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Medtronic, Inc. (NYSE:MDT)

Wells Fargo Healthcare Conference Call

June 17, 2014 02:20 PM ET

Executives

Gary Ellis - Chief Financial Officer

Analysts

Larry Biegelsen - Wells Fargo

[No formal presentation for this event]

Question-and-Answer Session

Larry Biegelsen - Wells Fargo

Good afternoon everyone, I am Larry Biegelsen the Medical Device Analyst at Wells Fargo and it’s my pleasure to introduce Medtronic. With us today we have Gary Ellis, Chief Financial Officer and Jeff Warren, Vice President of Investor Relations. In terms of format it’s going to be a fireside chat. I will start off asking Gary some questions and if anybody in the audience has a question please feel free to raise your hand and we’ll try to come around with a mic.

So obviously Gary yesterday big announcement from you guys with the announcement of the acquisition of Covidien which I thought made a lot of sense. So let me start with a few strategic questions. So there has been a lot of talk about the need for medtech companies depth, meaning going deeper in a given clinical area or breadth meaning covering a wide range of clinical areas. With the Covidien deal it seems you’re trying to do both. In the changing healthcare environment, is it possible to just have one without the other or do you think you need both depth and breadth and why?

Gary Ellis

Okay. Well, we do. Obviously back to the strategy we’ve been articulating for the last three to four years and probably even longer we think about it for Medtronic over its history. We’ve always believed that diversity of the portfolio and breadth was always clearly important and then obviously making sure that we have depth from the standpoint of all the various products that might be within various category. Clearly, with Omar’s leadership three years ago, he’s continued to focus on that and drive that across the organization and then in the changing healthcare environment we see at this point in time we just see this playing out over and over again where the strength of the portfolio and the breadth of the portfolio comes to play.

I mean we’ve seen it in our CVG strategy over the last several years. We are seeing in Europe with our Cardiac Cath Lab Management Services even our restorative therapies group within spine, we’re seeing spine our surgical tech business and our neuromodulation business doing a lot of things together and coordinating activities. And what we’re finding is really the situation that we need to basically focus on our customers, the physician, customers in the hospitals and really provide not only the implant but all the tools and all the services whether it’s diagnostic or monitoring later on around our various procedures that it’s no longer just being a supplier of products that are implanted and left behind; in the body it is really truly surrounding an entire procedure. And so with the acquisition of Covidien, we've obviously had a surgical tools business structural -- surgical technologies business in the past is a very fast growing part of our business overall and we have seen how leveraging those tools with the implant itself really helps benefit the physician, the customer and obviously the hospitals actually be more effective and efficient. Covidien really helps us to expand on that.

And because, with their surgical tools type franchise, little patient monitoring franchise that on top of -- it was very complimentary basically that what Medtronic is already doing with our implant business with some of our surgical tech business.

Their focus is they are getting into more and more even some of the therapy types of devices in peripheral vascular and neurovascular again fits very nicely into where our technology is we're at. As we're adding even in those categories some depth, because we need -- we have obviously very excited about our drug coated balloon that it had some very strong clinical data, but obviously we don't have a very strong peripheral vascular business, Covidien has a very strong franchise there and so we think that by leveraging those two [likes] could actually expand the growth overall.

So, there were just a lot of synergies, complimentary synergies to these two businesses coming together. And we think this is going to help us be much more competitive in this new healthcare environment, where it is not only in the U.S. but around the world that just gives us so much more capability to go in and talk to hospitals, insurance companies, government officials to talk about the entire portfolio and what we can bring to these management of these patients.

Larry Biegelsen - Wells Fargo

Very helpful. Can you talk about how the Covidien deal helps you with your globalization strategy to expand and grow in emerging markets? I think the combined company has almost $4 billion in emerging markets, sales were about 14% of total company sales?

Gary Ellis

Yes. I mean both of us obviously have had a similar strategy of focusing on the emerging markets. And in some ways Covidien is getting in some of these emerging markets even before us with because their surgical tools obviously are some of the first things, the hospitals are really looking for. You start with go down that process and you bring in basically the implantable devices and Medtronic as afterwards.

But the point is our infrastructure around the world. Both of us have a very strong infrastructure that first of all, we can leverage, there is a lot of synergies we think from combining those two organizations and leveraging that. But then again from the standpoint of the strength of the portfolio within these various emerging markets that gives us the opportunity whether it’s with private hospitals, government officials et cetera, we can walk in with a broader portfolio to talk about how we help them improve their healthcare in those communities.

There is also other benefits and Covidien has actually started to already establish an R&D capability outside. [I said] some of these emerging markets. We both obviously have manufacturing capability in these markets. So by combining that technology, we think the strength of the organization will entirely be enhanced with the acquisition. And we do think there is also quite a bit of cost synergies we will get out of that also. But overall, we're excited about it.

Larry Biegelsen - Wells Fargo

That's helpful. Let me transition to some of the concerns that have been raised in the last 24 hours since the deal was announced, and start with one around the political risk. So there is bill being introduced in Congress to make tax conversion more difficult. My understanding is that the Covidien deal is contingent under being no new laws or regulatory actions that would make an inversion deal, a legal work to prevent Medtronic from capitalizing on Covidien’s lower tax rate. So can you comment on the political risk?

Gary Ellis

Well again, it's hard to give any exact advice. And obviously we were well aware of the focus on inversions and what's -- all the concerns around that and on tax reform in general I should say. And so we knew that by focusing and doing a transaction with that inversion structure that we are running increased risk on that side. But let me backup and start, we focus on the strategy first. And the overall strategy was we thought that this made a lot of sense for both companies and both companies were convinced with that. Then we looked at what structure we might want to go, we looked at not doing an inversion, we looked at doing an inversion.

In the end, the benefits of the inversion outweighed what we thought was going to be the political risk. And both companies thought that it was important that we go forward in inversion strategy. And so as a result of that, that’s the structure we set up and that’s how we negotiated the deal and how the planned it going forward.

The contract as you said does have an [out], both boards obviously want to be in a situation that if that type of structure is not available because the rules have been changed on us, then we will have to reassess that make the decision on what we are going to do going forward. But I would tell you again from Medtronic’s perspective, we would do the deal whether it’s inversion or non-inversion. And we just think there is that much strategic value. But we’d obviously have to reassess that assuming the law is changed as we move ahead.

From our perspective it’s the political risk, it’s something we’ll just have to manage through. We’re making it very clear, we are making our story very clear, this is for strategy purposes, it’s actually to help us bring back cash into the United States such that we can invest more into the United States or return it to our shareholders. It gives us more flexibility, not more, which we are not doing this for tax rate, we are going to be paying the base that is same exact tax as after the deal both are getting in ourselves as we were before the deal.

So the tax rate itself is basically the same, other than some benefit from the transaction itself, the financing on the transaction, but basically the same. None of that changes. What all this does is the inversion gives us flexibility to get cash. So the strategy makes sense, it gives us ability to utilize the cash in the United States and from political purposes that’s the key message. What is that about, expanding the organization, giving us more flexibility, strategically makes sense but by the way it also increases our flexibility to bring cash back into the United States that seems like a good deal in our minds. And obviously that’s why we are going forward with it. But politicians will react how they are going to react. And we’re trying to make sure our story is heard and they understand the situation and we’ll manage it as we go forward. But we feel very, very good about the story. And we don’t think it looks great. The fact that they will reach a decision, especially on just inversion because I think that has to be done with overall tax reform and the idea that overall tax reform is going to occur before the deal closes, we think there is probably slight risk but it is one that’s out there and we have got it covered in the contract if that happens.

Larry Biegelsen - Wells Fargo

That’s very helpful. Before I move to the next question, let me see if there are any questions in the audience and so just raise your hand. Right here.

Unidentified Analyst

(Inaudible).

Gary Ellis

No I mean -- excuse me, the question was just waiting to kind of the transformational deal kind of come to play and what was the urgency and was there something I heard over the last couple of months that kind of pushed this issue forward. No, there is I think really the first; this was not necessarily in our mind, something we were thinking about going forward. We were focused obviously on driving our existing businesses and going and focusing on our overall strategy.

The conversation started in early April, Omar and Joe [meet] having a dinner and discussing what their strategies were and how they’re going forward across organization. We saw a lot of synergies. The conversation got into how do you think the organizations do work together and could be more effective. And from that point it’s kind of obviously work through to this point. A deal of this nature obviously you always worry about leaks and things like that so you got to be quick and you have got to make a decision quickly. You can’t go on with due diligence for six, seven, eight months. It needs to be something that you’re very focused on appropriate things and due diligence to make sure you understand it.

But the most of our time has been focused on the strategy; what’s the strategy, how do we really want to do it and I would tell you then in the last week or two it’s been once we decided yes it made sense then we start to talking about what the structure was and then we talked about obviously what the price would be. And that occurred relatively quickly in the last couple of weeks, which you need to do before obviously the leaks start getting out as far as what’s happening.

So I mean in general there was nothing that was pushing us to get it done now at this point. It just seem that this was the right thing for the organizations and the timing was very well ready and they were basically a willing seller and we were willing buyer at the appropriate time.

Larry Biegelsen - Wells Fargo

I think there was another question?

Unidentified Analyst

(Inaudible).

Gary Ellis

Okay. The question was again whether the revenue synergies, kind of what our assumptions are there and some of the slides we’ve talked about cross-selling the potential benefits and then just overall synergies from a bundling perspective in general. Again our main focus right now as we have focused on the strategies is we've got a very (inaudible) or complimentary types of products other than a couple businesses product lines where that makes sense like peripheral vascular will probably put underneath our CVG business and with the drug coated balloon, their neurovascular business will probably put underneath our [CG] business with the neurosciences. But the rest of Covidien we expect to kind of operate as an separate group. And so they just keep doing what they've been doing.

And so the main message Omar said to both organizations so far has been deliver your strategic plan, just do not get the focus, do not allow other than those synergies we just talked about in the cost synergies which are come later where there is a team focused on those, focused on delivering what your customers and your patients, what you have laid out as a strategic plan and let's not get be focused.

Because what we really believe is right now, we can accomplish that get the revenue, each achieve our mid single-digit revenue growth, get the $850 million cost synergies we believe that are there over the next two to three years, focus on those activities and drive that growth, but that basically will give us the cash, earnings per share accretion and GAAP earnings per share accretion by FY18 that we're expecting.

On top of that and as we kind of get engaged in this then let’s start working on some of the cross selling and initiatives going forward. But we don’t want a deep focused organization until we get to that point.

There is numerous things where I think there is opportunities, obviously surgical technologies business, our advanced synergy business has products that we would love to sell to other customer basis that we don't right now, some of their general surgery products we'd love to have being more focused on some of our areas and more focused around our technologies.

There are some things from a technology clinical perspective that we think we can help them with as far as advancing some of their technologies on a clinical and regulatory perspective. One of the things benefits that Covidien saw and that they communicated to us and if Joe was here what he would have say was that they saw that they clearly needed to expand their clinical on regulatory expertise as they got it into more and more PMA types of products and versus taking not investments, taking not rely on Medtronic where we have a lot of strength in that regard.

There will be avenues obviously as we go forward to both on a certain technologies group navigation, the navigation tools we have, some of the robotics things that they are working on; you combine that with the surgical tools, we think there will be a lot of combination in general. And then as we go forward all of that, even on our Cath Lab Management Services for example in Europe, where we need supplies, need surgical tools at our parallels Cath Lab Management, Cath Management Services now bundled ending upon that together, not only the devices, but whole again, the whole procedural kit what needs to be done on the hospital, we think will be a real strength.

Larry Biegelsen - Wells Fargo

Gary, there has been some discussion around how you came up with the $850 million in cost synergies. Can you talk about your level of confidence in achieving those synergies by the end of fiscal 2018? And I don't know from my experience companies tend to over achieve the cost synergies to be up side to the $850 million?

Gary Ellis

We obviously hope there is upside, the 850, is something we feel very, very strongly about that we can achieve that level at a minimum. It's interestingly came out at -- our sales need to go get it, and just looked as expense structure and said what do we think we can get Covidien from their side did the same thing and obviously they know their expenses are better than we do and we both kind of came forward and said that was not the number we -- this happened to be a similar number that we both hit.

Actually, we think there is upside over and above that, the number is actually that we both had was above that but we risk adjusted it (inaudible) more difficult. Right now, we're focusing on supply chain and logistics, fiscal distribution, we are focused on back office, there is not a lot of manufacturing synergies in this deal, but there is probably more opportunity there that we haven’t backed in. We are not touching the sales -- selling and marketing organizations, we’re just saying keep focused on that, and if we get some leverage there, there might be opportunities but right now that’s not even baked into 850.

And so do I feel comfortable with it, yes, we have been through it in great detail with our board into our own teams and feel confident. In addition, one of the requirements of Irish law which I am learning more and more about over the last two weeks is we actually have to have our auditors audit the synergy before we can even release that. And so they actually went through a process of checking it for reasonableness and determining that that was appropriate also.

So we have a Pricewaterhouse opinion stating that it’s a reasonable number. And we feel very confident about it ourselves as we go through. Now obviously, the detailed plans and how we absolutely go and achieve each of that, we have it laid out right now by kind of general categories and that will help implement that. And they will be in the full integration team that that will be their responsibility over the next two to three years to really drive that synergy number.

But I -- back to the original point, if anything I hope there is upside to that number, but we feel very, very good about at least getting to the 850.

Larry Biegelsen - Wells Fargo

Gary, you said the deal would be accretive on a cash EPS basis in fiscal 2016 and significantly accretive thereafter, but you haven’t given any details. You probably had a chance to look at some of the initial street estimates. For example, we are modeling about 3% accretion in fiscal 2016, 7% I think in fiscal 2017; have you or your IR folks seen any obvious layering in this case and how people are kind of modeling this?

Gary Ellis

No, I mean in general again, all we can say is [good one is] requirements by yourselves, I can’t give you much more input into those numbers other than what we have already said. But back to your point, we do play to get really cash accretive immediately significantly and thereafter in 2018 your definition of what significant is, I will let each one of you kind of decide. But based on as you just read your numbers and what we are seeing in the street, I don’t see anybody that’s way off, I mean it’s really a situation of if you take the two -- expectations for the two companies that collapse, I mean you put the 850 million synergies in there over a three year period of time, I think you will get very quickly to the fact that cash flow, earnings per share, it is accretive and significant there assuming how much -- it depends on how much of the 850 you assume you are going to get by year two, three and four or in two and three?

Larry Biegelsen - Wells Fargo

And recall you said the ramp, it would ramp pretty quickly.

Gary Ellis

It will but I mean obviously there is -- a lot of it we will see right away. But again, you are going to see that maybe at six months, you will see it. Well that means you are not going to get the full impact in the first year. So I mean maybe by the second year you are going to see a lot of the benefit already and obviously by the third year it’s when we’ll get the full benefit of the 850?

Larry Biegelsen - Wells Fargo

Switching gears for a minute; is it safe to assume you will start reporting cash EPS once the deal closes? And by our math, we are moving amortization from your non-GAAP EPS as about $0.29 or about 7% to your EPS.

Gary Ellis

Well as we did with the transaction, we provided both, the cash earnings per share impact and the GAAP earnings per share impact. Our guidance for -- prior to the close for Medtronic itself is still GAAP earnings per share and we are not changing that. Once we get to the point of giving guidance for the transaction or after the transaction is closed and we are giving it for the new Medtronic PLC with the combined entities, my comment to you is I think we’ll continue to probably provide, both GAAP and cash earnings per share which when we start using for guidance is still up for debate. I have a lot of investors obviously pushing that we should go to cash earnings per share. That’s possibility, we’re rolling that but I am not going to make a commitment at this point in time. But I would tell you from a management perspective we’re going to keep watching both because from our perspective we look at GAAP earnings per share and say we’ve made a major acquisition, we’ve got to hold ourselves accountable delivering the earnings per share even with the amortization in there. And so, we’re going to look at both but will we switch and go to a cash earnings per share, that’s a possibility especially with the level of amortization that you have in here, just to make sure everyone seems what the true operational impact of the transaction is.

But again from a management perspective, Omar and myself have been very adamant, we’re going to keep looking at both ways.

Larry Biegelsen - Wells Fargo

Let me scan the audience here, we’ve got about eight minutes; in the back here.

Unidentified Analyst

(Inaudible) anti-trust activity you’re in…?

Gary Ellis

No. I mean at this point in time, we think most of their product line is mostly complementary. There is not a lot of overlap between the two businesses. Could there be some small products here or there that the potentially there might be some questions about that is a possibility, but we don’t expect that. Our current expectation is that if you just look at their portfolio and our portfolio, there is very little of any overlap and it’s mostly complementary and we’re not expecting a lot of questions from anti-trust perspective.

Unidentified Analyst

(Inaudible).

Gary Ellis

Well, IBN at the close of transaction well IBN an ideal capital structure. The answer, no, I wouldn’t be strictly an ideal because I think again even with the inversion, inversion doesn’t solve all your cash U.S. OUS cash issues. The way I understand it and the way we’re assuming this is that basically it improves our mix of U.S. OUS, but not all the Medtronic legacy subsidiaries are out from underneath the cash restriction aspects.

So, it goes from maybe 35%, 40% U.S. right now to maybe 60%, 65% probably much larger number after the transaction and we'll continue to improve on that as we do other transactions et cetera. But it's not -- make sure everyone. And version is not the absolute answer. And so are we perfect yet, no, but we're much better off than obviously we're currently.

Larry Biegelsen - Wells Fargo

Gary, can you talk about, sorry, please?

Unidentified Analyst

(Inaudible).

Gary Ellis

Okay. The question was basically on return to shareholder, kind of commitment and whether should we expect to see any kind of increase in that as we go forward whether it’s dividend or share repurchase or both.

As indicated on the call and that's all we are committing to right now is obviously this transaction gives us, Chris as you indicated gives us a lot more flexibility on doing some things on the shareholder return. As you know our 50% commitment before, we were basically having to meet that strictly we were borrowing in the United States continuing to do that and cash accumulating outside. Obviously with our mix improving of the U.S. OUS as we indicated on the call that is our flexibility around that significant increases.

But as I communicated to many of you over the past we would love to take a look at our shareholder returns especially the dividend aspect if we had more flexibility, we have more flexibility now.

And so as a management team and a board will be looking at that. At the time of we get to the close, we'll give a little bit more guidance on what we're expecting in that regard. But at a minimum, obviously this gives us flexibility to make sure that commitment on 50% continues and gives us flexibility not only on the shareholder return, but obviously also to invest in the United States in acquisitions and in technology, it just increases our ability as we go forward. So we'll clearly be looking at that and one of the issues we've had has obviously been mitigated or improved dramatically, so we'll clearly have to consider that as we go forward.

Larry Biegelsen - Wells Fargo

Okay. I wanted to ask about a product category that we're often asked about and your commitment to and interest in, which is orthopedics. So I mean can you talk about your kind of just long-term strategy in orthopedics? Right now you're the number one player in the spine market. But you obviously don’t have a broad portfolio in orthopedics, which is a big and important category.

Gary Ellis

Well, we were buying that at one point in time too last week. But obviously orthopedics as we have talked about the over the years is an area that -- a big area that we're not in that we've always had some interest in getting in, but it's always been a struggle on figuring out exactly how. And it’s also something we didn't necessarily believed we need to be in at this point in time. Our spine business, we still believe in the U.S. and most of the developed markets spine and neuro actually have more synergies in some ways than in the spine and orthopedics area.

As the consolidation in the areas continues to change, and if that changes and we need to have more of an orthopedic product line to be competitive in spine, it’s something obviously we will look at, but it just never has made financials sense, we could never see exactly how we could become a strong player in that marketplace. And right now, our focus obviously is going to be on integrating the acquisition we do have underway. But so at some point in time, if you ask me in next 10-12 years as Medtronic somehow an orthopedics, probably; how we get there and at what time, I don’t know and I am not going to predict at this point.

Larry Biegelsen - Wells Fargo

We have a couple of minutes left, I have a couple of questions but I want to see, if there is questions in the audience before we run out of time. Let me ask about -- I don’t see any hands, so let me ask about the tax rate after the deal closes. And could the tax rate trend down over time and can you talk about how the IRS transfer price and situation could impact the combined tax rate?

Gary Ellis

Okay. Just quickly on the tax rate, as I have said, this transaction in the inversion itself does not change our tax rate much. The reality is I think our tax rate on an average has been around 19, I think there is around 17, the blended rate obviously of the two, because it doesn’t change. After the inversion, the amount we are paying on taxes in the United States, both of us and outside the United States in the various countries stays about the same, it doesn’t change; their earnings are the same and so that doesn’t change.

And so you have a blended rate that is maybe little bit lower. There is some benefit from the financing of the transaction because the interest income loss and the interest expense that we are incurring obviously is at the higher U.S. rate, I think that’s U.S. impact. And as a result of that there’ll probably be a slight, one to two point reduction just related to the financing cost itself.

After that no, we don’t expect necessarily to be a dramatic -- that that rate should be basically consistent because we don’t see any necessary activities are going to drive it higher or lower. And obviously there is tax reform in the United States and things shift and that could obviously have an impact on the overall tax rate but right now, we are not expecting any change on that.

The biggest issue we had that we talked about at the analyst meeting, we do have an outstanding transfer pricing issue that we expect over the next year to year and half will -- to be in tax court and resolved. We highlighted at the analyst meeting depending on which way that goes, if we -- if it gets to the situation of how we recorded it for book purposes, obviously it would have no impact on the rate but yet they’re bring back some cash or have the flexibility to bringing some cash back at that point in time of almost 2.5 billion to 3 billion. If the IRS’s position is upheld, then you could see an increase in our rate of a couple of percentage points.

Larry Biegelsen - Wells Fargo

That’s for Medtronic alone?

Gary Ellis

Just for Medtronic alone.

Larry Biegelsen - Wells Fargo

Okay.

Gary Ellis

Yes. And obviously combining now that would be a big [muted] from that perspective, but that’s a possibility. And that situation actually as well it also allows us to bring even more cash back. So that we expect get resolved here in the next year to 18 months as we resolve that with the IRS.

Larry Biegelsen - Wells Fargo

Perfect. Gary and Jeff, really appreciate you guys coming out to the conference.

Gary Ellis

Thank you.

Larry Biegelsen - Wells Fargo

Thank you.

Gary Ellis

I appreciate it.

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