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Medtronic Inc. (NYSE:MDT)

F3Q08 (Qtr End 01/25/08) Earnings Call

February 19 2008 8:00 am ET

Executives

Martha Goldberg Aronson - IR

Bill Hawkins - President and CEO

Gary Ellis - Chief Financial Officer

Analysts

Bob Hopkins - Lehman Brothers

Michael Weinstein – JPMorgan

Rick Wise - Bear Stearns

Glen Reicin - Morgan Stanley

Michael Jungling - Merrill Lynch

Bruce Nudell - UBS

Joanne Wuensch - BMO Capital Markets

Tao Levy - Deutsche Bank

Operator

At this time, I would like to welcome everyone to the Medtronic third quarter Earnings Call. (Operator Instructions)

I will now turn the call over to Ms. Goldberg Aronson. Please go ahead, ma'am.

Martha Goldberg Aronson

Good morning and welcome to Medtronic's third quarter conference call and webcast. During the next hour we will review the results of our third quarter of fiscal year 2008, which ended January 25, 2008.

Following these introductory remarks, Bill Hawkins, Medtronic President and Chief Executive Officer, will provide comments on the third quarter results. Gary Ellis, Chief Financial Officer, will follow with a financial summary of the quarter. After our prepared remarks, we will take your questions. Joining us for the question-and-answer session are Michael DeMane, Chief Operating Officer; and Pat Mackin, President of our Cardiac Rhythm Disease Management business.

A few logistical comments. This call is being webcast via our website, www.medtronic.com. Our press release, earnings statement, balance sheet, cash flow, revenue by business summary, non-GAAP to GAAP reconciliations as well as a transcript of the prepared remarks will all be posted on our website. The transcript will remain available on our website until our next earnings call.

Today's commentary should be considered and evaluated in light of the important disclosures and reconciliations contained within our press release as filed with the Securities and Exchange Commission. Please telephone Medtronic Investor Relations or Corporate Communications if you are unable to access the press release or the transcript.

Today's webcast include statements regarding Medtronic's anticipated financial results, market growth, acquisitions, divestitures, product acceptance and regulatory approvals as well as other forward-looking statements based on management's current expectations. It's important to note that our actual results may differ materially from those anticipated. Information on factors that could cause actual results to differ materially from those forward-looking statements is contained in Medtronic's Form 10-K for the year ended April 27, 2007 filed with the Securities and Exchange Commission. We encourage you to review this carefully.

All statements are made as of today's date, and we undertake no duty to update the information provided in this call. Unless we say otherwise, the comparisons we make today will be on an as-reported basis, not on a constant currency basis, and references to quarterly results, increasing or decreasing, are in comparison to the third quarter of fiscal year 2007.

With that, I am now pleased to turn the call over to Medtronic's President and Chief Executive Officer, Bill Hawkins.

Bill Hawkins

Good morning and thank you, Martha. This morning we released our fiscal year 2008 third quarter financial results. Revenue of $3.405 billion increased 12%, including a positive impact of $117 million from foreign currency.

After adjusting for special charges, certain litigation charges and acquisition-related and process research and development charges, third quarter earnings and diluted earnings per share on a non-GAAP basis were $713 million and $0.63 respectively. GAAP earnings for the third quarter were $77 million or $0.07 per share, which reflects a number of significant charges, several of which were previously disclosed. Gary will take you through this in greater detail later on the call.

Often as considered, I'm pleased with the performance of our global organization. We have achieved a number of highlights since our last conference call. $726 million of ICD revenue reflecting resiliency of our CRDM organization and the widespread support we've received from customers regarding our focus on patient safety during the Fidelis field action, the successful close of the Kyphon acquisition in early November, double-digit revenue growth in the Spinal, Neuromodulation, Diabetes and ENT businesses, over $715 million generated in free cash flow, OUS growth of 20%, and the February announcement of the FDA approvals of the Endeavor drug-eluting stent and the RestoreULTRA neurostimulator.

I'll touch on each of these items in more detail as I discuss the segment results, beginning with our CRDM business. This was a difficult quarter in our CRDM business. Given all that we had to do, I could not be more proud of the thousands of employees who worked tirelessly to serve the patients who have been our first priority from the very beginning. Given the business we are in, these types of situations are always a possibility and they are never easy. How we respond is incredibly important to patients and customers.

Our focus on serving patients, as stated in our company's mission, was our ultimate guide with the size, scale and dedication of our organization, allowing us to minimize the impact of this event. Many of our senior leaders, including myself, have spent a lot of time in the field this last quarter. And I must say I have been gratified by the strong support we have received from our customers for the courage we displayed in doing the right thing.

Third quarter ICD revenue was $726 million, up 2% compared to the third quarter of fiscal year 2007 and up 14% sequentially. Overall, these results reflect the organization's focus or managing the Fidelis field action, and again, the resiliency of our business. Our performance in ICDs was stronger than anticipated, but we did experience a negative impact due in part to the priority we placed on assisting customers and reprogramming their patient's devices versus focusing on new implants.

Secondly, in Japan, we did not have Quattro available until mid January. And finally, the lack of a single-coil lead impacted lead sales, and in some cases complete systems particularly in Southern Western European markets. We are on track to launch a single-coil Quattro lead in the first quarter of fiscal year 2009. Development work is also underway to reduce the size of our high-power leads, while also assuring best-in-class reliability.

During the quarter, we did receive the benefit of approximately $20 million in ICD revenue related to both filling the backlog of Quattro lead orders from the second quarter and reversing a portion of Fidelis returns reserve based on actual experience with Fidelis credits in the quarter. As you recall at the time with the Fidelis announcement, our worldwide lead manufacturing capacity supported a product mix of approximately 75% for Fidelis and 25% for Quattro and our inventory levels reflected the same general mix.

Our ability to meet customer demand following the field action was the result of multiple actions we undertook to maintain supply subsequent to our announcement of Fidelis. We worked with our suppliers and our manufacturing operations in Puerto Rico to ramp-up and transition manufacturing back to Quattro. We completely reengineered our physical distribution effectively moving from a build-to-forecast model to a build-to-order model.

And finally, United Parcel Service or UPS established operations with our Puerto Rico facility enabling us to ship directly to our customers. As a result of these efforts, we were able to meet customer demand following the field action, and by early January, we have reached for typical manufacturing and inventory levels.

A silver lining of this process has been the fact that our customers have come to better appreciate the value of CareLink, which have proven to be a useful tool in helping physicians manage their Fidelis patients. We added 40,000 patients to the CareLink network in the third quarter, which was a rate nearly 2.5 times faster than our closest competitor. CareLink is the largest remote patient management network in the industry with more than 225,000 patients and over 2,000 clinics and hospitals around the world.

So turning to Pacing Systems, our global revenue in the third quarter grew 4% to $478 million, while the market as a whole grew 8%. It's important to realize that a significant portion of our field organization's attention during the quarter was focused on survey Fidelis customers and patients. Although the implant rates in the first month following the field action were down significantly for both high-power and low-power, by the end of the quarter they have recovered to pre-Fidelis levels.

Looking ahead, we expect our CRDM business will benefit from a robust pipeline of new products, extending what is the strongest device portfolio in the market. In the next 12 months, we expect to introduce 25 new products in the US and Europe, which includes the Vision 3D platform of high-power and low-power devices, along with two new left ventricular leads, a family of new delivery systems and an entirely new platform for CareLink.

Additionally, early in the fourth quarter, we announced the start of the US clinical trial to confirm the safety and efficacy of the EnRhythm MRI SureScan pacing system, the first-ever pacemaker system designed for a safe use in MRI machines. We anticipate launching this new product in international markets this fall and in the US in fiscal year 2010. Lastly, in Japan, we intend to start our CareLink pilot this quarter.

Turning to our Spinal business, we saw 35% growth in the quarter driven in large part by the addition of $147 million in Kyphon revenue. We closed the Kyphon acquisition at the end of the first week of the quarter, ahead of expectations. Taking into account that we had 12 selling weeks versus the typical 13, we are pleased with the result.

Since then, we have made solid progress on the integration and are on track to meet the previously stated projections of $300 million to $325 million of revenue in fiscal year 2008. We are very optimistic about the long-term potential of this new platform and the opportunity to compete in the aging spine market.

Our teams are currently focusing their efforts on leveraging cross-selling opportunities and driving and cost synergies between the two organizations. Gary will take you through the Kyphon-related purchase accounting adjustments that impacted the quarter later in the call, but suffice it to say they too are in line with expectations.

When you look at our Spinal business excluding Kyphon, revenue grew 11% in the third quarter driven by strong double-digit performance in our worldwide Biologics business, along with solid growth in our Core Spinal outside the US. Taking together, Kyphon and Biologics helped to partially offset competitive pressures on our Core Spinal products in the US.

Prestige results have been slower than we initially hoped due to longer than anticipated physician trialing and lack of widespread reimbursement coverage. We remain optimistic about the prospects of this product and expect updated toolsets along with continued educational efforts to increase therapy adoption. We remain confident that these implants will become a standard of care in the treatment of cervical degenerative disc disease giving patients an alternative to traditional motion-limiting spinal fusions.

We remain committed to our Spinal business strategy of raising the bar of competition through continuous innovation and supporting the safety, efficacy and cost effectiveness of our products with robust clinical data.

During the quarter, we announced our intension to enter into a joint venture with the Shandong Weigao Group to market therapies in the spine and orthopedics sector in the Chinese market. Upon the close of this transaction later this calendar year, Medtronic will have access to Weigao's broad orthopedic and trauma product line and will be able to generate synergies from Weigao's strong presence and reputation in China. This joint venture will expand our footprint in China.

We expect that china will become our largest market outside the US in the next ten years. So, let me turn out to one of our biggest near-term opportunities, our CardioVascular business. Two weeks ago, we announced FDA approval and launch of Endeavor in the US and we are pleased to report that we are off to a great start. Endeavor is the first new drug-eluting stent approved for use in the US market and over four years and physicians are genuinely excited to have a safer and more deliverable alternative drug-eluting stent for their patients with coronary artery disease.

Although it's clearly too early in the launch to share specific metrics or results, customer reaction has been extremely positive. I spent last week visiting customers and I can report first time the excitement many have for this new product. Physicians appreciate that Endeavor offers the performance and efficacy of our first innovation drug-eluting stent, while setting new standards for safety and deliverability.

Physicians are telling us that Endeavor is clearly the most deliverable stent of the market. The multi-exchange or MX and over the wire systems have both received early phrase and we are confident regarding Endeavor's performance in the US market. Longer term we remain committed to market leadership in the Coronary Stent space, with the strength of our portfolio, including Endeavor and Endeavor Resolute, we continue to gain share outside the US.

At the end of the fourth quarter of calendar year 2007, our overall DES unit share was approximately 20% and they were over 15 markets were exceeded 30%. We are making great progress with our DES franchise and we look forward to share more specifics about the Endeavor launch during our fourth quarter earning conference call.

Turning back to our third results in the CardioVascular business revenue grew 7% with strong Coronary and Endovascular sales offset by somewhat slower growth in our Structural Heart and Revascularization businesses. Coronary growth of 8% was driven by $84 million in drug-eluting stent revenue reflecting market share gains from Endeavor and the OUS launch of Endeavor Resolute our second drug-eluting stent.

Coronary revenue during the quarter also benefited from the CE Mark approval and launch of our Sprinter Legend Balloon with a revolutionary zero fault technology, enabling an exceptionally low profile with no wrapped material no balloon shoulders. Leveraging advanced material sciences to bring this technology to market means, our customers will be better able to treat their most difficult clinical challenges.

Our Endovascular business grew 9% in the quarter, driven by 24% growth of our thoracic products in OUS markets. A new study published in The New England Journal of Medicine provides compelling evidence that endovascular intervention is a favorable choice for patients in need of AAA repair. The four year 23,000 patients study found that the short-term rates of death and complication were significantly lower just 1.2% for endovascular repair compared to 4.8% per patient, who underwent open surgery.

We expect continued growth in this market and we have the strongest endovascular product pipeline in the industry. In the US during the quarter we launched the AneuRx AAAdvantage Stent Graft of the new Xcelerant Hydro Delivery System, which features a hydrophilic coding design to aid navigation of device to tortuous arteries.

During the quarter we also announced that we filed the final PMA module for our Talent Abdominal Stent Graft System and we expect US launch in the first half of calendar year 2008. This will be followed by the US launch of our Talent Thoracic product in the second half of calendar year 2008. Availability of the two talent systems in the US market will accelerate Endovascular revenue in fiscal 2009 and beyond.

And finally, the first human implant of the Endurant next-generation abdominal stent graft occurred early November and we expect CE Mark and launch of this product in OUS markets by the end of calendar year 2008.

Now turning to our Neuromodulation business, revenue grew 10% to $320 million, adjusting for the impact of the previously announced divestitures of our diagnostic related product lines, Neuromodulation revenue grew 16% in the quarter. The overall pain market continued to show robust growth and our global pain revenue grew 13%.

Our movement disorders product lines grew 18% in the quarter, driven by the adoption of our Activa Therapy for Parkinson's disease. We are pursuing activities to help draw patients referrals, including strengthening neurologist understanding of the growing body of compelling clinical evidence. Growth in Gastro/Uro continued to be driven by revenue from our InterStim product line, which increased 26%.

Looking ahead in the Neuromodulation business, we anticipate accelerating growth during the fourth quarter and into fiscal year 2009, driven by the launch of RestoreULTRA. We announced FDA approval for this product early in the fourth quarter and expect the first commercial implants in the US to take place later today. RestoreULTRA will be the smallest and thinnest 16-electrode rechargeable neurostimulation on the market and will patient the ability to customize their pain control. It offers compelling technology that is unmatched in the industry.

Our Diabetes business grew 14% on new insulin pump adoption, a robust uptake in continuous glucose sensors and strong growth in markets outside the US. Even without widespread reimbursement coverage, continuous glucose sensor revenue is currently annualizing at nearly $60 million and we are building on this market-leading franchise.

For example, in the first week of this quarter, we received FDA approval and launched the CGMS iPRO, a new physician use diagnostic continuous glucose monitoring system designed to help uncover patterns and potential problems that often go undetected with standard glucose measurements.

Going forward, we will leverage two co-marketing meter agreements we entered into with Johnson & Johnson, LifeScan and Bayer earlier this fiscal year. Joint sales call, co-marketing event and other initiatives targeting patients using multiple daily injections are beginning to generate positive referral momentum. Last week, we launched our co-developed blood glucose meter with Bayer starting with initial shipments in the German market and we are on track for launching the LifeScan meter in the US market later this spring.

Our Ear, Nose & Throat business grew 15% in the third quarter driven by the successful launch of Fusion, an advanced new Image Guidance Surgery System to facilitate sinus surgical procedures, along with strong growth of power systems and nerve monitoring disposables outside the US.

Now regarding Physio-Control, our team continues to work with the FDA on appropriate corrective actions and we hope to resume full US shipments as soon as possible.

Finally, in terms of our geographic performance, our growth outside the US was 20% or 9% on a constant currency basis. Strong growth in our Diabetes and Spinal businesses of more than 25% was offset by the impact of Fidelis, particularly in the Japanese market. China revenue increased 24% in the quarter, led by CardioVascular. We will continue our focus on geographic expansion as it remains one of the most significant opportunities for us in the long-term.

Now, I'll turn the call over to Gary, and then I will conclude with a few closing remarks. Gary?

Gary Ellis

Thanks, Bill. As you heard earlier, third quarter revenue of $3.405 billion grew 12%. Breaking this out geographically, revenue in the US was $2.98 billion, up 7%. Outside the US, revenue of $1.307 billion increased 20%, including $117 million positive impact of foreign currency.

Net earnings for the third quarter, after adjusting for special charges, certain litigation charges and in-process research and development charges, were $713 million and diluted earnings per share on a non-GAAP basis were $0.63. GAAP earnings and diluted earnings per share were $77 million and $0.07 respectively.

The various charges in required purchase accounting for the Kyphon acquisition complicate this quarter's income statement. I will first provide additional details on the three charges that impacted our quarterly results, each of which is listed as a separate line item on the income statement. Then I'll discuss in greater detail the impact of the Kyphon purchase accounting before going through the rest of income statement.

First, we recorded the required purchase accounting IPR&D charges of $310 million, comprised primarily of $290 million charge related to the Kyphon acquisition. In addition, there was a charge of $20 million related to the purchase of intellectual property from Setagon, Inc.

Second, we recorded certain litigation charges of $366 million, $123 million related to the settlement of certain lawsuits relating to our Marquis line of ICDs, which we announced previously, and a $243 million charge related to reserve established for the litigation with Cordis. The Cordis litigation originated in 1997 and pertains to a patent infringement claim on a previous generation of bare metal stents that are no longer on the market. In January, the Federal Appeals Court made certain decisions that necessitated the recognition of an estimate for our expected liability in this case.

Third, we recorded a special charge of $78 million related to the impairment of intangible assets associated with our benign prostatic hyperplasia product line acquired in fiscal year 2002. After carefully evaluating the development of the market relative to our original assumptions and analyzing our estimated future cash flows utilizing this technology, we determined that the carrying value of these intangible assets was impaired and a write-down was necessary. Collectively, these charges, including the respective tax impacts, had a $0.56 negative impact on our third quarter diluted earnings per share.

In addition to these charges, there were two purchase accounting adjustments related to the Kyphon acquisition that had an impact in our quarterly results. First, we recorded $996 million in various intangible assets, which will be amortized over an average life of 10.5 years. The impact of this amortization was recorded in net other expense beginning this quarter.

Second, a $34 million inventory adjustment consisting of the mark-up of finished goods and work in process inventory that is required for purchase accounting was fully amortized to cost of goods sold during the third quarter. This item was a third quarter event only and will have no impact on future quarters.

Excluding the impact of IPR&D, there was a $0.05 diluted impact in the third quarter of fiscal year 2008 from the closing of the Kyphon acquisition. We expect another $0.02 to $0.03 of dilution this quarter, earnings neutral in fiscal year 2009 and accretive thereafter.

Let me now turn to the rest of the income statement. As previously discussed, this quarter's gross profit margin of 74.4% included the $34 million charge for the fair value adjustment of the acquired inventory of Kyphon. This charge negatively impacted the gross margin by approximately 100 basis points. Looking ahead, we would expect the gross margin in the fourth quarter closer to 76% with the potential for further improvements in fiscal year 2009.

Third quarter R&D spending of $329 million represents 9.7% of revenue, up 12.3% compared to $293 million in the prior year third quarter. We continue to be very committed to investing in new technologies to drive future growth.

SG&A expenditures of $1.207 million represents 35.4% of sales. SG&A as a percentage of sales excluding the Kyphon business was 34.5%. In the fourth quarter, we expect SG&A as a percentage of sales to be approximately 33% as we further integrate Kyphon and as investments, such as the build-out of the sales organization and preparation for the US Endeavor launch begin to pay off. We have several additional initiatives underway to leverage this cost structure even more as we enter FY '09.

Net other expense for the quarter was $119 million compared to $44 million in the prior year third quarter. This change is primarily due to $41 million in currency losses from marketing programs, amortization of intangible assets related to the Kyphon acquisition and the prior year inclusion of $26 million of accelerated deferred income.

The currency losses on our hedging contracts reflect the fact that the weak US dollar has benefited the translation of the rest of the income statement, but we have hedged at less favorable rates. Looking ahead to the fourth quarter, net other expense will be further impacted by an increase in Endeavor royalty expenses recognized upon the sale of units in the US market.

Net interest income for the quarter was $9 million, a significant decline compared to the $36 million in the prior year period, reflecting the utilization of cash balances to finance the Kyphon acquisition.

As of January 25, 2008, we had approximately $3.3 billion in cash and cash investments compared to debt of about $7 billion. We generated in excess of $750 million of free cash flow during the quarter defined as operating cash flow minus capital expenditures. Looking ahead, we expect our cash to continue to increase. However, lower interest rates will negatively impact our return on this cash.

Let's now turn to our tax rate. In this third quarter, our effective tax rate was 42.77%. Excluding the tax impact of special charges, certain litigation charges and the IPR&D charges as identified on the income statement, our effective tax rate in the third quarter was 19.84%. This rate includes a $30 million tax benefit related to the finalization of certain fiscal 2007 tax returns and the reversal of reserves for uncertain tax positions.

Excluding this $30 million benefit, our third quarter effective tax rate would have been 23.25% consistent with the rate in the first and second quarters of FY' 08. Exclusive of one-time adjustments, we expect our fiscal year 2008 tax rate to be in the range of 23% to 23.5%.

Third quarter weighted average shares outstanding on a diluted basis were 1.135 billion shares. During the quarter, we repurchased $564 million of our common stock, which represents over 11.4 million shares. As of January 25, 2008, we had remaining capacity to repurchase over 39 million shares under our Board authorized stock repurchase plan.

Going forward, we remain committed to continuing to return capital to shareholders, while ensuring a sufficiently strong balance sheet to execute on our strategies. This will continue to include opportunistic but disciplined stock repurchasing activities.

As before, we have attached an income statement, balance sheet and cash flow statement to this quarter's press release, and I direct your attention to these statements for additional financial details.

Let me conclude by commenting on analyst estimates for the full 2008 fiscal year. As you recall at the beginning of the fiscal year, we decided to limit our guidance to one year at a time and keep our guidance more directional in nature. Keeping that in mind while looking ahead to the remainder of the fiscal year, it is important to consider the following two factors.

First, we expect Medtronic revenue growth to accelerate in the fourth quarter due to the stability and gradual strengthening of the global ICD market coupled with our return to more normal sales operations as Fidelis-related activities subside; launch of Endeavor in the US; launch of Restore Ultra Neurostimulator; and contribution of the Kyphon revenue.

Second, as I mentioned previously, although we expect the Kyphon transaction to be earnings neutral in fiscal year 2009, we estimate it will have $0.07 to $0.08 diluted impact in fiscal year 2008. The bulk of which was recognized in the third quarter.

Current Wall Street fiscal 2008 earnings per share consensus is $2.52. Taken into account the above factors and the fact that our third quarter earnings per share of $0.63 was above the quarterly consensus of $0.61, we would not be surprised to see fiscal year 2008 earnings per share consensus increased by $0.02.

We have assumed Physio-Control is included for the remainder of the fiscal year, although we are committed to the eventual spin-off of that business. As in the past, all of my comments on analyst estimates do not include any unusual charges or gains that might occur.

I will now turn things back over to Bill, who will conclude our prepared remarks.

Bill Hawkins

Thanks, Gary. Before we open it up to Q&A, let me make just a few closing remarks. While my first full quarter as Medtronic CEO was characterized by some unanticipated challenges, in no way to these events change our long-term outlook for the opportunities we have, to deliver market leading performance. We operate in a dynamic environment.

Looking ahead its clear we need to continue to adjust our business model in several areas recognizing that some of our prior years assumptions have changed. We will focus on reallocating investments to those markets, where we see strong growth and streamlining other areas, where market conditions have slowed.

The near term prospects are bright with the Endeavor launch, Kyphon integration, Diabetes and Neuro momentum, steady growth in ENT then ongoing emphasis on our OUS markets. The focus going forward will be on relentless execution. I look forward to our next conference call and the opportunity to further update you on our journey ahead.

Now I'd like to open up things for Q&A. As Martha mentioned at the beginning of the call, Michael DeMane and Pat Mackin have joined Gary and me to address your questions.

So, operator, first question.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from the line of Bob Hopkins with Lehman Brothers.

Bob Hopkins - Lehman Brothers

Hi. Thank you, and good morning.

Bill Hawkins

Good morning, Bob.

Gary Ellis

Good morning, Bob

Bob Hopkins - Lehman Brothers

Couple of questions, first on the ICD side, you mentioned that you felt in the quarter there were about $20 million of positives from filling a backlog and reversing reserves, and then you mentioned there are also some negatives in terms of the folks being very focused on reprogramming and the like.

Could you identify the number related to that negatives, in other words $20 million positive, I'm just wondering what the offset in the quarter was on the negative side?

Bill Hawkins

Pat, why don't you maybe?

Pat Mackin

Yeah. Hi, Bob, I mean we're not going to get into specific numbers. I think the best way to look at this is, when we were back on October 15th, we announced the Fidelis recall, we obviously knew there were some headwinds. We knew that, we run in Japan with our Quattro lead. We realized we didn't have full supply of Quattro. We knew our field force would have to go out and reprogram a significant number of patients.

And I think the best way to look at the situation now, is that we got our lead in Japan faster than you expected. We're back in that market with a very complete portfolio. We reengineered our supply chain like you heard Bill talk about. We have full supply of Quattro.

Bill commented in the remarks about -- early in the quarter, the first month of the quarter, we did see our business impacted because our field was out refocusing on -- we are really focusing on patients and reprogramming those patients. We saw those -- basically the business returned to much more normal level later in the quarter. So, I think that we've come out of this much better than most of you expected.

Bob Hopkins - Lehman Brothers

Absolutely, Pat. I'm just curious, the $726 million number given there was some push and takes, I was just curious that we should, in your view, be looking at this number. Is this a relatively clean number than from which to build over the next couple of quarters or again there are a few more negatives or a few more positives. I'm just trying to get a sense for how clean this $726 million number is in your opinion?

Bill Hawkins

Yeah. Bob, this is Bill. It is the clean number. I mean other than what we gave you in terms of roughly $20 million that compiled both reversal, some of the Fidelis -- we had estimated as well as some of the Quattro inventory that we needed to restock. So, other than that I think you should look at it as a very clean quarter. So, we feel good about where we are and we're focused on moving ahead.

Gary Ellis

And Bob, This is Gary to add on to what Bill said. I mean, even as Pat mentioned. It's clean from our perspective plus than we will have a situation that we are going to have the some of the inventory both in Japan etcetera, as we go ahead now that they'll be a positive. And plus as you know, we also in our fourth quarter end up just because of the holidays etcetera happened up having about five extra selling days compared to the Q3. So, we always see an upward condition in our Q4, but other than the $20 million we mentioned in our comments, we think our overall the rest of the quarter was pretty clean the number that we reported.

Bob Hopkins - Lehman Brothers

Okay, great, then just one quick follow-up on spine. Bill, just some comments there in terms of what's going on in the US and the competitive structure and on the core spine business do you expect to return the growth as we go forward over the next 12 months?

Bill Hawkins

Michael, you want to address that.

Michael DeMane

Sure. This is Michael DeMane. And clearly there had been some competitive pressures in US. I mean, I think if you look at the business overall all US is growing exceptionally well and our Biologics business continued to perform exceedingly well given that product performance. So, really we are talking about the US core business and admittedly we are refocusing in that area.

I think that perhaps the sales organization in the US as we go through a pretty substantial integration, there might been a little bit of the starter step, but I'm confident that is going to come back and we are going to do quite well going forward and it will return to higher level growth in US on the core businesses.

Bob Hopkins - Lehman Brothers

All right, thanks very much guys.

Operator

Your next question will come from the line of Michael Weinstein with JPMorgan

Bill Hawkins

Good morning, Mike.

Michael Weinstein – JPMorgan

Yes, I want to focus if I could Gary just on your comments on the Kyphon impact, on the cost of goods sold and SG&A lines. I think, I might have missed some of that and you didn't break it out in the press release, you said the inventories step I just to be clear with that a 100 basis points on a gross margin line?

Gary Ellis

That is correct.

Michael Weinstein - JPMorgan

And then the Kyphon impact on the SG&A line?

Gary Ellis

It's about a 100 basis points. If you take our Kyphon, Kyphon has a lot of their operating over especially in SG&A was very high as a separate company coming in so, its that's had a 100 basis points through our overall SG&A, as we go forward with the integration and start to get some of the synergies you should start to see that in a leverage, but at this point it added about 100 basis points to this quarter.

Michael Weinstein - JPMorgan

Was there anything that was onetime in there, I mean Kyphon had a onetime event, so just to clear that, the 100 basis points you are talking step up is the, its by adding Kyphon to full this is a complete picture, but nothing you are saying is onetime in the SG&A line this quarter?

Gary Ellis

That is correct

Michael Weinstein - JPMorgan

But given and did you expect to get SG&A down to 33% of sales in the April quarter?

Gary Ellis

Yes, we do and there is, as I mentioned in our comments, there is a couple of things that obviously is impacting the SG&A more this quarter. One was just Kyphon, which we would expect to leverage and get the synergies out. The other is obviously we had all the expenses in place, all the people, all the sales force, marketing and etcetera related to Endeavor.

And with that being launched in the beginning of the fourth quarter and having no benefit of revenue in the third quarter that certainly obviously impacted the third quarter's percentages. As we get into fourth quarter you will to start to see the leverage that launch having impact on the SG&A line, plus we do have several other initiatives across the company that we have put in place and we are going to start to see some of the benefit as we get into the fourth quarter and into FY' 09.

Michael Weinstein - JPMorgan

With that in mind, I think you haven't touched on; in the couple of calls so much going on is the SAP system you put in place in the US. I think September 1, can you just update us on that and what type of impact that might have on margins going forward. Thanks.

Gary Ellis

Yes, with respect to SAP, as we've talked about it and discussed, I think even in the analyst meeting last year, we indicated that our IT costs of the total company had it been -- actually you got to be about 4% of revenue, which was above where you would normally expect to see company like ourselves at. In that while we had to do with the investment we were making in SAP across the organization.

We have now one live on SAP really looking about 85%, 90% of our businesses and so that's all in place and working relatively well. As you can match it with any new system implementation there continues to be a few issues here and there on reporting. That we are working through, but overall we've not had any major business disruptions, as a result of that. It has increased our cost a little bit just from the standpoint of having a deal with the training, education and getting people up to speed and understanding the systems. We haven't got the productivity of the system yet from the standpoint of what we do as far as reducing SG&A.

Going forward we would expect of our IT costs as we've indicated will start to drop and we have a goal of getting the IT costs down to run -- actually by less than 3% around 2.5% to 2.6% of revenue over the next nearly 18 months. So, there are a lot of steps in place, but the investment has been made, now we need to see the payoff in the leverage.

Michael Weinstein - JPMorgan

Okay. Last question and I'll drop. Bill, you weren't specific this time just on Physio-Control in the timing of the resumption of all shipments in the US. Do you know what the timing of now the FDA inspection?

Bill Hawkins

Well, we are still hoping that we can get this done by the end of the fiscal year. That that's where we are working to, but, in dealing with the FDA, you can't ever really pin point in exact timeframe, Mike. So that why, we are moving forward, the FDA has come in recently for their inspection, so we're working through that right now. And as I said hopefully, we'll be able to be back in full swing before the end of the fiscal year, but I don't want to be kind of nail down that date because again -- working with the FDA on this.

Michael Weinstein - JPMorgan

Understood, thank you.

Bill Hawkins

All right.

Operator

Your next question will come from the line of Rick Wise with Bear Stearns.

Rick Wise - Bear Stearns

Good morning, everybody. Sorry for the scratchy voice here. Going back to Endeavor, can you help us understand a little bit the Endeavor Resolute mix, OUS and maybe a little more granularity on your RX version as you're initially launching Endeavor in the US?

Bill Hawkins

So, you're talking about the OUS sales, Rick?

Rick Wise - Bear Stearns

OUS first and then just -- again just initially in United States. Are you seeing much use of your version of Rapid Exchange Catheter?

Bill Hawkins

Yes.

Rick Wise - Bear Stearns

The next two, I think it's called right.

Bill Hawkins

Yeah that's correct, that's correct. Well, OUS I believe our mix I mean clearly in the Western European market. We have both products available and we find it to be a very compelling value proposition. We would say two-thirds of one-third Endeavor Resolute at in that area. In terms of the Rapid Exchange, clearly we do have a slight impairment without the Rapid Exchange in the US, but we found that our customers really do want the safety profile of Endeavor and they are adapting and adapting well. So, we are still pretty optimistic.

Gary Ellis

And one other thing Rick that we have found is that, with the Endeavor I mean the advantages of the chromium-cobalt driver platform and the deliverability of this really in many cases opt sort of offsets it is the issues that you have maybe the MX and itself, so as to say I was last week traveling many accounts and was very encouraged by what I'm seeing, but it's again too early to really make any strong predictions, but we'll see at the end of fourth quarter.

Rick Wise - Bear Stearns

Okay. And just two other quick ones, obviously its important you have a single-coil ICD catheter. Can you help us quantify in some kind of way that how significant it is or what percentage of the US market that might would be that your in a sense sort of excluding from short-term.

And on neuro, you talked about obviously grew 16% very good number and you talked about accelerating in the fourth quarter beyond which I assume is there were restore impact. Does the business that has currently existed continue to grow at the mid-teens rate and restore is on top of that. Maybe you can help us understand a little bit about the opportunity for restore, and what that could do incrementally? Thanks so much.

Pat Mackin

Hey, Rick, this is Pat. As far the single-coil, the mix is less than 10% in Unites States and typically it's kind of a one-off situation, whereas in Europe it can run roughly 30%. And as Bill made in his comments, we saw some system impact here. So clearly it's a high priority for us and we're planning to launch that product in the first quarter FY '09.

Rick Wise - Bear Stearns

And on the neuro front?

Bill Hawkins

Yeah. Just real quickly on the neuro front. The good news about neuro I mean the pain stent market, if you look at it this quarter again, grew in excess of 20%, with annualized again over a $1 billion. So I mean, in fact, if you'll look at our performance, which was not a bad performance, we actually loss a little bit of share this past quarter.

So with the RestoreULTRA, we think that that's going to give us the opportunity to recapture some share, and if we can continue to grow the market at 20%, I think that bodes well for us.

Rick Wise - Bear Stearns

Very helpful, thanks Bill.

Operator

Your next question will come from the line of Glen Reicin with Morgan Stanley.

Glen Reicin - Morgan Stanley

Good morning, folks.

Bill Hawkins

Good morning, Glen.

Glen Reicin - Morgan Stanley

Thanks for reporting in the morning. Really, appreciate it. You talked a little bit about what happened sequentially with respect to reserve reverse of ICDs. Can you just give us a sense of what the change was sequentially due to bulk orders?

Gary Ellis

Glen, this is Gary. Just really quickly, the bulk orders basically for the quarter returned not they were above what we obviously had in Q2, where they head in significantly lower, they returned to kind of a historical level and the inventory levels then as a result in the field from the hospitals, some what we can tell basically were basically pretty consistent with what we saw at the end of Q2.

Glen Reicin - Morgan Stanley

Okay. Now is there any way to quantifying it, just to be flexible if you say like from a share perspective last quarter share was depressed because of this, obviously it will enhance this quarter, if you want to give us dollar number just anyway of quantifying it?

Gary Ellis

Well. I'd argue that the share wasn't enhanced this quarter it was obviously versus Q2 I think as we've said before. Again the inventory levels in the field are basically at the levels they are consistent with where they were at in the Q2, and so we didn't see any benefit from that aspect in this quarter. But you obviously saw as we've said before in our Q2 results they were negatively impacted our margins -- our share was negatively impacted at that point in time.

But at this point I don't think there is any impact on share, other than as we try to clarify there was the $20 million of reserve reversal and Quattro inventory, lead inventory that we did build up here during the quarter. So, that's the impact in the quarter on from a share perspective from what we can tell.

Glen Reicin - Morgan Stanley

Okay. It was just looking like domestically the $60 million of sequential increase, – is that mostly bulk orders or is that more having to do with the $20 million reversal?

Gary Ellis

No, I mean again I think it depends on what if you're looking in sequentially, you are comparing against the last quarter, where as we talked about we weren't able to fill some of the bulk orders that we had at the end of the quarter because of the lack of Quattro supply at that point in time. So, you're comparing against a quarter that was unusually low.

If you compare it against a normal quarter prior Pre-Fidelis basically what we saw on this quarter was consistent with what we would have normally seen from both bulk purchase orders and obviously implants during the quarter. And I just, Pat you could add on it.

Pat Mackin

Yeah, Glen and listen there was obviously a lot of things happening in the quarter. I think the easiest way to look at this, is that if you take the $20 million that Bill talked about is the two reversal we have talked about and move that back into Q2, and Gary's comment about inventory levels and change out there, so other than it's a pretty normal quarter

Glen Reicin - Morgan Stanley

Okay, crystal clear. Two other just follow-up questions here, just conceptionally when do you think you're going to have some French lead back in the US, I would be talking about three years from now, never five years from now and then on the spinal side maybe Mike can talk little bit about the Prestige, when do you start to reevaluate the potential for that product given the slow start and you will in a size that operate now by yourself?

Pat Mackin

Hey Glen, this is Pat I will take the first one. Obviously this is something we are working on a smaller body lead, we've obviously had a product in the market, and we know a lot about of the system. We've got a full team in place working on this now. I think the one thing we can't predict is what the regulatory environments kind of look like here in the US.

We obviously want to make sure that our next product we come back is got the highest level performance and liability. Our goal is targeting FY '10 for Europe and sooner after later in that in the fiscal ten timeframe for the US.

Glen Reicin - Morgan Stanley

Okay.

Michael DeMane

Okay and Glen this is Michael. On the Prestige clearly we are still fighting a reimbursement battle there and we have decide to do that on the case by case basis, is reimbursement really as important in surgical, arthroplasty, the reason being when patients are present they are in excruciating pain. They really want to be fixed as they are debilitated and there is a very long wait to get a reimbursement answer, sometimes they opt for the traditional procedure.

So that is the really critical barrier for us and we've got to get over that and we have the resources in place. I think we've demonstrated in the past. We can do that and work through those barriers and we intend to do so.

Now in terms of scoping it our long term, just to understand that we do look at cervical arthroplasty or motion bearing in general, as a continual, I mean this is not our only product we have a next generation product on deck right now, which is the PRESTIGE LP, low profile, we also have the BRYAN arthroplasty product that we expect to have within the next 12 months. So when you put it altogether, we do see having a portfolio of products to address this and also having a reimbursement there as we move so the patients can be treated with this and advance rapidly.

Glen Reicin - Morgan Stanley

And it's fair to say that without Kyphon, the whole cervical spinal disc area will if expected to be the largest growth driver will that spinal disc area.

Bill Hawkins

I think it's hard to make that statement, I'd say that I think there is an overarching trend towards non-fusion or motion sort of therapies and I think that would be correct and it can be in lumbar even though the lumbar options that are on the market now that was great success for some of the reasons that I think you know quite well.

I do think that we can address that market and between cervical and lumbar in the use of therapies such as the [Diom] and [Nextstop] I think we will have a pretty good motion portfolio that can move the ball forward.

Glen Reicin - Morgan Stanley

Thank you.

Bill Hawkins

Okay next question.

Operator

Your next question will come from the line of Michael Jungling with Merrill Lynch.

Michael Jungling - Merrill Lynch

Good morning, everyone.

Bill Hawkins

Good morning.

Michael Jungling - Merrill Lynch

I have three questions first can you give us the constant currency growth rates for the third in CRDM spine excluding Kyphon, neuromodulation and diabetes? Secondly, what is your appetite for making another large acquisition?

And the third question is, if I look your evaluation today, there appears to be a meaningful discount to companies in medical devices that have got inferior constant currency sales growth inferior margins, but you traded discount. What do you think the market does not appreciate or not like about your business model? Thank you.

Gary Ellis

Well, you're having three questions. First of all, let me kind to get to the first one with respect to the constant currency on the various business pieces. As we mentioned in our comments, overall foreign currency impact was $170 million in the quarter and I don't have the details to breakout by business, where that's at and I don't know whether we or even providing that at this point of time as we went through it.

So, I don't have that in front of me, didn't give you the breakout there. Maybe I'll take the third question and Bill can kind of respond to it also. What is the market missing, I think overall we continue to perform very, very well on the revenue growth and we have a lot in front of us from the product perspective. And we are in some very good markets that provide us some real opportunity to continue to grow this business on the top line.

We do have the opportunity for some operating leverage, now we have to -- have that come through and I think that's been kind of a complicated over the last couple of quarters as a result of the Fidelis and even the Kyphon acquisition kind of a complicates what the income statement looks like. So, I don't think people are realizing what that potential is as we move forward, but as we start to show that, I think you will start to see the investor based understand. Overall what our growth opportunities are on, not only in the top line, but overall in the bottom line. And as we can show that we can execute against that overall plan.

So, I think those are which you are right I think we are not getting the message out yet as far as, but the real opportunities are and that's why we have to continue to focus on.

Bill Hawkins

Yeah, let me just add. You ask specifically about acquisitions. First, we feel very good about the line up of our products and business. Right now as we try to articulate in this call with again with Endeavor, with Kyphon, with the Neuromodulation business, we've got a lot to work on and as I said our focus is going to on relentless execution going forward.

In terms of acquisitions, we'll continue to look to find that sort of tuck in the deals that could strengthen current franchises and we'll be opportunistic in terms of anything that will be larger in that. But right now our focus is very much on the relentless execution of the opportunities that we see with businesses I talked about and as well as we've got some internal things that we've talked about in previous calls. So, that we continue to be excited the hep-C opportunity, the gabapentin opportunity, some of the things to post our pain, so there is a lot to work on right here in the walls of Medtronic.

Michael Jungling - Merrill Lynch

I'm kind of bit concern, so over the next 12 months only bolt-on acquisitions, but nothing of a large magnitude.

Bill Hawkins

Yeah. Well, I'm not going to be that specific I mean again I can tell our focus is what I described in terms of relentless execution of our current businesses.

Michael Jungling - Merrill Lynch

Great, thank you.

Bill Hawkins

Thank you. Next question?

Operator

Your next question will come from the line of Bruce Nudell with UBS.

Bruce Nudell - UBS

Good morning. Thanks for taking my question. First two questions that pertain to ICDs, is it fair to assume that we won't expect any further revenue re-reversals, as it were, and just from your perspective absent a seven French lead. Do you think there will be much share pressure over the next 12 months in the US and OUS?

Bill Hawkins

Well, let me take the first one. As far as just the revenue reversals, etcetera, that we might see in the Q4. I don't think there will be anything of any significance, Bruce. There are still some things that we will be cleaning up with the respect to Fidelis credits and we'll have to see whether their Quattro inventories supply might go a little bit higher in some accounts.

But it will be much less than the $20 million that we mentioned this quarter. And it's not going to be any significance in Q4. And I just don't know where that would at this point, but it will be much less than that going forward.

Pat Mackin

And Bruce, this is pat. Regarding your question about share pressure, I mean obviously, I think all of our competitors are interested in our position. And I can tell you we're launching 25 products that we've been developing over the last several years.

We've invested hundreds and millions of dollars in new devices, new delivery systems, new data systems, we're launching them as systems. We have a phenomenal portfolio coming in the marketplace and we will aggressively defend our position and opportunistically go after share. So, I guess we'll see.

Bruce Nudell - UBS

And Bill, I have a strategic question for you. I think the US ICD market this year, assuming that all the reversals netted out this quarter was down 2%, the OUS constant currency, I think was 13%, down from 22% the year before.

The stent market, not speaking of your place within it is kind of more of -- when you look at the product portfolios you have across very wide range of businesses. Do you think with what you is the kind of the businesses that you've got in hand that you could grow the top line at 10% sustainably, and just as a little twist to that. It looks like you're dipping your toe into orthopedics in China.

Is this an area that is an 8% to 10% market, is that a market worldwide that might be of interest to you?

Bill Hawkins

Well, first in regards to the question about growth. Yes, we do think we have the portfolio that would enable us to grow in that, if you will high-single digits, low-double digits, the 9% to 11% kind of a range. Okay, I mean the CRDM market is still a very important business for us, and what we have said in the past. And I think it's still valid going forward. We think that market can grow in sort of the mid-to-high single-digits, somewhat like we've seen in the Pacemaker business.

And then on the vascular or the CardioVascular space, look we've got some stair steps left in that market with the US which is our focus now, but then Japan next year or so and who knows what's going to happen beyond that. So, I mean this is a very dynamic market, and we are all looking for ways to extend the benefits that you get with minimally invasive vascular intervention. So I think, I wouldn't write-off any of those markets.

But the other one is endo I mean the whole Endovascular business, which is kind of a sort of little bit of a sleeper, I mean is we've been quietly building that market with now with the Talent AAA and the Talent Thoracic, I think some all legs left to go there. So, I think overall, Bruce we feel very good about the internal courses that we have that can enable us to deliver market leading performance, and we think that's and that sort of around 10% kind of a range.

On the orthopedics question, we are excited about the ups and need to learn more about the business outside the US and China, and we'll, we think it's going to strengthen our final franchise and give us a chance to really present ourselves is more of a local company and again that said, we think the China could be the second, there could be the biggest market outside the US in the next ten years and so we are taking the appropriate steps to position ourselves in that regard.

Bruce Nudell - UBS

What I guess structurally, the orthopedics major reconstructive any 7% or 10% market is that simply, kind of below what you need to see in a space get interested?

Bill Hawkins

Well I’ll take that would be reason we wouldn't get into it, I think there is, it is been a solid performer for a long period of time and if you look out going forward with the demographics, the aging, the population, the fact that it's got a fairly good value proposition and its less subject to people starting the clinical trails, I would tell you that you

should put a hip in. I think people are going to be pulling hips and knees for a long time to come. So, I think it's a good market for those who are in it.

Bruce Nudell - UBS

Thanks so much.

Operator

Your next question will come from the line of Joanne Wuensch with BMO Capital Markets.

Joanne Wuensch - BMO Capital Markets

Thank you very much. Mich in terms of Endeavor outside the United States you commented to that your value share was 20%, can you give us as a feel for using the dollars shares?

Michael DeMane

That was more of the dollar share, I mean its.

Joanne Wuensch - BMO Capital Markets

So, you think the dollar shares, so let me ask question in a different way that, what’s your valuable share?

Michael DeMane

Well we are going to -- I'm not going to go there, but if you look today and you combine their metal and drug-eluting stents, I'd submit that we are close if not the market leader outside the US.

Joanne Wuensch - BMO Capital Markets

Okay. In the United States can you give some idea of where you were pricing and how you are thinking of selling the Endeavor and your initial marketing plans for that?

Gary Ellis

Well, as we all know in the US it's a highly competitive market and I'd say that we have a good product, we are confident about the product and we're going in aggressively. We need to get into a lot of accounts, I can't say we are going in as if you will, the value leader on the other hand we are going to be very competitive in all the accounts.

So, I wouldn't say that we are going in any particular price point, but we are remaining flexible in order to gain entry to large accounts. I also need to say that we are off to an exceptionally strong start as Bill mentioned in his introductory comments. And I think our customers are finding the product to be in addition to the safety profile, superb deliverability and that is allowing us to take those accounts.

Bill Hawkins

Operator, we will take one more call. I want to be mindful of the time and so one more call.

Operator

And your next question will come from the line of Tao Levy with Deutsche Bank.

Tao Levy - Deutsche Bank

Hey, thanks a lot. Good morning. So, a couple of questions, one I just wondering if you wouldcomment on the pricing trends in the US ICD market and also if you could just venture to give us a sense of how you felt the ICD markets grew both in the US and internationally in sort of the calendar fourth quarter, now that you have seen the other companies report?

Michael DeMane

Yes, first on the pricing on the US ICD market, I mean, it's fairly stable as we reported last quarter. I mean really not a lot of movement. As far as the market growth, again notwithstanding the comment if you don't make any adjustments for the $20 million that Bill, alluded to that should probably be back in Q2. The US market grew about 2.5% and the international markets grew it over 20%.

Tao Levy - Deutsche Bank

Did you expect those to continue – at a similar rate there?

Michael DeMane

Yeah, I think we've seen -- I seen in the US, I think we've seen a couple of quarters in row of low single-digit growth in the US and outside the US we've seen in the 15 to 20 range.

Tao Levy - Deutsche Bank

Okay. And just, for Gary quick clarification on, to your guidance is that include the tax benefit that you had this past quarter?

Gary Ellis

Yes, it would. It would include that that well, again from the standpoint not obviously that relates to onetime and yes the tax benefit would be included in that numbers.

Tao Levy - Deutsche Bank

Okay. And just lastly, does the situation in France, is Xience enjoying there and with that also have an impact on Fourmies just because Boston had made a comment on their earnings call, they expect to launch Fourmies in France in the near future.

Bill Hawkins

Well, as you know, we have been in court with our evYsio patent in France. We do think that Xience does infringe. We have heard that there maybe a design around, but we're yet to see inside the product at this time. So, we need to simply hold judgment on that until we see it and make an assessment. But we feel that our patent coverages are broad, so we look forward to that assessment.

Tao Levy - Deutsche Bank

Great, thanks a lot.

Bill Hawkins

Okay. Maybe just a couple of comments, while there are -- as I've said in the past there are many moving parts in a company of our size. The sum total of those parts is poised to do what we do best and that is to serve more patients. We are confident that the ingredients are in place for us to deliver top tier performance in the years ahead. And our heighten efforts to identify pan-Medtronic cost synergies will allow us to fund new product opportunities that are essential to serving more patients while generating leveraged earnings growth.

So, now on behalf of our entire management team many thanks again for your interest and continued support and stay tuned. We look forward to seeing you at the end of our fiscal year.

Operator

Ladies and gentlemen that does conclude our conference for today. You may all disconnect and thank you for participating.

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Source: Medtronic Incorporated F3Q08 (Qtr End 01/25/08) Earnings Call Transcript
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