expect these price pressures to continue, and they will be a drain on our results.

In medical supplies, sales were a bit below our expectations this quarter. Harvest sales were up subsequently and we have made significant progress in improving margins, holding the line on pricing, improving the portfolio of a number of low-profit product lines.

While these activities restrained our top-line performance in this segment, it is much more profitable and provides a good ROIC.

We are not managing supplies to the sales growth engine, but it is delivering on its charter to increase margins, hold down expenses, and provide good cash flow.

In addition to EV3, we are selling out to acquisition of some Somanetics during the quarter, a leader in cerebral and somatic oximetry. This acquisition closed yesterday, and will complement our oximetry in monitoring the product line.

We also announced the divestiture of our specialty chemicals and sleep therapy business during the quarter. Both these divestitures are expected to close in the fourth quarter.

I’ll now pass the call over to Chuck, who will discuss Third Quarter in more detail and provide a full year update.


Thanks, Rich. I’ll focus the majority of my comments on the items below the sales line, and then briefly discuss our latest statement on 2010.

As noted in the release, we delivered a 120 basis points increase in gross margins this quarter, paced by favorable volume and mix, particularly in the medical devices segment, portfolio management activities, benefits from our restructuring program, favorable foreign exchange and manufacturing cost reduction efforts.

Third Quarter SG&A spending was up slightly, versus a year ago, primarily due to additional expenses from recent acquisition, partially offset by increase legal cost.

Also, we wrote off about $20 million of accounts receivable in the quarter related to our business in Greece.

As we noted previously, continued spending for growth initiatives expenses related to the launches of PENNSAID and EXALGO, and the affect of acquisition, all put upward pressure on SG&A.

R&D was on was on plan, and we remain committed to our goal to increase research and development to 5% to 6% of sales over the next few years. As planned, we continued to make progress lowering our tax rate, as our year-to-date adjusted rate was nearly 500 basis points below a year ago.

Next, let me take you through some cash flow highlights.

We again generated strong cash flow in the quarter and continue to expect that free cash flow, which is cash from operations minus capital spending, will be about $1.5 billion this year. We also bought back a half a million shares in a quarter. We’ve now completed the original $300 million buy-back program buying back 7.5 million shares at an average price of around $40.

We continue to target returning 25% to 50% of our free cash flow to shareholders through dividends and share repurchases. We expect 2010 to be right in this range.

Also, following the close of the quarter, we successfully completed a $1.5 billion debt offering at an average interest rate of 3.1% to finance a portion of the EV3 acquisition.

Finally, I’d like to briefly discuss our 2010 outlook. Our long-term goals remain; deliver mid-single digit sales price and double-digit EPS growth, achieved through a combination of operational and financial leverage.

Consistent with past practices, we will not be updating our guidance for 2010 today. However, given all the changes since we last updated in April, I wanted to make a couple of brief comments on our current expectations for the year.

We remain comfortable with our medical device sales projections. But now, expect that pharmaceutical sales will be well below last year, and that medical supply sales for 2010 will be consistent with the year to date performance.

In pharmaceuticals, our older brands will face significant declines due to generic competition, and we expect a slow build for our two new branded products with the wholesaler and retailers stocking behind us.

A year ago, fourth quarter also included sales from the nuclear pharmacy’s, which have been divested.

Turning to operating margin, our year-to-date results were at the upper end of our stated guidance range, and we expect to be within that range for the total year. [inaudible] will include SG&A expenses related to the EV3 acquisition.

On tax rate, we are slightly below our guidance range year-to-date, and expect that we will finish the year below the range as we implement additional tax-planning strategies in the fourth quarter.

As always, these comments assume foreign exchange remain constant at today’s rates and exclude the impact of any one time items.

As you may recall, last November we estimated the impact of foreign exchange rates would have on earnings per share this Fiscal 2010. While there have been significant currency movements since that time, we now expect a 2010 impact to be slightly below the range we provided to you in November.

Now I’ll turn the call over to Cole for Q&A.

Question-and-Answer Session

Cole Lannum

Thanks, Chuck. As maybe you may have noticed, we have, once again, cut back on our on prepared remarks this quarter to allow more time for your questions.

For Q&A, we really are going to limit you to one question and followup if needed so we can give everyone a chance to get their questions in. If you have additional question, you can put yourself back in the queue, or feel free to contact us after the call.

Janada, can you please repeat the process once again for signaling a question?


Thank you. (Operator Instructions)

Your first question comes from the line of Mike Weinstein of JP Morgan. Please proceed.

Kim – JP Morgan

Hi, guys. This is actually Kim here for Mike. A couple questions. I guess the first one would just be looking at the sales performance in medical devices against the backdrop of what we’ve seen from some of your competitors.

Can you just talk about your overall performance relative to volumes, any changes you’ve seen from the first quarter to the second quarter? And maybe also a little bit more color on some of this share movements within soft tissue, maybe touching on sutures.

Rich Meelia

Sure. We have not seen dramatic shifts in procedure volumes. This third quarter was a little bit better than the second quarter. You know, there’s still just a general softness that we’re seeing and I think it’s been commented on by others as well.

You know, capital purchases, we had a little bit of an uptick, but nothing dramatic. So we still think there’s still some overall softness, both elective procedures, capital procurement, and maybe general procedures as well.

In terms of share movement in soft-tissue repair, you know, our biologic mesh had good double-digit growth. Our synthetic mesh had high single-digit growths. Both of those did very well. And with the tissue mesh, we’re continuing to invest in clinical data and health economics data to support that product.

So we continue to be very confident in the press-link strategy, and we intend to provide clinical data to continue to support that.

Our softness was primarily in the fixation for the global attacking system. And you know, we saw a competitor come on the market within the last several quarters, and that’s where you’re seeing – we, with the very large market share in soft-tissue fixation, bearing the brunt of some of those share losses as a result of the new entrant.

But overall, we feel very good about our hernia business. And in suture, you know, we allow primary folks in sutures, specialty sutures. Our V-lock was launched a couple quarters ago. But we know, in the third quarter, have launched the full range, the D-90, the D-180. We’re just about 90 days on a follow up on a prospective 100-patient trial on that and we intend to be releasing some data, which I think will provide even more support for the bio-suture technique.

It’s a market we’re kind of driving, we’re seeing our sales increase month over month. And while it has fallen short of what we anticipated when we launched the product, we still feel like that can make a big difference for us in the suture market.

Mike Weinstein – JP Morgan

Hey Rich, it’s Mike. Let me just ask, you made some of the comments early on to investor feedback. And I think part of it has been the A, the downdraft in [inaudible] investments. But B, as well, people’s view of the company’s capital allocation strategy had led to part of that.

I think what would be helpful is if you just talked about, now that you’ve done the EV3 deal and you’ve had the investors and acquisitions for the last several months, how we should think about capital allocations of the company going forward, the company’s view of the tradeoff between M&A and share repurchases and dividends. Thanks.

Rich Meelia

Yeah, sure. Chuck, you want to –

Chuck Dockendorff

Yeah. This is Chuck Dockendorff. Just a couple comments on that.

You know, I think we’ve been relatively consistent in our capital strategy, and Rich reiterated that in his opening comments. But you know, we really see the free cash flow of the business, which is very strong, to be continued to be invested in some of the growth initiatives, acquisitions, and licensing. We think this will drive the growth and profitability of the business over the long term.

We also want to maintain a strong balance sheet, you know, investment grade, a strong investment-grade balance sheet. And in fact, we have that now. And even after the acquisition, financing for EV3, we have maintained that strong investment grade status.

And then on top of that, we looked to send about 25% to 40% of the free cash flow that we have back to shareholders. We think this is the right kind of balance for the company, both to continue to drive the long-term growth as well as provide some money back to the shareholders through dividends and share repurchases.

And as we look the criteria on acquisitions, and we look at the investment decisions that we make, certainly there’s a whole host of subjective things we look at; strategic fit, and other things that we do. But from a financial standpoint, the key metric we look at is the cash-on-cash returns. And that these really need to exceed the cost of capital.

And we feel that if we can invest in businesses and growth initiatives that do this, this is a better return to the shareholder than acquiring shares. We look at the internal rates of return, and the net present value, and we certainly risk adjust all of these things. But we think that that is a better use of cash if we can find those opportunities.

And I know that some of the concern from the investors on EV3 around their dilation, and the size of that transaction, but a big piece of that dilation that’s coming from EV3 next year is related to the amortization and under the new accounting rules.

Close to half the purchase price of EV3 is going to put in – be put up as an intangible, which will be amortized over a period of 12 to 15 years. We’re still going through that.

And you know, I think it’s important, and Rich mentions it, that from a cash basis, EV3 is accretive, after our financing in 2011. So we see it as driving positive cash flow, and eventually returns higher than our costs of capital later on.

And I would mention that a lot of our investments that we do, in growth initiatives, in research and development, most of these investments are dilutive from an earnings standpoint and a cash standpoint for a number of years before we get the return.

If you think about an R&D project, it could be two to three years. If you think about adding sales people, it usually takes a year before you recoup that investment. Some of the restructuring programs take multiple years to get returns.

So an acquisition is not – is very much like these other investments that we make. And of course, the timing and when that occurs, you look at it from a risk standpoint as how far out that is before you do get those returns.

But I would just close and say that, you know, like a deal like EV3 certainly, it has a longer term horizon on the returns getting to that point where it does exceed the cost of capital. So it’s a transaction that certainly has risks with it. We understand that and we’ve got all that out with our teams. But you know, the medical device team really worked on this. They feel very strongly about it.

And I think if you look at the results of our medical device segment, and the good work they’ve done, improving operations and making these growth investments work, Rich and I feel very comfortable that they’re going to be successful in this acquisition.


Your next question comes from Bob Hopkins with Banc of America. Please proceed.

Bob Hopkins – Banc of America

Hi. Thanks very much. Can you hear me okay?

Chuck Dockendorff

Perfect, Bob. Good morning

Bob Hopkins – Banc of America

Great. Good morning. So I wanted to talk a little bit about the comments on pharma. First of all, could you just put it in perspective for us in terms of, you know, what percentage of your total pharma sales are being impacted by this generic competition that you say is going to be ongoing here. And is that a high-margin business relative to the corporate average, or low-margin business relative to the corporate average, just to put it in perspective to start.

Rich Meelia

Yeah, it’s about $400 million in special generics, very profitable business.

Bob Hopkins – Banc of America

Okay. So knowing those fact, I guess, how does that – how does what you see going on in the marketplace, in the new competition, how does that affect your growth outlook for that business? You know, not necessarily in the immediate term because we know it’s going to be a hit in the immediate term, but longer term? And is it a big enough deal to make you kind of, you know, rethink your growth and profitability objectives for the whole company longer term? I just wanted to try to, again, put this whole thing in perspective.

Rich Meelia

Yeah. I think the notion of this happening is not a surprise. And this is the nature of generics, that you know, they come into the market and they decrease in price over time as more generic competition materializes, which is exactly why we’ve embarked upon our branded pain strategy where, you know, we can have more protection and longer-term profitability.

And so I wouldn’t say that this now changes the whole picture of what we hope to do in pharma, or certainly the profitability picture for the company as a whole because, you know, we’ve got a lot of triggers that we’re pulling to help increase gross margin, operating margin, EPS, etcetera. And you know, this is certainly a headwind, Bob.

But I think it’s one of those headwinds that we, as the management team, have to get our arms around and, you know, fortunately, we’ve got [inaudible] early, the early prescription data for PENNSAID and EXALGO are positive. And you know, we’re thankful that our management team down there had the foresight to start building this capability at a time when we’re seeing more pressure on the generic side.

Bob Hopkins – Banc of America

And then very quickly, for Chuck, you gave us a lot of number and thought on the full-year 2010, which obviously only has one quarter left to go. But I was just, you know, wondering to kind of sum all that up, I think, you know, concensus, I believe for 2010 is in the 325 range. Is that a number that you’re comfortable giving all the different moving parts that you just talked about?

Chuck Dockendorff

Yeah, Bob. I looked at some of the forecasts and kind of took an average of the P&Ls out there. And for the year, I think in general, our sales will be a little lower than what’s in those forecasts. I think our tax rate will be a little lower as well. Those are probably the two areas that are off on those projections right now.

But as far as the EPS, you know, it’s right in the range, and we feel very good about it on a full-year basis.


Your next question comes from the line of Rick Wise with Swanson. Please proceed.

Rick Wise - Swanson

Good morning, Rich. Good morning, Chuck. I wanted to follow up on Bob’s question of pharma. You know, when I looked back at my notes, you sort of talked about – so again, you’re always talking about pharma growth potentially, sort of flat, up low-single digits over time.

Do we have to rethink that long-term growth? And specifically, I’m going to sort of ask one question, but with a couple of parts. You know, we’re seeing push back on opioids, basically the message seems to be too much prescription, you know, for too long for patients. You have the API pressures up maybe post J&J’s issues. EXALGO sounds like a little slower launch. And you, again, can you help us rethink, or think about that longer-term forecast in the light of those points?

Chuck Dockendorff

Sure. Well, first of all, Rick, as you know, we’ll have our investor day in just about six weeks. So we’ll give you lots of color and lots of detail. But I would say it would have to affect us. This was a bit of a surprise. We weren’t expecting this competitor to come out and start creating some of these pricing pressures. So clearly, we weren’t anticipating it.

So given that it’s happened, it has to change what we see long term. I don’t think it materially changes because the whole plan strategically at pharma is to emphasize the much higher margin, much better growth potential of these branded pains like we’re seeing with EXALGO and PENNSAID. And you’ll hear more about that rovian and zurcon, which you’ve heard about before, I think, at our last investor day. You’ll hear what’s happening just in the year, and a lot has happened.

So, it certainly doesn’t change our strategy. It might affect what we see from a sales growth for the next couple of years. But having said that, you know, these things come and go. I mean, this is narcotics. You’re dealing with quotas. Small competitors appear, they do things and then sometimes they disappear.

So it’s not exactly the same thing as a non-narcotic generic. But you know, for sure, this has been an unanticipated headwind.

Rick Wise - Swanson

And just as a quick followup to that, is this something that you address to try to offset and improve over the next couple of years, you address totally internally, or does this raise the greater likelihood that you’ll try to seek some technology products externally? Thanks.

Chuck Dockendorff

Sure. We don’t comment specifically on M&A. But I think what you’ve seen in the past with pharma, what we’ve done is built up a nice clinical regulatory, scientific capability. We know have a sales force in this controlled-substance area. I think there will be other opportunities to do the kind of licensing deals that will bring in new product opportunities where we can leverage our skills in those areas I just mentioned, as well as our sales force.

I like our strategy, and I think that’s where you’ll see our strategy continue to focus from a growth standpoint.

Thanks Rick. Next question please.


Your next question comes from the line of David Lewis with Morgan Stanley. Please proceed

David Lewis – Morgan Stanley

Good morning. Rich, I appreciate your comments on sort of the three-year review of the business. And one of the hallmarks of the prior three years was a very dramatic SG&A investment, which was very beneficial for certain product lines.

In this particular quarter, and the last two quarters, you’ve seen very dramatic operating margin expansions really coming on the backs of sort of SG&A reduction, or SG&A constrainment, or SG&A leverage.

I wondered if you could talk thought your confidence that you can continue to deliver these types of operating margin performance going forward without sort of continuing to invest in the business? So sort of, what is the relationship between your top line growth and the SG&A leverage that you’ve been posting here the last couple of quarters?

Rich Meelia

Sure. I’m going to ask Chuck to weigh in, David.

Chuck Dockendorff

Yeah, I think, David, if you look at kind of our operating income performance improvement, a lot of it has been driven by the gross margin piece of the business. You know, that’s had the most significant increase.

And in fact, SG&A has been climbing as a percentage of revenue and there has been a number of factors for that. You know, related around some of the portfolio moves we’ve made, and some of the growth investments that we’ve made in that piece of it.

In fact, this quarter, you know, as we look at it, it is down as a percentage of revenue compared to the prior year for the first time.

But we certainly will have some upward pressure on that going forward, certainly as we look at the EV3 acquisition and begin to roll those numbers in.

We’ve always stated that as we look at this, we think we can leverage the SG&A going forward on the base business. And we’re beginning to see that. We are leveraging the G&A components as we expand into cost reductions and create share service centers around the globe to reduce our costs in those areas. And those are in process and are successful, and we’re realizing some of the benefits from those now.

But going forward, as you see, we begin here to leverage SG&A. I would expect it to go up some with the EV3 acquisition but then to begin to leverage at that point forward.

David Lewis – Morgan Stanley

Very helpful. And Chuck, just one more follow up on margins, perhaps. Obviously strong performance in the quarter, but just help us understand the impact of currency, specifically on gross margins. If you could give us any more granularity, trying to understand the operating performance in the quarter versus obviously FX tailwinds.

Chuck Dockendorff

Yeah. The majority of it, you know, I think if you look at FX in the quarter, it is very minor. You can see it realized in our sales growth rates, and we had a 1% FX component in our medical device segment. Really, overall in total sales, it was no difference between our reported and what we call our operational sales growth.

So FX is a very small component quarter over quarter. So almost with parody in the prior year.

And it did have a slight favorable impact in gross margin, but most of it was operational improvement, mix improvement, cost reductions and things like that that we’ve implemented.

Thanks David. Next question please.


Your next question comes from the line of Matthew Dodds with Citigroup. Please proceed.

Matthew Dodds - Citigroup

Good morning. A couple question, Chuck. When you talked about the guidance for the business’s medical devices you said wasn’t changed. I think the last time you commented on it, it was 9% to 12% reported. Is that right?

Chuck Dockendorff

That’s correct.

Matthew Dodds – Citigroup

So when you look at it now, it includes EV3 and Somanetics, which I don’t think was in before, but also I would assume the FX is worse. So is that the right logic?

Chuck Dockendorff

Yes. Somanetics, we really – but yeah, we include easy trade.

Matthew Dodds – Citigroup

Okay. And then also on the comments you made earlier you said you took a $20 million accounts receivable write off in the quarter. That was in SG&A?

Chuck Dockendorff

It was, yes.

Matthew Dodds – Citigroup

Is that right to think that was about $0.03?

Chuck Dockendorff

It was $20 million so –

Rich Meelia

Yeah. If you do the math, that’s ballpark $0.03 a share.

Matthew Dodds – Citigroup

All right. Perfect. Thanks, Chuck.


Your next question comes from the line of Adam Feinstein with Barclays Capital. Please proceed.

Adam Feinstein – Barclays Capital

Thank you. Good morning, everyone. I guess with a lot of noise out there about what’s going on in the hospital world, and a journal article today talking about less people going to the doctor, and just a lot going on, I’m curious to get your thoughts in terms of end-market growth as you think about your biggest segments within the medical device segment.

So clearly, there’s market share shifts, but as you guys just think about the pure end-market growth, I'm just curious what your updated thoughts are in some of those key markets, and how much that’s changed in the last six months just so we can better understand in terms of what the growth opportunity is within Endo, and soft tissue, and energy. Thank you.

Rich Meelia

Yeah. I think that, you know, we’ve been pretty consistent in our view of this in that it’s mostly been elective procedures. But you are beginning to see some impact on more critical and non-elective procedures. And we have very little presence in elective procedures. So we just haven’t been affected.

You know, going forward, the demand for these product, and the procedures that use these products, I believe will begin to grow once again. The demographics are just so strong and the ultimate demand is going to continue to increase.

We’ve always liked the space we’re in. We call it kind of a mid med-tech. It’s not quite as visible as some other areas that seem to get a lot of attention. And so we believe that the kinds of surgeries that our products are used in are surgeries that, you know, are really critical and they’re life-saving, and life-altering. And so as the demand has increased for these kinds of procedures as a result of just the demographics, you know, some of this softness in our end markets, we think will start to return to more typical levels.

Adam Feinstein – Barclays Capital

Okay. And then just one quick follow up if I may here. Some of your earlier comments about acquisitions and return criteria, you know, maybe this is a good opportunity since you guys are doing a few deal. Some of the deals you did last year, you know, as you look back over the past year, maybe you could just comment in terms of the returns you generated on some of those transactions and whether those were better than what you anticipated. So just, I know, kind of a bigger-picture questions there, but just I’m curious to get just in the general thoughts.

Rich Meelia

It’s a very reasonable question, and we do track these returns very carefully. And just from the high-level standpoint, I’ll say that VNUS, you know, which was growing, again, at about a 15% sales growth rate when we acquired it, is exceeding our proforma expectations, which were, in fact, slightly higher than that growth rate.

Aspect is growing faster than we had anticipated. And the profitability of these businesses are exceeding what we had put in our proforma.

Those were the two big ones from last year. Generally we go back and look at all these transactions, and do post mortems on them, and we gather learnings from them, where we did better, where we did worse. I’ll tell you, the majority of them have exceeded what our expectations are. We’ve had a few that have not, but most of them have.

And the bigger ones have done better.

Chuck Dockendorff

And we do have a pretty good track record, you know, relative to how it performs to our proforma. And you know, EV3 is really early, obviously. We just recently closed. But you know, their recent quarter was obviously [inaudible] exceeded what they had projected in consensuses. And our model that justifies the returns had a sales growth rate even less that what they had.

So we were very excited about the results that they had, and continue to see very strong demand in the news they received in their flow diverter from the FDA was also good news.

I think, while it’s a controversial acquisition, I think primarily because of its size, that will turn out, I believe, very strongly to be one of the best acquisitions.


Your next question comes from the line of Sam Gunderson with Piper Jeffery. Please proceed.

Sam Gunderson – Piper Jeffrey

Hi. It’s Tom here. Good morning everybody. You broke out U.S. and O.U.S. , but could you give us a little bit more color breaking down international sales? Maybe a little comment on Europe, but particularly on emerging markets, BRIC and if you could, a little color on investing in the infrastructure in countries like China and Brazil in advance of higher sales coming from that area?

Rich Meelia

Yeah. I’d say in Europe, Tom, we were just right about, I think, 4%, you know, which is in the range where you typically see that kind of mature market.

In Asia-Pacific, somewhere around 5% to 6%. And I don’t have it broken out like by the work country specifically. But just your question about infrastructure, it is a major initiative for Covidien, especially in China. But really, in all the emerging markets.

We’ve recently reorganized management, so more focus and it reports higher up in the organization. But in China, as an example, we’re adding significance to the sales infracture, to the training infrastructure, business development people; right down the line. Pretty significant investment.

You’ve heard us talk, since Covidien launched, about growth initiatives because we really were motivating and incentivizing our businesses to come up with opportunities for growth, and then we would fund them and get the payback. And that’s what has driven a lot of our growth.

This is probably our biggest growthing initiative right now, the emerging markets. So we’ve been very successful over the last few years in emerging markets, but you know, when you read about the investments of a place like China, is making into healthcare, into hospitals. It warrants a kind of investment that we’re making in there.

I think come investor day, we’ll be able to give you a little bit more detail on exactly, you know, how many sales people, you know, what kind of infracture, specifically. I mean, it’s a little bit proprietary and you don’t want to tell your competitors exactly what you’re doing. But we can help you understand maybe the scale and the scope of what you’re talking about.

Sam Gunderson – Piper Jeffrey

Okay. Thanks. And then, Chuck, just a detail on EV3, but EV3 had significant NOLs going forward. How are those going to be handled in the broader Covidien space?

Chuck Dockendorff

We’re going to utilize those in our tax-plan strategies. You know, we had looked into that prior to the acquisition, so we can utilize those as we move forward.

Rich Meelia

I think that was one of the frustrations that, you know, we don’t talk a lot about tax plans. I think our track record shows with Covidien having started out around 31 or something like that, and where we are today, that we have great tax planning capability. And you know, not only do we have the NOLs that existed at EV3, we know have our ability to utilize some of our tax planning capability on their behalf to help drive some of the value and bring the returns that maybe weren’t immediately apparent to some people.


Your next question comes from the line of David Roman with Goldman Sachs. Please proceed.

David Roman – Goldman Sachs

Good morning, everybody. And thank you for taking the questions. Rich, could you talk a little bit about the trend we could expect to see in medical supplies this year? Could you maybe give us some perspective on that business on a go-forward basis?

And then, that is a business where we’ve seen margins expand pretty significantly over the past couple quarters. Can that continue at a lower run rate of sales growth?

Rich Meelia

Yeah, that’s a business that’s going to be flat to a couple percent growth. That’s the markets in which they compete. That’s where we think they grow. And it’s a constant battle of working through your portfolio and your SKUs and making sure you’re cleaning out the ones that don’t bring value. But also recognizing there’s certain sales that you want to keep. And ideally, you know, for this business to stay at a growth rate close to the market and it continued to edge up operating margins, that would be a good performance.

And as I mentioned in the opening comments, their ROIC is well above the company’s average. So it’s a very good business. It generates a lot of cash. You know, I think they’re going to be a 200 to 300 basis points potentially for the year. You definitely cannot expect that to repeat every year. But we will expect them to show profitability improvements year over year. That’s part of their charter, you know, they’re not a big growth engine, but they’re constantly looking at low-cost sourcing, private labeling using the [inaudible], some of the other brands that make sense, sourcing products by the labeling and utilizing their several-hundred person sales force that they have, both in EMEA, most Europe, not so much MEA. But Western Europe and the U.S.

I mean, that business is important to us. We measure it a little bit differently, but it still is very important to us.

David Roman – Goldman Sachs

Okay. Then if you look at our R&D spending as you integrate EV3 with Covidien, obviously EV3’s R&D spending as percentage revenue, it was higher than yours. How close does that get you to the 5% to 6% goal if you just sort of add the two together? Is that the right way to think about it, or are there programs that you might slow or cut out over the immediate term?

Rich Meelia

No, I think that that overall goal is the one that is the appropriate target for our kind of business. You know, if you, even within devices today, you’ll see higher than 5% to 6% at places like energy, where there’s just tremendous growth opportunities.

And so the overall average of 5% to 6% for these kinds of businesses, we believe is sufficient to drive the new product necessary to get our growth rate.


Your next question comes from the line of Michael Matson with Wells Fargo Securities. Please proceed.

Michael Matson – Wells Fargo Securities

Yeah. I was wondering if you could give us your revenue growth excluding all the moving parts, acquisitions, investitures, etcetera. I know that might be kind of hard to get to, but I’m just wondering what the true kind of organic growth was in the quarter.

Chuck Dockendorff

Yeah. This is Chuck. Interesting, you know, when we look at all these portfolio moves and what we’ve divested and acquired, and we just list those all out, it really had a very small impact on the revenue on most of the – down to zero. It just happened that way. But so all of that operational growth is organic that we report.

Michael Matson – Wells Fargo Securities

Okay. And then just on the soft tissue side, given the patent victory in Germany, can we expect a patent suit in the U.S.? And do you believe that you’ve got strong enough claims on your patents to maybe force your competitors off the market here as well?

Rich Meelia

Mike, just to clarify, we’re not going to comment on litigation, other than the fact, I will say we have filed patent infringement suits against that competitor on that product in the United States already.


Your next question comes from the line of Joanne Wuensch with BMO Capital Markets. Please proceed.

Joanne Wuensch – BMO Capital Markets

Hi. I have two questions. The first one is, how do we think about your constant currency growth rate on a go-forward basis. And the second one is, how should we think about the hospital supply’s business? Is that just simply being managed for cash generation at this stage?

Rich Meelia

The constant currency growth rate, you’re talking about the impact on FX again, and the quarter is very nominal. I think you can see that in our revenue components.

And I think from an earnings standpoint, we have slight favorability this year. And at current rates, we expect that to probably be a slight negative next year.

Joanne Wuensch - BMO Capital Markets

I’m sorry. That’s not quite the answer I was looking for. Maybe I misworded it wrong.

If FX is a slight negative going into next year, are we thinking of the organization as a mid-single digit constant currency revenue grower?

Rich Meelia


Chuck Dockendorff

Maybe I can help you a little bit here. Nothing has changed to our long-term commentary that we think the business, on a normalized basis, constant currency, is a mid-single digit kind of top line revenue growth business. That hasn’t changed.

Obviously, we’ll give you more clarity on 2011 specifically in September at the investor day.

Joanne Wuensch - BMO Capital Markets

Okay. And then my second question on hospital supplies?

Rich Meelia

Yeah, Joanne, this is Rich. Hospital supplies is a key component of Covidien. I don’t think you could ever do a transaction involving investiture that would be anything but extremely dilutive. It generates cash, it takes very little capital. I think I just mentioned the ROIC is good.

And so it’s a slow-growth business, and it’s a lower-margin business. There’s nothing we can do about that. But the financial returns, we tried to make a big emphasis in the opening comments that we have not strayed from our strict financial criteria. We used to make these kinds of decisions, and so that’s what drives that decision, you know, to continue to manage supplies is a part of the portfolio. I mean, those people are held accountable and we work with them constantly, but they’re not trying to grow their business in mid-single digit growth rates like we are with the rest of the business.


Your next question comes from the line of Christian Store with Deutsche Bank. Please proceed.

Christian Store – Deutsche Bank

Hi. Thanks for taking my question. Chuck, I was just wondering if you could give us the actual cash flow from operation figures? You mentioned cash flows were strong this quarter as well as the depreciation and amortization in the quarter.

Chuck Dockendorff

Yeah. Cash flow for the quarter is a little over $500 million, and it’s $1.2 billion year to date. A little over $1.2 billion.

Christian Store – Deutsche Bank

Okay. And then depreciation amortization in the quarter, and you had also commented earlier on the EV3 deal that a lot of the dilution would be expected to be related to the increased intangible amortization because of the change in accounting. Have you guys gone back to estimate what that will be on an annual basis?

Chuck Dockendorff

We’re in the process, Christian, of going through that right now in closing the transaction. And we’re revising our estimates around the intangible. We did some proforma stuff earlier on. I think we’ll wait and comment on that until we get it done, and we should have it done by the end of this month. We’ll incorporate that into our guidance for next year.

But I think it’s roughly, close to half of that purchase price would go into intangible, somewhere in that range.

As far as depreciation amortization for the year, I don’t have that in front of me, and rather than quote a number, I think we could get that to you later.

Rich Meelia

Yeah. Whenever we file the QL, we’ll have the full cash-flow information, Chris, and that should be coming in the next several days.

Christian Store – Deutsche Bank

Okay. Thanks very much.


Your next question comes from the line of Josh Jennings with Jefferies and Company. Please proceed.

Josh Jennings – Jeffries & Co.

Hi. Good morning, gentlemen. Thanks. First off, just looking at the pharma business and looking at sort of new perspectives on the divisional outlook, there’s no change to the peak sales forecast that you guys have historically given for PENNSAID, EXALGO and [inaudible], that 50 to 100 million for PENNSAID, the 200 to 300 million for EXALGO and the 30 to 40 million for [Inaudible]?

Chuck Dockendorff

At this point there’s no change in either of those numbers, Josh. But I do want to clarify again, from a run-rate standpoint, those are peak numbers, and for the brand-new branded products, we would not expect to get there for several years. And obviously, we did have the inventory stocking phenomenon this quarter for both PENNSAID and EXALGO.

Josh Jennings – Jeffries & Co.

Okay, great. And just looking at your comments in terms of continuing to look at the medical device segment for the rest of this year, being constant in that 9 to 12 growth territory with EV3, can you break that out ex-EV3 in terms of your expectations? Are we looking at sort of this 5% run rate here in Fiscal Q3 is carried over into Fiscal Q4?

Chuck Dockendorff

I want to be really careful, Josh because we don’t give any quarterly guidance. We’re just trying to give you some color to help you there. I think the pieces are all out there, EV3 was a publically traded company. You should have a general idea of what their September would have looked like as a standalone company. You know the year we closed on it. I think you have all the pieces, you can do that math yourself.


Your next question comes from the line of Jason Bedford with Raymond James. Please proceed.

Jason Bedford – Raymond James

Good morning. Thanks for taking the questions. Just to follow on the supplies business, and I hate to pepper you here, but you mentioned the market is flat, up a couple percent, but you were down in the quarter. The guidance seems to imply you’ll be down in the fourth quarter. Are you losing share, or does the growth reflect some discontinued items that are just not visible to us?

Rich Meelia

It’s a lot of the later. We task them to really look at the marginal SKUs in that business and focus on the ones that actually can be a kind of positive contributor. So that’s a big part of it. You did see some distributor restocking more in the second quarter than the third.

And then just being more demanding in terms of some of the pricing. And so they’re constantly – managing price in a commodity business, as you know, it’s tricky. So sometimes they may get overly aggressive and lose business that they hadn’t intended to in the pursuit of higher price and profitability. It’s a little bit of those three things.

Jason Bedford - Raymond James

Okay. And then just secondly, maybe this is me just simply misinterpreting your comments on the EV3 call, but at that time, I came away with the sense that revenue growth was tracking a little stronger than what you put up in the quarter. So I guess my question is, I’m wondering, did you see any notable weakness in the month of June? Thanks.

Chuck Dockendorff

Yeah. We did. June came in quite a bit softer than what we had expected. And you know, the daily sales rates, you can see the difference in June versus April and May.


And our next question comes from the line of Larry Keusch with Morgan Keegan. Please proceed.

Larry Keusch – Morgan Keegan

Good morning. Rich, I just want to follow up on that last question. As you looked at the month of June and you dissect where, perhaps geographically, or any color you can give us. Where did that softness occur and what do you think is behind it?

Rich Meelia

Well, it was pretty much broad based, which when that happens, it generally means that there’s just kind of a general malaise, you know, at the overall customer level because it wasn’t – I mean, we’ve talked about you know, new competition in the tacking system, and hernia, and some of the response from J&J; all that stuff we’ve been talking about. It’s the constant give and take of being in a competitive environment.

But when you see – what we saw in June was king of what we saw in the second quarter a little bit, where across the board, you began to see – you just saw a slow down.

Chuck Dockendorff

And Larry, you know, I think this is a very important point. I think we all want to be careful about implying too much precision on week-to-week, or month-to-month kinds of trends. But I think it’s very important given, you know, what Jason’s earlier question. I want to be crystal clear here. We were sitting here on June 1st, looking at the trends of the quarter. They were looking a little bit better than what we ended up having.

And so I don’t think it’s a full interpretation to have heard what we said in June, and then end up looking at the number today and seeing that they were a little bit lighter than what we implied because they were a little bit lighter than what we expected at that point.

But I think that illustrates the month-to-month variability that you sometimes get in these businesses. And at this point, I think I’d be careful about drawing too much of a conclusion from it.

Larry Keusch - Morgan Keegan

Okay. Point well taken. And then, again, just as you look across the business and you guys sit there as managing the entirety of this business, as you face some of the pharma challenge, which obviously sound like they are a bit more pronounced than you had initially anticipated, what sort of proactive steps can you take around that to protect your bottom line? And what are you doing right now as you manage this business as a whole?

Rich Meelia

Well, you’re constantly looking at managing your costs, so they do that. Trying to stay close to your customers because, you know, there are only so many choices in narcotics and if someone makes a decision to go to a smaller-newer entrant, then you run the – you’re constantly trying to explain the benefit of being with somebody who’s been around and has proven reliability, quality supply capability.

And then, I think most importantly, just keep driving the [inaudible], the PENNSAID, the EXALGO and finding those opportunities to bring new growth with the protection of, you know, branded product in the controlled substance segment that gives you that protection longer term.

Cole Lannum

Operator, this is Cole. We’re coming up on the bottom of the hour. Are there – maybe we could just do one more question and we’ll wrap it up for the day, please.


Your last question for today comes from the line of Thomas Kouchoukos with Stifel Nicolaus. Please proceed.

Thomas Kouchoukos – Stifel Nicolaus

Good morning. Thanks for taking my questions. One, just on the pharma side, with all the publicity going on with the Tylenol recalls, I just want to see if you could frame maybe how that impacts your acetaminophen business going forward?

Rich Meelia

We’re a big supplier to McNeil, so it definitely has affect our API business. There are other people now trying to make up for that, and we had the opportunity to supply. So API has been affected. But API is not a big profit driver in the pharma business.

Chuck Dockendorff

From a revenue standpoint, and Tom, do understand, this is very much a moving target, and we certainly defer to our partners at McNeil, you know, who are more aware of what’s going on there. But you know, it’s probably going to affect our revenue on an annualized basis, maybe $10 to $20 million to the net downside at this point.

Whether and how much that bounces back depends somewhat on McNeil’s ability to address and get back in that market. But it’s important to understand, we are getting some alternative business there from some of the generic players that have come in and filled in the market as Tylenol has gone down in revenues.

Thomas Kouchoukos – Stifel Nicolaus

Okay, that’s helpful. And just one quick follow up. Looking at the surgical business, you know, SILS was an area that drew a lot of excitement not too long ago. And I’m just wondering, as a procedure, has the recession kind of muted some of the impact or enthusiasm for that procedure? And then do you still see your SILS platform as a growth revenue for the business going forward?

Chuck Dockendorff

I don’t think it’s so much the recession. I think it’s more the typical adoption challenges, most of which is training. We just launched the hand instruments in April at SAGES, so it’s really new. And we’ve also, as you may know, we have our training on wheels, where we have this huge tractor trailer going around hospital to hospital training people on the SILS technique. And we did that because our established training sites were just booked solid.

So you know, we still like SILS a lot. It’s getting up there in $30, $40, $50 million kind of level of sales, and very profitable. So it’s still kind of a cosmetically driven procedure, but you know, we’re very comfortable with that. We’ll work to find other clinical benefits as we work with our medical trans group. But SILS, we’re still very confident in SILS. And receiving the benefit of it.


I would now like to turn the call back over to Cole Lannum for any closing remarks.

Cole Lannum

Thanks, Janada. Starting at noon Eastern Time today, a replay of the call will be available. Additionally, the replay will be available on our corporate website a few hours from now.

For members of the media who listen to the call and have additional questions, please contact Eric Krause, our head of Corporate Communications.

For analysts having more detailed questions involving non-material information, both Brian and I will be available to take your calls throughout the day.

Thanks, and have a great day.


Ladies and Gentlemen, that concludes today’s conference. Thank you for your participation. You may now disconnect.

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