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St. Jude Medical, Inc. (NYSE:STJ)

Q4 FY07 Earnings Call

January 23, 2008, 9:00 AM ET

Executives

Daniel J. Starks - Chairman, President and CEO

John C. Heinmiller - EVP and CFO

Eric S. Fain, MD - President, Cardiac Rhythm Management Division

Analysts

Glenn Reicin - Morgan Stanley & Co.

Tao Levy - Deutsche Banc Securities

Kristen Stewart - Credit Suisse

Frederick Wise - Bear Stearns

Michael Weinstein - JP Morgan

Operator

Welcome to the St. Jude Medical's Fourth Quarter 2007 Earnings Conference Call. Hosting the call today is Mr. Dan Starks, Chairman, President, and Chief Executive Officer of St. Jude Medical.

The remarks made during this conference call include forward-looking statements within the meanings of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Such forward-looking statements include the expectations, plans and prospects for the company, including potential clinical successes, anticipated regulatory approvals, and future product launches and project revenues, margins, earnings, and market shares. The statements made by the company are based upon management's current expectations and are subject to certain risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. These risks and uncertainties include market conditions and other factors beyond the company's control and the risk factors and other cautionary statements described in the company's filings with the SEC, including those described in the company's Annual Report on Form 10-K filed on February 28, 2007, and quarterly reports on Form 10-Q filed on August 9, 2007 and November 2, 2007.

The company does not intend to update these statements and undertakes no duty to any person to provide any such update under any circumstances. At this time all participants have been placed on a listen-only mode and the floor will be open for questions following the presentation.

It is now my pleasure to turn the floor over Mr. Dan Starks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Thank you very much, Sharona. Welcome everyone to the St. Jude Medical's fourth quarter and full year 2007 earnings conference call.

With me on the call today are John Heinmiller, Executive Vice President and Chief Financial Officer; Eric Fain, President of our Cardiac Rhythm Management Division; Mike Rousseau, Group President; Joe McCullough, Group President, and Angie Craig, Vice President of Corporate Relations.

Our plan this morning is for John Heinmiller to provide his normal review of our fourth quarter and full year financial results for 2007 and to give sales and earnings guidance both for the first quarter and full year of 2008. I will then address several topics and open it up for your questions.

And with that, I'll turn it over to John.

John C. Heinmiller - Executive Vice President and Chief Financial Officer

Okay Dan. Sales for the quarter totaled $1.018 billion, up approximately 18% over the $864 million reported in the fourth quarter of last year. Favorable foreign currency translations versus last years' fourth quarter increased this quarter's sales by about $41 million.

For the full year 2007, net sales were $3.779 billion, up about 14% over 2006. Favorable foreign currency translations versus those in 2006 increased 2007's net sales by approximately $100 million.

During the fourth quarter, we recorded after-tax charges of $71 million, approximately $50 million of which are non-cash items, including asset impairment charges and write-offs of inventory related to discontinued products. The remaining charges are primarily associated with initiatives being undertaken to streamline the company's operations,

Comments during this call referencing fourth quarter results and our guidance for 2008 including earnings per share amounts will be exclusive of these charges. Additionally, comments during this conference call referencing 2007 full year operating results, including earning per share amounts, will be exclusive of special items referenced in previous 2007 quarterly conference calls.

Earnings per share were $0.54 for the fourth quarter of 2007, a 38% increase over adjusted earnings per share of $0.39 in the fourth quarter of 2006. For the full year 2007 earning per share were $1.85, a 21% increase over adjusted earnings per share of $1.53 for the full year 2006.

Before we discuss our fourth quarter 2007 sales results by product category, with guidance for 2008, let me comment on the currency exchange rates we're using currently in our outlook for 2008. The two main currencies influencing St. Jude Medical's operations are the euro and the yen. For the euro, we are assuming each Euro will translate into about $1.44 to $1.49, and for the yen we are assuming each 103 yen to 108 yen will translate into $1.

Now for the sales... now for the discussion of sales by product category. For the fourth quarter total Cardiac Rhythm Management sales, which include revenue from both our ICD and pacemaker product lines, were $637 million, up 19% from last years' fourth quarter.

As we announced earlier this month, we estimate that included in our fourth quarter CRM sales was approximately $20 million of revenue related a competitor's recall of an ICD lead. This should be viewed as a one-time benefit.

Total CRM product sales for the full year 2007 were $2.369 billion, representing a 15% increase over 2006.

For the fourth quarter, ICD sales were $358 million, up 24% from last years' fourth quarter and above our previous guidance that ICD sales would be in the range of $310 million to $340 million this quarter.

U.S. ICD sales were $230 million, up 12% from last years' fourth quarter. International ICD sales were a $128 million, a 52% increase over the fourth quarter of 2006 with $12 million of the increase due to favorable foreign currency translations.

For the year 2007, ICD sales were $1.305 billion, up 19% versus 2006. Favorable foreign currency translations versus those used in 2006 increased 2007 ICD sales by approximately $30 million.

For low voltage devices, sales for the fourth quarter totaled $279 million, up 13% from last year's fourth quarter and above our previous guidance that pacemaker sales would be $260 million to 275 million this quarter.

In the United States, pacemaker sales were $128 million, an 8% increase compared with last year's fourth quarter. In our international markets, pacemaker sales were approximately $151 million, up 18% from the fourth quarter of 2006, including a $13 million increase due to favorable foreign currency translations.

For the year 2007, pacemaker sales were $1.064 billion, up 11% over 2006. Favorable foreign currency translations versus those used in 2006 increased 2007 pacemaker sales by approximately $33 million.

As we have previously stated, we view our ICD and pacemaker business as a single integrated business characterized by interdependent growth dynamics that is best looked at on a consolidated basis instead of as separate product lines. As a general rule, the same sales force presents both product lines to the same customers. All ICDs have pacemaker functionality in them. Many patients are indicated for both an ICD and for a pacemaker leaving it to physician and patient discretion, whether the device of choice for a particular implant will be an ICD or a pacemaker.

The pacemaker market has grown faster than the ICD market, each of the last two years. And we have roughly similar shares of both market segments and expect both market segments to grow at single-digit rates in 2008. For these and related reasons, we think it is more predictive and more meaningful to provide sales guidance on a consolidated CRM basis and not separately for ICDs and pacemakers. And we will begin doing so starting this quarter. We will, however, continue to report actual sales results separately for ICDs and pacemakers.

Given that introduction, for the first quarter of 2008, we expect total CRM sales to be in the range of $600 million to $630 million. And for the full year 2008, we expect total CRM sales to be in the range of $2.6 billion to $2.7 billion, up approximately 10% to 14% versus 2007.

Atrial fibrillation or AF product sales for the fourth quarter totaled $117 million, up 29% over the fourth quarter of last year and above our previous guidance that AF product sales this quarter would be in the range of $100 million to $110 million.

For the full year 2007, AF product sales were $410 million, an increase of 26% over 2006. For the first quarter of 2008, we expect AF product sales to be in the range of $105 million to $115 million. We expect full year 2008 AF product sales to be in the range of $490 million to $520 million.

Total sales of cardiovascular products for the fourth quarter of 2007 were $205 million, up 9% over the fourth quarter of 2006. Total cardiovascular product sales for the full year 2007 were $790 million, up 7% over 2006.

Within this category of products, sales of vascular closure products in the fourth quarter of 2007 were $91 million, a 5% increase over the fourth quarter of 2006. Total vascular closure product sales for 2007 were $355 million, up 4% over 2006. Sales of heart valve products in the fourth quarter of 2007 were $74 million, a 12% increase over the fourth quarter of 2006. Total sales of heart valve products for 2007 were $290 million, up 7% over 2006.

For the first quarter of 2008, we expect cardiovascular product sales to be in the range of $190 million to $205 million, and we expect full year 2008 cardiovascular product sales to be in the range of $820 million to $845 million.

Total sales of neuromodulation products in the fourth quarter of 2007 were $59 million, up 18% from the fourth quarter of 2006. For the full year 2007, neuromodulation product sales were $210 million, up 17% over 2006. For the first quarter of 2008, we expect sales of neuromodulation products to be in the range of $53 million to $58 million, and we expect full year 2008 neuromodulation sales of $230 million to $245 million.

Let me pause at this point and recap our 2008 full year sales guidance. For Cardiac Rhythm Management devices, we expect sales for 2008 in the range of $2.6 billion to $2.7 billion. Sales of our AF products for 2008 are expected to reach $490 million to $520 million. We expect sales of neuromodulation products to be $230 million to $245 million, and for cardiovascular products we expect 2008 sales in the range of $820 million to $845 million. If you add up the sales across all growth platforms, total sales in 2008 are expected to be $4.140 billion to $4.310 billion.

The geographic breakdown of St. Jude Medical sales in the fourth quarter of 2007 was 53% in the United States versus 47% outside the United States or OUS. This compares to 57% U.S. and 43% OUS in the fourth quarter of 2006. A detailed geographic breakdown of this quarter's sales by product shows high voltage at $230 million U.S, $128 million OUS; low voltage at $128 million U.S., $151 million, OUS; atrial fibrillation products at $50 million U.S. and $67 million OUS; cardiovascular products at $83 million U.S. and $122 million OUS; and finally, neuromodulation products at $51 million U.S. and $8 million OUS.

The gross profit margin this quarter was 73.8% representing a 130 basis point improvement over the fourth quarter of 2006 and up 20 basis points sequentially from the third quarter of 2007.

For the full year 2007, the gross profit margin was 73.5%, an improvement of 70 basis points over 2006. For the full year 2008, we expect gross profit margins to be in the range of 73.5% to 74.0%.

For fourth quarter, SG&A expenses were 36.1% of net sales compared with 37.0% in last year's fourth quarter and 36.4% in the third quarter of 2007, primarily reflecting the leveraging of the investments made in our U.S. field sales and support organizations, and market development programs beginning in the second quarter of 2006.

For the full year 2007, SG&A expenses were 36.6% of net sales compared to 36.2% in 2006. For the full year 2008, we expect SG&A as a percentage of net sales to be in the range of 36.0% to 36.5%.

Research and development expenses in the fourth quarter of 2007 were 12.2% of net sales compared with 12.5% in the fourth quarter of 2006. For the full year 2007, R&D expenses were 12.6% of net sales compared with 13.1% in 2006. For the full year 2008, we expect R&D expenses to be in range of 12.0% to 13.0% of net sales as we continue to balance delivering short-term results with the right investments and long-term growth drivers.

Other expense was $1 million in the fourth quarter, and for the first quarter of 2008, we again expect the other income and expense line item will be a net expense of approximately $1 million. For the full year 2008, we expect the interest income earned on cash and cash equivalents to slightly exceed the interest expense related to our outstanding debt resulting in other income of approximately $2 million to $5 million for the full year.

For 2007 our effective income tax rate was 27.0%. For 2008 we expect the effective income tax rate to be in the range of 27.0% to 27.5%. This rate anticipates the extension of the Federal Research and Development credit for 2008. To the extent it is not extended, our overall effective tax rate would increase. And we have also assumed extension of the Federal Research and Development credit in the earnings per share guidance being provided for 2008.

Moving on to the balance sheet, at the end of December 2007 we had $389 million in cash and cash equivalents and $1.388 billion in total debt. The outstanding debt on our balance sheet includes $1.2 billion of 1.2% senior convertible debentures issued during the second quarter of 2007, and 182 million of notes issued in Japan which are due in 2010 and can vary interest at a fixed rate of 1%.

Next, I want to offer some comments regarding our earnings per share outlook for the first quarter and the full year 2008. In preparing our earnings per share guidance, we have assumed that in the first quarter of 2008, the share count used in our fully diluted EPS calculation will be about 353 million to 355 million shares with the weighted average outstanding shares for the full year 2008 estimated at 358 million to 360 million.

The company expects consolidated earnings per share for the first quarter of 2008 to be in the range of $0.50 to $0.52. And for the full year 2008, we expect consolidated earnings per share to be in the range of $2.08 to $2.13.

I will now turn it back to Dan Starks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Thank you, John. I would like to begin by thanking all 12,000 of St. Jude Medical's employees for their contributions to our outstanding accomplishment of delivering our first quarter with over $1 billion in sales. This sales volume translates into an estimate that another St. Jude Medical device helped save or improve a human life, an average of approximately once every three seconds of every hour of every business day somewhere around the world. The employees who make up St. Jude Medical truly are a special group of people who are making life better for millions of people.

I would like to address my next comments this morning to highlight a number of St. Jude Medical's accomplishments during 2007 and then look forward to 2008. First, all of us at St. Jude Medical are pleased that our growth and success in 2007 was so broad based. For each quarter in 2007, every major segment of St. Jude Medical's business contributed to our growth, market share gains or both. The fourth quarter of 2007 was particularly illustrative.

Over 85% of our global revenue grew at double-digit rates during the fourth quarter compared with one year ago. This includes revenue growth of 29% in our atrial fibrillation business. 24% in our ICD business, 18% in our neuromodulation business, 13% in our pacemaker business, and 12% in our heart valve business.

It is even more noteworthy that all of these same businesses grew at double-digit rates for the full year 2007, with a single exception of our global heart valve business where revenue grew 7% for the full year. This validates our decision in April 2006 to expand our investment in the people, products and programs needed to drive our success long term rather than cut spending in April 2006 to maximize short-term results.

A second highlight of this past year is that we delivered on our commitment to improve our operating profit margin beginning in the second half of 2007. During the third and fourth quarters of 2007, gross margin improved 50 basis points versus the first half of the year.

SG&A as a percent of sales dropped 60 basis points over the same period. We do not expect ongoing productivity gains to be linear, but we are on track to achieve our goal of improving our operating profit margin to approximately 29% by 2012.

Another major goal we set for 2007 was to deliver full year earnings per share in the range of $1.70 to $1.75. We met and exceeded this goal by delivering adjusted earnings per share of $1.85 representing 21% growth for the full year 2007.

As we turn next to 2008, we look forward to hosting each of you in person or by Internet in our Annual Investors' Conference on February 8 where we will update you on our new product pipeline for the coming year. At that meeting, we also will discuss other key components of our 2008 and long-term growth programs.

I would like to focus the remainder of my comments on our expectations for our Cardiac Rhythm Management business in 2008. We expect the $10 billion global market for ICDs and pacemakers to grow at a mid to upper single-digit rate or around 5% to 7% on a combined basis in 2008.

Within this market St. Jude Medical is positioned better than ever to gain ICD share. Our Merlin Patient Care System is now fully deployed in most major markets. We began full launch of Merlin.net, our next generation remote patient care system only two months ago. We launched our Current and Promote RF ICDs in the United States and other major markets just one month ago. We are first to the market with the advantages of a consolidated hardware platform for ICDs and pacemakers.

We are leaders in connectivity with electronic medical records. We are the only manufacturer with a 7 French high voltage lead and recently announced regulatory approval for our second generation of 7 French high voltage leads.

We are just beginning to leverage the competitive advantages of our unique QuickOpt timing optimization technology, our OptiSense lead technology and our QuickFlex family of CRT leads. The market does not yet fully realize this. But while our competitors have focused on other priorities appropriate to their circumstances, St. Jude Medical has emerged with the leading portfolio of products for the ICD and pacemaker market in a full product pipeline. We look forward to providing you additional details at our February 8 investors' conference.

I want to highlight an additional reason why St. Jude Medical is better positioned than ever to gain ICD market share in 2008. The strongest product portfolio in the world is useless unless it is properly represented and supported in the field. We went to extraordinary lengths over the last two years to expand our field sales and support organizations on a global basis to ensure that when the product portfolio was ready, all of St. Jude Medical will be prepared to leverage it. For example, the 450-person expansion of our U.S. field sales and support organizations is now mature. Non-compete restrictions are largely behind us. Training is complete. Most of our new employees are now fully engaged with their core job responsibilities giving our entire field organization more time to devote to value-added customer activities.

Last but not least, the fact that St. Jude Medical has dramatically transformed itself as a company is beginning to be recognized in an encouraging volume of meaningful new contracts, potentially accelerating our selling cycles. All of these dynamics have converged as we enter 2008 to position St. Jude Medical better than ever to gain ICD share for the 8th year in a row.

In the interest of time, I will defer comments on our expectations for the remainder of St. Jude Medical's business in 2008 to our investors' conference on February 8. However, suffice it to say that the breadth and depth of our growth across all of our major product platforms in 2007 reinforces our confidence that we are investing in the right markets and that our long-term growth program is on track.

I'd like to allocate our remaining time this morning for all of us to answer your questions. Please limit yourself to two questions, so we can get to as many people as possible. And with that, I'd like to turn the call back to our moderator, Sharona and ask you to please begin the questions.

Question And Answer

Operator

[Operator Instructions]. Thank you. Our first question is coming from Glenn Reicin from Morgan Stanley. Please go ahead.

Glenn Reicin - Morgan Stanley & Co.

Yes. Good morning folks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Good morning.

Glenn Reicin - Morgan Stanley & Co.

A couple of questions. One easy one for John and then a product question. John, I'm just curious why you're electing not to repurchase stock this quarter or this year. They creep up, to me, in the share count that's costing you between $0.05 and $0.07. I'm curious given your cash position why you wouldn't do that. And then Dan, just with respect to your calculation for the one-time effect for the ICDs from the Fidelis recall. Can you go through the math and how you came up with that number? Thanks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

John, I appreciate that you're not going to directly answer Glenn's question. Do you want to make any comments on the topic of cash and cash management and the outlook for 2008?

John C. Heinmiller - Executive Vice President and Chief Financial Officer

I think that as you would point out our balance sheet provides a lot of flexibility. We have had a strong cash flow here during 2007. It positions us well as we work to pay off the debt that will come due here at the end of 2008. And then we have a lot of flexibility to pursue a number of opportunities including buyback shares. We currently do not have an authorization from our Board of Directors to do a share buyback. So, we completed that authorization earlier in 2007.

Glenn Reicin - Morgan Stanley & Co.

So, would I be spinning it, if I said that your share count projections or estimates are a worse case scenario? Are those really probable outcomes?

Daniel J. Starks - Chairman, President and Chief Executive Officer

I don't think we could weight that for you, Glenn. There is the possibility of upside to the share count. But the share count that we've given you, I wouldn't characterize it as worse case or best case. I'd just characterize it as our best estimate with today's data.

Glenn Reicin - Morgan Stanley & Co.

Fair enough.

Daniel J. Starks - Chairman, President and Chief Executive Officer

With respect to the $20 million estimate of one-time impact of Medtronic's device recall, we looked at it from a number of different perspectives. We looked at it on an internal basis, with a number of... with quite a little bit of data that we don't provide publicly. That includes kind of the internal forecasting that we generated prior to our being aware of the Medtronic's recall. And then what happened to the actual sales results versus what we expected to see prior to the notice of the recall. We also used a qualitative data from our global field organizations to give us their best assessment of what impact the Medtronic's recall had on their sale success during the fourth quarter. And we also used the other... the forecasting for Q1 here of 2008 to sort through how much of the run rate from the fourth quarter did we expect to see continue into the first quarter. So, those were three of the methodologies that we used.

And then in addition, if you look at our sequential quarter sales trends, both in 2007 and historic periods, it's always tricky because there always are unusual dynamics either by way of product launches or competitive dynamics or other market dynamics in different periods. But still if you could see that our sequential quarter trend in ICD sales results from Q3 to Q4 of 2007 was really a very normal trend and very similar to the trend that we saw one year prior.

On the international side, however, you see that the sequential quarter gain Q3 to Q4 2007 was quite a bit higher this year than it was in last year and then we typically see in prior periods. So what we really saw was very little impact from Medtronic's recall to our U.S. ICD and pacer sales. We... There undoubtedly was a little bit of impact that would be very difficult to quantify, and that typically wouldn't be on our radar screen. Where the real impact was, was international, and within international their real impact was in Japan. So, it was almost entirely a Japan sales impact for the fourth quarter for St. Jude Medical. The rest of our business was largely unaffected with respect to fourth quarter results.

In Japan, we picked up both additional high voltage lead sales without an additional ICD. We also picked up additional ICD system sales with both the ICD and the lead. The sales gain, the one- time sales gain in Japan, besides the high voltage leads sold on a standalone basis, the additional gain was primarily in the dual and single chamber ICD side of things. We didn't really pick up much CRTD in Japan on a one-time basis because we did not yet have B2B timing in our CRTD platform in Japan. So, most of the CRTD sales went to Boston Scientific or to one of the other players during the fourth quarter in a way that we would expect to be a one-time basis.

So, and then additionally just to round out our assessment of impacts of Medtronic's recall on our fourth quarter results. We really didn't see customers outside of Japan unable to get leads from Medtronic. So, we're actually not aware of a single customer in the United States, for example, who could not get Quatro leads from Medtronic during our fourth quarter. So, there evidently was quite a nice inventory built up with the time of Medtronic's advisory, is our assessment based on all of the field data that we saw.

Glenn Reicin - Morgan Stanley & Co.

Okay.

Daniel J. Starks - Chairman, President and Chief Executive Officer

That's about the best answer I can give you.

Glenn Reicin - Morgan Stanley & Co.

Can I push you on two items on Japan?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Yes, then we go on to the next question. So, go ahead.

Glenn Reicin - Morgan Stanley & Co.

Okay. I just want to understand a little bit about the impact of the change in ownership of the Guidant infrastructure over there, and how you sort of look at that as being a contributor. And then can you talk a little bit about the lead to generator ratio? And why do you think that, that has permanently changed for you guys being the only 7 French company out there?

Daniel J. Starks - Chairman, President and Chief Executive Officer

On the first part of your follow-up, the best information of course would be from Boston Scientific or directly from Lifeline Medical in Japan. And I would refer you to them to get clarity and to make sure that the information that we have is exactly correct. The information that we have from our Japan organization which historically has been extremely reliable, is that Japan Lifeline still has the Boston Scientific CRTD line. Sherring [ph] evidently does not yet have approval for CRTD in Japan. So, I think there was continuity in the business with respect to CRTD, but again check that information with the organizations. They are actually quite a bit closer to the product lines.

On lead to device ratios, we clearly saw in increase in our lead to device ratios. We will need some time. I think we'll need the next two quarters to see how much of that sticks and how much of that was one time. No question that a meaningful amount of that increase is one time there. We clearly had standalone high voltage lead sales in the fourth quarter that we do not expect to see recur. The good news is any time customers get in a new experience with our product line including with our leads, the experience is far more often than not a very favorable experience in any time that you generate a new favorable experience with your products. With the new customer you have built up some goodwill. You've increased your credibility. All of that is helpful to a selling cycle. All of that is helpful to the opportunity to shift share long-term. But we would not expect a dramatic uptick on a permanent basis in our lead to can ratios on the basis of a single quarter's experience when a competitor has a product outage during that same period. So... that's probably about the best I can do to answer your questions. And let's ask Sharona to please move on to the next questioner. Sharona, would you like to take the next question?

Operator

Our next question is coming from Tao Levy from Deutsche Banc. Please go ahead.

Tao Levy - Deutsche Banc Securities

Hi good morning. It's Tao Levy here, Deutsche Banc. So, my first question, maybe you could give us a sense of how Q4, I guess in the U.S market shaped up for ICDs in the sense of... was there a key major headwind from Medtronic's recall? Obviously we don't have everyone's numbers but just qualitatively what were your sales reps telling you?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Qualitatively, Tao we did not see a change in the U.S market growth for ICDs during the fourth quarter. The... and maybe the best way to answer it is that the growth in the U.S. ICD market in 2007 has been and still is slow. There is growth more on the replacement side than on the de novo implant side. No question about that. All of that nets out to very slow growth in the U.S. ICD market. We... when we've indicated in the past that looking forward into 2008 we have given you a number for the combined pacing and ICD market growth in our own internal modeling. Inside that we'd expect to see the ICD market itself grow at an upper single-digit rate with the idea that in the U.S. everything we saw on the fourth quarter is consistent with our expectations that the U.S. market will grow slightly. In 2008, we expect a low to mid-single digit growth on the US side. We expect a mid to upper teens growth again on a currency neutral basis in international markets total for the ICD side. So all of that nets out to our expectation that in 2008 we'll see upper single-digit growth in the ICD market. And that's probably the best way to answer your question.

Tao Levy - Deutsche Banc Securities

And since you mentioned the assumptions in your guidance for the ICD part, maybe could you also mention on the pacemaker side?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Yes, on the pacemaker side, we... first, we are looking forward to seeing the other major players' numbers for the fourth quarter here to update our model. But based on our view today, it's a little bit striking that pacer market has grown faster than ICD market here in 2007. It really seems to have grown at or above the mid single-digit rate. And we're not counting on that for 2008, although we do note that there has been a surprising level of growth in the pacemaker market. For 2008 we are assuming something in the range of low to mid-single digit growth for pacing. There may turn out to be some upside to it. I think if the ICD market grows a little slower, we'll probably see that pacer market grow a little faster and vice versa.

Tao Levy - Deutsche Banc Securities

And just for John, if the tax credits don't continue, what impact do we see on that rate that you mentioned?

John C. Heinmiller - Executive Vice President and Chief Financial Officer

We... the tax rate is worth about a penny a quarter to our earnings per share. And the way the accounting rules work that... if this extension is not in place through legislation as we prepare our first quarter results we'll have to wait. And then there will be... hopefully, ultimately if the extension is put in place, then there'll be a reversal of that. And we've seen this in the past. So that's what we're dealing with.

Tao Levy - Deutsche Banc Securities

So right now in Q1, Q2 you'll assume the tax credits go through. So it's worth about a penny, is what you're saying?

John C. Heinmiller - Executive Vice President and Chief Financial Officer

We think ultimately it will be in place for calendar 2008. And then it's just a matter of when does that happen? And can we factor that into our rate calculations?

Tao Levy - Deutsche Banc Securities

Okay, great. Thanks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Sharona, go ahead.

Operator

Our next question is coming from Larry Biegelsen from Wachovia. Please go ahead.

Unidentified Analyst

Thanks. Good morning. It's Steve Bishop [ph] for Larry. On the R&D line, the guidance for 2008 gives a fairly big range. Can you give us an idea of what the drivers are there in R&D? And sneaking in with that question, can you comment on expectations for clinical trials in 2008 for St. Jude and for CRM more broadly?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Steve, the one reason that the R&D percentage has a little bit of spread to it is that our total sales range has a little bit of spread to it. So, even if we had a precise... if we were to give you a precise dollar amount for R&D spending which we of course have in our operating plan, but which we're not going to provide to you. If we gave you the precise dollar amount, we still have a range on what R&D will be as a percent of sales. So that's the really the primary factor. And it's that... the percentage is volatile as the quarters, the sales in each quarter tend to be lumpy, stronger and weaker, and stronger and weaker and...but the actual spending on the R&D side is far more stable than that.

Having said that we do make adjustments to all of our investments as we go through the year depending on how strong when sales are coming in. So, if sales are coming in weaker we will be more disciplined on the discretionary margin of some of our investments including on the R&D side. If sales are stronger, we'll go deeper into our list of... into our wish list of additional projects that we'd like to fund if the environment permits. So all of that is what we take into account in offering up a rate. I think as the percentage sales growth increases, one might see the R&D as a percent actually dropped a little bit even though the R&D spending would continue to expand. Because we tend to lag sales growth a little bit with our ability to cost effectively expand R&D projects.

On the topic of clinical trials, we have such a strong product pipeline, such a full product pipeline. A lot of the new products are surrounded by clinical trials. On a market development basis, we have again a full portfolio of additional clinical trials from the perspective of attempting to better risk stratify patients who will benefit from our technology. We also have quite a little bit of clinical trial work intended to really research and give us answers to new scientific questions to spark additional product development. So, I'm not going to... I'm not able to give you specifics. But we just have... every one of our divisions has a full portfolio of clinical trials. And to go through it would be far beyond what we can do on the call. We will offer some additional information on major clinical trials at our February 8 investors' conference, but I couldn't do much better for you this morning.

Unidentified Analyst

Okay, thanks Dan. Back to the commercial side, can you give us any more color on in the fourth quarter, what might be some indicators of the extent to which you can take advantage beyond the $20 million one-time gain of the disruption in the market? Can you tell us anything about your entry into new accounts, how many new accounts you might have been able to access and what might be the trends in the market in terms of the use of 7 French leads? And then if you would talk about Durata. We haven't heard much on that from you this morning.

Daniel J. Starks - Chairman, President and Chief Executive Officer

There are a number of leading indicators for our confidence that we will continue to gain ICD share in 2008. They are the same leading indicators that we have offered a number of times. It does include first ICD implants in new accounts. So, we continue to gain first ICD implants in new accounts in each of our four quarters in 2007 and again in the fourth quarter of 2007. So, similarly to prior years, that's where one of our strongest leading indicators. And that was positive for us and has contributed to our confidence. It will continue to gain share in 2008.

Another leading indicator that we focus on a number of times is the footprint that we have in follow-up clinics where the follow-up is both pacers and ICDs and the market share that we have of the programmers. And so that our launch of the Merlin Patient Care System was a major event for us, a number of quarters ago. We looked then at the... at our gain of pacemaker market share. We looked at the delta between our pacer share and ICD shares about 3 points... 3 or 4 points in the U.S. And so that's a leading indicator. That would indicate the degree of training and acceptance and at times, preference for our programmer in follow-up clinics. And it's easier for the follow-up clinics to use the same programmer for their pacer and ICD patients particularly given the pacemaker technology inside every ICD and the way that, that's among the parameters that are viewed and managed during the time of follow-up. So, those would be a couple of the major leading indicators.

Another leading indicator, of course, is expansion of our field sales force. The start-up time with new people in the field, the start-up time that is eaten up by non-compete agreements and then our experience with what the normal upward trend is when people who are experienced in the field come off there when you are non-competes and re-engaged with their customers. So, those would be three of them.

And the... with that maybe I would ask the President of our Cardiac Rhythm Management division, Eric Fain. If... Eric, if you would like to comment on the Durata lead that we announced recently. And after then we'll go on to the next questioner? Eric, what's... what would you like to say about the Durata lead?

Eric S. Fain, MD - President, Cardiac Rhythm Management Division

So for the Durata lead, we're just launching that now. So in terms of initial feedback we had some... did our new technology assessment in accounts. The feedback was very favorable. The response to Riata as being the only 7 French lead in the market still continues to be a driver force. And the Durata... the changes in the Durata lead are really second generation for that 7 French lead. We expect that to be... also viewed very positively.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Sharona, would you take the next question please?

Operator

Your next question is coming from Kristen Stewart from Credit Suisse. Please go ahead.

Kristen Stewart - Credit Suisse

Hi, good morning. And just as a point of clarification. The $20 million that was the benefit from Medtronic's lead recall, is that only in the ICD business? Or did you see anything affecting the pacemaker side?

Daniel J. Starks - Chairman, President and Chief Executive Officer

We're estimating that there was a very small amount of pull-through on the pacemaker side, but really very little. So it might be within the rounding, it might be $1 million or $2 million. At the same time our assessment is really a more qualitative than quantitative. So it's not a precise number. Our estimate of $20 million is really our best estimate but only an estimate.

Kristen Stewart - Credit Suisse

And then on foreign exchange, I know that you do not have any hedging contracts in 2004, 2005 or 2006. I was wondering if you can comment if you had any foreign exchange hedging contracts in 2007 and to what extent that has benefited the bottom line?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Let me just ask our Chief Financial Officer, John Heinmiller to come in.

John C. Heinmiller - Executive Vice President and Chief Financial Officer

We did not have any foreign currency contracts in 2007, and we don't have any in place right now.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Sharona, would you take the next question please?

Operator

Our next question is coming from Mark Richter from Jefferies & Company. Please go ahead.

Unidentified Analyst

Hello.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Yes, you are on the line Mark.

Unidentified Analyst

Actually, it's Dave Hertz [ph] from Gunamar [ph] Research. Couple of things. Congratulations for the solid quarter. Regarding operational improvement initiatives, what are you guys doing in terms of lean manufacturing, GPN, Six Sigma and how are you measuring these metrics into your overall metric?

Daniel J. Starks - Chairman, President and Chief Executive Officer

David, I apologize. We need to ask you to just restate that question, just a little bit of it came through garbled. What did you ask me about manufacturing?

Unidentified Analyst

Questions are, what are your operational improvement initiatives regarding like lean manufacturing, Six Sigma and GPN?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Yes, all of those initiatives are embedded in our manufacturing environments and our strong part of our corporate culture. We have strong programs training, and at the front end, a number of years ago, we began to train Six Sigma, further ago the net lean manufacturing techniques we work with, black belt, green belt, all kinds of... just all of the components, the components that you'd expect to see in a structured continuous improvement program relating not only to manufacturing but also to our product development environment and also to our non-operations, our business processes and general business activity. So we place a high priority and we provide significant training. We provide significant reward and we have structured programs with projects that are reviewed on a regular basis, across the board in all of our businesses with all of our major functions to set expectations for what level of productivity gain we're fighting for and then to measure and hold accountability and offer reward for our success in delivering those productivity gains.

So, everything that you are working to get at is if you were to come in and audit our continuous improvement processes, you'd be extremely impressed. And you'd find that we operate at a state-of-the-art level, always with the idea that there is far more improvement available to us. In addition, then the... we have... last year we closed down a significant new manufacturing facility in Puerto Rico. We will exit 2008 with ICD manufacturing beginning in Puerto Rico that will start improve our tax rate in 2009. We have other initiatives to expand manufacturing on a global basis commensurate with our global sales to leverage cost advantage manufacturing environments to the extent that we can do that with good efficiency to our quality, and good efficiency to our ongoing product improvements and ongoing product development.

Then, we do have quite a bit of low-hanging fruit deliberately as a result of our significant expansion of our field sales and support organizations during the four quarters that began in the second quarter of 2006. So as we have indicated previously, we deliberately accelerated investment for a disciplined period with the idea that once that expansion was complete, we then would leverage it going forward to bring our financial ratios back toward best competitive benchmarks, which we've described as our goal of returning to 29% operating margin by 2012. So those would... those would be my major points.

Unidentified Analyst

How are you guys measuring metrics? I mean in terms of are looking at OE Arona [ph] and a lot of CEOs in your industry are measured on return on your net assets right now and that's helping them look at shareholder value. How are you being measured on that?

Daniel J. Starks - Chairman, President and Chief Executive Officer

John, do you want to comment any further on any specific metrics along that line?

John C. Heinmiller - Executive Vice President and Chief Financial Officer

Right. I think that as it relates to CEO measurement and that's really a Board matter that

Unidentified Analyst

Not only CEO measurement but the company as a whole, I'm not asking Dan, are you just comfortable telling about...

Daniel J. Starks - Chairman, President and Chief Executive Officer

I think let me just tell you David that what we've done is with the metrics that we are especially focused on are the metrics that we've already provided and that we regularly report on. And it would be what we'll focus on. We of course look at all kinds of metrics and all kinds of metrics versus best competitive benchmarks. Every metric that you would mentioned as part of our operating plan, part of our strategic plan, part of our assessment of where we're going to target the next structured continuous improvement priority. But what we would encourage people to particularly watch is the reduction of SG&A as a percent of sales, increase in gross margin and our maintenance of the healthy level of R&D as a percent of sales.

And with that, Sharona would you take the next question please?

Operator

Our next question is coming from Rick Wise from Bear Stearns. Please go ahead.

Frederick Wise - Bear Stearns

Hey Dan. Good morning everybody. Couple of things. Dan, you said in your prepared comments, if I understood you correctly is that with the non-competes completed. And this is the part that I didn't understand. Their major contracts available to you potentially accelerating selling cycles, if I wrote this down correctly. Can you, for this slightly sick of hearing, can you help me understand little more clearly what you meant? And does this suggest that there are some major contracts that could push numbers higher than you're forecasting or just give us some perspective.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Sure. Rick, first to the extent I convey the impression that our success in contracting in any way type to non-compete agreements, I didn't make myself clear. There is not a connection. I didn't mean to suggest there was one. And that if my remarks created that impression, I didn't articulate well and I apologize. They're entirely separate points. The point about the non-compete agreements was that... was again within the context of the significant expansion of our U.S. field sales and support organizations and the timing of our return on that significant expansion.

And then when I concluded commenting on contracts, I was actually moving on to another point, to kind of it was a bit of trifecta to say that our product line has become best in class with the full product pipeline, number one. Number two, our global field sales and support organization are reaching their prime. They have been substantially increased. We have significant depth, significant experience, significant training and the start-up time from our expansion is now partly behind us. And we're advancing in this next couple of years a primetime of return on that investment.

Then, I was making the third point that the besides that, besides products being really the strongest they've ever been with good momentum to sustain our best-in-class status, and besides having the global field sales and support organizations of on the ground and now running besides that... the way that we have improved the value we bring to customers, the way that we have dramatically transformed ourselves as a company over the last several years is beginning to be recognized in an encouraging volume of meaningful new contracts. So, I was making a third separate point that is part of the convergence of dynamics that leads us better position than ever to gain ICD share in 2008.

With respect to specifics on the contracting side, our customers are very sensitive about having their names thrown about by industry. And so we don't want to really offer customer level information about contracts. But a factor that we're very focused on and that just by way of working to make ourselves transparent, we're working to win share is that selling cycles are very significantly affected by contract status. And their contracts are one-year contracts, two-year contracts. There even are contracts for practical purposes turning out to be three-year contracts. When we strengthen ourselves, but we're outside the contracts, we have a significant barrier to fight through. And we've been doing that now, a number of years running. But we've made a lot of progress fighting through additional contract barriers in 2006 and then even more so in 2007.

And so once you've gained contract status, that doesn't mean... sometimes it does but by and large that does not mean an automatic increase in sales. But that means that a significant barrier is now gone and now you have really taken a major step through your selling cycle where you're going to start to get an increase in participation in the implant rotation in the centers or in the chains or in the national organization or et cetera that you have gained some contract status here. That was my point.

Frederick Wise - Bear Stearns

Very helpful. Just one quick follow up. When I was up at the Boston AF meeting last week, I heard a number of physicians speak about the newly launched version of EnSite, your imaging system for AF. And several doctors just in private conversation said to me that they thought that now your imaging capability was as good as anybody. Maybe some perspective or insight and how do we think about the impact that's going to have on your AF business going forward? And does this potentially accelerate because you now have... you've plugged the key hole there? Does this potentially accelerate growth on the AF side? Thanks so much.

Daniel J. Starks - Chairman, President and Chief Executive Officer

On the topic of accelerating growth, I would caution one not to be greedy. 29% growth is pretty decent. And we would be happy to sustain a 29% growth on our AF business. On the EnSite, this is just a good example of the value of combining technologies and the value that we can bring to good technology platforms as an acquirer. As a standalone business, Endocardial Solutions had a great technology. They had some leading intellectual property. And they were really under-funded to fully leverage all their fruits of their brain power. We've been able now on a multi-year basis to significantly just expand the investment in advancing that platform. I think you're right that what we've done is we've leaped ahead.

And the feedback that we get is that the capabilities of our platform now have achieved best-in-class status, not as good as but best-in-class status. There is a number of unique capabilities in the EnSite imaging platform now. It's really a testament to our... both to the core technology of Endocardial Solutions originally and then to the leadership of our atrial fibrillation division and the creation... all the focus, all the energy that we've put into atrial fibrillation. So, what the feedback you're re getting on EnSite really is characteristic of the advances that we have made across the board in our atrial fibrillation program. And again as with the case of pacers and ICDs, we have a full pipeline of devices on atrial fibrillation side. And we expect atrial fibrillation to continue to be just a major... continue to be a very strong growth driver and to become increasingly significant as a percent of our total sales to drive our growth between here and 2012 and beyond.

Frederick Wise - Bear Stearns

Yes, that's a very helpful. Thanks Dan. I hope your cold gets better.

Daniel J. Starks - Chairman, President and Chief Executive Officer

No, I'm trying to hide it. But thank you. And then let's see. I'm going to take one last question. And then we're just unfortunately out of time. Sharona, would you take one last question please?

Operator

Our next question is coming from Mike Weinstein from JP Morgan. Please go ahead.

Michael Weinstein - JP Morgan

Thank you. Can you hear me?

Daniel J. Starks - Chairman, President and Chief Executive Officer

Yes Michael. Go ahead.

Michael Weinstein - JP Morgan

Thanks. I thought I got lost after the manufacturing Q&A.

Daniel J. Starks - Chairman, President and Chief Executive Officer

No, you're coming through loud and clear.

Michael Weinstein - JP Morgan

Okay, good. Let me just clarify a couple items. Dan, I want to get a better sense on and where you are strategically with the company with portfolio. And there was a question early on in the call about... on share count and why the share count rises so quickly and isn't the company buying back stock? But my question is probably a couple of parts. One, I just want to better understand how you're thinking about use of cash in 2008. Is it principally to set up to pay down of the debt? And then strategically Dan, for the portfolio, if you think about the mix of markets that the company is in right now, you're re obviously gaining share pretty consistently in CRM. And you should gain share this year in heart valve. But the only two businesses you're in right that are double digit growth markets are AF and neuromodulation. That's 17% of your sales. And if the company wants to be a double-digit grower over long term other than gaining market share, it seems like... it still needs to get into some higher growth markets. Can you maybe just talk little bit about that? I mean, it's great to be able to gain share every year but it's also a lot easier to be in faster growth markets. And should we could think about the company's shifting the mix of its business over the next couple of years? Thanks.

Daniel J. Starks - Chairman, President and Chief Executive Officer

Michael, let me start with the question of use of cash. Currently, as you indicated our current plan is to continue to pay down... continue to pay down debt. So that's the baseline. Going forward, we pay a lot of attention to maintaining the capacity of the flexibility to take advantage of any selected appropriate rigorously reviewed business development opportunities that might arise. So, we are always... give that a high place on our priority list to have that capacity and to have an amount of powder dry so that if the... all of the dynamics align. And a good acquisition is available to us that makes sense on a financial basis as well as on our strategic basis, and that makes sense and by all of the other factors that we use we can take advantage of it. So that's always a potential use of cash.

Similarly, the opportunity to buy back stock is always available to us. That you have seen us do it the last two years. And so we have a constant balancing of the best use of cash with respect to acquisition opportunities or keeping it available for potential acquisition opportunities on the one hand, and on the other hand, to the extent that it otherwise makes sense in stock buyback is going to make sense. Then we have... we keep that capability and we've done in the past. We won't be reluctant to do it in the future, if we think that's the best use of that amount of cash at the time. So, both of those alternatives are potential uses of cash in addition to our core activity on paying down current debt.

With respect to the mix of markets, it's a great topic, is one that we are regularly reviewing. The first thing I say though is that the pacer and ICD business, although it's not currently double-digit growth market continues to be just extremely opportune for St. Jude Medical and a source of significant available growth for St. Jude Medical. It has been to date that we expect it to continue to be going forward. And I will look forward to commenting more about that at our February 8 conference as well as I am planning to offer an overview of exactly what you're talking about Michael, with respect to mix and strategy. I will be offering a presentation on what we expect St. Jude Medical to look like several years out. And it's all actually exciting and it's... we pinch ourselves to be in the situation we're in. And I think we've got just a great opportunity going forward to continue to sustain our growth and deliver superior results.

The thing about the pacer and ICD business that, that we're not to overlook is even though the growth is mid-to-upper single-digit, it's growing. And the barriers to entry are huge. We're one of only three major players, and we consistently are gaining share and we are positioned to continue to gain share and even have an opportunity, knock on wood, upside to our guidance to accelerate our gain of share. So, that those are... it's not just a single-digit growth market. It's a single-digit growth market with unusual opportunity for St. Jude Medical and a huge one. So, think that as a strong pillar of growth going forward over the... is still over the next five years.

And then if you look at now where are the... just on a market growth basis, just as you said what's exciting. We were the first into the atrial fibrillation business. Now everyone understands that it's an exciting opportunity. We are at the forefront of it. It's a great place to be, lot of growth available. Where else is just a clearly a hot growth area of the medical device space. Neuromodulation, the breadth of opportunity for new growth drivers in the neuromodulation space is second to absolutely none. We said at the time that we were fortunate enough to bring our neuromodulation colleagues into the St. Jude Medical organization. We said that this then over the next 20 years, that this is going to be a huge. There are so many potential growth drivers. Some of them will fall out with clinical data that doesn't prove out. But a number of these new growth drivers are going to hit. We only need one or two of these new indications to end up turning into commercial opportunities, to develop the market, to create the reimbursement, to create the referral patterns, to have a really... just as bigger growth opportunity over the next 20 years as there is in the medical device space.

What we're not going to do is we're not going to chasse, just chase possibilities, high risk possibilities. So, every dollar or euro or yen, that we earn we hold very dearly. There are plenty of places that we could put money, most of them as we have avoided. So many places that we're superficially enticing, as acquisition opportunities and then with hindsight, boy, did we ever make the right call. So, the discipline of not chasing after ghost on the one hand, and on the other hand, keeping alert for a selective opportunity that passes our rigorous review that we will take some risk on but we take as an appropriate risk. We are active screening for those opportunities every quarter and have been for the last... we're very active screening for those opportunities in 2007. We'll continue to be very active screening for those opportunities in 2008, but we also will continue to be very disciplined.

Michael Weinstein - JP Morgan

Great, Dan. Thanks. I'm looking forward to seeing you at the meeting.

Daniel J. Starks - Chairman, President and Chief Executive Officer

You're welcome. With that we've actually gone over time. And I apologize to those of you who wanted to ask a question that we didn't get to. Sharona, would you please make your concluding comments? And thank you everyone for joining us today.

Operator

Today's call is being recorded and will be available for a replay beginning at 12.00 PM Eastern Time. The dial-in numbers are 820-642-1687 and 706-645-9291 and enter PIN number 26431713.

Thank you. This does conclude today's teleconference. Please disconnect your lines at this time and have a wonderful day.

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Source: St. Jude Medical, Inc. Q4 2007 Earnings Call Transcript
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