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Medtronic Inc. (NYSE:MDT)

F4Q08 Earnings Call

May 20, 2008 8:00 am ET

Executives

William A. Hawkins III – President and Chief Executive Officer

Gary Ellis – Chief Financial Officer

Jeff Warren – Investor Relations

Analysts

Matthew Dodds – Citigroup

Michael Weinstein – J.P. Morgan

Lawrence Keusch – Goldman Sachs

Larry Biegelsen – Wachovia Capital Markets

Frederick Wise – Bear Stearns

Bob Hopkins – Lehman Brothers

Tao Levy – Deutsche Bank

Paul Choi – Merrill Lynch

Operator

Good morning. My name is Lucretia, and I will be your conference operator today. At this time, I would like to welcome everyone for the Medtronic fourth quarter earnings conference call. (Operator instructions) Mr. Warren, you may begin your conference.

Jeff Warren

Thanks Lucretia. Good morning and welcome to Medtronic’s fourth quarter conference call and webcast. During the next hour, Bill Hawkins, Medtronic’s President and Chief Executive Officer, and Gary Ellis, Chief Financial Officer, will provide comments on the results of our fourth quarter and fiscal year 2008, which ended April 25, 2008. After our prepared remarks, we will be happy to take your questions. Also joining us for the question-and-answer session will be Scott Ward, President of our cardiovascular business.

A few logistical comments: This call is being webcast by our website www.medtronic.com. Our press release, earnings statement, balance sheet, cash flow, revenue by business summaries, non-GAAP to GAAP reconciliations, as well as a transcript of the prepared remarks will 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 Exchange Commission. Please telephone Medtronic Investor Relations or Corporate Communications if you’re unable to access the press release or the transcript.

Today’s webcast includes 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 is 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 these forward-looking statements is contained in the Medtronic’s Form 10-K for the year ended April 27, 2007, filed with the Securities 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 fourth quarter of fiscal year 2007. And with that, I’m now pleased to turn the call over to Medtronic’s President and Chief Executive Officer, Bill Hawkins.

William A. Hawkins III

Good morning and thank you Jeff. This morning we released our fiscal 2008 full year and fourth quarter financial results. Fourth quarter revenue of $3.860 billion increased 18%, and revenue for the fiscal year increased 10% to $13.515 billion. Fourth quarter earnings and diluted earnings per share on a non-GAAP basis were $884 million and 78 cents respectively. Fiscal year earnings and diluted earnings per share on a non-GAAP basis were $2.973 billion and $2.60 respectively. Our annual and quarterly performance reflected the benefits of Medtronic’s diversified businesses focusing on multiple chronic diseases across a range of increasingly important global markets. Our quarterly results also demonstrate that our leadership team is taking a more disciplined approach to not only achieving sales growth but also delivering growth and operating income. Highlights of our quarterly performance included double-digit revenue growth in 6 of our 7 businesses, spinal at 35%, cardiovascular at 22%, neuromodulation 17%, diabetes at 20%, and our surgical technologies group, formerly known as ENT at 18%, over $800 million in ICD revenue, $174 million in DES revenue – split $81 million in the US and $93 in OUS markets. Revenue growth outside the US of 22% and on a non-GAAP basis operating income grew 27% reflecting improved margins from the reduction in operating overhead from 43.4% of sales in the prior year to 42.6%. Now, I’ll touch on each of these items in more detail as I discuss the segment results beginning our CRDM business.

Fourth quarter CRDM revenue of $1.4 billion grew 6%, driven by balanced growth across both the high power and low power product launch. Fourth quarter global ICD revenue grew 5% to $806 million reflecting the successful recovery in the marketplace following the Fidelis field action. We estimate the world ICD market grew over 7% during the quarter and we were encouraged to see our worldwide market share rebound to over 50%. Availability of the Quattro lead in Japan for the entire quarter helped us return to our historical share position in that market. Revenue in some geographies continued to be impacted by the lack of a single-coil Quattro lead which we anticipate launching in the first quarter of fiscal year 2009. Turning to pacing systems, worldwide revenue in the fourth quarter grew 7% to $540 million driven by positive implant trends and sequential gains in worldwide market share. We estimate our OUS market share now exceeds 50%, its highest level in recent history. During the quarter, we continued to extend our lead in remote pacer management and recently passed the milestones of having over 250,000 patients enrolled in the CareLink systems around the world.

Other highlights for the quarter included the continuing evolvement of the EnRhythm MRI clinical trial which we have now enrolled more than 350 patients. We anticipate launch of the MRI SureScan technology in markets outside the US later this fiscal year and the US launch early in fiscal year 2010. We continue to believe this unique capability will ultimately change the basis of competition. Looking ahead, our CRDM business should benefit from our robust pipeline of new products extending what is the strongest device portfolio on the market. At the Heart Rhythm Society meeting last week, we announced the FDA approval and pending launch of the first of over 20 models in the Vision 3D portfolio of devices. This platform offers unparalleled clinical benefits that are built into our industry leading pacing and ICD exclusives, such as Conexus Wireless, PainFREE, MVP, OptiVol, and the industry’s first ICDs with complete automaticity. Vision 3D gives us the flexibility to meet a wider range of customer needs across a broader mix of price points. We also continue to advance our leadership in lead technology. In the first quarter, we intend to launch the Attain StarFix left ventricular lead with deployable lobes which will set a new standard for steerability and fixation. Finally, while the CRDM market appears to have stabilized, we continue to aggressively re-align resources to protect and improve our overall operating margins. One of the focal points of this effort is the continuing re-alignment of our global workforce which in the case of our CRDM business started more than a year ago. Changes in the CRDM global workforce alone are expected to produce annual savings of more than $150 million.

Turning to our spinal business; revenue of $869 million grew 35% in the quarter driven by the addition of $150 million in Kyphon revenue. Strong performance in Biologics continued again this quarter with growth of 16%. Taking together Kyphon and Biologics helped to partially offset continued competitive pressures on our core spinal products in the United States. We remain committed to our 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. We also remain committed to enforcing our portfolio of intellectual property. During the quarter, we had a positive Markman hearing against one of our competitors. This case is the first significant assertion of key intellectual property including the Michelson patents against a growing number of competitors who we believe infringe our IP. In regards to Kyphon, combined revenue in the third and fourth quarter of $298 million was at the low end of our previously stated projection, and while the fourth quarter results were disappointing, I remain confident about the strategic fit and the ultimate contribution coming from this business. We believe an unusual set of circumstances help explain the softness of the Kyphon business this quarter. The four-month period between January and April represented kind of a bridge period between Kyphon’s historical fiscal year end in December and Medtronic’s fiscal year end in April. We did not optimally structure an aligned sales force compensation during this period, which is reflected in the fourth quarter results. I have to say I was out in Sunnyvale a couple of weeks ago and I came away confident that we are well positioned for re-accelerating growth in this area. The pipeline is full and we are making good progress in our reimbursement efforts. Going forward, our focus will be on continuing to execute on our integration plan including further refining our sales training and internal programs, leveraging the combined sales management teams, building and developing our OUS operations, continuing to optimize and integrate our back-office functions, and further utilizing the core spinal sales organization to drive X-STOP. We recently established new leadership in both Memphis and Kyphon who were focused on leading our combined spinal franchise to the next level. We remain confident about the long-term potential of the Aging Spine market and the fundamental health of this business.

The fourth quarter revenue in our overall cardiovascular business grew 22% driven by the successful launch of the Endeavor Drug-Eluting Stent in the US market. Coronary growth of 41% was fueled by $174 million in total DES revenue. International DES revenue of $93 million reflected ongoing market share gains from Endeavor and Endeavor Resolute. US DES revenue of $81 million reflected the launch and acceptance of Endeavor. Our sustained success in Europe and the OUS reinforces our confidence that Endeavor has become and will be a significant product with traction going forward. Endeavor is the first new drug-eluting stent approved for use in the US market in over 4 years and customer reaction has been very positive. Since the launch, I have personally visited many accounts that clearly recognize Endeavor’s safety, deliverability, and overall strong clinical benefits. Endeavor’s compelling safety and efficacy profile was further validated last week when 4-year data from the Endeavor II pivotal trial and 1-year data from the 8000-patient E-5 registry were presented at the EuroPCR conference. Endeavor’s safety profile is now undeniable, even after 4 years, and its efficacy has been validated once again even in real world patients. Physicians’ acceptance is reflected in the market share that Endeavor gained in its first three months on the US market. We estimate Endeavor captured an average of 19% of the US market during the fourth quarter and exited the quarter above 20% market share. Despite some reports and competitor comments to the contrary, we have maintained a disciplined pricing strategy. Endeavor’s average selling price is consistent with the current US market average. Customer feedback has been very positive and physicians continue to report that Endeavor is clearly the most deliverable DES on the market. Our MX or the Multi-Exchange System accounted for more than 50% of total Endeavor units sold in the US during the quarter. We feel the Endeavor launch helped to strengthen the ongoing recovery in the DES market and we estimate the US DES penetration rate recently increased to approximately 65%. Outside the US, the strength of our broad coronary stent portfolio including Endeavor and Endeavor Resolute allow us to continue to gain share. Excluding the Japanese DES market, during the quarter we achieved total coronary stent unit market leadership in markets outside the US with total stent revenue of $153 million and 28% market share. As we announced last week, we have initiated enrollment of the Resolute III trial, a 2300-patient randomized pivotal trial comparing Resolute to Xience with a primary end-point of target lesion failure at 12 months. The results of this trial will serve as the basis for our US regulatory approval.

Our Endovascular business grew 6% in the quarter including 17% growth in OUS markets driven by the strong performance of our thoracic product line. We continue to advance the strongest Endovascular product pipeline in the industry. During the quarter, we obtained FDA approval for the Talent AAA stent graft which we will launch next month. We anticipate FDA approval of the Talent thoracic product later this spring. Availability of the two Talent systems in the US market will accelerate endovascular revenue in fiscal 2009 and beyond. And finally, we completed enrollment of the CE mark trial of our Endurant next-generation abdominal stent graft, and we anticipate regulatory approval and launch of this product in OUS markets by the end of the calendar year 2008.

Now, I’ll turn to our Neuromodulation business. In this past quarter, overall revenue grew 17% to $381 million. Adjusting for the impact of the divestitures of our diagnostic related product lines earlier in the fiscal year, Neuromodulation revenue grew 22% in the quarter. Our pain management product lines, the largest component of the Neuromodulation franchise, continued to see healthy market growth. Revenue grew over 20% in the quarter and we re-gained market share primarily driven by the launch of the RestoreULTRA in March coupled with continued momentum for the launch of our 565 surgical lead. With RestoreULTRA, we are the only company that gives patients the freedom and flexibility to control the stimulation to optimize their therapy through the exclusive [Target My Stim] feature.

Our Movement Disorders product lines grew 23% in the quarter driven by the adoption of our Activa therapy for Parkinson’s disease. We continue to pursue activities to help draw patient referrals including strengthening neurologists’ understanding of the growing body of compelling clinical evidence. During the quarter, positive initial clinical data for deep brain stimulation for both obsessive-compulsive disorder and depression were presented at a major medical meeting. We have received FDA approval for the initiation of a randomized controlled trial evaluating DBS for depression and anticipate enrollment commencing during the second half of the calendar year.

Finally, our Gastro-Uro product lines had another strong quarter driven by revenue from our InterStim product line which had its eighth consecutive quarter of greater than 25% growth.

Our Diabetes business grew 20% in the quarter fueled by strong performance across the entire business. Growth was driven by continued strong adoption of insulin pump therapy as well as our rapidly expanding continuous glucose monitoring business that more than doubled compared to the prior year and is currently annualizing at over $80 million. Sales of consumables were also particularly strong around the globe. Pump growth was highlighted by sales to new patients and strong performance in many international markets where the Paradigm REAL-Time system has been more recently introduced offset by a modest slowdown in our US replacement business as we complete the initial wave of upgrades to our latest technology among our installed base of pump patients. Looking at Diabetes revenue for the full fiscal year, we recognized a number of major milestones. Global revenue for the year grew to over $1 billion, cumulative sales of glucose sensors passed the 1 million unit point, and we celebrated our 25th year of market leadership in insulin pumps. While we do not break out operating income by business, we have invested to grow our Diabetes business and we have also worked extremely hard to improve margins. These efforts have paid off and over the last five years, Diabetes sales have grown at a 17% compounded annual growth rate, and during this time, operating margins improved from the low single digits to over 20%. These collective achievements reflect the consistent market leadership and the financial strength of our diabetes franchise. Going forward, we will continue to leverage the two co-marketing meter agreements we entered into with Johnson & Johnson LifeScan and Bayer. Joint sales calls, co-marketing events, and other patient-focused initiatives are beginning to generate positive momentum.

Turning to our Ear, Nose, and Throat business, revenue grew 18% in the fourth quarter driven by the successful launch of Fusion, an advanced image guidance surgery system to facilitate sinus surgeries. Strong global performance in nerve monitoring in growth and power systems outside the US continued to contribute to revenue growth for the year. We recently announced the integration of our Surgical Navigation franchise into ENT, and in order to more accurately reflect the expanding scope and the focus of this franchise, we have renamed this business Surgical Technologies.

Turning to Physio-Control, during the quarter we announced that we have reached an agreement on a consent decree with the FDA addressing issues raised by the FDA during inspections of Physio-Control’s quality systems. The consent decree outlines actions we must take in order to resume unrestricted distribution. Although we are clearly disappointed at the delay, we are encouraged to now have a plan in place that formalizes the path to resuming full operations, and we are confident we have the resources in place to execute the plan. Needless to say we will work with the FDA to expedite the process. Our intent to spin off this business remains unchanged.

Looking at our fourth quarter performance below the revenue line, I’m pleased with the increasingly broad efforts underway to identify and capture meaningful cost synergies that will allow us to improve our margins while funding new products. Across the enterprise, there is a renewed focus on optimizing our cost structure and delivering leveraged earnings growth. I will now turn the call over to Gary, and then I’ll conclude with a few closing remarks.

Gary Ellis

Thanks Bill. As Bill mentioned earlier, fourth quarter revenue of $3.860 billion grew 18%. Breaking this down geographically, revenue in the US was $2.323 billion, up 15%. Outside the US, revenue of $1.528 billion grew 22% including a $160 million positive impact of foreign currency. After adjusting for restructuring and purchased in-process research and development charges, fourth quarter earnings and diluted earnings per share on a non-GAAP basis were $184 million and 78 cents respectively reflecting EPS growth of 18%. GAAP earnings and diluted earnings per share were $812 million and 72 cents respectively. On a non-GAAP basis, our operating income grew 27% reflecting the operating leverage we had been projecting. As adjusted for special, restructuring, certain litigation, and IPR&D charges, fiscal year 2008 earnings and diluted earnings per share on a non-GAAP basis were $2.973 billion and $2.60 respectively. GAAP earnings for the fiscal year were $2.231 billion or $1.95 per diluted share. The Kyphon acquisition was diluted to our fiscal year 2008 earnings per share in fourth quarter and total fiscal year by approximately 3 cents and 8 cents respectively, which was in line with our previous estimates. This dilution was the result of required purchase accounting adjustments, and we continue to believe that Kyphon will be earnings neutral in fiscal year 2009.

I will now provide additional details on the charges that impact our quarterly result, each of which is listed as a separate income statement line item. First, we recorded restructuring charges of $31 million related to our global re-alignment initiative that we began in the fourth quarter. This initiative which is part of our ongoing efforts to eliminate unnecessary cost focuses on shifting resources to those areas where we have the greatest opportunities for growth and streamlining operation. This initiative which will include charges in both the fourth quarter and first quarter fiscal year 2009 impacts most businesses and will result in an involuntary elimination of approximately 1100 positions. We recorded $4 million of the $31 million within cost of goods sold relating to inventory write-offs and asset impairments associated with these restructuring activities. Second, we recorded IPR&D charges of $47 million comprised primarily of a $42 million charge related to the acquisition of MVI Medical, a privately held development stage company developing a urinary urge incontinence therapy. Collectively, these charges including the respective tax impacts had a 6-cent negative impact on our fourth quarter diluted earnings per share.

Turning to the rest of the income statement, the gross profit margin was 75.6% compared to 73.6% in the fourth quarter of last year. Gross margin was positively impacted by favorable foreign currency, overall efficiencies in manufacturing a product due to the increased volume, and ongoing initiatives to reduce product cost. Fourth quarter R&D spending of $349 million increased 7% compared to the $327 million in the fourth quarter 2007. For the full fiscal year, R&D spending of $1.275 billion represented 9.4% of revenue. We remain committed to investing in new technologies to drive future growth. Fourth quarter SG&A expenditures of $1.296 billion represented 33.6% of sales compared to 33.4% of sales in the prior year fourth quarter. Kyphon had a 100 basis point negative impact on the current quarter and SG&A without Kyphon would have been 32.6%. SG&A was also a little higher than we expected due to increased incentive payments driven by the strong revenue and earnings per share results. We have several initiatives underway to further leverage this cost structure by approximately 100 basis points in fiscal 2009 when compared to 2008. We will provide more details on these initiatives and their impact at our institutional investor and analysts meeting on June 2nd. Net other expense for the quarter was $188 million compared to $52 million in the prior year fourth quarter. This large increase is primarily due to $88 million in currency losses from our hedging programs. As you know, we hedge our operating results so that during periods when the dollar is weakening, the benefit of higher translated revenues is offset by currency contract losses. In addition to currency losses, the change in net other expense in the quarter was also impacted by amortization from intangible assets related to the Kyphon acquisition, an increase in Endeavor royalty expense, and the inclusion in the prior year of accelerated deferred income from a product supply agreement. These factors were partially offset by income recognized in the Diabetes business in conjunction with the meter home marketing agreements with J&J and Bayer.

Net interest expense for the quarter was $5 million compared to $41 million income in the prior year period, which reflects the impact of cash utilized to finance the Kyphon acquisition as well as lower interest rates. As of our fiscal year end, we had approximately $3.7 billion in cash and cash investments and debt of $7 billion. We continue to generate approximately $750 million of free cash flow per quarter defined as operating cash flow minus capital expenditures. Let’s now turn to our tax rate. Our fiscal 2008 effective tax rate exclusive of non-GAAP reconciling items was 21% for the year. This represents a 22% tax rate on our profit before tax reduced by a $37 million tax benefit related to the finalization of certain fiscal 2007 tax returns and the reversal of our reserves for uncertain tax positions. At the beginning of fiscal 2008, we lowered our effective tax rate to 23.25% and maintained that rate through the first three quarters. However, the tax benefit from our OUS operations was more favorable than we anticipated and resulted in our adjusting the tax rate to 22%. In the fourth quarter, the collective impact of restructuring and IPR&D charges along with the catch-up benefit from lowering the effective tax rate to 22% had a tax impact of $40 million resulting in an effective tax rate of 19%. Fourth quarter weighted average shares outstanding on a diluted basis were 1.130 billion shares. During the fiscal year, we re-purchased $1.544 billion of our common stock which represents over 30 million shares. As of April 25, 2008, we had remaining capacity to repurchase over 30 million shares under our board authorized stock repurchase plan. 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 providing our 2009 fiscal year guidance. As you recall, at beginning of fiscal 2008 we decided to provide guidance 1 year at a time but more directional in nature. By way of background, current Wall Street fiscal 2009 revenue consensus, it is $15.1 billion and earnings per share consensus is $2.96. We anticipate our fiscal 2009 revenue to fall in the range of $15 billion to $15.5 billion at today’s foreign exchange rates. We anticipate our fiscal 2009 earnings per share to fall in the range of $2.94 to $3.02. Based upon the current market conditions, we are more comfortable with the lower end of these revenue and earnings per share ranges. This guidance reflects the following major assumptions: The inclusion of Physio-Control for the full year – although as Bill stated we still intend to spin off Physio-Control, we’re providing guidance with Physio-Control included as the timing of this eventual spinoff remains uncertain. Gross margins of approximately 76%. R&D spending would continue at approximately 10% of revenue. SG&A expenses of approximately 33.8% of revenue – this estimate reflects the 100 basis point improvement I discussed previously. Net other expense of approximately $150 million per quarter at today’s foreign exchange rates – this estimate reflects a reduction in our currency losses from the fact that we have more favorable hedging rates, Endeavor royalty expenses, and the amortization of Kyphon intangible assets. A reduction in net interest income given our reduced cash balance and lower interest rates. And an effective tax rate in the range of 22% to 23% – this estimate reflects our expectation that some of the one-time benefits of fiscal year 2008 will not continue nor can we be assured of the renewal of the R&D tax credit. Finally, opportunistic, but disciplined stock repurchasing activities reflecting our ongoing commitment to continue to return capital shareholders while ensuring a sufficiently strong balance sheet to execute on our strategies. As in the past, all of my comments on guidance do not include any unusual charges or gains that might occur during this fiscal year. And I’ll turn things back over to Bill who will conclude our prepared remarks. Bill?

William A. Hawkins III

Yeah. Thanks Gary. Before we open it up to Q&A, I would like to make just a few closing remarks. Our solid performance during the fourth quarter was a positive end to a fiscal year that was characterized by a myriad of challenges. The 10% growth we achieved in the face of these obstacles reflects the strength of our diversified business model and the perseverance of our global organization. Looking ahead to fiscal 2009, while much work remains and the environmental uncertainties have never been greater, I feel we are well positioned to execute on a number of near-term opportunities to include the ongoing Endeavor launch, the stabilizing global ICD market, the increasing momentum in Diabetes and Neuromodulation, the emerging potential of our Surgical Technologies business, and an ongoing emphasis on our OUS markets. As many of you know, we recently made some organizational changes designed to better align our senior leadership team and global workforce with our strategic priorities, and I believe these changes position us well for solid execution. We continue to identify and execute on a broad set of restructuring and cost reduction initiatives that will allow us to fund new products, serve more patients, and generate leveraged earnings growth. Our financial strength will allow us to generate increasingly significant capital and we will focus on continuing to strike the right balance between reinvesting for growth and returning capital to our shareholders. I would now like to open things up for Q&A; so operator, first question please?

Question-and-Answer Session

Operator

Your first question comes from Matthew Dodds with Citigroup.

Matthew Dodds – Citigroup

Good morning. I had a couple of questions. First, for Bill. When you look at the ICD numbers, you came almost all the way back internationally and share if you look at where you were – I mean your fiscal fourth quarter ’07 – in the US you are still a couple of hundred points below. What I am wondering specifically is, is Quattro more important in the US for single coil, and internationally is there something else there that’s made the recovery a little bit slower. And then the second question – I guess for Bill and Gary, when you look at the full year guidance, when you’ve had a really good fourth quarter sometimes in the past, the Q1 comes in a little below expectation, and Gary, now you are not giving Q1 guidance, but is there any reason to think there is going to be an acceleration through the year in fiscal ’09.

William A. Hawkins III

Let me just respond to the first question on the market share in the US and OUS. No, I wouldn’t suggest that there is any reason to believe that the Quattro is anymore important in the US than it is OUS. I mean, we feel very good about our position. We’re continuing to assert our new products and as you’ve seen, I think, we’ve recovered nicely from Fidelis and we are optimistic going forth. So, it’s a marathon, it’s on a sprint, and we keep on running.

Gary Ellis

Matt, this is Gary. Just let me make a couple of comments on the guidance. And you’re right. I am not going to give you Q1 guidance. I’ve given you kind of an annual number, but what I would expect to be an answer to your question could you see things accelerating as we go through the year. In some ways what I would say is I think you can see – the guidance I gave – the revenue itself – the revenue growth will probably be higher in the first part of the year just because of the fact that you have Kyphon obviously put the first six months that we didn’t have in last year’s numbers. So, you get to the comparison in the back half of the year. So, the growth rate in revenue will actually be probably higher in the first half of the year than they would be just in the back half just for that fact alone. Otherwise, I’d say the rest of the growth rates – and also on Endeavor – the reality would be – Endeavor you would see more growth rates in the first obviously three quarters than you would see in the fourth quarter where you have the comparison with Endeavor this year. So, growth I’d say – in revenue – growth rates would probably be higher probably earlier in the year and may be even coming down a little bit as we got closer and with tougher comparisons in the back half. On the other hand I would agree that operating leverage will continue to improve as we go through the year because some of the initiatives we have just taken underway as far as reducing cost, etc.; those initiatives will start to play out or continue to play out as we go through the year itself. We’ve seen some of that benefit in the current year, but that will obviously come over time, and so the operating leverage component of our guidance, I would say, you will start to see that playing out more as you go through the year itself versus just being in the first quarter. And just to end, I just want to highlight, we had a very strong fourth quarter, but there is no indication to us that that momentum that we had in the fourth quarter is going to hurt the momentum as we enter in the current year. We had a strong fourth quarter, but that momentum, from what we can tell at this point in time, continues to be strong. So, we feel good about even entering into the current year.

Matthew Dodds – Citigroup

That’s perfect. Thank you Gary and thank you Bill.

Operator

Your next question comes from Michael Weinstein of J.P. Morgan.

Michael Weinstein – J.P. Morgan

Good morning. Can you hear me okay?

William A. Hawkins III

Yeah. We can Mike.

Michael Weinstein – J.P. Morgan

Okay. Perfect. Gary, let me start with you with the fiscal ’09 guidance – the two items I would just love to hear was more down on the income statement, you said gross margin is 76% which would be higher end of what you have been expecting. And so, I’d like to talk a little bit about mix assumptions within that. And then second and more importantly really is the SG&A line – your forecast and a 100 basis points of SG&A leverage in ’09 versus ’08, and I was hoping you could talk about the components of that and obviously talk in the context of the recent headcount reduction. Thanks.

Gary Ellis

Okay. Thanks Mike. With respect, first of all on the gross margin itself, as we saw in this quarter, we’re at 75.6% gross margin, and that’s obviously including the Kyphon business in there which has higher margins. We also are starting to see with Endeavor and the volumes coming from Endeavor – that has a positive mix benefit for us as we see more of that in the US. So, from a mix perspective, that is a slight positive for us as we go into the current year. The foreign exchange of that margin was obviously – assuming the foreign exchange rates stayed where they are at currently – any big change there could have a slight impact, but the point is our product mix is going in the direction of increasing slightly in margins. The other thing is some of these product cost initiatives that we’ve talked about over the last 18 months to 2 years – and we’ve talked about that – are starting to have a real benefit on our product cost and reduction in product cost. So from our perspective right now, we would expect to be right around 76% and being able to take 20 or 30 basic points on either side of that at this level. On the SG&A, we’ll go into more detail on all of the initiatives that we have underway with respect to SG&A at our June 2nd analyst meeting as I mentioned in my comments. You are correct – part of that will come from the 1100 positions we eliminated just recently announced, but those will obviously be coming forward not so much in the first quarter, but as I mentioned earlier, as we go through the back half of the year, you will start to see some of those benefits, but the other part is that we’re seeing the leverage that you would expect from the costs we put in place related to Endeavor, to restart also some of these new products that we’ve just introduced, we made the investments and as that revenue continues to come in, that will continue to provide the leverage as we go onto the next fiscal year. So, all in all, that’s all I want to say right now about the SG&A. Again, in our June 2nd meeting, we’ll get more specific about some of these initiatives that we have underway and what we’re actually trying to accomplish on reducing our SG&A cost.

Michael Weinstein – J.P. Morgan

Gary, on this quarter, the one you just reported, you [came in with] something about expectations on the operating line. Would you [pay back] some on the other expense line because [of your apex] hedging losses. Your hedging loss is actually more than double sequentially from the January quarter to April quarter, but you are forecasting that to come down as we look at your FY’09 guidance. Can you maybe just talk about why they were so high this quarter?

Gary Ellis

Well, clearly in our fourth quarter, the dollar as you know weakened dramatically during that quarter from January. The dollar itself during this period got up to actually close to 1.60 during that period of time on the Euro for example, and it saw a dramatic change and the dollar weakened during that period of time, which obviously was also a slight benefit for us in the revenue because we receive more benefit on the revenue as we dropped that also. But because we were basically hedged a very little of that benefit drops to our bottomline – it is offset in that currency line that you mentioned. So our currency losses were greater in this quarter than what we had been experiencing and what we’ve been running previously just because of what happened with the dollar, and the magnitude of our revenue also in the quarter had some impact on that. Going forward, we expect that to come down a little bit because the reality is for next year, we’re hedged as Medtronic here, at more favorable rates than we were for the ’08 timeframe. And so the currency losses even at today’s FX rates will be less than what you will experience during Q4 because we have more favorable rates for next year.

Michael Weinstein – J.P. Morgan

Great. And then the last question for Bill. There’s been a fair amount of concern out there about the Kyphon integration and then with the management changes you made at the start of the new fiscal year – and probably played into people’s psyche going into this quarter – can you just talk with your own view on how you feel like that’s going and whether you feel like you’ve got all the pieces in place for Kyphon to get back on its prior growth trajectory. Thanks.

William A. Hawkins III

Yeah. A couple of comments; first of all, the integration overall I think has gone well – particularly in the sale force – which is critical. We have integrated the sale force under one common sales management. We took the Kyphon regional vice president and the Core Spine regional vice presidents and put them at the same level and have them now reporting to two area vice presidents, and all in all that’s gone very well. We’ve been able to really hold onto all the people that we wanted to in the core business and we’ve had a little bit of challenges outside the US. We did lose some people that we would like to have kept outside the US, but we’ve got the right person running that organization, a guy named Steve Foster, and I think that is settling down, and I feel good about our position going forward. So, as you expect in these kinds of integrations, some things go well and some things are bit more of a challenge. So, I think net-net things have stabilized – I feel good about the team – I feel good about where the business is – as I said I was out there literally a couple of weeks ago and came away very enthusiastic about the outlook for this year and I feel like in fact to be candid even more encouraged about what I saw in the pipeline – some things that they’ve made a lot of progress on in the last six months. So, I feel like we’re in good shape.

Michael Weinstein – J.P. Morgan

Great. Thank you.

Gary Ellis

Thanks Mike. Next question?

Operator

Your next question comes from Lawrence Keusch of Goldman Sachs

Lawrence Keusch – Goldman Sachs

Hi. Good morning. Just coming to the OUS de-fib market growth, I am wondering if you guys can give us a feel for perhaps what FX was for CRDM or de-fib specifically, and then Bill, maybe touch a little bit – since there’s been a lot of concerns about what’s been going on in the overseas market with de-fib – that would be question one. And then I guess question two, your guidance for ’09 implies 11% to 15% topline growth. Obviously Kyphon has a positive benefit there, Endeavor has a positive benefit, but sort of how you are thinking about the growth in your core markets particularly given the competition in the Core Spine business.

William A. Hawkins III

Yes. Let me respond to the first question on the de-fibs outside the US. If you look at the market of the de-fibs outside the US, it was about 20% growth, and if you look at it and take FX out, that’s probably in the high single digits kind of a level. Good solid performance outside the US. Even with the backdrop – the coverage that we have on the line with Fidelis, and while we made a lot of progress this quarter, we still don’t have the single coil outside the US, and as I said we will have that in the first quarter of FY’09 and I think it will help us in many other markets – there are a lot of markets where some were pretty much exclusive to single coil. So we still got some upside in respect to getting the single coil back. Net-net I still feel very good about the OUS market for de-fibs – and particularly when you take a step back and you look at just the overall penetration rates and you compare those across different geographies, there’s a lot of disparities which says to me there’s a lot of opportunity. We don’t see anything fundamentally changing in our belief that this can be a double-digit growth rate market opportunity.

Gary Ellis

Larry, let me respond to the guidance aspect. You’re right – the revenue guidance that we provided – the $15 billion to $15.5 billion in revenue – is about an 11% to 15% growth versus the current year revenue. But as you indicated, you take off the Kyphon – the six month benefit that you get from the acquisition of Kyphon and you take out that impact – you are probably down more closer into the 9% to 11% range on revenue growth. Bill and I have been talking about it really since back in the spring of the year here that that is what we think we can achieve as an organization – both not only for the next year, but on an ongoing basis. So, from our perspective on that 9% to 11%, the biggest assumption you have there is basically that CRDM continues in that single digit growth overall between pacing and de-fib – in a single digit growth – and that all of our other businesses are clearly up in the double digits – low to mid teens – depending on the business themselves. Again, we’re pretty excited about what obviously Endeavor is doing on the Vascular side – we’ll have that obviously not only in the US – we’re going in Japan next year – so the reality is that that’s real positive. Diabetes, as you heard today, is doing very well. Neuro is doing extremely well. Spine, with Kyphon, clearly would be a benefit, and the spine business itself came back a little bit for us this quarter. So, overall, we’re feeling good as we go onto next year, we still think the revenue guidance we’ve given is reasonable based in line with what we’ve communicated previously, and we’ll do the best we can to exceed that, but at this point in time we think that’s a reasonable guidance.

Lawrence Keusch – Goldman Sachs

And Gary, just on the Core Spine side, obviously there has been some changes in leadership there and you guys [have acknowledged us] over time that there has been increased competition in that business. How much are you assuming that that business changes from where you are today to get to that guidance number?

Gary Ellis

The business would be basically growing about the same rate as it did here in ’08 for us to get to those kind of numbers.

William A. Hawkins III

And again, obviously, we’ll be doing everything we can to improve on that, but from our perspective, that would just have to continue for us to achieve those kind of numbers.

Lawrence Keusch – Goldman Sachs

Okay. Great. Thanks guys.

Gary Ellis

Thank you.

Operator

Your next question comes from Larry Biegelsen with Wachovia Capital Markets

Larry Biegelsen – Wachovia Capital Markets

Hi. Thanks for taking my question. Two questions – first, was there any one-time stocking in the quarter for Endeavor or for ICDs – any kind of restocking for ICDs – or something – one time in nature? And then I have another question.

William A. Hawkins III

No. There wasn’t. In fact, if you look at ICDs, we were at one of the lowest levels that we’ve been in a long long time in terms of inventory in the field. So there were no special quarter-end deals that got us to where we got to. I think the numbers reflect very much the market demand. On Endeavor, there wasn’t as well. There is not an impact, neither on Endeavor nor on the ICDs.

Larry Biegelsen – Wachovia Capital Markets

Okay. Could you talk a little bit on how you are addressing the Fidelis fractures. We heard some anxiety at HOS from physicians. At this point, Medtronic, HOS, the FDA, are recommending to prophylactically replace Fidelis leads because the risk of prophylactic intervention is greater than the risk of serious injury from lead fracture, but you recently posted data to your website showing that the fracture rate is increasing over time and you noted that you expect the lead survival curves to continue to trend downward – have you or your advisory board, FDA, or HOS identified a fracture rate at which the prophylactic intervention appears to be less than the risk of serious injury resulting from lead fracture, and if so, what is the rate, and do you think we’ll eventually reach this point? Thank you.

William A. Hawkins III

We recently sent a letter to physicians updating them on the performance of the Fidelis, and in that letter, there was no change to the recommendations. The failure rate was well within the balance that we had characterized in our initial characterization of the issue; so, it is trending where we had expected it would trend, which is well within the balance, it says that we’re doing the right things, and so at this juncture, the recommendation is no change to what we initially said back in October when we alerted patients of the potential issue.

Larry Biegelsen - Wachovia Capital Markets, LLC

Thank you.

William A. Hawkins III

Next question.

Operator

Your next question comes from Frederick Wise of Bear Stearns.

Frederick Wise – Bear Stearns

Good morning everybody. Bill you said, if I heard you correctly, that you felt the market was up by – I think in the quarter – may be 7%, but if I’ve got the right number, that’s against weak comps, can you give us any more perspective or granularity on referral patterns, and when you look out at fiscal ’09 against maybe more apples to apples comps as we go through the year, is 7% or upper single digits the right number for looking at the global ICD market growth or US? Any perspective would be welcome.

William A. Hawkins III

Yeah Rick, our assumptions are that this market will grow in the mid to upper single digits in FY ’09 – that’s the assumptions – that’s what we saw as we got through some of the turbulence after the Fidelis – yeah, we’re getting to see the market stabilize a bit, and our market data tracking would suggest that that’s a very good number, that mid to single digit kind of a number. And all the kind of field checks that we do, we see that again there’s still a big unmet need out there – we think we understand some of the dynamics that have to do with some of the referral patterns and we’ve got a lot of initiatives underway here in the US and outside US quite frankly to try to free up some of the pent-up demand that’s out there, and so, all that kind of factors into our view that this is a market that can grow in that mid single digits.

Frederick Wise – Bear Stearns

Okay, turning back to Endeavor, again, what’s picked into your’09 numbers in terms of share – obviously, Endeavor had a very strong fourth quarter, it sounds like there’s more to go; are there accounts just still not selling into and so you think you’ll have momentum as you go through fiscal ’09 – and again, help us understand if the competing stents hit the market the next 3 to 6 months, which sounds likely, can you hold share, how many you’re losing? Again any perspective would be great.

Scott Ward

Hi Rick, this is Scott.

Frederick Wise – Bear Stearns

Hi Scott.

Scott Ward

I think actually you’re correct – we had a very strong first quarter launch for Endeavor. We do anticipate that we’ll continue to see strong momentum in the United States and outside of the United States; in fact, as we exited fourth quarter, our share exceeded 20%. We do anticipate obviously additional competitive stents to come into the market. However, if you look outside of the United States, Endeavor has done extremely well versus the competition, we continue to gain share. In fact, in fourth quarter, as Bill mentioned, we achieved what we consider to be a market leading position now in our addressable markets in coronary stents. So, we feel really good outside the United States about our full product pipeline. We’ve got the market leading bare metal stent, we’ve got Endeavor and Endeavor Resolute, and acquisitions are just extremely well. I think coming out of PCR, we were very pleased with the results that we presented there, with the results from Endeavor II and our E-5, where we show that Endeavor just continues to get stronger and stronger, and the safety and efficacy profile continued to be very strong out of 4 years; so that I think is going to continue to give us strength in the United States. We have penetrated a large number of the accounts that we intended to get to in the US. We’ve got about another month of new account growth, and then we will be pretty stable in the US. We’re really pleased with MX, the MX now is over 50% of our mix, and we’re demonstrating that we can be very successful using the MX system. So, I think we can sustain this share as we go forward, and I think we’ll continue to do well outside the United States.

Frederick Wise – Bear Stearns

And one other quick one on Endeavor since I got you Scott – maybe talk if you could a little about your strategy on RX when the patten mix fires in October and how much benefit you expect in fiscal ’09, and maybe just actually the mix OUS has in Endeavor and Resolute. Thanks so much.

Scott Ward

Yeah, the OUS mix on Endeavor and Resolute, it differs by country – it’s about a quarter to a third of our mix depending on where you’re at in OUS markets. In terms of Rapid Exchange – the Rapid Exchange patents – principally the [Yak] patents expire at the end of October. When those patents expire, we intend to launch Rapid Exchange in the United States as soon as we have freedom to operate, and we do anticipate that that will help us sustain and accelerate our share growth as we head into the second half of the year in the event we do get access to Rapid Exchange.

William A. Hawkins III

But just to clarify, the third that Scott talked about is Resolute versus Endeavor, and on the Rapid Exchange, that is not in our guidance.

Frederick Wise – Bear Stearns

Thanks again.

Operator

Your next question comes from Bob Hopkins with Lehman Brothers.

Bob Hopkins – Lehman Brothers

Thank you and good morning. First question is on Endeavor – just to pick up where we left off there – what was the specific average selling price for Endeavor in the quarter in the US?

William A. Hawkins III

Bob, we don’t disclose the specific average selling price, but I can tell you that it was consistent with the overall market average selling price in the US.

Bob Hopkins – Lehman Brothers

So, despite the fact that your competitors are saying that you’re at about a 10% discount, you dispute that, you think you’re coming in at about flat on average with the competition right now?

William A. Hawkins III

That’s absolutely correct. You know that the average selling price in the US is probably between 2000 and 2100 across all of the competitors, and so, that’s about where we’re at.

Bob Hopkins – Lehman Brothers

Thank you, and then, should we expect that to come down as Xience Promus launches throughout the course of the year?

William A. Hawkins III

Well, that’s a good question – I think it’s really a complicated question, Bob. I think we’ve got to see what Xience and Promus does in terms of their pricing and how they come into the market place – I think it’s a little bit hard for us to comment from our perspective. We’re in the market, we’re pleased that Endeavor is doing very well. I think it’s at about the average selling price that’s out there, and we’ll see what Boston Scientific and Abbott decide to do with their own pricing as they come into the market.

Bob Hopkins – Lehman Brothers

Okay, thank you, and then, quickly one for Gary – you guys put up very strong operating margins this quarter and reasonably there’s more to come – just curious, as you look out over the next couple of years, do you think you can get beyond where you used to be in sort of the mid 30s range as a target looking forward?

Gary Ellis

Bob, that’s a tough one – from our perspective right now, I would say, no. I think that we’re getting back to kind of where we were historically, and I think in the mid 30s would be a great result in the market place, and as we go forward, we expect there will continue to be pricing pressures, etc. Obviously, we don’t have a number that we’re going to just move to and stop, and so I mean the reality is we’ll do the best we can, but I think to be reasonable at this point in time, if we can get back to the kind of the historical level we were at prior to making some of these investments and driving some of the declines on the operating margins over the last few years and we can get back to that historical level, we would deem that a very successful expectation. Again, we’ll drive as much as we can, but you also have to continue to invest in this business, and there’s just going to continue to be pressures on pricing; so, from our perspective, that would be a great result to get back to where we were at historically.

Bob Hopkins – Lehman Brothers

Okay, great, and then finally, a quick one for Bill – I just wonder if you could talk a little bit more about the significant management changes that were implemented in the previous couple of weeks, and I guess from a 30,000-foot level, what do those changes allow you to do now that you couldn’t do before?

William A. Hawkins III

Well, first, I couldn’t be more excited about the team that I have and the changes – I took the opportunity to kind of streamline the organization to re-align the team around, some of the key strategic priorities with the focus that I’m putting on operating performance with James Dallas, the opportunity to do a better job looking across the enterprise and making better choices on how we allocate R&D with Katie Szyman and her role, and then having the business unit heads reporting directly to me and then having international consolidated under John Luke, it all works. So, I feel really good about it – we’ll talk more about this at the June analyst meeting, and we’ll give you a bit more in-depth profile of some of the people and what they’re doing – it’s a good thing, and I am very very excited about the team, and the team is excited about the opportunities that we have in front of us.

Bob Hopkins – Lehman Brothers

Will the analyst meeting be primarily you and Gary speaking for the morning, or will it be all the business heads as well?

William A. Hawkins III

We’re going to have a format – it is not dissimilar to what we did a year ago, where we have Gary and I, and James Dallas will actually be kind to give some prepared remarks or give some short presentations, and then we’re going to provide plenty of time for Q&A with the business unit heads; so, rather than trying to anticipate what you want us to say, we’re going to give you the chance to really interact with all the BU heads.

Bob Hopkins – Lehman Brothers

Great, thanks very much.

William A. Hawkins III

We’ll take a couple more questions here.

Operator

Your next question comes from Tao Levy with Deutsche Bank.

Tao Levy – Deutsche Bank

Thanks, good morning. Internationally, the ICD market [inaudible] I think you mentioned this quarter grew single digit. Now granted that you were up against a relatively tough comp last year, but what gets that market going – I don’t think there’s much new data really coming out – we’ve talked about low penetration rates in the past – is it bit of an overhang from Fidelis that maybe hurt the business this quarter?

William A. Hawkins III

Yeah, as I mentioned before, I think a little bit of that is going on and the fact that we still don’t have a single-coil lead, the Quattro, which we’ll have in the first quarter of FY ’09, and the impact that that had in a couple of markets – Japan has come back a little bit for us, but Japan continues to be, we think, a big market where there’s a lot of head room for growth; we’re continuing to invest and to see the fruits of those labors and some of the emerging markets which are small but growing like China, Russia, India, and the Western European markets. So, there’s more and more focus on implementing the guidelines, what the ESC [at Nice]; so, to add it all up, we feel good that we can get this market into that double digit growth rate.

Tao Levy – Deutsche Bank

Okay. And at the HRS, we talked to some clinicians and they’re pretty excited about the MRI compatible pacemaker – when do we actually finally see some data on that, and are there any challenges on the manufacturing side of that product?

William A. Hawkins III

Well, we’re completing the clinical trial on that and we’re expecting to have that in Europe later this year – this fiscal year; and then I think it’s FY ’10 that we’ll have it in the US – and you’re right, we were very excited about this – we think that this is going to be a game change in technology. We think that the ability to have a product that is labeled for MRI compatibility will be very important for customers around the world.

Tao Levy – Deutsche Bank

Is there a day when there is going to be data release…

William A. Hawkins III

I don’t know when we’ll present if there’s any data – no, I don’t think there’s going to be any data sincerely.

Tao Levy – Deutsche Bank

It either works or doesn’t.

William A. Hawkins III

Yeah.

Tao Levy – Deutsche Bank

And then just lastly on the Spine business, any changes with the X-STOP product or growth of that product – the last few months, at one of the recent conferences, the feedback from surgeons was that that product may not be leading up to the early clinical expectations that had been seen before.

William A. Hawkins III

Well, I don’t know what you’re referring to in that regard, but one of the challenges we have had is in expanding reimbursement, and we’ve got a terrific person heading up our reimbursement efforts at Kyphon, and we are every day getting more and more covered lives for X-STOP; so, the product was shown in a randomized control trial to perform well and better than conservative care – and we’ve got a whole sort of portfolio in development with the X-STOP, with [inaudible], with the Spherion which is the next generation. So, we believe very strongly in this category, and we’re investing to support that.

Tao Levy – Deutsche Bank

Thanks a lot.

William A. Hawkins III

Okay, I’ll take one more question.

Operator

Your final question comes from Michael Jungling of Merrill Lynch.

Paul Choi – Merrill Lynch

Hi good morning. It’s Paul Choi pinch hitting for Micheal here. If I could ask two strategic questions – first, with respect to spending your operating base – Gary, is there additional room for downsizing of the sales force or reduction on the G&A side this year above and beyond what you’ve sort of indicated that potentially maximizes free cash flows and sort of reorient your business model. And secondly, with respect to some of the personnel changes you’ve had in senior management, given some of the departures, would it be correct to infer that you no longer focus on large-scale acquisitions, and you’ll reduce your M&A activity for the near term? Thanks.

Gary Ellis

This is Gary, let me address the first one, and Bill, you can take the second one. With respect to the restructuring and continuing to evaluate whether its our sales force or G&A functions, etc., Medtronic will continue – and always has – we will continue to take a look at our infrastructure and where we have resources allocated, whether it’s by business, whether it’s by function, and so when we continue to see areas where we’re focused on as far as in reduction, no matter what function it happens to be, yes I think you’ll see some of that as we continue to leverage the organization. What we’ve done here currently doesn’t mean that that’s all what we’re going to do. As an organization, any business continues to evaluate where its resources are at and what we need going forward. So, I think we’ll continue and you should expect, as a company, we will continue to look at that in and to evaluate whether there is a different resource allocation that’s necessary in each one of our functions or businesses, and if that’s appropriate, we’ll take the same steps that we’ve just taken here recently as we move ahead. I also want to highlight the fact that at the same time we’re making those reductions, we are investing in those areas where there are tremendous growth opportunities that occur in an organization whether it’s on the sales side, marketing, engineering, etc. So, we will continue to make those shifts. Bill?

William A. Hawkins III

And just quickly in response to your question about the personnel changes and would that reflect strategic shift in our kind of acquisition strategy, I wouldn’t rate anything into that per se, but I would go back and remind you what I’ve been saying, and that is, right now, we feel very good about our portfolio; we feel very good about the opportunities in front of us. I think you’ve seen from the recent quarter that we have a lot of opportunities on our existing businesses and that’s where our focus is right now. We’ll continue to do the sort of tucked-in acquisition like we did with the NDI and Restore that will complement the existing businesses; so, that’s where we expect to get growth over the next couple of years, that’s where our focus is going to be.

So, let me just conclude, and as we look forward ahead to the next new fiscal year, I just want everyone to know that I’m confident we can deliver top-tier performance. I look forward to seeing many of you in New York at our institutional investor and analyst meeting coming up on June 2nd where we’ll have an opportunity to further update you on our plans and strategies for delivering sustainable top and bottomline growth. So, on behalf of the entire team, we look forward to seeing you in New York. Thank you very much.

Operator

This concludes today’s conference call. You may now disconnect.

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Source: Medtronic Inc. F4Q08 (Qtr End 04/25/08) Earnings Call Transcript
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