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Executives

Charles Dockendorff - Chief Financial Officer and Executive Vice President

José Almeida - Senior Vice President and President of Medical Devices

Richard Meelia - Chairman, Chief Executive Officer and President

Coleman Lannum - Vice President of Investor Relations

Analysts

Joshua Jennings - Jefferies & Company, Inc.

Matthew Dodds - Citigroup Inc

Michael Matson - Mizuho Securities USA Inc.

Steve Beuchaw - Morgan Stanley

Konstantin Tcherepachenets - Morgan Keegan & Company, Inc.

Robert Hopkins

Jayson Bedford - Raymond James & Associates, Inc.

Thomas Gunderson - Piper Jaffray Companies

Paul Choi - Caris & Company

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Topher Orr - Goldman Sachs Group Inc.

Kimberly Gailun - JP Morgan Chase & Co

Unknown Analyst -

Joanne Wuensch - BMO Capital Markets U.S.

Covidien plc (COV) Q2 2011 Earnings Call April 21, 2011 8:30 AM ET

Operator

Good day, ladies and gentlemen. Welcome to the Second Quarter 2011 Covidien plc Earnings Conference Call. My name is Latisha, and I will be your operator for today. [Operator Instructions] I would now like to turn the call over to your host for today, Mr. Cole Lannum, Vice President of Investor Relations. Please proceed, sir.

Coleman Lannum

Thanks, Latisha, and thanks, everyone, for joining us on what is a very busy morning for earnings and a very busy week I know for earnings. With me today are Rich Meelia, Covidien's Chairman, President and CEO; Chuck Dockendorff, our Chief Financial Officer; and Joe Almeida, the President of our Medical Devices business. We'll be making some brief introductory comments and then spend most of the time this morning answering your questions as we always do. The press release with details of the second quarter results was issued earlier this morning and is available on our website and on the newswires.

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. We ask that you please refer to the cautionary 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. 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 quarter, we reported GAAP diluted earnings per share of $0.92. And after adjusting for certain specified items, our non-GAAP earnings came in at $0.93 per share.

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

Richard Meelia

Thank you, Cole. I'd like to begin with some brief comments on the overall healthcare marketplace. Generally speaking, we have not seen significant changes since we talked last quarter. As we noted then, third-party forecasts showed slow and choppy growth for 2011. Hospital admissions were projected to be flat while volume for select procedures such as bariatric and general surgery were expected to grow modestly.

Given that market environment, we're pleased with our second quarter results. Revenues were right on plan. We again improved our adjusted gross margin, operating margin came in ahead of our expectations and EPS growth was on track. In our large Medical Devices segment, we achieved double-digit quarterly gains that were led by Vascular and Energy products. The segment results were aided by the acquisitions of ev3 and Somanetics, but they were partially offset by the divestiture of sleep products.

In Endomechanical, we posted good growth for stapling products paced by Duet TRS and Tri-Staple. Both of these innovations are doing very well in the marketplace, enabling us to grow faster than the stapling market as a whole. The multiyear rollout of Tri-Staple continued with the curved tip and black reloads launching during the quarter. In the laparoscopic instrumentation line, sales were about even with last year as we face competitive pressure in trocars.

In Soft Tissue Repair, sales in the large suture business were above last year helped by our innovative V-Loc product. That said, sales growth in mesh and fixation slowed due to difficult comparisons in the U.S. While we made good progress in synthetic, our biologic mesh business lost market share. Obviously, it has not met our expectations, and we are in the process of addressing this underperformance.

We recently announced the interim results of 2 clinical studies that bode well for our future growth. The first study showed that using our SILS Port for gall bladder removal produced better cosmetic outcomes than the more traditional four-port laparoscopic approach. The second study showed that our Parietex Progrip mesh significantly reduced early pain following inguinal hernia repair. These studies are examples of our increased commitment to evidence-based medicine and to using clinical studies to expand our product leadership in the marketplace.

In Energy, we again delivered strong double-digit growth in vessel sealing. And when I say again delivered, I mean for our the 22nd consecutive quarter. We have an exceptional lineup of new products including the LigaSure 5, Advance too and the Impact. We recently received FDA approval for the LigaSure Curved, Small Jaw and launched it in the United States. This innovation is used in surgeries where a small jaw footprint is needed. Perhaps, the most exciting news in Energy is our Sonicision Cordless Ultrasonic Device that was FDA approved last month and will be launched later in 2011. This is our first foray into the $800 million ultrasonic market. Sonicision will target general, bariatric, colorectal, urological and gynecological procedures. The addition of Sonicision not only broadens Covidien's portfolio of energy-based devices, it also gives customers one source for their advanced energy solutions, potentially offering savings from standardization. Both our electrosurgical and hardware products led by the ForceTriad energy system posted good quarterly growth. Energy hardware sales were at their highest level since the fourth quarter of 2008 indicating a positive shift in capital equipment purchases by hospitals.

Turning to Vascular. Both the Neurovascular and Peripheral Vascular product lines performed well this quarter. Both generated strong double-digit increases on a pro forma basis. Integration activities are proceeding smoothly, and we're very confident about the growth potential for this business.

We recently launched the TurboHawk Peripheral Plaque Excision System and we'll soon be rolling out the Pipeline Embolization Device, which recently received FDA approval. We remain optimistic about opportunities in carotid artery stenting and expanding the indication to lower-risk patients is a positive development for us.

In addition, we've just completed patient enrollment in the definitive trial. This is an important step in generating clinical evidence to support plaque excision as a frontline therapy for the treatment of peripheral arterial disease. Our traditional product lines in Vascular also performed well in the quarter: Chronic Venous Insufficiency, dialysis and compression products all posted double-digit sales gains.

In Respiratory, we registered good growth in Oximetry and Monitoring. We grew our large-based sensor business as well accelerated sales of the Aspect and Somanetics product lines well above the standalone growth rates.

In Airway and Ventilation, sales were below last year due to the divestiture of the sleep therapy line and a decrease in ventilator sales. While vent sales were well below those of a year ago, primarily due to difficult comparisons, they represent only a small portion of the category and we expect they'll recover in the second half.

Turning to Pharmaceutical segment, our top line results, while below a year ago, were in line with our expectations. The sales decline was almost entirely due to the divestiture of our U.S. nuclear pharmacies, a sale that took place in the third quarter of last year.

In the Generics business sales were up slightly, and we again saw a sequential stabilization in pricing.

We also launched the fentanyl patch and saw increased sales of the fentanyl lozenge. While our Radiopharmaceuticals business benefited from improved supply, efficiency measures that customers implemented during the last year's shortages restrained growth in the quarter.

As we noted last quarter, 2011 will be a difficult revenue year for the Pharma business. However, we're more optimistic about pharma's second half revenue performance once we've anniversary-ed the generic price cuts and the nuclear pharmacy divestiture.

Turning to Medical Supplies. Sales rose slightly from the year ago paced by increases in Medical Surgical and Nursing Care products. As you know, the flu season was relatively mild this year so we did not see major volume impact this quarter. As we had told you, we expected a sales turnaround in supplies this quarter and we delivered. We anticipate continued positive top line results for the remainder of the year with supplies.

Looking at our overall business in the 2 largest markets, our U.S. business met expectations in the second quarter; while in Europe, we were sequentially better as operational sales rose for the first time in 3 quarters. That said, we remain cautiously optimistic.

I was in Europe last week, meeting with our leadership team and spent time reviewing external factors impacting our business, as well as the industry. Similar issues like austerity programs and regionalized tenders exist across the continent. Though the outcomes of these dynamics vary at the country level, it must be managed accordingly.

As you know, economic concerns especially in southern Europe persist, which have an adverse effect on procedures. We expect this will continue through 2011. That said, pockets of opportunity exist, and we believe this is a positive for those companies that are positioned to think and act in a more localized manner with products that meet real clinical needs.

On pricing. We continue to estimate that we'll face a 50 to 100 basis point headwind this year, though the second quarter was essentially flat.

Now let me give you a quick update on our business in Japan, a market that accounted for about 8% of our net sales in 2010.

I'm pleased to report that all of our facilities are operating normally, including our Fukuoka factory and training center. Because our distribution centers are in southern Japan, we escaped the devastation that occurred in northern Japan. As a result, we saw a small gain in second quarter sales as our supply chain met some of the increased market demand. It is unclear whether this positive impact on our business will continue later in the year.

I will now pass the call over to Chuck, who will discuss the second quarter in more detail and provide an update on our thoughts for the balance of 2011. Chuck?

Charles Dockendorff

Thanks, Rich. I'll focus the majority of my comments on the items below the sales line and then discuss our updated guidance for fiscal 2011. As Rich mentioned, we are pleased with our results for this quarter. As sales came right in on plan, we had continued improvement in adjusted gross margin and our operating margin and EPS both met our expectations.

Our reported second quarter sales results received a small benefit from foreign exchange rates. While the euro moved against us in the quarter, versus a year ago, this was more than offset by other currencies including the yen, pound and Australian dollar. With the dollar index generally trending lower, our second half results will benefit somewhat from favorable exchange assuming today's rates remain unchanged.

As noted in the release, we recorded an increase in adjusted gross margin this quarter paced by positive business mix, recent portfolio moves and benefits from our restructuring program, but partially offset by unfavorable foreign exchange.

In addition, we saw an uptick in raw material prices, particularly in the supplies business, which restrained the margin increase. Looking forward, foreign exchange should be less of a drag on gross margin on a comparative basis for the rest of 2011 based on today's rates.

Second quarter SG&A spending was up versus a year ago, primarily due to acquisition-related expenses including amortization, spending for new product launches and investments we've made to expand our sales force in businesses such as Pharmaceuticals and Energy. As we've noted previously, continued spending for growth initiatives, such as our Asia expansion plan; expenses related to the launches of PENNSAID and EXALGO; and the impact of acquisitions will all put upward pressure on SG&A in the second half of 2011.

Research and development increased 14% to 4.6% of sales in the quarter, and we remain committed to our goal to further increase R&D to 5% to 6% of sales over the next few years.

Our Q2 adjusted tax rate was somewhat above Q1 and above the guidance we had given last quarter. The income tax rate reflects a change in the geographic mix of income for the year with more of our income coming in the higher tax jurisdictions. We again generated strong cash flow this quarter with free cash flow in excess of $600 million.

Now turning to our 2011 outlook. As we have communicated, our long-term goals are to deliver mid-single-digit sales growth and double-digit earnings per share growth, achieved through a combination of operational and financial leverage. Our year-to-date results are right in line with these goals.

As we noted on our last call, the combination of operational strength and foreign exchange rates have clearly put upward pressure on the revenue and profitability targets that we previously communicated. As a result, we have updated our sales and operating margin guidance for 2011, reflecting our good results for the first half, coupled with some favorability on exchange rates. As you know, the dollar index has fallen about 10% since we provided our initial guidance on Investor Day last September .

At current exchange rates, we are increasing our overall sales growth by 200 basis points and now expect total company sales to be up 8% to 11% versus 2010. By segment, at current rates, our expectations are for sales in Medical Devices to be in the range of up 13% to 16%, a 300 basis point increase versus our prior guidance.

For Pharmaceuticals, we have tightened the range somewhat and now expect sales to be down 3% to flat. There is no change to our previous guidance for Medical Supplies sales, flat to up 3%.

For operating margin, we are upping our guidance by 50 basis points to a range of 21.5% to 22.5%. On the tax rate, we are now expecting the full year rate to be between 18.5% and 19.5%. Both operating margin and tax rate guidance are before any one-time items. As a reminder, our fourth quarter and fiscal year 2011 include an extra week, which will skew our Q3 and Q4 results versus our historical performance.

Turning to cash flow. Our prior guidance had been for free cash flow of at least $1.6 billion. Given the strength in the business and our expected core operating cash generation, we now think that number will be at least $1.7 billion this year.

We also want to give you a little more clarity on our free spend tax matters, including the tax sharing agreement. We believe we'll be paying out about $400 million sometime this fiscal year. As we have discussed before, the timing of these payments are very unpredictable and the accounting of them will affect our operating cash flow. We have not included this $400 million payment in the $1.7 billion free cash flow guidance number. Based on our first half results and our current outlook, we are very confident that we can deliver on all of our financial goals for 2011.

Now, I'll turn the call over to Rich for a closing comment. Rich?

Richard Meelia

Thanks, Chuck. Before we move to Q&A, I'd like to briefly comment on the senior leadership change we announced last month. As you may know, I've headed this business for more than 15 years and my decision to step aside is consistent with the statements I made at the time of Covidien's separation in 2007, mainly that I would devote 3 to 5 years to our newly independent company. We built a very strong management team at Covidien to lead our more than 40,000 highly motivated employees. We're very fortunate that an exceptional leader like Joe Almeida will be Covidien's new CEO. With Joe taking over, you should expect no major changes to our company's strategic direction or financial rigor. Joe has played an integral role in our growth and success to date, and his leadership will build upon a strong foundation. Joe has a tremendous work ethic, complete dedication to achieving results, comprehensive knowledge of our industry and markets and an aggressive approach to driving global business growth.

I know Joe well, and I know that he possesses the professional skills and personal attributes needed to successfully lead Covidien.

Now I'll turn it back to Cole.

Coleman Lannum

.

Thanks, Rich. [Operator Instructions] As a reminder to everyone, we do have Joe Almeida on the call as well, so please feel free to direct any questions to him, as well as to Dr. Rich or to Chuck. Latisha, can you please once more review the process for signaling a question?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Lawrence Keusch of Morgan Keegan.

Konstantin Tcherepachenets - Morgan Keegan & Company, Inc.

This is Konstantin for Larry. I wanted to get some perspective from Joe in terms of kind of what do you hope to accomplish over the next several years. I mean, with Rich who kind of had a pretty straightforward mandate, increase R&D, do some portfolio moves, and kind of what are your goals, what is your mandate?

José Almeida

Looking at the future of healthcare on a global basis, a couple things come to mind. One is the expansion of Covidien aggressively into emerging markets. That's one of our priorities. We've been investing money there. We also continue to look at innovation as the way to deliver clinical results and economical results to the market. And this has continued along the lines of not delivering just technology but things that make a difference such as products like Tri-Staple and some of the Energy products and Vascular. So continue down that path. We also will continue to look at cost headroom as a company and make sure that we're delivering to the shareholders as much as we can and leveraging our SG&A going forward. So those are the basic things just that we're going to be doing in the future.

Konstantin Tcherepachenets - Morgan Keegan & Company, Inc.

And do you feel from an M&A perspective that the focus is going to continue to be on growing the device franchise?

José Almeida

I believe the growth of the device franchise is one of the key drivers for Covidien. We're going to do that organically and inorganically. As I mentioned before in previous meetings, we will be looking at tuck-ins, small adjacencies and things that we've done in the past. In the near future, we're not going to be looking at a new platform, but that's not out of our sight, meaning if I look 5 years from now, I can't tell you that Covidien will not be getting into a new platform. But in the near future, Covidien will be looking at tuck-ins.

Konstantin Tcherepachenets - Morgan Keegan & Company, Inc.

Got you. And then one last one for me, just wanted to confirm that if in Ireland, if they decide to increase the tax rate, is that really just going to impact your tax on the sales in Ireland and not the kind of the overall tax structure?

José Almeida

I'll pass that on to Chuck.

Charles Dockendorff

This is Chuck, yes. Yes, it would only include an increase on the tax on the income we earn in Ireland. That is correct.

Operator

Your next question comes from the line of Mike Weinstein of JPMorgan.

Kimberly Gailun - JP Morgan Chase & Co

It's actually Kim for Mike. The first question I think is for Chuck. Any update on the ev3 accretion dilution outlook? How that's tracking versus your expectations? And with that, if you could talk a little bit about the pipeline device launch plans and expectations for that product.

Charles Dockendorff

Yes, I'll talk about the accretion dilution. Maybe Rich or Joe could pick up on the pipeline. But basically, I think, as we said last year, we saw -- originally, we started out with it being dilutive. It was $0.13 to $0.15 and improved off of that at the beginning of the year. And now we see it's slightly accretive in our numbers from an earnings per share standpoint. So the business continues to be strong. We see great revenue growth both in Peripheral and Neurovascular around the world. It's right in line with our expectations and exceeding our expectations on the bottom line front. So we feel real good about where that acquisition is going and the results from it, and it is positive to our earnings this year.

Richard Meelia

And Joe, do you want to comment on the pipeline?

José Almeida

Yes. As you know, we're very happy with the decision by the FDA and the panel, everything that happened about a month ago. But I want to caution our investors that the pipeline is a slow ramp product. It's a complex product to sell. Requires a significant amount of physician training. And don't want to expect it's -- no, it's a good sized market, about $100 million to $150 million at its peak. But don't expect that ramp to be fast. This is very different than a surgical or Energy product, and we expect a slow ramp.

Kimberly Gailun - JP Morgan Chase & Co

Okay. That's helpful. And then just one follow-up on one of Rich's comments regarding Japan. You've indicated there was a small benefit in the quarter. Is that anything that you could quantify, and maybe specifically which lines benefited more than the other? Thanks.

Richard Meelia

Yes, Joe?

José Almeida

Yes, I will take that. What happened in Japan, we have a product line in Japan that is only made for Japan. And those are more big clients in central venous capital lines. And those are the ones that the demand was higher in the quarter. We didn't see a global product demand higher in Japan, but the Japanese designed and made products for Japan. The demand was higher. The comment that Rich made during the call is that we think some of the sales were driven by the devastating disaster that happened in Japan. We don't think that those sales may repeat themselves in the future quarter, and the amount is not material to the overall Covidien sales.

Operator

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

Matthew Dodds - Citigroup Inc

And Rich, I want to chime in as well. I didn't expect given what happened at Tyco with Covidien all those years with the budget that you would have pulled off and what you've done, so congratulations. So first for Joe, when you look at the vessel sealing business, it actually accelerated a little bit from last quarter, and it's been a strong driver, and I know you talked about SAGES. But how important is this Small Jaw in opening up the markets to these open procedures versus is this just generally just broader acceptance of vessel sealing in general?

José Almeida

I think it's a little of both. Our vessel sealing had very, very good growth, almost twice as much as our competitor in this past quarter. And Small Jaw is another product in the arsenal that our Energy group has in terms of expanding the use of Energy. The Small Jaw was launched in Europe before the U.S. and it's doing extremely well there in different types of surgeries, not just one type, but it's been successful in breast for instance. In the U.S., it's a general surgery device and it's doing well as well. So it's just another one in a series of several successful launches.

Matthew Dodds - Citigroup Inc

Right. Thanks, Joe. And then one quick one for Chuck. Chuck, on the gross margin, you said the foreign exchange hit, which was pretty heavy, is going to moderate a little bit the back half. What are some of the things that might kind of offset that, like what are some of the negatives? I assume materials will get a little heavier. But what should we expect to kind of temper down the gross margin expectations in the back half, or should we not?

Charles Dockendorff

Well, I think in this second quarter, I think if you look, just the year-over-year comparison was tough because our last quarter -- second quarter of last year was our highest within that quarter, so that threw a little bit of it down. And then this current quarter, the negative foreign exchange that came through our gross margin was mostly related to the mark-to-market on the hedges which flows through that line. So that will start going forward. What we see continuing on is probably some increases in raw material prices, mostly in Supplies. We're seeing increases across the board there that will impact them. And then, I think on a foreign exchange basis, we have better compares quarter-over-quarter as you get out into Q3 and Q4, so it will be a little better.

Matthew Dodds - Citigroup Inc

Thanks. Thanks, Chuck. Thanks, Joe.

Operator

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

Topher Orr - Goldman Sachs Group Inc.

Thanks for taking the question. It's actually Topher Orr in for David. I guess my first question regards capital environment. I know you guys said earlier that heightened CapEx spending poses a key component for your Energy segment. I was hoping you could provide a little more color regarding U.S. possible CapEx trend. Was there anything in this quarter that stood out that was more one time in nature or do you see general trends improving throughout the remainder of the year?

José Almeida

Dave, we see trends improving slightly in the U.S., nothing extraordinary. But on a comp basis there, they're looking better.

Richard Meelia

The only thing I'd add is that it's important to remember that Covidien really is not like a bellwether for capital purchasing. A very small portion of our total sales are tied to capital. But the ForceTriad, as we mentioned in the comments, has shown increased growth. And so that's what we look at to determine what's happening from the capital standpoint.

Topher Orr - Goldman Sachs Group Inc.

Okay, thanks. And then one more question, I guess, regarding Europe. I know you guys have taken some steps already. I think, you decided before that you're -- you shifted some back-office operations to Prague. Are there any other steps that you guys have taken? Or that you can provide a little more color on going forward to kind of combat some of the trends going on over there?

Charles Dockendorff

Yes. This is Chuck. I did I mention some of that. We have pretty much completed some of the financial back office for Europe, and that is in Prague. We're looking at other functions within Europe that we could also now build into that base structure. So we think there's clearly some opportunities for further cost savings and productivity improvements in that area, and we are out looking at those now. So those will be continuous through the next couple of years as we continue to drive through more efficient operations in that region.

Topher Orr - Goldman Sachs Group Inc.

Okay, thanks.

Operator

Your next question comes from the line of Kristen Stewart of Deutsche Bank.

Unknown Analyst -

It's actually Rob filling in for Kristen here. My first question is on price. I know you reiterated guidance was down 50 to 100 basis points, it looks like price is down 60 bps in 1Q and flat in 2Q. And then a lot was mainly on Generics. As those price cuts anniversary in the second half, do you think there's any upside potential for price? Or are you kind of just sticking to that down 50 to 100 bps?

Richard Meelia

I think the 50 to 100 basis points is a fair estimate just given the uncertainty of the environment. Just given what we've seen overall -- I mean and obviously, we feel good about the second quarter, but I think we're going to stay with that range for now.

Unknown Analyst -

Okay. And then secondly I know you mentioned previously that if FX and operational sales become more positive, you anticipated reinvesting some of that back into the business. And I want to know is that still the case and is there any area or areas that you're looking at more closely given the results thus far?

Richard Meelia

Joe, you want to pick up on that?

Charles Dockendorff

Yes, this is Chuck. It is our intention to invest in those areas. As you know, we've had the Asia expansion growth plan going on. And that part of it is just beginning to ramp up, so you'll see more investment in there in the second half of the year than would be in the first half of the year. And there's other things that we'll be looking at. But again, we've always stated that our financial goal, as we did in the script here, was to talk about the mid-single-digit sales growth and double-digit earnings per share growth, which is what we're achieving through this year, and we would continue to go after that.

Unknown Analyst -

All right. Thanks, guys.

Operator

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

Joanne Wuensch - BMO Capital Markets U.S.

Thank you very much for taking my question. You raised the total revenue growth rate to 8% to 11% from 6% to 9%. Previously, your guidance included organic revenue growth rate of 2% to 4%. Is that raise organic because things are doing better? Or is that entire 200 basis point spread just an FX event?

Charles Dockendorff

This is Chuck. It's a combination of both. So both our base underlying business is doing a little better, and we are reflecting in that guidance some improvement from the foreign exchange. But both are improving.

Joanne Wuensch - BMO Capital Markets U.S.

And you launched several new products that were supposed to help out at the end of the year in Pharma such as EXALGO and PENNSAID. Could you give us an update on uptake of those products please?

Richard Meelia

Sure, this is Rich. EXALGO's right on plan, doing very well, and there's a lot of expectation that it may exceed our original forecast, so that's good. PENNSAID, there's been some competitive headwinds as well with some reimbursement issues. And so that would be slightly behind where we thought it would be. But overall there, I mean, they're very profitable. And we still feel very positively about both -- on the EXALGO is demonstrating the results, and we think PENNSAID, we understand what we need to do. So they're doing fine.

Joanne Wuensch - BMO Capital Markets U.S.

And then my final question has to do with the Solitaire FR. You put out a press release that you had halted that clinical trial but still plan to file with the FDA. Is there anything to that you could add? Thank you.

José Almeida

Joanne, no. We just -- our work with the FDA to get the FDA approval defined [ph] for that product. And I will keep you guys informed as we progress on that end.

Joanne Wuensch - BMO Capital Markets U.S.

Thanks.

Operator

Your next question comes from the line of Bob Hopkins of Bank of America.

Robert Hopkins

Thanks. I have a question on Pharma and a question on use of cash. I'll start with Pharma. Joe, I was wondering if I could get you to comment on the Pharmaceutical business. And from a long-term perspective, do you consider the Pharma business to be a core part of Covidien going forward?

José Almeida

Bob, the Pharmaceutical business is part of Covidien's business today, and we always evaluate every business of ours to see if they strategically fit, but more so, if it belongs with somebody else better than it belongs to us. And it's all about any of our business. If somebody is interested in buying it, and they offer enough money that will satisfy our shareholders, it's our responsibility to look into it. Right now, that business is part of Covidien and there are no plans in sight in the short term to do anything different than manage it very well.

Robert Hopkins

And then in the terms of the leadership timing there, new leadership timing?

José Almeida

We're looking at some very strong résumés, and we are continuing with the process. I would say 2 to 3 months, we'll have somebody...

Richard Meelia

Yes. Let me, since I've been handling more of that than Joe, Bob. A couple things. We are being very specific, and we find there's quite a few options for us to consider. And so we're just going very carefully before we make any moves there. And the other thing I'd point out is that our CFO, Matt Harbaugh, has stepped up very effectively. And so, I think the fact that the business is doing well, it's being managed well, it's giving us the luxury of time to make the absolute right selection. This next hire is a key hire. And so, I think the performance of the business gives us the luxury of patience here.

Robert Hopkins

Great. And then for Chuck, on the cash flow side. Can you give me a sense as to, in the guidance, what sort of buybacks you're assuming in the second half? Are they going to be more limited relative to some of the tax sharing issues that you talked about? And just when do you think we get back to sort of a more normalized buyback scenario for Covidien?

Charles Dockendorff

I think, again, our policy is at 25% to 40% of free cash flow allocated to share buyback and dividends. We expect to continue that. That would be at least that. We've exceeded that last year. So at least that. The timing of these payments on the tax things, it could slip into next year, Bob. These are very unpredictable and there's a lot of negotiations going on. So I think we'll see how that goes. We still have strong cash flow. So I would expect that we will be right in line with that capital policy that we've had in the past and continue on with some share repurchase.

Robert Hopkins

And can you just give us what shares you repurchased in the quarter? Sorry, I didn't see that.

Charles Dockendorff

In Q2, we did not purchase any. And we had this significant management transition we announced and so at that point, we didn't go into the market this quarter.

Robert Hopkins

And in the EPS guidance or the guidance that's assumed for the rest of the year, again, do you assume that buyback happen?

Charles Dockendorff

Well, again, we assume -- I think you'd assume some would happen because of our cash flow in the sense of 25% to 40%, but it's not in our guidance because we don't give EPS guidance.

Robert Hopkins

Right. Thanks so much, guys.

Operator

Your next question comes from the line of Tom Gunderson of Piper Jaffray.

Thomas Gunderson - Piper Jaffray Companies

My single question to you guys is you commented on Europe and sequentially up for the first time in a while. Can you talk a little bit about U.S. procedures? How they're tracking, where you think we are relative to pre-economic downturn, and just kind of an overall -- may be split it up between general surgery and Vascular if you can.

Richard Meelia

Yes, let me take a crack at that, Tom. If Joe has anything to add, he can feel free -- we're seeing general surgery is up more towards where the kind of the pre-2008, at least heading in that direction. Bariatric surgery is high single-digit growth according to what we're looking at. Vascular surgeries, I don't have the actual surgery growth itself, but we're just doing so well relative to the new product launches at ev3 that we're kind of mitigating any headwind there with just absolute outstanding performance with new products. So there's just that -- we definitely feel like that we've hit bottom and we're beginning to bounce back. So there's -- definitely if you look at the admissions, they're flat, but they were declining. And now we're starting to see growth in different procedures, several of which are important to Covidien. Obviously, we're not digging into some procedures, whereas others like general, like thoracic, bariatric are important to us. Joe, anything to add to that?

José Almeida

No. Just one point on what you may see in terms of our numbers is we've been experiencing some market share gains in the U.S., primarily in Endomechanical that gives the impression that procedures may be going at a faster pace that Rich just mentioned.

Thomas Gunderson - Piper Jaffray Companies

Great. Thank you.

Operator

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

Steve Beuchaw - Morgan Stanley

It's Steve Beuchaw here for David. One question about free cash flow. The earnings profile the company has changed a bit given the business development activity over the last year. So should we expect that the trend of free cash flow growth relative to earnings growth over the next few years is consistent with what we've seen historically? Or should there be any change there as a function of other changes in the business?

Charles Dockendorff

No, I think when you think about our free cash flow, our capital expenditure plan had been in the range of $400 million to $425 million each year, and we've kind of been running in that. So it's not really a capital-intensive type industry that we have out there so. And our working capital, even through these difficult economic times, has remained relatively good, and actually we've seen some improvements in some of those statistics out year-over-year towards Q2. So I think the relative ratio you'd seen at free cash flow relative to our earnings should remain going forward.

Steve Beuchaw - Morgan Stanley

That's very helpful.

Charles Dockendorff

And as you know acquisitions and things like that are after free cash flow, so that really wouldn't impact it.

Steve Beuchaw - Morgan Stanley

Thank you. And then within that context, not so much this year but longer term, the deployment of free cash flow to shareholders, still thinking about 25% to 40% number is right. And any comments about the change in the views on dividends versus buybacks there?

Charles Dockendorff

Again, I think that we reiterated that I think 25% to 40% is what we would like to do in that range of our free cash flow. We have increased our dividend in the last couple years and would expect dividends to increase, commensurate with earnings as a go forward. So we would expect that. And the balance of it would mostly be in share repurchase.

Steve Beuchaw - Morgan Stanley

And one quick one on currency just for modeling, could you give us your sense of what the impact of currency was on the bottom line in the quarter and your changed expectations for its impact for the balance of the year?

Charles Dockendorff

Yes. I think for the quarter, it was actually negative from an earnings per share standpoint, a couple of cents. And so despite some strength in those currencies we've seen over the last couple of months, it was negative year-over-year. And that was really as a result of the compare. And going forward, we continue to see the dollar weaken, which will only strengthen our results.

Steve Beuchaw - Morgan Stanley

Great. Thanks, everyone.

Operator

Your next question comes from the line of Josh Jennings of Jefferies & Company.

Joshua Jennings - Jefferies & Company, Inc.

Thanks for taking the questions. I just wanted to sort of go back to pricing a little bit and try and break it out between the U.S. and Europe. You gave some good color about what you're seeing in Europe, but I'm not sure if you spoke to the pricing environment and with some of those dirty [ph] measures that are being pursued over there. Can you just talk about, I know you're flat on the quarter, but what type of pricing you're seeing in Europe and what type of pricing you're specifically seeing in the U.S. in terms of environment?

Richard Meelia

Yes. We had a pretty extensive meeting just a couple of weeks ago. Joe was there with me. And what we -- we walked away with a sense that you can't talk about Europe as one. Some markets are struggling. But even in some of these markets that are struggling, if you launch an exciting product that really meets a clinical need, the reimbursement systems find a way to -- at least this is what we found in Neurovascular, Energy, Tri-Staple. We're seeing some really good growth. Now some of the more commodities, you're seeing the pressure. So it's really difficult to describe one Europe. I mean -- so overall, it's improving for us. But I think we're seeing the improvement being driven by our success versus our competitors, and really it's a real tribute to the folks that are developing products at the different businesses throughout Covidien. They're just -- they've got their eye on the ball, they're sensing what the clinicians are looking for, and they're delivering on that. So we're being successful in Europe despite a difficult environment.

Joshua Jennings - Jefferies & Company, Inc.

Okay. Great. So basically, the pricing is flattish across the board U.S. and o U.S.?

Richard Meelia

Yes. I think it's pretty consistent. We see that pretty consistently.

Joshua Jennings - Jefferies & Company, Inc.

Great. And just maybe just one more question on Soft Tissue Repair side. You commented on some share losses on the biologic hernia repair product lines. Can you just talk about the competitive environment on the synthetic and biologic side of it? And what strategically, are you going to do to try and regain share on the biologic side? Thanks a lot.

José Almeida

We are happy with synthetic growth, was in the high single digits on a global basis. This is an indication that our portfolio moves that we made in the last 12 months with some new products are starting to take hold. The 2011 fiscal year for us on the synthetic is a year that we continue to build on our portfolio. When it comes to biologicals, that's the one that we have just one product. We continue to ascertain some more clinical data to be able to differentiate our product, and we continue to look at options organic and inorganically to complement that product line.

Operator

Your next question comes from the line of Thomas Kouchoukos of Stifel, Nicolaus.

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Thanks for taking my questions. Rich or Joe, I think I heard you say that the peripheral component of ev3 grew in the double digits this quarter, which I think would suggest you're outpacing market growth by a pretty healthy margin. And was just wondering if you could point any within that business that has picked up that growth rate, whether it be new products or things that are working within that business.

José Almeida

I think in the Neurovascular space, we have a complete product line with liquid embolics to coils to accessories and now pipeline coming in line. So a lot of that is execution. It is the ability to deliver products on a global basis, and our team in Irvine is doing a great job on that. When it comes to Peripheral Vascular, our team in Minnesota is also doing a great job. I would say, I will highlight plaque excision. We continue to see the other parts of the Peripheral Vascular business performing well, but plaque excision is doing well and it's a very focused team. So that advantage of us having retained a great group of people with the acquisition of ev3.

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Okay. Thank you for that. And then just as a follow-up, Joe, you were talking about the synthetic mesh business for hernia in new products. I think one that really stood out at SAGES was the Progrip product. And I was wondering if you could talk about where you are in the launch on that, and then what you see for that product in terms of the next 12 months, and what it means for the business.

José Almeida

The product is doing well. We have a new generation of that product in design right now to be launched in the next 12 to 18 months. So that kind of technology is taking a grip, no pun intended, and having a great success in the global basis. So that was a pinnacle for us to get the high single-digit growth in a market that is very low single-digit growth overall. There are some -- a couple more products that we're going to be bringing into market, introducers and things of these sorts that will help our synthetic business continue to outperform the market.

Thomas Kouchoukos - Stifel, Nicolaus & Co., Inc.

Great. Thank you very much.

Operator

Your next question comes from the line of Paul Choi of Caris & Company.

Paul Choi - Caris & Company

Thank you. And thanks for taking the question. My first question is on the device side on Endomechanical. It looks like growth picked up a little bit on a sequential basis, and I know you have some new products out there like Tri-Staple. Could you maybe comment on how you think you did on a share basis relative to J&J? And secondly, if we think this growth rate should sort of improve from where it stands right now for the rest of the year?

Coleman Lannum

Joe?

José Almeida

Yes, I will not comment on market share data as this is relatively difficult to get right after the end of the quarter. But I will tell you that if you peel the onion one more layer and look at the Endomechanical, look at our stapling franchise with Endomechanical in the U.S. for instance, was double digits and in several parts of the world. So that tells me that our Tri-Staple is doing quite well. And it's starting to get momentum in most parts of the world that we launched. Please be mindful that we did not launch this product everywhere. What we see in terms of a little bit more pressure is the more commoditized part of Endomechanical such as trocars and accessories. But when it comes to the technology that Covidien is bringing to market like Tri-Staple, we're doing quite well. And we will continue to see penetration of that technology not only in Covidien accounts, but we are seeing in competitive accounts across the globe.

Paul Choi - Caris & Company

Okay. Thanks for that. And then a follow-up for Chuck, it sounds like from previous questions that you saw pricing pretty flat. But in terms of gross margins, can you maybe break out for us what the mix benefit was and then what the currency impact was as well? Thank you.

Charles Dockendorff

Again, the mix and the portfolio changes we've made about the same and roughly adding about 100 basis points each to gross margin. And the FX was the negative, it was over 100 basis points. So that's really what kind of diminished some of the gross margin within the quarter.

Operator

Your next question comes from the line of Michael Matson of Mizuho Securities.

Michael Matson - Mizuho Securities USA Inc.

Thanks for taking my question. I guess just given all the moving parts from an acquisition investiture standpoint, I was wondering if you could just give us the net impact from all the moving parts there on your revenue growth?

Richard Meelia

Yes, we talked about this at our Investor Day. And when we went back and talked about it, we also have the 53rd week within this fiscal year. That also skews our results a bit in the guidance. So when you take out all the portfolio moves, the 53rd week, as well as the acquisitions we've done, we saw an underlying growth in the base business of 2% to 4% and within Medical Devices of 3% to 5%. What we commented on this quarter was that we had seen some improvement in the base underlying growth of the business. So the 2% to 4%, higher up in that range and then 3% to 5% with Medical Devices. And we also saw overall in our guidance, the increase was mostly driven from foreign exchange with some operational and organic improvement.

Michael Matson - Mizuho Securities USA Inc.

Okay. So basically, you were still in that range of the 2% to 4% range but at the higher end of that ranger for this quarter?

Richard Meelia

Yes. We improved upon it from where we thought we were at the beginning of the year in the first quarter.

Michael Matson - Mizuho Securities USA Inc.

Okay. And then in your branded drug business. I know you kind of commented on how you're doing with the new branded drugs, but at what point do you think you're going to see these new branded products start to offset the declines that you're seeing in your old products that have run off patent?

Richard Meelia

I would say we're starting to see it already, just not at the extent that it would totally compensate for the loss. And I believe we're talking in excess of $100 million between RESTORIL and tofranil. And so a couple years from now, I mean you'll see -- I think within 12 to 18 months, you'll see that kind of sales volume being generated by EXALGO and PENNSAID and feel pretty comfortable. Those are peak year sales of I think PENNSAID was $150 million or so, EXALGO was $200 million, in that category.

Michael Matson - Mizuho Securities USA Inc.

Okay. And then just one final question. The guidance increase, is it possible to break that out between the impact of currency and kind of the underlying operational performance of the business both from a revenue and then earnings or I guess margin standpoint?

Coleman Lannum

No, it's really hard to quantify. And that's one of the things we do. We try to give you a range of things. Remember, where we fall within that range can vary as well. But as Chuck said, and certainly, the intention of raising both the bottom end and the top end of that range is reflected both of currency and the beats that we've had so far in the first half of the year.

Michael Matson - Mizuho Securities USA Inc.

All right. Thanks a lot.

Operator

Your next question comes from the line of Jayson Bedford of Raymond James.

Jayson Bedford - Raymond James & Associates, Inc.

Thanks for squeezing me in. Just a couple quickies. On your non-U.S. growth, can you just comment where the bulk of that growth is coming from? Maybe compare growth in Europe versus growth in other geographies.

Richard Meelia

Joe, you want to cover that?

José Almeida

Sure. We had, as always, a strong growth in Asia and Latin America. We had good growth in Japan in the second quarter. And like Rich's comment in the prepared remarks that we had sequentially better results in Europe.

Richard Meelia

Yes. We continue to see double-digit growth in those emerging markets, Jayson. So that's been the case for several years now. And as Joe mentioned, that's one of the major areas of investment for us, so we don't see that as stopping anytime soon.

Jayson Bedford - Raymond James & Associates, Inc.

Did Europe grow year-over-year?

Richard Meelia

Yes.

Jayson Bedford - Raymond James & Associates, Inc.

Okay. And then maybe just for Chuck a quick one. Your restructuring efforts, where are you with these? Are you kind of middle innings? Or just kind of frame it from how much is left?

Charles Dockendorff

We have, I think, the second -- we're done with the first program. The second program we announced was around $200 million. I think we're roughly in around $130 million $140 million of spending within that program right now.

Richard Meelia

Then I would just add just Joe's comments earlier too, was creating additional cost headroom is a major part of what he's thinking about going forward, so I mean, we can use the baseball analogy relative to our current restructuring programs. But in terms of where the opportunities for additional cost reduction, I mean, it's still a target race. The key isn't so much finding the target, it's who can execute. So far, we've been executing well. And we have a lot of confidence in the team here in terms of making cost reductions a reality.

Jayson Bedford - Raymond James & Associates, Inc.

Thank you.

Operator

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

Unknown Analyst -

It's Dan Philip [ph] in for Adam. Just that said, I wanted to drill down on, well, I mean, what was I guess one small pocket of weakness versus what we're expecting. So I'm looking at the Soft Tissue business, sutures actually seem strong. I mean, there were some tough comps in mesh and fixation, maybe a little bit of share loss in mesh as well. Just kind of wanted to see if you can kind of give any color, how you see those business maybe playing out for the balance of the year.

Coleman Lannum

Joe?

José Almeida

Sure. As I mentioned before, 2011 for us is a rebuild years in terms of portfolio. Clearly, we're not happy with the current performance of that business, and we're taking measures to fix it. And one of them is through the portfolio and also make sure we have the right sales representation in the field. We should continue to see positive results coming out of the synthetic business, the synthetic mesh business. I would say fixation with a high market share that Covidien still holds, that is more of a mix of business and keeping it at a low single-digit growth. And then when you go into the synthetic, this is the -- I'm sorry the biologics is the area that you have that I have mentioned that we need to have organic and inorganic adjacencies to make sure that we are in a mark with a competitive product line.

Unknown Analyst -

Great. And then just real quick. I mean, looking back at SAGES, I mean, you guys were really pretty upbeat on, I guess, like on power. And just kind of want to see if you had any updated timing on that. I mean, do you guys have on fiscal '12, just wanted to see if have any update there. Then maybe just while we're still on SAGES, just want to reconfirm kind of, for Tri-Staple, I think you guys had about 3 years until you get to peak sales there?

José Almeida

In terms of Tri-Staple, yes. The whole launch would take another 12 months. And then to get to peak sales, I think about 3 years. What we are seeing right now is performance better, much, much better than we planned. That's why our launch is not done on a global basis. But where we launch this product has taken a tremendous amount of momentum. When it comes to power, we're still very confident on FY '12. We have one of our products right now in the market tests and it's performing very well, and we're learning a lot about the performance. And going into 2012, we're confident we're going to have a great product for the market.

Unknown Analyst -

Thanks very much, guys.

Coleman Lannum

With that, folks, we're going to have to call it. Thank you very much for taking the time, particularly with all the other competing calls out there. Starting at noon Eastern time today, a replay of this call will be available. Additionally, the replay will be available on our corporate website, covidien.com, a few hours from now. For members of the media who listened to the call and have additional questions, please contact Eric Kraus, our head of Corporate Communications. For analysts having more detailed questions involving nonmaterial information, both Todd and I will be available to take your calls all day today and tomorrow. Thanks and have a great day.

Operator

Thank you for joining today's conference. This concludes the presentation. You may now disconnect. Good day.

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