Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Coleman N. Lannum - Vice President of Investor Relations

Jose E. Almeida - Chairman of the Board, Chief Executive Officer and President

Charles J. Dockendorff - Chief Financial Officer and Executive Vice President

Analysts

Robert A. Hopkins - BofA Merrill Lynch, Research Division

David R. Lewis - Morgan Stanley, Research Division

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Frederick A. Wise - Leerink Swann LLC, Research Division

Kristen M. Stewart - Deutsche Bank AG, Research Division

Anthony Petrone - Jefferies & Company, Inc., Research Division

Matthew J. Dodds - Citigroup Inc, Research Division

David H. Roman - Goldman Sachs Group Inc., Research Division

Adam T. Feinstein - Barclays Capital, Research Division

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

Glenn J. Novarro - RBC Capital Markets, LLC, Research Division

Jason Wittes - Caris & Company, Inc., Research Division

Michael Matson - Mizuho Securities USA Inc., Research Division

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

Covidien (COV) Q2 2012 Earnings Call April 27, 2012 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2012 Covidien plc Earnings Conference Call. My name is Brent, and I will be your operator for today. [Operator Instructions] As reminder, this call is being recorded for replay purposes. I would now like to hand the call over to Cole Lannum, Vice President of Investor Relations. Please proceed.

Coleman N. Lannum

Thanks, Brent, and good morning, everyone. With me today are Joe Almeida, Covidien's Chairman, President and CEO; and Chuck Dockendorff, our Chief Financial Officer.

We'll be making some brief introductory comments as usual and then spend most of the time this morning answering your questions.

The press release, with details of our second quarter results, was issued earlier this morning and is available on our website and on the newswires.

Now during today's call, we'll make some forward-looking statements and it's possible that actual results could differ materially from our current expectations. Please note that under the Safe Harbor rules, we are under no obligation to update these forward-looking statements, even if actual results or our future expectations change materially. We ask that you please to 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 $1.01. After adjusting for certain specified items, our non-GAAP earnings came in at $1.05 per share. For clarity, please note that the leap day had no impact whatsoever on our results and that there were no material impact on sales in the quarter from either acquisitions or divestitures.

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

Jose E. Almeida

Thanks, Cole. We're off to a very strong start in fiscal 2012. Our second quarter sales came in ahead of plan, up 5% as reported and up 6% operationally, and we again registered year-over-year improvement in gross margin. We also delivered a 13% increase in adjusted EPS.

In the Medical Devices segment, we had another solid quarter with broad-based growth led by Energy and Vascular products. In the Pharmaceuticals business, sales growth was paced by a very good performance for Specialty Pharmaceuticals, led by PENNSAID and EXALGO, coupled with higher generic sales. In Supplies, sales were even with the year ago.

As we noted in the release, our European business accelerated for the second consecutive quarter. While there are certainly some areas of concern in the region, we're cautiously optimistic that we have the right mix of products and technologies to be successful in the European marketplace.

In our emerging markets comprising Eastern Europe, Middle East and Africa, Asia and Latin America, sales again grew at a double-digit pace in the quarter with broad-based gains led by stapling and energy products. We registered exceptional growth in the BRIC countries, led by Russia and China where we'll continue to make incremental investments to accelerate growth and expand our product offerings.

In our large Endomechanical business, stapling products continued to perform well, led by innovative Tri-Staple Reloads. We're making good progress increasing Tri-Staple capacity, however, we are experiencing strong demand for the product as we gain incremental market share.

During the quarter, we launched Tri-Staple in Asia, and we believe it's on track to become our most successful new product ever.

Sales in Soft Tissue Repair were up slightly from a year ago. We've made decent progress in the large suture category, but increases were partially offset by declines in mechanical fixation and BioSurgery. This was due, in part, to the impact from competitive product launches in both the U.S. and Europe. But we believe the competitive environment is stabilizing after several quarters of disruption.

Our Energy business had another robust quarter, as new products such as the LigaSure 5 and the Small Jaw, coupled with growth in electrosurgery, contribute to our performance. We'll be rolling out the innovative Sonicision Cordless Ultrasonic device next week on a limited basis. The launch will keep Energy at the forefront as a growth engine for Covidien, driven by low penetration, technology adoption and hospital patient economics and outcomes.

Also, of note during the quarter, we closed the acquisition of BÂRRX Medical, a market leader in treatment of Barrett's esophagus syndrome. This acquisition broadens our position as the global leader in RF ablation technology, although as Cole said, the sales in the quarter were immaterial.

Turning to our Vascular franchise. We again achieved excellent results. Our second quarter performance, led by Peripheral, Neurovascular and Chronic Venous Insufficiency products, all of which registered exceptional growth. While the Peripheral business benefited from a competitive recall, the underlying growth was still quite strong and it has been for the last several quarters. The Pipeline Embolization Device continues to perform ahead of expectations, and the launch of Solitaire in the U.S. is on track. Looking ahead, we're making significant investments in selling, marketing and clinical trials to deliver further growth in the Vascular category.

Sales of Oximetry & Monitoring products were above a year ago, led by monitors. All 3 of our franchises, Nellcor, BIS and INVOS grew at double-digit pace for the second consecutive quarter. For the first time in several years, we believe our overall market share has relatively flat -- rather, was relatively flat versus a year ago.

In the Airway & Ventilation category, sales were about even with last year due to lower ventilator sales, reflecting capital pressures, which were mostly in Europe. We are on track to launch our new ventilator platform next year, which should help that business grow incrementally.

Turning to our Pharmaceuticals business. We registered exceptional growth in our specialty product line, partially benefiting from production issues at a competitor, policy pricing in the generics business and growth of our pharm -- Radiopharmaceutical products.

In contrast products, sales were well below last year due to customer order timing, product line discontinuations and competitive pressures in the U.S. Following an unusually strong increase in the first quarter, sales of Active Pharmaceutical Ingredients declined this quarter, reflect a decrease for narcotic products and some order timing issues. As a reminder, the API business can be volatile from quarter-to-quarter based on these timing issues.

In Medical Supplies, sales were unchanged overall. That said, we saw good growth for incontinence and for Medical Surgical products led by electrodes. While the markets in this segment are generally showing little or no growth, we continue to look for opportunities to launch innovative products. The Medical Supplies business space has a strong price competition, but it continues to meet our expectations and provides good flow -- good cash flow and ROIC.

Overall, we are very pleased with our results in the second quarter. We continue to experience broad-based growth in areas such as stapling, vessel sealing, Vascular and Specialty Pharmaceuticals.

Before passing the call to Chuck, I'd like to briefly address some of the market-related influence and their impact on us. As you know, surgical procedures growth has been somewhat depressed over the last few quarters. Despite lower organic growth in the market, we have been able to prosper. This is largely due to our broad portfolio -- broad product portfolio, investment in expanding our capabilities, geographic diversity and opportunities were captured from increased penetration of our products, particularly in Vascular and Energy. Finally, our customer mix, favoring the larger hospitals and the broader demographic trends are both moving in our favor. As a result, we believe Covidien is well -- very well-positioned for further growth as we expand our global share in our current categories, grow our business in adjacencies and look for white spaces -- white space opportunities to accelerate our performance.

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

Charles J. Dockendorff

Thanks, Joe. As Joe mentioned, we're very pleased with our performance in the quarter as sales came in ahead of plan with 6% operational growth. We had improvements in gross margin percentage and continue to make incremental investments in R&D, selling and marketing to ensure our future growth.

The tax rate also improved, which, combined with the operational improvements and share repurchase, resulted in a 13% increase in adjusted EPS over the prior year, in line with our expectations. As noted in the release, we registered an 80 basis point increase in adjusted gross margin this quarter, driven by positive business mix and our ongoing manufacturing cost-reduction program.

Reported SG&A spending was up versus a year ago largely due to continued spending on our growth initiatives, including the Asia growth plan where we are expanding our sales and marketing presence. These investments were primarily funded by our productivity improvements.

While we will continue to deliver productivity gains for the remainder of the year, we do expect that SG&A spending will be up sequentially going forward as we increase our investments in selling and marketing in emerging markets and in the Vascular and Energy categories. In addition, amortization related to our recent acquisition activity will put upward pressure on our SG&A.

Research and development increased 28% to 5.7% of sales in the quarter, though this included the onetime payment related to a license agreement. Excluding this payment, R&D was still up 19% in the quarter, and we remain committed to our goal to further increase R&D over the next few years.

On an adjusted basis, our operating margin at 22.1% of sales was about even with the year ago and in line with our annual guidance range.

Interest expense was on plan. The adjusted tax rate, while in line with our annual guidance, improved by 270 basis points over the prior year, primarily as a result of tax planning activities.

And we delivered a 13% increase in adjusted EPS to $1.05 in the quarter.

During the quarter, we repurchased about $150 million of stock. In the last 12 months, we have returned more than $1.4 billion in cash to shareholders, representing more than 85% of our free cash flow over that period.

As Joe noted in the release, we remain comfortable with the guidance we issued previously for sales, operating margin and tax rate. In addition, we remain comfortable with our current annual EPS consensus estimates.

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

Coleman N. Lannum

Thanks, Chuck. I think it's the shortest introductory comments we've ever had. We're trying to have as much time as we can for Q&A. As you know, we moved the call to a Friday this morning to try to keep it clear versus other people reporting earnings. Because of that, we have quite a long list of questions out there. [Operator Instructions] Operator, can we go into the first question please?

Question-and-Answer Session

Operator

Our first question comes from Bob Hopkins from Bank of America.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

A quick question for Joe and then for Chuck. First, Joe, just looking for some perspective, the last 3 quarters, your organic growth has gone from 3% to 5% and now up to 6% even on tougher comps. My question is are you seeing any positive signs on the utilization front, or is all of this acceleration coming from new product flow and market share? And do you think this 6% type of growth rate is sustainable?

Jose E. Almeida

Bob, we haven't seen any changes in utilization for the products, for the Vascular products that we sell. As you're very well aware of, the products that we sell were not heavily dependent on elective surgery, and we've seen the volume is stable. What has been driving our growth with this quarter x FX 6%, is our stapling franchise, the Tri-Staple. We're clearly gaining market share there. We're able to stabilize our Soft Tissue Repair, primarily the fixation is much more manageable now. Our Vascular business is firing in all cylinders. Peripheral Vascular and Neurovascular and CVI with huge -- low 20s growth year-over-year. So it is market share, our Specialty Pharmaceuticals is doing very well. So we find that our efforts in a mix of organic and inorganic plays that we made in the last 24 months are paying off in sustainable organic growth.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Great. And then just for Chuck, can you talk about how much amortization will impact SG&A this year from the new deals? And at this point in the year, you're halfway through and above the high end of your range and I understand there were some special items in the first quarter, but -- so can you comment on the amortization? And then also, at this point, are you comfortable with the upper end of the 22% to 23% operating margin range that you gave?

Charles J. Dockendorff

I guess on the amortization page, the only deal we've actually got in the quarter was BÂRRX at this point in time and we're in the process of closing the other acquisitions. So I think I'd defer on giving an amortization number on those deals going forward. Just suffice to say that there will be some increase in expense. And we've talked about that in the past and SG&A from the amortization of those deals. We can give you more information on that once they are completed and we have those accounting things completed in the analysis. As far as the guidance range, I think we're just comfortable. We really don't want to talk about what end of the range we're there. We're comfortable with the range we give and have talked about the dynamics of that going forward. We finished off the first quarter very high. We mentioned that was high. And that the operating margin going forward in the next couple of quarters will be lower than the first quarter as a result of these increased investments we're making and some of the additional acquisitions we have coming in here.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

How long will that SG&A investment continue?

Charles J. Dockendorff

I think, Bob, I think what you're seeing here is a business here with an increased organic growth rate that's been improved over the last couple of quarters and it's a result of these investments we're making. As you know, our goal here is to leverage some income growth off the sales line, and we have a lot of opportunities to invest to continue to drive sales. It's really kind of a unique situation where we really have probably more opportunities out there than we can sit in and fund through the P&L. And we're going through and looking at these opportunities. So I think it'll be a constant thing. We're investing in the Asia growth plan. We're investing in clinicals and things around Vascular, but these businesses are growing dramatically high. We don't want to miss out on that opportunity. So I think it's something that we'll continually look at. Having said that, as an organization, we're also sitting here and driving through some significant productivity gains because we want to drive bottom line growth as well. And so we're funding a lot of these investments with productivity gains. But the opportunities are there and we just want to take advantage of them as we look forward.

Operator

Our next question comes from David Lewis from Morgan Stanley.

David R. Lewis - Morgan Stanley, Research Division

Joe, just a couple questions on the growth program. The first is just thinking about Oximetry, I mean certainly this has been an area where there is one of your slowest growth divisions over the last couple of years and I noticed this quarter, if our math is right, the organic growth is probably the strongest in Oximetry we've seen in 2 years. And I wonder, have you gotten to a point now where you have assembled the appropriate parameters and technology to kind of reaccelerate this segment and compete with your principal competitors?

Jose E. Almeida

I like to move the conversation from Oximetry to Monitoring. In Monitoring then answers the question the Oximetry is one of the parameters that we offer. We offer cerebral oximetry. We offer depth of anesthesia. Now we just got approval for respiration rate, so we have one sensor that will be launched with both SPO2 oximetry and respiration rate. We also just bought a capnography company, so you've got to think about our business going forward not as an oximetry business, as a monitoring business of a specialty parameters. I will tell you that the business, the team involved there is fired up. There are a lot of work in the R&D. I think we have our sales force stabilized. We have the best of the best. And there's no reason for us to not be at par with competition. So I feel much more comfortable to date -- and there's lots to be done, lots to continue to improve. But a big, big weight has been removed from our shoulders in terms of having a business that was underperforming. Now we're looking forward to product launches and integration of these acquisitions.

David R. Lewis - Morgan Stanley, Research Division

Very helpful. And just a follow-up question here on Energy. The Energy franchise has grown a lot more robustly than we expected for a lot longer. And then recently, you're coming off the SAGES meeting, there's a lot more sort of competitive noise from traditional mainline competitors and then nontraditional competitors, how are you thinking about sort of the Energy franchise and forward growth rates in light of the increasing competitive environment?

Jose E. Almeida

The whole thing about Energy is we -- the Radiofrequency business, we built that business. So in terms of technology, we believe we're still ahead of the competition by a few years. Second, I'd like to highlight that the whole segment of Energy is under penetrated across the globe. Little less in U.S., significantly in Europe and very significantly in Asia and Latin America. So there's a great opportunity to continue to grow that business. Now Covidien needs to have to have the right portfolio product to be competitive and we continue to develop. We just launched a new 5-millimeter blunt tip this week. We're launching the Sonicision. We're making sure that our technology is still ahead of the competition. And as the people who have the largest market share in this space, we've got to make sure that we don't fall behind in neither technology nor our ability to commercialize across the globe. But keep that in mind, that penetration is the keyword when you talk about Energy.

Operator

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

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

A couple of items, Joe, just to follow up. So first, Endomechanical, your performance relative to your principal competitor widened this quarter, so would love to hear your thoughts as to why that's the case. Obviously, Tri-Staple has been rolling out in various versions over the last year-plus. And then second, can you give us a little bit more on Vascular just to get a sense of the relative performance of Neurovascular, Peripheral Vascular than the rest of the portfolio?

Jose E. Almeida

Mike, our Endomechanical business is growing well across-the-board. I like to highlight first in the U.S. and Europe, the launch of Tri-Staple was a significant pivotal point for Covidien. As we brought this new technology to the market, the ability to gain market share increased significantly. We also have very strong sales force and contract sales force who's doing a great job bringing the product into places and customers that we didn't reach out before. So if you think about our franchise growth for Endomechanical, when you go into the stapling part of it because, I tell you, the more commoditized hand instruments and trocars continue to be pressured in terms of pricing. I would say that franchise, this quarter, grew close to 10%. So that is unbelievable. But what I would like to highlight in emerging markets, our folks in emerging markets are doing a phenomenal job in bringing that technology now to our customers there. So it's been a global effort. I don't want to just pinpoint U.S. and Europe. In Japan, in Asia, in Latin America, great work across the globe on that franchise. When it comes to Vascular, now our Neurovascular business is growing 40%. A lot of that is due to Pipeline Embolization Device and also the Solitaire, and I was able to see a couple procedures where the Pipeline Embolization Device was used and I'm amazed. That is a transforming product. So we're very happy to be at the cutting edge of the Neurovascular technology and helping the physicians achieve such a miracle in such a short period of time. The procedure that I saw took about 35 minutes. And the patient that would not have a choice before had a phenomenal opportunity to walk out of the hospital a couple of days later. Our Peripheral Vascular, great job, 24%. And let me tell you, just go fill in. When somebody goes in back order or when somebody goes into a recall, it's not an easy task. So now that business is looking forward to retention of some or most of that business that went into the recall. And I call attention lastly to our CVI business, which is the acquisition of VNUS, growing 23%. So it's phenomenal. So I highlight that our Vascular business is very healthy and our management team there is doing a great job.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

That's actually very helpful. Chuck, let me just follow up with one on the financial side just so I understand. The acquisitions of the last few months, superDimension, Newport, Oridion, I think I captured the 3 major ones there. You spent about $700 million with the amortization and the other R&D spend at those companies. There is some dilution. You're absorbing that into your guidance. Can you just maybe put some more parameters around how much you think you are absorbing over the balance of FY '12?

Charles J. Dockendorff

Yes, I think the 3 transactions or the ones we've talked about, BÂRRX and superD, Oridion and Newport, those -- BÂRRX is in our numbers for Q2, partially. The balance of those we'll be due in there. Each one, individually, as we went through it was just slightly dilutive and we would cover that through operations. And then on the 4 deals combined, it's a few pennies of EPS that we're looking at. In case of dilution, we're covering that operationally. I think, as well, as we started out the year, the FX changed, down little bit. So I think from that standpoint, we're covering that as well. So operationally, the business is coming through much stronger than what we anticipated in the beginning of the year and it's able to fund some of these pressures on FX and as well as these deals that we're able to do.

Operator

Next question comes from Joanne Weunsch from BMO Capital Markets.

Joanne K. Wuensch - BMO Capital Markets U.S.

I actually have 2. Is there any update on the pharmaceutical spin that you can share with us, including, I would expect, between now and that stage, you're going to get -- or SG&A numbers are going to go up little bit as you start to build out that franchise?

Jose E. Almeida

Joanne, I'll take on the spin status. Chuck will talk about the SG&A buildup. Not much to report. It's going on schedule. Great deal of work on the separation, the outside of the U.S. business. That's a monumental amount of work because the way Covidien is integrated. But our hiring plan is on schedule. Everything on our dashboards are showing green right now.

Charles J. Dockendorff

Yes, I think as far as the expenses, Joanne, we'll have -- we are calling that out in the non-GAAP to GAAP reconciliation and separation costs. So as we build those structures in Pharmaceutical and bring people on to manage that business as a public company, we'll be capturing those costs separately and disclosing it. So I think that's something you'll be able to see as we go on.

Operator

The next question comes from Rick Wise from Leerink Swann.

Frederick A. Wise - Leerink Swann LLC, Research Division

Chuck or Joe, can you update us on your latest perspective on price? In the first quarter, you'd highlighted that you saw continued pressure, but less than historical ranges. Are you seeing anything different now? And maybe as part of that, a large insurer commented earlier this week on their call that they thought they were seeing hospital inventory restocking helping medical device results. Was that any kind of factor in the quarter?

Charles J. Dockendorff

No, it really wasn't, Rick. Again, the pricing that we saw in the quarter was right in the range that we've given for the historical pricing ranges we've had in the past. So we've seen no additional pressures from that. And again, those are same-store sales, pricing that we measure. It doesn't reflect the increased prices we're getting as we launch new products like the Pipeline and Tri-Staple and things like that. So no, we don't see that. It didn't impact our margin at all on a comparative basis going forward.

Frederick A. Wise - Leerink Swann LLC, Research Division

And that inventory restocking?

Jose E. Almeida

Rick, I hear all kinds of different things from our businesses from movement in inventory in distributors and things that happen on the supply chain. I have not heard anybody speak to me about hospitals restocking their inventories and this being the reason why medical device sales are looking up. I haven't heard that comment. I don't know where that came from, and I can't comment on it.

Frederick A. Wise - Leerink Swann LLC, Research Division

It came from Aetna, but just was checking it out. Just a just a quick follow-up. Sonicision, Joe, you talked about it at SAGES, it launches next week. Can you just update us on little bit on the ramp and your expectations and what we should look for over the next 6, 12 months?

Jose E. Almeida

Rick, we just -- I was speaking to Bryan Hanson. We have the first use of the device in man [ph] recently and was a tremendous success. The comments from the doctor were very, very positive, and we're very excited about technology. With that said, I would say that the ramp's going to be slow, so we should not look for a significant amount of sales ramp-up in 2012. I think the show begins in 2013 when the technology is more understood by the hospitals and their central supply groups and center stores at the hospitals how to deal with the batteries and things like that. But so far, early indications look like the technology is being accepted and it looks like things are going as planned.

Operator

Our next question comes from Kristen Stewart from Deutsche Bank.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Thanks for clarifying on the selling days. Any impact from weather, Cole, in the quarter?

Coleman N. Lannum

No, no. I don't think any issues whatsoever there. Not good or bad.

Kristen M. Stewart - Deutsche Bank AG, Research Division

I think I just wanted to check because some have kind of talked about weather in that regard. More importantly, just kind of going over your guidance, you guys reiterated guidance. Does that now include all of the acquisitions that you've done in Medical? Any change to that divisional number at all?

Coleman N. Lannum

So just to be clear, it just includes BÂRRX. We haven't -- I mean we haven't closed on the other deals yet. We'll make any comments if need be afterwards.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. And even with those acquisitions from an earnings perspective, you're still comfortable with where the current consensus EPS estimates are today?

Coleman N. Lannum

Yes.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay, and then Chuck, I was wondering if you could just maybe go through the year-to-year change in gross margins with us. I know you mentioned mostly business mix and manufacturing savings. But any impact from FX? And if we look at just kind of the core margins within Medical Devices, is that something that on an apples-to-apples basis just in the Medical Devices we're seeing some improvements there from a gross margin perspective with the launch of all the ev3 products as well as maybe just from an operating margin perspective?

Charles J. Dockendorff

Yes, I think if you look at the quarter, in quarter 2, we were up 80 basis points over the prior year. That was down from Q1 sequentially about 70. And we talked about, in Q1, that we did have a favorable FX gains within that quarter, and we're expecting gross margins to be down. But on a year-to-date basis, when you look at 6 months versus the prior year, we're up 110 basis points on gross margin. And then when you look at the drivers of that, we've talked about them in the past. But the biggest component and the biggest driver of that is mix. Now that doesn't -- that would include some of the increased margins we're getting from some of the new products we're launching and things like that. But it's also the underlying portfolio where our higher-margin products are growing faster than the rest of the portfolio. And we would expect that mix component to continue throughout the balance of the year. And the other components of FX, pricing, cost reductions, they'll go up -- the pricing, like I said, has been pretty much in line with what we've had historically. I think actually it was down a little bit in Q2 compared to Q1 as far as a lower negative price. But that will fluctuate just slightly quarter-to-quarter depending on the mix of what we sell there. But the other things like cost reduction, they're coming through and offsetting that. So overall the mix being the biggest driver, I think the other components will just offset each other as we go through the quarters.

Kristen M. Stewart - Deutsche Bank AG, Research Division

And I guess just the outlook for gross margin, should we think about this as a level that's sustainable in your mind? Or given FX, we should expect to see gross margins kind of tail off through the balance of the year?

Charles J. Dockendorff

I think we may have some slight decreases in gross margin compared to Q1 and Q2. I think we'll be up on the full year over the prior year. But I think as you look at quarters, you'll see some maybe slight decreases in net. Some of that has to do with some of the acquisitions that we're layering in and they have higher costs associated with them initially when we start them out. But I think, overall, when you look at the full year, we'll be up year-over-year.

Operator

Our next question comes from Anthony Petrone from Jefferies Group.

Anthony Petrone - Jefferies & Company, Inc., Research Division

I have 2 financial questions and one on Soft Tissue for -- first, for Soft Tissue. Joe, can you just comment on we've had competition in the space there in fixation. One of your competitors also spoke of pressures and hospital declines in the use of biologics last quarter that showed up in IMS numbers. So can you comment on that? And then the financial questions: One, you booked an R&D license expense. It looks that had a $0.03 impact. Is that recurring or onetime? And lastly, on the top line guidance for med tech, the first 2 quarters you're trending at the high end or above the 2% to 5% range you put out there. So just wondering as we look into the back half, where you're seeing some of the pressures?

Jose E. Almeida

Anthony, the soft tissue question regarding -- let's talk about fixation first. We've said about 2 quarters now that we have seen impact of competition when one of the competitors launched a new product. And what we did say is that we've seen that it's stabilizing. For the first time now we've seen in this quarter, the numbers are much more stable they were before, meaning that probably the prior period and the conversions some of them didn't go through, some went through. And for us, going forward with high market share like we are in a market growth that is very low single digits, we find that to be acceptable for our business. In terms of biologicals, there are couple of things. One is the market, that we've seen that market contracting and we alerted of that 2 quarters ago. And so it's not surprising to us that some of our competitors are starting see this now. Covidien has made a decision not to invest in the biologicals business, meaning the mesh hernia repair for biologic -- using biologicals any longer. It's part of our bag, but it's not something we invest any R&D money in it. It's a very expensive product line to get approvals and the approvals are very limited. In terms of scope, and it doesn't meet our criteria for new products and new applications. So with that, I think I answered your question on soft tissue. I think Chuck could take the other 2.

Charles J. Dockendorff

Yes, on the R&D license impact, that was in our numbers. It was called out again in the GAAP to non-GAAP reconciliations. So it is not part of the $1.05 of EPS that we reported in the quarter on a non-GAAP basis. But that is a onetime event. It was related to technology acquisition that we -- small technology license that we picked up.

Coleman N. Lannum

Yes, and if you look at Footnote 3 in the GAAP to non-GAAP pages, it'll take you through that. The R&D should have been $155 million after excluding that cost.

Charles J. Dockendorff

And I think as far as the med tech revenue question, the thing we're facing in the back half of the year, 2 things: The FX component year-over-year will be negative on our reported growth, on our operational growth. And secondly, in the fourth quarter, last year, we had an extra week and so that will not be here this quarter. So that will cause reported growth to be down in the fourth quarter, but operational it will have no impact.

Operator

Our next question comes from Matthew Dodds of Citigroup.

Matthew J. Dodds - Citigroup Inc, Research Division

I guess either, Joe, probably for you. If you look at Specialty Pharm and how you did this quarter and you break up the pieces: EXALGO, PENNSAID and the generics. I think PENNSAID, they -- the competitor's coming back. But what's your expectation for EXALGO and some of the generics at least for the next quarter in terms of the growth rate?

Jose E. Almeida

We are -- we expect that competitors, like I said, to come back. We're looking at PENNSAID sales to be about $40 million per year on a normalized base. So don't take the number from this quarter and run with that. And in terms of the generics business, we have always a dependence on the quota from the DEA, and that quota can vary. So the quarter-to-quarter numbers show some volatility, but there's nothing exceptional there that indicates to us that we have much better than planned or much lower than planned. We're still pretty comfortable with the growth that we have indicated.

Matthew J. Dodds - Citigroup Inc, Research Division

Okay, and then just one quick follow-up on Sonicision. If you look at the ultrasound market overall, it's lowered a lot more than RF. Part of it is share gains, but I think also part of it is a big increase in reprocessing. Is that a risk for Sonicision, or is this going to be harder to reprocess?

Jose E. Almeida

We don't design products with the intention of not allowing them to be reprocessed. We design the products for best clinical and economic outcome for our patients and providers and surgeons. So when you look at the Sonicision, the concept is completely different. The only part that gets disposed is the shaft. Everything else gets reused. So you -- because the handle is where the battery's housed, so I would say to you that there's probably less economic or financial incentive to reprocess that. Okay. I'm not saying there's not going to be reprocessed, but there's a less of an incentive.

Operator

Our next question is from David Roman from Goldman Sachs.

David H. Roman - Goldman Sachs Group Inc., Research Division

Joe, I was hoping you could expand a little bit on the comments you made in the press release regarding emerging markets. And maybe you could just remind us for perspective, how big that is as a percentage of revenue, what the growth rate is and then maybe what are the primary drivers of growth there. Is it introducing new products to markets that you're not currently selling? Is it increasing penetration? Maybe just frame the perspective there and the outlook?

Jose E. Almeida

Okay. Our emerging markets, our team is doing a phenomenal job. They have accelerated our growth plan in Asia. Brian King, our President, for that group has led acceleration of the hiring and we'll be about 80% done at the end of this first quarter -- I'm sorry, at the end of this fiscal year rather, with the hiring programs. So that's very, very nice acceleration and we're accelerating because we can sell and we can absorb those folks quite well. Our growth in Q2 was about 14%. Our BRIC markets, which are really focused, the growth is mid-20s. And that's about $1 billion for Covidien today, and we have the aspiration in 3 to 4 years to double that.

David H. Roman - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. Then maybe just on the R&D spending. Obviously, we've seen a nice acceleration in organic growth as was pointed out earlier. Can you maybe give us some perspective on the timing between when you sort of accelerate R&D spending to when you see a turnaround positively in the top line -- maybe just, for example, you look at the growth that you're generating now, when did those R&D programs begin and if we look at the acceleration in R&D spending today, when do you think we'll start to see a positive return from that?

Jose E. Almeida

About 18 to 24 months. That's the cycle of new product for Covidien. We have products like ventilators, that's 5 years in the making. That is an exception. We're looking at 18 to 24 months to get a product out. So that's where we expect. We have created efficiency measures now for R&D in terms of we call R&D effectiveness, and we're starting to measure that and push for better utilization of every dollar that we spend. We're still in the 5% to 6% over time range and we feel comfortable with that. Now as you know, we had a $12 million charge this quarter for a licensing agreement, but that's pretty much if you remove that, we really within the range that we have spoken about.

Operator

Our next question comes from Adam Feinstein from Barclays.

Adam T. Feinstein - Barclays Capital, Research Division

Maybe just a quick question for Joe and I have a follow-up for Chuck. Maybe Joe, just can you comment on little bit more about Europe? Just the numbers were good as you guys highlighted. And were you anticipating that and what do you think is going on there? It seems like there was a positive trend here?

Jose E. Almeida

Adam, we spoke about this before that it was important to note that throughout this austerity programs that every country in Europe has undertaken, differently actually, each country have their own way of doing it. We were very -- we underscored that technology always was getting paid. And if you look at CVI growth in Europe, you look at Neurovascular, you look at Energy and look at Tri-Staple, there's significant growth there. Now products, there are more supplies like the Medical Supplies business in Europe and probably trocars, those are more depressed. This is where the price pressure comes in. So we're doing better in Europe. Now mid-5% growth there is a great thing for Covidien. We're happy with that. I want to highlight also that when you look at the austerity, the austerity's been in place for a couple of years, so you have some comps that help not only Covidien, but the industry in general when you compare this second quarter were less with 2011. So technology gets paid. We're doing well with that and -- but also we have comps that work on our favor.

Adam T. Feinstein - Barclays Capital, Research Division

Okay, and as a quick follow-up, probably for Chuck here. So as you guys have talked about the SG&A costs and the opportunity there in terms of driving future growth. So I guess just how do you think about the returns from that? Is that something we'll see the benefit from in 12 months, or do these investments normally take 18 months of ramp-up? Just how are you thinking about the time line in terms of the ramp-up or seeing the benefit from the investments you're making?

Charles J. Dockendorff

Yes, I think the SG&A, selling and market investments clearly come at a quicker clip than R&D. It is selling people we're putting in the field in emerging markets and even on our Vascular product lines, which are in high demand, which require very sales-intensive effort by our people. So I think you're seeing that reflected in our organic growth rate today of the 6% -- operational growth of 6%. So going forward, in emerging markets, typically sales people began to pay for themselves within 6 months to a year, so those are much quicker. But some of the investments we're making are in post-market clinicals and those can take a little longer. But they broaden the opportunities for the product into the markets and they would probably be more in line with kind of R&D investments as far as timing. So you're seeing the increasing growth come from a combination of the sales people we're putting out there as well as some of the advanced clinicals we're doing on the products.

Operator

Our next question comes from Tom Gunderson from Piper Jaffray.

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

Tri-Staple, the last few, maybe several quarters, you've talked about capacity versus demand. You want to try and guess what growth might be or might increase by on Tri-Staple if you had unlimited supply right now?

Jose E. Almeida

Tom, that's tough because we're limiting where we're going and the more volume you have in your hands, the accounts become more difficult to convert. We all know that. But I would say to you there's still upside, and I will continue -- we'll continue to see good growth throughout a couple of years of this product as it gets penetration in accounts. Notwithstanding the fact that MIS by itself, minimally invasive surgery, is still an under-penetrated modality of surgery. So that helps the business and, business, all boats rise. But despite of that, I would say if I had more capacity, think about Covidien having a good growth engine on the Tri-Staple for a few years as we continue to increase the capacity for our penetration in MIS.

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

And under penetration in MIS is a good segue to my second question, bariatric surgery. JAMA a few weeks ago had an issue on bariatric surgery and its positive impact on type 2 diabetes. You guys have talked about this in the past and not recently. Can you give us an update on some of the clinical studies and how you're seeing that as a growth engine either now or going forward?

Jose E. Almeida

There were 2 studies actually, and I think they confirm what we've been seeing for a while. I think the biggest thing is that the resolution of type 2 diabetes associated with the procedure. This is the biggest thing. But I tell you, this is an effort not Covidien alone or our competitor alone would do. This is an industry-wide, in association with medical associations and physicians, because you still have 1% or 2% of patients that have the thought that they may undergo some kind of procedure for obesity that really get to the operating room table. So the funnel -- if you think about a yield of 1% on this effort, that's significant amount of opportunity. I think we welcome those papers that were published. And we continue to be very bullish about any kind of bariatric procedure, either gastrectomy or Roux-En-Y. But we also think that Covidien has a phenomenal portfolio of products that fit that right into this procedure, and with Tri-Staple and the launch of Sonicision and our RF products such as vessel sealing, LigaSure. We feel that we're -- it's right in our sweet spot. But I want to remind everybody that yield is ridiculously low still. So the opportunity is great, but the hurdles are very high.

Operator

Our next question comes from Larry Keusch from Raymond James.

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

First, for Chuck. Chuck, the tax rate I think for the 6 months is at the lower end of the 17% to 18% guidance that you provided and you've talked about some of the tax planning strategies that have led to that performance thus far. How should we think about the influence of the tax rate or what would influence the tax rate, I should say, on a go-forward basis through the next 6 months of the fiscal year?

Charles J. Dockendorff

The biggest influences on the tax rate going forward would be, again, the mix of income and where we are in and around the world because we pay taxes in that and that drives a big part of our rate. And so the components that drive that would be foreign exchange changes and changes in our income mix that could have the impact on the rate up or down. The other one is there's some credits out there that need to be extended, the R&D tax credit, things like that are still not approved for the year but they typically do it every year, so that could have an impact as well. So would be the 2 bigger drivers within our tax rate going forward.

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

So just on that, is it fair to sort of think about that trending still towards the lower or could it come up in the second half of the year?

Charles J. Dockendorff

I think what we do is I think with our guidance now, we look at the full year income projections when we look at our tax rate, so we take that into consideration. So 17.2% year-to-date tax rate is our best guess for the full year at this point or best estimate.

Lawrence S. Keusch - Raymond James & Associates, Inc., Research Division

17.2% for the full year, okay, perfect. And then I guess the other quick question maybe for Joe is relative to -- I just want to get your thinking on the med tech tax, and again how you guys are thinking about dealing with that issue when it shows up, whether it be through attempting to drive some price increases, which I would think would be difficult in this environment or looking at some potential restructuring moves. Any thoughts there would be helpful.

Jose E. Almeida

Glenn, I have to process my answer by saying how absurd we think this tax is and how much of a penalty is imposed in the medical device industry. And with that said, I will say that this, for Covidien internally, we need to deal with this like we deal with any business issue. So we are not prepared to disclose how we're going to deal in terms of the treatment of the tax. But it's a business issue for us so there's cost reductions that we're attempting to put through to be able to offset. But all options are open and we're evaluating every single one of them.

Operator

Our next question comes from Glenn Novarro from RBC Capital Markets.

Glenn J. Novarro - RBC Capital Markets, LLC, Research Division

Two questions. One, on the increase in R&D, can you maybe talk a little bit about some of the projects or the area of focus or do we need to wait till September to hear more? And then just a quick on the split up. That's still on target for sometime in the first half of calendar 2013, correct?

Coleman N. Lannum

Yes, on the spin of Pharma, I don't think I'd be cute enough to say the first half of 2013. There's a lot of things that have to happen between now and then. We'll be very able to talk about that, that in September once we get some clarity on things. What I would say is you shouldn't expect even the Form 10 to be filed until early 2013 at the earliest. It would be subsequent to that, and of course, that's dependent on things like SEC review and a number of internal things that still have to get done before we'll have a more tight time schedule on that.

Jose E. Almeida

I just want to clarify that '13 is the calendar year '13. So it's not a fiscal year. So in terms of R&D increase, I'm not prepared to give you a list of our products that are in the pipeline, but I'd tell you that we have efforts, Glenn, in vessel sealing. So we continue to look for new generation of LigaSure. We're looking at the expansion of our Pipeline Embolization Device as well as the Neurovascular is a big focus for us, the Peripheral Vascular. We continue to invest in our stapling franchise and I want to highlight that we have a significant effort going on in emerging markets. We have 3 R&D centers and it's important that people understand that those R&D efforts are done in accordance with the global business units, but it's an effort led by emerging markets. So they're designing products for those markets. And they are looking at stapling, energy, all kinds of different products. They are designed exclusively for those markets. So we're very bullish about our R&D efforts. With that said, we'll continue to push for efforts for better efficiency and efficacy of that group.

Operator

Our next question comes from Jason Wittes from Caris.

Jason Wittes - Caris & Company, Inc., Research Division

Just 2 questions. The first one is I didn't see the emerging markets breakout, maybe I missed it. But I know you're spending heavily there. A, what was the growth in emerging markets? And B, what percentage of revenues does it work out to be this quarter?

Jose E. Almeida

The growth in the second quarter was 14%. The sales it's about even, so it's probably -- they'll run about $250 million, $260 million.

Coleman N. Lannum

Still about 10% of revenues.

Jason Wittes - Caris & Company, Inc., Research Division

Still about 10% of revenues. And then just sort of a clarification. I mean you basically mentioned Oximetry & Monitoring products, basically Monitoring driving growth there. I got the impression that the growth rate we saw this quarter is something that's probably going to continue into the next several and I also get the impression, if you could break it out, I assume Oximetry is still negative but the Monitoring business is actually growing quite significantly. Could you give us a little bit of parameters to kind of understand exactly what's going on there from that perspective?

Jose E. Almeida

Jason, we don't break below what we give you guys, and specifically, there are reasons why we don't do it. There are competitive -- we don't want our competitors to know specifically what the numbers are. You can always note that the U.S. number, looking at MIS -- I'm sorry, looking at the IMS data. I will say to you that we feel comfortable that, for the first time, our market share has stabilized. So we feel at par in terms of the fight that we are fighting right now, so that's as much as I can tell -- I can talk to you.

Jason Wittes - Caris & Company, Inc., Research Division

So I mean just to clarify, sorry, the Oximetry business is basically stabilized you're saying, and the Monitoring, I mean, just to follow up...

Jose E. Almeida

We have double-digit growth in that INVOS and BIS sensor. And the Oximetry business is stable, meaning we have not lost market share to our competitor like we did in previous quarters.

Coleman N. Lannum

These markets are continually becoming more ingrained. It's hard to talk per individual ones.

Operator

Our next question comes from Michael Matson from Mizuho Securities USA.

Michael Matson - Mizuho Securities USA Inc., Research Division

I guess, first of all, just wondering if there's any risk that some of this step-up in activity by the government to crack down on abuse of pain medications could hurt your Pharmaceutical business? There's been a couple articles written about that about some of these drugstores, I guess, the amount of volume of these type of drugs that they've been selling and just the abuse has exploded. So I understand you guys do everything you can to prevent that, but I'm just wondering if things really tightened up if that would potentially hurt your growth?

Jose E. Almeida

We're working very closely with the government, and we understand that the issues that the government has and we are a willing and participative part in that ongoing effort. At this point in time, we don't have any indications that, that's going to be detrimental to our business.

Michael Matson - Mizuho Securities USA Inc., Research Division

Okay, and then I just had a follow-up on superDimension. I was just wondering why you decided to put that business into the Endomechanical business versus your Airway & Ventilation business given that it is pretty capital-oriented and there's maybe a similar call point to the pulmonology specialty?

Jose E. Almeida

We don't have a call point into the pulmonologist in the respiratory business. What that business is acute care business, so the Oximetry business is intensive care and anesthesiologist. And the Ventilator is ICU as well. It's an intensive care and airway specialist, somebody who specialize in the hospital in making sure that the patient's airways are being ventilated properly. So the pulmonologist is a new call point. But why is that into the, what we call, our surgical business? Because that is a diagnostic tool that is used to accelerate an intervention in case of tumors in the lung, so that is more aligned to surgery than it is aligned to office diagnostic. That is a procedure that is performed at the hospital level and you're better off speaking to the surgeon who is doing that procedure as well as the pulmonologist. So that division. So first of all, this is new call point for Covidien, so we decided to put in a place where we think it will have more affinity with few further iterations of that product.

Operator

Our final question comes from Jonathan Palmer for CLSA.

Jonathan J. Palmer - Credit Agricole Securities (USA) Inc., Research Division

Just one quick follow-up on your emerging market coming. You talked about the accelerated growth plan in Asia and that being about 80% done by the end of the year. Does the profitability of those markets improve once that plan is kind of wrapped up?

Jose E. Almeida

It will slightly improve. Let me clarify what I said. The Asia growth plan is a plan we put together. It was a 3- to 4-year plan, we put together about 2 years ago and we're going to be at the end of the second year and we'll accelerate it. So what it is a hiring of 1,000 sales reps, primarily in China where pretty much we'll be about 80% there. What we are doing for next year, we're looking at acceleration plans in Brazil, acceleration plans in Russia and other places that will continue to provide investments in that business. So I want to clarify that the emerging markets business for Covidien, in terms of gross margin, is accretive to the Covidien average. So we make a lot of gross margin money in those markets. We are making a little less money on the operating income, which is, by the way, accretive to Covidien's average. Why? Because of the investment. So I get this question all that time. Our emerging markets business is highly profitable for Covidien. But once we finish the Asia growth plan and accelerate, then we're going to go into the Latin America, primarily the Brazil plan.

Coleman N. Lannum

Thanks, everyone. I just want to say something as we wrap up here. As you know, we try to experiment this quarter to do earnings on Friday mornings so there wouldn't be such a rush of people announcing at the same time. Let us know what you think about it. If you think this is a good thing or a bad thing, I want to hear what you think of it.

In addition, 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've listened to the call and have additional questions, please contact Eric Kraus, our Head of Corporate Communications. And for analysts having more detailed questions involving nonmaterial information, Todd and I will be available to take your calls throughout the day. Thanks, and have a great day.

Operator

Thank you, ladies and gentlemen, that concludes your conference call. You may now disconnect. Thank you, all, for joining, and have a very good day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Covidien's CEO Discusses Q2 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts