Covidien plc (COV) The 30th Annual JPMorgan Chase Healthcare Conference January 9, 2012 11:30 AM ET
Michael N. Weinstein - JP Morgan Chase & Co, Research Division
Good morning, everybody. I'm Mike Weinstein. We're going to go ahead and get started with our next session. It's my great pleasure to introduce the Chief Executive Officer of Covidien, Joe Almeida. Joe is going to give us a brief update on the company, and then we'll have a Q&A session across the hall. Thank you. Joe.
José E. Almeida
Michael. Good morning. I'm going to take the next 25 minutes to cover several topics I think will be of great importance to you today. I would like, before we start, to go over the forward-looking statements, if you'll read them.
We're going to be talking about the changing market dynamics. We get asked a lot of questions about pressuring in terms of volume, in terms of price. We're going to talk a little bit about that and how Covidien is going to deal with that in terms of long-term perspective for growth, top line and also bottom line. Go back and look at some of the performance that Covidien has demonstrated in the last 4 years, as well as what would be the growth drivers, so Covidien could continue to deliver sales and OI above market.
The changing market dynamics, the tailwinds are pretty clear. We still have the need for healthcare across the globe. You look at emerging markets. I was recently in Brazil about 3 weeks ago, and the ascension of middle class is unbelievable. And the need for healthcare is ever -- has not been so high in the 23, 25 years since I left the country. You look at the demographics across the globe, the aging population, so all the demographics are there. And so the demand for medical devices is still in place.
What concerns us is that there's a significant change in terms of market growth rate in some of the developed markets, like U.S. and Europe. We see that happen in the last 12 to 18 months. We also see a shift in the dynamics between what used to be a volume-driven business to a value-driven business. And that's key for us in of terms when we look forward, where Covidien put its monies and where we put our focus will be in areas that will bring that value instead of bringing only the volume.
And lastly, the environmental aspects of the regulatory aspects in all countries are being scrutinized in a much higher level. We always think that it's a great opportunity, and we invest significantly in emerging markets. But there are significant barriers to entry there, as well, not only in China but Brazil as well, places like India. So you've got to be able to have an organization that can cope with that. And these are the changes that concerns us, and we're adapting the company to continue to thrive in this environment.
So if you look at the strategic initiatives that we have, how do we position the company to win in this environment? First and foremost is the innovation. And innovation is not the launch of a new technology or a new product line extension that would just add volume to your sales reps' bag. The innovation is the ability to provide the products that are clinically more relevant than what's in the market today and has the ability to be cost-effective to the provider.
To be able to get into an innovation cycle that is effective, Covidien needs to continue to improve its ability to launch products on time and launch larger platforms every so often. So we have made tremendous progress since we went public in 2007. I'm happy with the progress, I'm now satisfied with the pace. We're going to continue to improve our ability to deliver those new products because the largest amount of value to any shareholder of Covidien is Covidien's ability to take our technology and put it in the hands of clinicians, technology that adds clinical value and economical value.
So if we look what we have done in the last couple of years in terms of product development and launches, we have in front of you an example why Covidien was so successful in bringing growth to our top line. The majority of the growth that you've seen in Covidien's top line the last 4 years is attributable to new products, and they are displayed here. I like also to give us some comfort that going into 2012 and 2013 and '14, we have the same focus in delivering new products.
The new products are not only coming from the legacy business that Covidien has, but also it's coming from the acquisitions that we made in the last 24 months, vis-à-vis, ev3, Somanetics, Aspect. Those business and those acquisitions are doing quite well and they have a significant contribution to Covidien's top line. So we have more than 100 products planned to launch in the next 2 years.
When it comes to Pharmaceutical, that is something that I'm amazed with about the pipeline that we're able to create in the last 2 years. If you think about, we have about 12 ANDAs in process. We have the Depomed patents that we acquired about 2 years ago. We have 2 products that will be launched within the next 18 to 36 months. And those look very, very promising. So the strategy for Pharmaceutical, when you shore up your efficiencies in all your operations and drive the growth of that business by bringing specific pain molecules to the market that's exclusive to us, is a winning proposition for that business.
So I like now to double-click on portfolio management. We're going to continue to aggressively manage our portfolio. And let's talk about some of the acquisitions and some of the philosophy that Covidien has on acquisitions.
First of all, acquisitions are opportunistic. Second, Covidien will continue to do tuck-ins. As an example of that, we acquired BÂRRX Medical, great technology to treat dysplasia, high cases of dysplasia in severity. That technology will open Covidien to a brand-new area of care, new space in terms of call points. That technology has future use in medical therapies.
So when we acquire companies now, the first thing we do, we do a deep dive in those technologies that we acquire and find out what is -- what are the other areas of care that can immediately be made available with that technology, not only what we know from due diligence but also we do this rapid due diligence that understands how can we go deeper in a company like BÂRRX. And this is happening as we speak, and we find that opportunity very unique. We also will continue to acquire tuck-in technologies, such as total vasoocclusion that we just will be announcing soon. And we also have other plans for smaller tuck-ins across our business. It's mostly Medical Devices.
I want to speak to you now about the recent announcement that we had of divestiture of pharma business. We spoke about enough about why we decided to divest and why now. Let me just talk to you specifically about 3 things. One is that the divestiture of pharma will not affect Covidien's FY '12 numbers. Second, the spin is an 18-month spin, and the reason is quite simply it's a highly complex spin. When you think about how Covidien is integrated, Covidien's integrated on a global basis. If you go to Paris, you see Covidien France that has all business of Covidien. So it will take us a fair amount of time to disentangle our Pharmaceutical business for the rest of Covidien. And third, that this is a tax-free spin for U.S. shareholders.
So what are the things that will not change after the spin of pharma? We're not going to change Covidien's focus on delivering mid-single-digit growth in the top line and double-digit growth on the bottom line. We're going to continue to invest in R&D. And our focus is to continue to deliver an OI that is consistent with our top line growth.
Going back to the areas of opportunities for Covidien. The third one is the emerging markets. We've been talking about emerging markets the last 18 months with all of you. We are very serious about that. We have invested over 1,000 sales reps, that are currently in plan to be hired, more than half are hired. The back office is being augmented, and we have a new ERP system going in place. The whole infrastructure is well ahead of schedule. And we have opened now 3 R&D centers: 1 in India, in Hyderabad; 1 in China, in Shanghai; and Singapore. And we should have the first product for emerging markets designed and ready to be commercialized at the end of FY '12. So things are going well. We just surpassed $1 billion in sales, and that business under the leadership of Brian King is doing quite well.
Covidien has done a very good job in managing our gross margin. A great portion of that increase in gross margin is not only mix shift, but is also the ability to deliver on cost reductions. This is something that is our second nature, it comes with the DNA of the company. And we have done a significant amount of investment. And now we just announced in July 2011 our restructuring plan that is going into effect now. And that great part of the restructuring plan is continue to deliver on operational improvements.
So we are reducing our manufacturing footprint by 26% since 2007. We had rightsized our footprint on a global basis. We now have a global shared service organization in the U.S. That U.S. organization is one business away from being a total U.S. service center, so we don't have several customer services across the country. We don't have several areas where people collect and pay bills. We have one shared service for the company in Massachusetts.
We've also done the same thing in Europe. As we look at Europe, the opportunities to continue to improve our ROIC in our business in Europe has continued to become more effective and more efficient in everything we do. We consolidated our back office for most of our countries in Europe, in the Czech Republic, our customer service is up in Dublin. So we continue to look at ways of becoming more effective, more efficiency.
We also recently -- for obvious reasons, we brought our surgical division and our energy division together. That, in Europe, eliminated 2 layers of management, in the U.S., 1 layer of management. And that business continues to do quite well, and that was a logical move for Covidien to bring them in place. So if you think about the things that we are doing in terms of continue to deliver operational efficiencies to the business, Covidien's goal is to become the most efficient medical technology company in the world. And we're going to continue to pursue that target.
So if you have to take 4 things away in terms of how Covidien's going to deal with all the headwind and all the changes and uncertainties in the marketplace, we are redefining our strategies to continue to deliver growth. We're going to be doing that through innovation, by delivering clinically relevant products with economically sound solutions to the provider. We're going to grow above market by being able to allocate our resources.
When we talk about portfolio management, it's not only about acquisitions and divestitures, it's about taking the money from businesses that have lower growth potential and putting it in higher growth potential. We do those reviews every 3 months and we make sure our businesses on a business unit level is doing that, and also at a company level, we're doing that. We're taking money from businesses that are underperforming or businesses that have commoditized portfolio and invest in white spaces.
Covidien today has 4 investigational white spaces in process internally. We probably end up 1 or 2 areas of growth that Covidien is going to continue to invest further in 2013. And we have a strong cash flow that will allow us to do that without deviating the fact that we have to return cash to the shareholders, and we do that effectively. So our objective through innovation, through efficiencies, through understanding how to grow the top line by reallocating money between our business units and going into white space will continue to deliver increased shareholder value.
If we take a look at our financial performance in the last 4 years, you can see we accelerated our top line growth, significantly improved our gross margins and have delivered, even with increased R&D and increased SG&A investment, a better adjusted operating margin without impacting our free cash flow. When you look at the last 7 years, top line growth, close to 7%. And if you look at the driver of growth here, it's primarily mix shift, which is driven by new products. By growing the most profitable business of Covidien, which is the Medical Device segment -- within the Medical Devices, the Endomechanical franchise, the energy franchise, the Vascular franchise, that mix has generated significant growth in the top line for the company.
We talk a great deal about pricing. Is Covidien affected by pricing? Sure, we are. It's in front of you here, about $183 million, but it's a small fraction. We tell you that our margin, our price erosion is about 50 to 100 basis points a year. And that's what it is.
Do we have price pressures? We sure do. You talk to our Medical Supplies President, Jim Clemmer, he'll tell you. The fight is hard and we fight for price every single day. It didn't get easier, it got tougher. But through a series of changes in portfolio and the rapid portfolio moves, which in, at the end, will add shareholder value, we're able to minimize that. Our earnings per share adjusted have a CAGR of 11%. So we're on track to what we told you in 2007, and we will continue to deliver low double-digit growth in our earnings.
Let's talk a little bit about our free cash flow and how we're deploying our cash. We have said specifically that Covidien will not hold cash in its balance sheet; we have no reason for doing that. If we don't have a specific acquisition, if we don't have a specific use for the cash, we will deliver the cash back to the shareholder either by share buybacks and/or dividends. And 2011 was a year that we did not have an acquisition within the company. That was not because we didn't try. We tried hard, but we didn't find a company that had the right value and the right strategy that will match value and strategy for the company. In that case, we're able to deliver over 75% of free cash flow to the shareholders, a total of close to $1.4 billion.
So I'd like to close today by talking to you specifically about what are the growth drivers. Why am I sitting up here today, standing up here in front of you and telling you that our underlying organic growth for the business is solid? There are areas that I'm very confident that we will continue to execute.
We had a tremendous turnaround in Pharmaceuticals in 2011; that business has done well. They were poised for, in 2012, to deliver solid growth. Our Endomechanical franchise continued to gain market share. Our Tri-Staple product within Endomechanical is doing quite well, as well as our energy base and the Neurovascular division is doing extremely well with very high growth.
We're going to continue to allocate resources. As I said, we'll take from business which we don't think have growth potential, we're going to turn that to business that have higher potential. And why do I underscore that so much? Because in 2007, when we became a public company, we had a value proposition to you and we said we're going to increase R&D. We gave a shot to almost all businesses with exception of few.
Today, Covidien has a more sophisticated portfolio management capability and is drilling specifically in businesses and white spaces that have higher potential to deliver top line growth. We do understand the ROIC is highly important to the shareholders, and we're focused on that. And as we continue to trend that in the right direction, we do understand the top line growth is what creates the most amount of value. We understand that R&D is the biggest vehicle for delivering value to our shareholders.
We have the capital flexibility in the company to support our growth. We generate close to $2 billion in free cash flow. We're going to continue to use that in our advantage. If we don't find the acquisitions, if we don't find the right opportunities, we will deliver that cash back to the shareholders. And we have proven that we can do that.
We have a proven management team that understand how to create shareholder value. And we have, above all, one of the best teams in healthcare. We have a great bench. In 2007, we had to hire a lot of people from the outside to bring this company to what it is today. But today, I stand up here and say that we have a phenomenal team that can deliver on the top line growth and the OI that we have promised to investors. And the bench is deep.
So with that, I'd like to conclude our presentation. And I think we have Q&A across the hall.