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

Executives

Coleman N. Lannum - Vice President of Investor Relations

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

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

Analysts

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

David R. Lewis - Morgan Stanley, Research Division

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

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Matthew J. Dodds - Citigroup Inc, Research Division

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

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

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Matthew Taylor - Barclays Capital, Research Division

Kristen M. Stewart - Deutsche Bank AG, Research Division

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

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

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

Covidien (COV) Q3 2012 Earnings Call July 26, 2012 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q3 2012 Covidien plc Earnings Conference Call. My name is Clinton, and I'll be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And now, I'd like to turn the call over to Cole Lannum, Vice President, Investor Relations. Please proceed, sir.

Coleman N. Lannum

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

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

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

During today's call, we'll make some forward-looking statements, and it's possible that actual results could differ materially from our current expectations. Please note that under the Safe Harbor rules, we are under no obligation to update these forward-looking statements even if actual results or our future expectations change materially. We ask that you please refer to the cautionary statements contained in our SEC filings for a more detailed explanation of the inherent limitations of such forward-looking statements.

We'll also discuss some non-GAAP financial measures with respect to our performance today. A reconciliation of non-GAAP to GAAP measures can be found in our press release and its related financial tables as well as in the Investor Relations section of our website, covidien.com.

For the third quarter, we reported GAAP diluted earnings per share of $0.93. And after adjusting for certain specified items, our non-GAAP earnings came in at $1.07 per share.

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

Jose E. Almeida

Thanks, Cole. We delivered a very solid performance in the third quarter. Sales were on plan, up 6% operationally and 3% as reported. Our recent acquisitions contributed about 1 point of revenue growth in the quarter. We again registered year-over-year improvement in adjusted gross and operating margins.

In the Medical Devices segment, we had an outstanding quarter with 8% operational growth led by Energy and Vascular products. In the Pharmaceuticals business, we again registered a very good performance for Specialty Pharmaceuticals paced by PENNSAID and EXALGO. And in Supplies, sales were somewhat above a year ago.

Before I go into more detail on our third quarter results, I'd like to spend a moment discussing the overall health care products marketplace. In the U.S., we have not seen any significant change in volumes, procedures or utilization in the last few months. Volumes remained depressed, largely due to continued high levels of unemployment and delays in elective procedures.

In Europe, austerity programs and the economic slowdown continue to pressure all of med tech.

Emerging markets are growing rapidly and we expect this to continue as access to health care expense, and the demographic trends are favorable.

Our results this quarter showed the positive impact of our broad portfolio and global leverage. In the U.S., sales grew 6%, driven by very strong 9% increase in the -- for Medical Devices. In Japan, we delivered double-digit growth with good gains in Energy, Vascular and Stapling products. We also made solid progress in other developed markets including Canada and Australia. In our emerging markets comprising Eastern Europe, Middle East and Africa, Asia and Latin America, sales again grew at a double-digit pace with broad-based gains led by Endomechanical, Soft Tissue Repair and Energy products. We registered exceptional growth in the BRIC countries, led by China and Brazil, where we will continue to make incremental investments to accelerate growth and expand our product offerings.

This positive progress was partially offset by somewhat slower growth in our European business, which was up in the low single digits operationally this quarter. Across the business, we saw a significant slowdown in Spain. The sales grew in many other markets despite the difficult conditions. We believe we have the right mix of products and technologies to be successful in the European marketplace.

As now I get into my comments on individual product categories, I would discuss our growth on an operational basis excluding the negative impact of foreign currency. I'm doing this because I believe they provide of a better picture of our progress.

In our large Endomechanical business, stapling products continued to perform very well with a double-digit increase led by the innovative Tri-Staple reloads. We experienced a strong demand for Tri-Staple as we continue to grow above the market and gain incremental share in stapling.

Sales in Soft Tissue Repair were up slightly from a year ago. We made good progress in the large suture category, gaining share, but increase was partially offset by declines in mechanical fixation. This was due in part to the impact from competitive product launches in both the U.S. and Europe.

Our Energy business had another robust quarter as new products such as Sonicision and the LigaSure Small Jaw, coupled with growth in hardware, contributed to our performance. While it's still early in the launch cycle for Sonicision, we're encouraged by the progress thus far. We continue to expect Energy to be a key growth engine for us, driven by low penetration, technology adoption and hospital patient economics and outcomes.

Turning to our Vascular franchise. We achieved excellent results. Our third quarter performance was led by exceptional growth for neurovascular and a very strong performance for peripheral products. In neurovascular, flow diversion and Solitaire drove our results while the peripheral business benefited somewhat from the competitive -- from a competitive recall. As we noted earlier, we're making substantial investments in selling marketing clinical trials to deliver further growth in new products in the Vascular category.

Sales of Oximetry & Monitoring products were above a year ago. And as we continued to make progress in this category, our 3 franchises, Nellcor, BIS and INVOS, provide us a broad platform for growth. Our recent acquisition of Oridion would expand our portfolio into capnography, a key technology to monitor the adequacy of ventilation and provide an early indication of airway compromise to make patient care safer and easier.

In the Airway & Ventilation category, sales were above a year ago. We registered double-digit growth in ventilators, the best performance in a couple of years, and led by strong sales in emerging markets. Our business was negatively impacted by the earthquake in Italy as our factory was shut down for several weeks and our distribution centers sustained significant damage. While our factory is up and running, we would likely feel the negative impact of the earthquake on this business for the next couple of quarters.

Turning to the Pharmaceuticals. We again registered exceptional growth in our specialty product line, more than doubling sales of PENNSAID and EXALGO, higher generic sales and increase for our Radiopharmaceutical products.

In Contrast products, sales were well below last year due to customer order timing, product line discontinuations and continued weakness in the U.S. We expect this weakness in Contrast to continue for the next several quarters.

Sales of Active Pharmaceutical Ingredients improved, primarily reflecting an increase for pain management products.

Turning to Medical Supplies. Sales were above a year ago, led by mid-single-digit increases in Nursing Care and for Medical Surgical products. Growth, however, was partially offset by lower SharpSafety sales due to a strong price competition. The Medical Supplies business continues to meet our expectation and provide good cash flow and ROIC.

Overall, we are very pleased with our results. We continue to experience broad-based growth in areas such as stapling, vessel sealing, vascular and specialty pharmaceuticals. As I noted, our broad product portfolio and geographic diversity are keys to driving growth. We continue to make investments in expanding our capabilities and to capitalize on opportunities we are capturing from increased penetration of our products, particularly in Vascular and Energy. Our customer mix, favoring the larger hospitals and the broader demographic trends, are both moving our favor. These factors all contribute to our belief that Covidien is very well-positioned for further growth as we expand our global share in our current categories, grow our business in adjacencies and look for additional opportunities to accelerate our performance.

Before I turn the call over to Chuck, I'd like to briefly comment on our recent portfolio management activities. As you know, we made a number of acquisitions in 2012 that complement our Surgical, Energy, respiratory and Vascular businesses. We're very excited about each of these acquisitions and are in the process of integrating them with Covidien.

On a combined basis, the markets that these companies compete in represent more than $10 billion globally, growing at a double-digit rate that offers entry into several promising clinical areas, including gastrointestinal disease, oncology and hypertension. Each of these portfolio additions are consistent with the acquisition strategy I discussed at our Investor Day last September. Each one provide us entry into a fast-growing market opportunity, is adjacent to or overlaps our current product lineup and provides us access to products or technology that will accelerate our growth. They strengthen our core business and provide us opportunities to leverage our geographic footprint and functional capabilities.

I will now pass the call over to Chuck who will discuss the third quarter in more detail. Chuck?

Charles J. Dockendorff

Thanks, Joe. As Joe noted, we're pleased with our performance in the quarter as sales came in about on plan with 6% operational growth, driven by 8% growth in Devices. We had improvements in adjusted gross and operating margin percentage and made further investments in R&D, selling and marketing to ensure our future growth.

As noted in the release, we registered a 90 basis point improvement in adjusted gross margin this quarter, driven by positive business mix, subdued pricing pressure and excellent progress on our ongoing manufacturing cost-reduction program.

Reported SG&A spending was up versus a year ago, largely due to continued investments for our growth initiatives including the Asia growth plan where we are expanding our sales and marketing presence. SG&A also included separation and transaction costs.

The growth investments were largely funded by our productivity improvements and leverage on our back office costs and base business SG&A.

While we expect to accelerate productivity gains, we do expect that SG&A spending will be up over the next several quarters as we increase our investments in selling and marketing in emerging markets and in the Vascular and Energy categories as we see continued opportunities for growth in these areas. In addition, amortization related to our recent acquisition activity will put further upward pressure on SG&A.

R&D increased 15% to 5.3% of sales in the quarter, and we remain committed to our goal to further increase R&D over the next few years to develop products that are clinically relevant and economically valuable.

On an adjusted basis, our operating margin at 22.5% of sales was up 40 basis points from a year ago and in line with our guidance.

Net interest expense was slightly higher, reflecting our recent $1.25 billion debt offering and lower interest rates on our invested cash.

The adjusted tax rate was in line with our annual guidance and we delivered a 6% increase in adjusted EPS to $1.07.

During the quarter, we repurchased about $225 million of stock. In the last 12 months, we have returned nearly $1.4 billion in cash to shareholders, representing more than 80% of our free cash flow over that period. Note that we returned this cash in addition to investing nearly $1.1 billion in strategic acquisitions.

We also collected a significant portion of our outstanding accounts receivable in Spain and saw a positive trend on our outstanding balances in Italy.

As you know, we have traditionally not updated guidance on our third quarter calls and today is no exception. However, as a result of the extra week included in our fourth quarter 2011 results, we face a difficult comparisons for this year's fourth quarter and the full year. Therefore, I'd like to provide some qualitative comments on our expectations for the fourth quarter in relation to the results we have just reported in the third quarter.

Through the first 9 months of fiscal 2012, our adjusted EPS increased 12% over the prior year, and we have beaten consensus estimates by about $0.13. Our goal of double-digit EPS growth was achieved as a result of strong operational performance, improved margins, productivity improvements and positive momentum from the investments we've made in new market opportunities.

We continue to balance investments for future growth of the business while staying focused on delivering shorter-term earnings growth. We expect the operational improvements and investments to continue into the fourth quarter. However, we do expect fourth quarter earnings will be lower than those in the third quarter, consistent with the historic seasonality of earnings for the company.

There are also a couple of other factors, which will impact us going forward. First, foreign exchange was a slight positive for us in the first 6 months of 2012, but turned slightly negative in the third quarter. At current rates, exchange will be more of a drag on our results in the fourth quarter as the strengthening of the dollar lowers our reported sales and puts pressure on our gross margin, tax rate and translation of profits outside the U.S.

As a reminder, although we consistently hedge the majority of our net operational currency exposure, those hedges are marked to market quarterly while the operational impact of moves in the dollar will impact us negatively over the next several quarters.

Second, while the acquisitions we made in 2012 have not had a material dilutive impact individually, on a combined basis they will be dilutive by a few cents per share in the fourth quarter.

As we said last year, we believe the extra week contributed 7 to 8 percentage points of revenue growth with a leverage positive impact to the bottom line. Our current expectations are that fourth quarter earnings will be sequentially lower than the third quarter as is typical for us, but also well below last year's fourth quarter, which received the benefit of the extra week.

Before we go to Q&A, I would like to briefly discuss our capital allocation program. As you know, our plan is to return 25% to 40% of our free cash flow to shareholders each year through dividends and share repurchases. In the last couple of years, we have returned cash at a much higher rate. In the last 4 quarters, cash returned to shareholders was more than 80% of our free cash flow. This was done during the same period we invested more than $1 billion in acquisitions. We expect our cash flow to remain strong, and we are now increasing our commitment to return more than 50% of our free cash flow to investors through dividends and share repurchases. We will discuss this in more detail at Investor Day in September.

As you can see from our year-to-date results, our sales, operating margin and tax rate are in line or better than our previous guidance for fiscal 2012. As we look to 2013, we continue to feel very good about our prospects, giving our -- given our expanding product portfolio, geographic diversity, growth-driving investments, new product pipelines and strong cash flow. We'll provide full guidance for fiscal 2013 at our September 13 Investor Day meeting.

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

Coleman N. Lannum

Thanks, Chuck. [Operator Instructions] I'm sure as everyone knows on the call, it's a very busy morning for med tech earnings. We want to get through this as quickly as possible. [Operator Instructions] Clinton, could you please review the process once again for signaling for a question?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of David Roman of Goldman Sachs.

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

I wanted to just ask 1 strategic question for Joe and then a follow-up on the P&L, Chuck, per your commentary at the end of the call. So maybe first, for Joe, as you look at fiscal 2012, the revenue growth that you've been able to put up sort of sustainably in that 5% to 6% organic range, has an incredibly strong relative to your peer group. But if you put that into some context, you have a lot of new product launches this year whether it's Solitaire pipeline, you're doing very well in Energy. Can you maybe just speak to the sustainability of that growth on a go-forward basis and whether to what extent fiscal 2012 organic numbers saw major benefit from new product launches and whether that can continue on a go-forward basis?

Jose E. Almeida

Dave, this has been the story of Covidien, coming from a very poor R&D investment profile pre-spin. We have counted on new product launches to augment our growth on a year-to-year basis above share gains, so I don't see that easing going further -- going into the future. And I will highlight one thing that is important to all. Understand that when we launched new products, med tech is very different than pharmaceuticals. We achieved big sales 2 to 3 years into the launch of a product. So we still have a significant amount of good opportunities into the future. And also, think about the penetration of our products and some of the technologies that we have, coupled with some strategic acquisitions that we just made to complement our product lines. So I feel comfortable that Covidien's commitment to above market growth on the top line is sustainable into the future.

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

Okay. And then for Chuck, as I think about the comments that you just made at the end of the call in terms of potential pressures on the P&L, can you maybe help us sort of think through some of the headwinds and tailwinds as we go forward here? And the way I'm thinking about it is, obviously as Joe just referenced, thinking about sustained top line growth as a tailwind, positive mix as a tailwind, but then as we think through foreign currency exchange rates, the tax rate and the med tech tax as headwinds, how does it all square together in the P&L and to your goal on double-digit earnings growth?

Charles J. Dockendorff

Well, we're going to talk more about fiscal '13 in detail at our Investor Day. I don't want to get too much into that on this call today as we typically update our guidance for next year at that point. But I think the thing now, the sustained revenue growth, the operational growth that we see, we see continuing forward, we certainly have a favorable mix within our gross margin and some of the restructuring programs. We see that as continuing through the next year. That's continued this year, and we see those tailwinds or benefits continuing through the following quarters. The FX piece is one that is dramatically turning around. If you look at our year-to-date, we're slightly positive, but in the third quarter it was negative. And it will end up negative for the year, both when you look at gross margin and EPS year-over-year. And those will continue into the next quarter, a couple of quarters of '13 if rates stay at the same rate they are today. You can see the rate comparisons and the impact to us going forward. But other than that, we expect to continue to drive productivity improvements through SG&A. We're achieving significant leverage and productivity improvements on this line item. But we're also reallocating some of those into the high-growth investment opportunities that we see in Vascular and in the emerging markets. So some of it is a reallocation of those SG&A expenses while we're driving through the productivity. [indiscernible] we said we'll deal with that.

Operator

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

David R. Lewis - Morgan Stanley, Research Division

Chuck, thanks for your comments on capital deployment. I think people appreciate the elevated commitment. I wonder if you could share with us, that 50%, have you given some more thought in addition to the elevated commitment in terms of the mix of how that capital could be deployed back to shareholders in terms of buybacks or dividends?

Charles J. Dockendorff

Yes, I think we're discussing that right now, and again, I don't want to get into any specifics and we'll cover a little bit more of that into Investor Day. But certainly, we would expect the dividend to increase commensurate with earnings that we've had in the past. And we have an event next year where our Pharma business is going to be spun off and decisions need to be made around the capital plan for Pharma and whether they have dividends or we retain all of that dividend. So our payout ratio may go up from that alone as we divest Pharma depending on the amount of dividend they take in. So we're going to take that into consideration and we'll have more clarity around it on Investor Day in September. But clearly, it will be a mix of share repurchase and dividend increases as we go forward.

David R. Lewis - Morgan Stanley, Research Division

So that's very helpful. And then, Chuck, maybe just one more question, follow-up on the P&L. If you think about 2012, it certainly seems that the new management strategy has been to obviously reinvest to drive growth and that's been very successful. So this year, the way it played out, as you saw GM upside, really not much SG&A leverage. I'm just trying to interpolate your comments. It sounds like fiscal '13, without providing specifics, may shape up somewhat like fiscal '12 where you get gross margin upside but less SG&A leverage, is that kind of a fair way of framing it?

Charles J. Dockendorff

Again, I think where we, as a company, we drive to the double-digit EPS growth. That's what we try to do. And we're trying to balance off some of the investments for the long-term health of the business, which we've been able to make this year in Vascular, Energy, emerging markets, as well as achieving these short-term goals. And it's all different components of that, whether it's FX, raw materials, SG&A leverage. I would tell you, though, that we're driving through every line to drive through productivity and gross margin. We're driving through every line on SG&A to drive productivity there, tax rates, everything. So we use all the forces and all levers we have to drive through those improvements. We can't control some of the other factors, but we try to mitigate those as much as we can. But I think the trends that I talked about with -- in gross margin with the mix, the favorable mix, and some of the SG&A leverage, it's our intention to drive further improvements to those going forward.

Operator

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

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

Let me start here with the context of this call, which is a pretty negative second quarter earnings season for most of the sector. And you guys report what I would characterize as the strongest results in a large cap med tech to date. Your U.S. performance, if anything, was better this quarter than it was last quarter and obviously better than it was a year ago. So I would just appreciate, Joe, your own sense of why you're doing better and it's not just ev3 in those markets, but it's your base business. Why is your base business, you think, doing better than what we're seeing from a lot of these other reports? And why do you think your end markets are healthier today than some of the other data points we're either picking up on in the U.S. or Europe?

Jose E. Almeida

Mike, I think there are couple of things. One is related to choices in the portfolio of Covidien and how we balance risk, growth and deployment of our capital. And we've been making bets that have been paying off better than the ones that did not pay off. So if you think about our bets, you've asked our bets in -- it continues to invest in stapling, that's -- for most people think of stapling as being a franchise. There's -- have 2 players and a stapler -- as a stapler Covidien believed that there's more technology, more benefits for the patient so we invest more money. So it's about the bets that we made first. So the portfolio management is very important to Covidien. The second thing is the inorganic plays that we decide to participate. I think we've been making better bets as we're getting more mature in terms of understanding the markets and the spaces that we want to participate. And third, and most importantly, are the people that we have. Our folks are execution-driven. Everybody knows there's a tough market out there around the globe and we have very, very good people. I would say, if not the best, one of the best in med tech. So those are the main 3 factors that give me confidence in our company.

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

And Joe, with Chuck's comments about increasing the return of capital to shareholders or at least let's call it the commitment because you guys have been, where does that leave room for business development? And could you just talk, as you look forward over the next 6 to 12 months with ev3 having gone as well as it has, how we should think about business development activities and the potential for additional acquisitions?

Jose E. Almeida

What Chuck mentioned is a minimum -- elevating that to a minimum of 50% in that return to shareholders. That's a great commitment that we embarked and then we're going to get you more details in September, as Chuck said. But I would say that Covidien has very strong cash flows and the projection is healthy. So we need to make sure that nothing's left on the table that is -- that doesn't need to be left on the table. So we made our commitment to our shareholders not to leave money on the balance sheet. But also, we made a commitment to invest in the company for the future. So as we see dividends and share buybacks as an immediate reward to our shareholders, we have planned, in our numbers, to have acquisitions on a yearly basis. We look at acquisitions all the time. The size of the acquisitions depends upon the space that we're planning to participate, adjacency or white space. But I will say to you that our strategy has mainly been focused on adjacencies. And to that end, Covidien has plenty of cash to continue to participate in those types of acquisitions. Now as I always say is there's a great deal of opportunistic -- those in any acquisitions that we participate. If something bigger comes about, Covidien always has the opportunity to tap into its good credit rating. And our ability to evaluate, you know how cheap money is now, so we have several avenues if something bigger comes about. But we have a pretty healthy dose of M&A in our future projections of cash flow.

Operator

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

Robert A. Hopkins - BofA Merrill Lynch, Research Division

So 2 quick things. As we look to 2013, and I know you'll be giving guidance in September, and obviously there's a ton of cross currents here and I'm not going to ask you to go through each one. But I think the things that people will be very interested in hearing from you is if you exclude the things that you can't really control, which is the medical device tax and foreign exchange, do you see 2013 as a year where you'll still be able to drive to sort of what I would call underlying operational EPS, double-digit EPS growth?

Charles J. Dockendorff

That's our goal, Bob. And again, we don't want to say it, but I think you see the trends of the business. We've driven double-digit operational growth. We don't see anything when you take off FX and device tax and things like that. We don't see anything in the underlying operational business and the components within there that would change that dramatically for 2013.

Coleman N. Lannum

Remember, Bob, too, you have this accounting distortion because of the extra week and last -- in the fourth quarter of last year. If you compound the growth and take that out of the equation, you'll see that we've had compounded double-digit growth over that entire period.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Right, okay. So that's very helpful in terms of underlying trends and your confidence going forward. So now if we layer in the medical device tax and FX, would you guys consider any incremental restructurings to the one that you've already announced to help you offset some of those headwinds in 2013? Could we anticipate any, again, incremental restructurings in addition to the things you've already announced?

Charles J. Dockendorff

We've already got significant restructuring going on now, Bob, with the programs we have. We're aggressively going in our manufacturing facilities, we're looking at our SG&A around the world, we've got productivity improvements we're driving through. They're coming through at a very good clip. The thing is that we struggled with as a company, we have a lot of investment opportunities. We have more opportunities than what we can invest in. So we constantly balance off this investment for the long-term growth of the business versus achieving our short-term goals. What we don't want to do is to get into a position where we're really sacrificing our long-term investments to meet a very short-term goal when you have strong headwinds against you that really are not under operational headwinds, but rather outside forces. So we could sit here and invest at a much higher rate, but we temper this and we have these things in the bullpen and we drive through these productivity improvements and that's what funds the level of investments we can do going forward.

Operator

The next question comes from Matthew Dodds of Citigroup.

Matthew J. Dodds - Citigroup Inc, Research Division

I'm probably going to pile on a little bit with Bob's question, but when you look at fiscal '13 and everything you laid out, Chuck, the other thing that you talked about earlier was the dilutive impact of these new deals in the fourth quarter. Shouldn't that continue also into '13 and take down what would be a normal number by, I don't know, $0.05, $0.10?

Charles J. Dockendorff

No, that's not the case because the deals when you initially buy them because of the amortization and the ramp of it in the early quarters, there's some dilution but they improve as they go forward. So when you look at a year-over-year comparison, that dilution doesn't exist.

Matthew J. Dodds - Citigroup Inc, Research Division

Okay. And then one other thing. You mentioned subdued pricing environment, at least this quarter versus a couple of the prior quarters. Can you give a little more color to that, what you meant with the ASPs and if there's anything in particular driving that?

Charles J. Dockendorff

In this particular quarter, we saw pricing better than it has been in the past. But our assumptions, going forward, we don't think this is a change. We don't -- we would not extrapolate this into our future results. It's more something that happened within the quarter for whatever reason. It could be mix or a couple of other things that are driving that or new product launches that are driving some of that. So we're not really sure what -- but we see continued pressure out there and we would expect it to continue. And that's what we have in our assumptions going forward, that our pricing pressure will be similar to what we've experienced over the past couple of quarters.

Operator

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

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

The ev3 EverFlex, you have talked about the S.M.A.R.T stent recall. Can you give us a little granularity what the growth was worldwide and whether it's a sticky growth, not only do you think you'll maintain it, but you also think that you're gaining other products within Vascular once you take over some of these S.M.A.R.T. stent accounts?

Jose E. Almeida

Tom, we took an opportunity to take the competitor's product vacuum left. And I think there's always a percentage of accounts that would be retained. And I don't want to speculate how much, but our people are working very hard at our peripheral vascular group to retain as many accounts as possible. As far as I understand the competitor is back in the market, and we will do our best. It has been a good opportunity for Covidien to be able to get into accounts that we didn't have before. And I think because the quality and performance of our products, we're probably going to be able to retain those accounts. How many, we don't know yet.

Thomas J. Gunderson - Piper Jaffray Companies, Research Division

Got it. And then maybe a little off script, if you look over the revenue results of the last 3 to 6 months and you look in particularly in the areas that are more challenged, the U.S. and Europe, is there anything that is surprising to you or Chuck as you look at the numbers that you say, wow, why is that doing better in this particular part, sub-geography or maybe a particular product, not just new products or areas where you've gone into recently but things where it really outperformed to your internal expectations?

Jose E. Almeida

I would say in Europe I was surprised 2 different ways. One is with the resilience of countries like France, Germany, some of the -- Belgium, Holland and somewhat the northern part of Europe, their resilience throughout a difficult period for Europe. I was surprised, on the other way, how quickly Spain deteriorated in terms of the capability of procuring product and growth. So I just have those 2 that, that was a big contrast. Because we had low single-digit growth in Europe. But when you dig into it, Spain was a significant reduction in volume. So everybody else picked up a little bit more. So that is one of them. The other is in the U.S. We are in mostly nonelective procedures. So we are not seeing those nonelective procedures change the profile. I think elective procedures will have more of an impact. If you look our classes of trade, our products, Endomechanical, Soft Tissue Repair, what we are seeing is when you have clinical evidence associated with economical evidence, which is the case of our Energy products, it shows significant amount of resilience. So they help us understand how in the future and when in the future we're going to be investing money. Instead of spreading investment across-the-board, we just need to be more focused in the areas there that we have indications we will be paid in the future.

Operator

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

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

Gross margins have been steadily marching north, which is very nice. Can you tease that out a little bit between FX and mix? And is that a path that we can continue to expect to move on?

Charles J. Dockendorff

Yes, in the quarter the mix was especially strong, a little higher than what we've experienced in the past. But again -- or a little higher than what we've achieved year-to-date. But we expect that mix to continue when we look at the product portfolio and how it's growing and the margins of those products. That is something we expect to continue over the foreseeable future. The big change within the quarter probably was in foreign exchange. While -- when you look at it from both an earnings perspective, it also happened in gross margin. It was a slight favorable to us through the full year, 9 months, but it was negative in the quarter itself. And we would expect to see some more pressure from that in gross margin as we go forward over the next couple of quarters, some negative pressure on that piece of it. Cost reductions, we're continuing to drive out close to 3% to 4% of our costs each year, offsetting inflationary pressures and other things that go in there. So we are anticipating that will continue as well.

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

And then as a second question, it looks to me like the Surgical Devices was a little bit softer than what we were looking for. Is that a tough comp or is there anything I need to understand about the market or the competitive dynamic?

Coleman N. Lannum

Yes, I think a lot of that from an operational standpoint really was right on track to what has been historically, in fact, maybe a little bit better particularly in Soft Tissue and Endomechanical. Some of the things that we've talked about historically, though, Joanne, with some of the competition we've gotten in instrumentation, that continues. And the fixation market in Soft Tissue was a little bit weaker in the quarter. So you may have seen it on a reported basis a little bit weaker. But on an operational basis, we were actually very, very pleased with the number.

Operator

The next question comes from Matthew O'Brien of William Blair.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Just one obligatory Pharma spin question. Is everything still on track there in terms of the potential timing of that spin-off?

Jose E. Almeida

Yes. No -- nothing extraordinary to report.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Okay. And then just quickly, you mentioned some stellar growth in neurovascular in the quarter. Can you give us a sense of what that actually was during fiscal Q3? And then how much of that, do you think, is related to Solitaire versus market growth? And can you just give us any kind of anecdotal feedback initially on the launch of Solitaire?

Jose E. Almeida

The growth was a little north of 30%. And if you think about how the growth has been achieved is by having disruptive products in the marketplace. So it's pipeline as well as Solitaire. But above and beyond that, our coils and accessories are doing well as well. So in terms of market growth, we tend to think the market growth for those devices are between 8% and 10%. So we are going way excess of the market. And primarily, as I said, it's the disruptive nature of the products that we have and they are products that, clinically, are well understood. So for patients who are very, very sick, these are great products.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Okay. Just quickly, the anecdotal feedback on Solitaire so far?

Jose E. Almeida

We're doing very well. We're adding significant amount of centers to our customer list. And I think the prospect is to continue to go on. This is a long-term product. I had mentioned earlier on about time to pick sales. This product specific has a much longer time to pick sales because the market development that gets to be done and how you develop the markets. For instance, we just got approval in Brazil for this product. There's a significant amount of work that Covidien will be doing with the government in stroke prevention, in stroke treatments. So it is important that you understand, the folks on the call, investors, that this is a great product, great platform, but it's a longer-term product for us.

Operator

Your next question comes from the line of Matthew Taylor of Barclays.

Matthew Taylor - Barclays Capital, Research Division

Just wanted to ask another product one, on Sonicision. You mentioned a strong start. How should we expect that ramp to progress? And is it meaningful this year or next year? And can you give us a little bit of color on just the receptivity of physicians to your product?

Jose E. Almeida

We are pleasantly surprised with the launch. The ramp has been exceptional. With that said, I would say it's a tremendous market potential. It's about $400 million and that's not going to be tackled in the first 2 quarters of the launch. So I would move your expectations in terms of good growth rate into 2013 when we think we're going to have a better understanding of the product, how that product works in the hospital. Remember, this is a semi-reposable product. You have a battery and you have a bunch of things that we use at the hospital level. The batteries are rechargeable batteries. And when we convert an account, there's significant differences in converting an account to selling a disposable product. So I'm very excited about the product. I think it can be really good for the whole system because its reposability. And I would -- I will say that the first -- I would say first, second quarter of 2013 is when we should see this thing taking off.

Matthew Taylor - Barclays Capital, Research Division

And just on the cash, can you just remind us what your mix of U.S. cash flow to o U.S. is? And without giving the details that you don't want to provide before Analyst Day, what was some of the key factors that drove your decision to increase that commitment to returning cash?

Coleman N. Lannum

Yes, on the U.S. versus o U.S., Matt, we don't disclose that. But let me remind you that we don't have the same tax implications for pulling cash into the United States as most U.S. companies do because of our incorporation. Chuck will take the question on the whys.

Charles J. Dockendorff

On the change in the capital program itself, what it is it's more a reflection of what we've actually been doing. So when we started out as a company, we had established our initial capital policy about 1.5 years after we became public and we wanted to make sure the business was good and healthy and the cash flows are there. We had some legacy things we've taken or we were watching and things like that. So as we got more confident, we came up with the initial capital policy. So what we stated today is more a reflection of what we've actually done. We've actually been paying out at a higher rate than 50% and we would expect that to continue. And so when we look at the cash flow going forward, and I'd say we pay out more than 50%. We've been paying out 80% while we've done acquisitions over $1 billion over last year. So as we look at our cash flow going forward, it's very strong. We see very little variability in it. We see slow, consistent improvement like our earnings. And we feel that we can still do significant acquisitions and meet this capital commitment.

Operator

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

Kristen M. Stewart - Deutsche Bank AG, Research Division

Sure. Just a quick follow-up on the cash flow, and apologies if this is addressed already. But any update on the legacy tax potential liability and how that might affect your future cash flow? I think you're reserved for it already?

Charles J. Dockendorff

Yes, we are reserved for it. We made a payment this year on that. It was close to a couple hundred million. Again, we're working with them. These are long term-type settlements, we'll make another payment probably next year, probably not as large, but it's hard to predict specifically when they go out. We don't see it coming as one big lump sum or anything, but more kind of paid out over the next 4 to 5 years as we begin to settle these things with the IRS.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Perfect. And then just so I understand, the comments around 2013 and just kind of your comments just kind with FX and whatnot. Chuck, I think in the prepared remarks, you had mentioned that you did achieve the goal of double-digit operational growth. I just want make sure I understand. Your outlook is still to achieve that double-digit operational growth, although we should also think about FX next year as being a continuous headwind at least for the first couple of quarters. And then, do you have the medical device tax rate as being about a 300 basis point kind of difference, I guess, if you will, in the earnings growth rate with that impact for at least the first, or I guess, last 3 quarters of the year?

Charles J. Dockendorff

300 basis points growth, we haven't looked at it in those terms yet. I think the -- we -- it's about 2% and 1/2 our revenues are subject to that tax. It will begin in our second quarter because our fiscal year ends at September. So we've always said it's probably about 70 to 80 basis points on our net income percentage as we look at it.

Coleman N. Lannum

Yes, and Kris, I'm glad you brought that up. It's a good reminder because I think there has been some confusion about this for us, at least. I want to remind everyone that tax is going to flow through our SG&A line. So what you're going to see, everything else being equal, is starting in the second quarter of 2013, that SG&A line being pressured solely due to the med tech tax even if nothing else changed. So I want to make sure everyone has modeled that correctly.

Kristen M. Stewart - Deutsche Bank AG, Research Division

And that tax, is it about $30 million a quarter on a pretax basis that would be included within SG&A roughly?

Charles J. Dockendorff

It's not that high, not that high. A little lower than that.

Kristen M. Stewart - Deutsche Bank AG, Research Division

Okay. Then last real quick one. Is the Pharmaceutical spin-off still expected to be domiciled in Ireland?

Jose E. Almeida

All indications is that the company will be incorporated in Ireland, yes.

Operator

The next question comes from the line of Lawrence Keusch of Raymond James.

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

Obviously, emerging markets continue to be a very important component of your growth. And Joe, you again sort of mentioned how well it did this quarter. Could you just review for us again sort of what you're doing with the infrastructure and how we should think about currently what's generating that emerging market growth now? I think everybody tends to lean towards China. But I have a suspicion that you're actually generating quite a bit of growth in revenue dollars elsewhere.

Jose E. Almeida

Yes, we are. And we put -- when we talk about emerging markets, as you said, everybody thinks about China. China is growing exceptionally well, our deployment of our growth plan there including the infrastructure. But also the sales force and how we are understanding the market and how we are penetrating several different facets of the market has been great for Covidien. But we also have plans in Russia and we're doing extremely well in Russia, in other parts of Asia as well. And in Latin America, like Brazil, is doing extremely well, doing so well, we're starting to invest more. We have a Latin America investment plan that we're putting in place and Brazil is going to be one of the highest investments within Latin America. And you're talking about 25% to 30% growth ongoing for some of those BRIC countries. So things are starting to pay off. There's lots to get accomplished. Brian King and his team are doing an exceptional job there, so we just need to continue to support them and understand. And I want to make sure that everybody understands here that Covidien is very profitable in emerging markets. So this makes it easier for us to justify investments.

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

Okay. And then just the other question and I know you're very engaged right now in the spin in the Pharma business. But can you just walk through briefly the strategic rationale for holding onto the medical products business? I mean the operating margins are obviously half of what the Medical Devices business is. The growth is substantially lower. I understand that it generates a lot of cash flow, but strategically why does it need to be part of Covidien?

Jose E. Almeida

There's couple of reasons. First of all, the consistency of cash flow is one of them. The second of the rationales is that as I mentioned in my prepared remarks, there's a potential for future consolidation of hospitals in the U.S. I think in having the ability to provide a better and bigger vascular products to hospitals is a benefit of Covidien. And that business has a deep reach into every facet of care, acute -- from acute all the way to the home. So that offers a great platform. So Covidien, when we need to test and learn something in home care, for instance, we use our supplies infrastructure to do that. So at this point in time, we find that it's important for Covidien to be well represented as the market dynamics continue to favor companies who can provide large solutions to hospitals.

Operator

The next question comes from the line of Anthony Petrone of Jefferies Group.

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

One product question and a couple of financial questions to follow up. On the product side, can you just give us an update on the recall on the Duet staple products. I know it was announced late in the quarter there, just in terms of where you are in the recall process and what the costs would be behind that, and is that reflected in sort of the dilutive nature you outlined for the fourth quarter? And then some financial questions. The overall OpEx has increased $44 million in Q3 and $78 million last quarter. How much of that actually goes away as a result of synergies from closed acquisitions, for one, and eventually as the Pharma spin winds down, for two?

Jose E. Almeida

I just want to clarify the Duet recall that Covidien put in place was put in place in the second quarter.

Charles J. Dockendorff

Yes, January and February.

Jose E. Almeida

Yes, it was the second quarter of Covidien, okay, and that was related to the thoracic application. We, at that point in time, had mentioned that, first of all, the recall is probably near complete. There's no -- there was not a significant impact to Covidien overall. Moreover, the fourth quarter has no -- there's a negligible impact in the fourth quarter, if any, that is specific recall.

Charles J. Dockendorff

As far as the operational expenses, they did go up. We're driving through productivity and we're getting significant leverage and productivity in our SG&A. But we are making investments in primarily emerging markets and vascular therapies, which are very high-growth opportunities for us so that's driving those expenses up a bit. And deals had some impact to it, but not a lot. I mean there were some increase from the deals in the quarter that will continue into Q4, but that was pretty much driving that. As far as OpEx synergies or what we look at once the Pharma spins, certainly we'll have some transitional activities going on once Pharma spins. We need to figure out how long those transitional activities will last, but it is in our plan to reduce our base SG&A once that division does spin. The timing of that will be dictated around the timing of those transition services agreements.

Operator

The final question comes from the line of Jonathan Palmer of CLSA.

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

Chuck, could you just comment on the FX in the quarter? If we think about the impact, could you just bifurcate between euro or European exposure and other emerging market currencies? And then how does that ratio change on the bottom line?

Charles J. Dockendorff

It's -- we've seen all different kind of movements within FX. We've seen the yen strengthen, the euro fall during different periods and we make significant profits outside of Europe. We make profits in Japan, Australia, Canada, all over the world. And so it's hard to just correlate that or say in general currencies are moving this way and that way. But I think if you look at our FX, the EPS impact from it, for the full year, we expect it to be down, probably year-over-year. It's going to have an impact of somewhere between $0.05 to $0.08, something like that. And so if you think about it through 3 quarters, we're positive and we're going to go negative here in the fourth quarter when you do the year-over-year comps. So it's been trending down as we go out through the year. So generally, the dollar has strengthened against most currencies during this period. Beyond that, I can't get into too much detail around it. But I think generally, you're going to see that trend continue into the next couple of quarters.

Coleman N. Lannum

Okay, folks, thank you very much for your time. Again, I know it's been a very, very busy morning in med tech land. Starting at noon Eastern Time today, a replay of this call will be available. Additionally, the replay will be available in our corporate website, covidien.com, a few hours from now. For members of the media who listened to the call and have additional questions, please contact Eric Kraus, our Head of Corporate Communications. For analysts having more detailed questions involving nonmaterial information, Todd and I will be available throughout the day to take your calls. Thanks, and have a great day.

Operator

Thank you for your participation in today's conference. This concludes your presentation. You may now disconnect. Good day.

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

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

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

Source: Covidien Management Discusses Q3 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts