Covidien Ltd. Q3 2008 Earnings Call Transcript

Aug. 5.08 | About: Medtronic plc (MDT)

Covidien Ltd. (COV) Q3 2008 Earnings Call Transcript August 5, 2008 8:30 PM ET

Executives

Cole Lannum – VP, IR

Rich Meelia – President and CEO

Chuck Dockendorff – EVP and CFO

Analysts

Taylor Harris – JP Morgan

Rick Wise – Leerink Swann

Tao Levy – Deutsche Bank

Matthew Dodds – Citigroup

Bob Hopkins – Bank of America Securities

Kristin Stewart – Credit Suisse

David Roman – Morgan Stanley

Jason Bedford – Raymond James

Operator

Good day, ladies and gentlemen, and welcome to the third quarter 2008 fiscal year Covidien Ltd. earnings conference call. My name is Theresa and I will be your coordinator for today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this call. (Operator instructions) I would now like to turn the presentation over to your host for today’s call, Mr. Cole Lannum, Vice President of Investor Relations. Please proceed.

Cole Lannum

Thanks, Theresa, and good morning everyone. With me today are Rich Meelia, Covidien’s President and Chief Executive Officer; and Chuck Dockendorff, our Chief Financial Officer.

The press release with details of our third quarter results was issued earlier today and is available on our web site and the news wires.

During today’s call, we'll make some forward-looking statements and it's possible that actual results could differ from our current expectations. Please refer to the cautionary statements contained in our SEC filings for a more detailed explanation of the inherent limitations in such forward-looking statements.

We'll also discuss some non-GAAP financial measures with respect to our performance. A reconciliation of non-GAAP to GAAP measures can be found in our press release and its related financial tables as well as on our web site, covidien.com

For the third quarter, we reported GAAP diluted earnings per share from continuing operations of $0.65. After adjusting for certain one-time items, our non-GAAP results came in at $0.72 per share.

Now, I would like to turn it over to Rich who will give a brief overview before Chuck gets into the numbers. Rich?

Rich Meelia

Thank you, Cole. Overall we had a strong third quarter performance which was somewhat above our expectations aided by favorable currency and strong performance across the business. We are on track to meet our 2008 goals and are well-positioned for a strong finish to the year.

Third quarter sales growth was broad-based as we grew 9% in the US with good gains in all four segments. Outside the United States, sales increased 22% for the quarter with double-digit gains in all geographies. These positive results are due in part to the investments we have made to expand our sales force in the last couple of years.

We again significantly improved our gross margin due to favorable product mix, the benefit of exchange rates, and manufacturing cost reduction efforts. We also increased R&D spending as planned and continued to make other growth driving investments. We generated strong cash flow and lowered our net debt by nearly $700 million in the quarter. Over time, we will use our strong operating cash flow to continue to fund strategic healthcare growth opportunities including acquisitions, licensing agreements and specific growth initiatives.

We will also continue to return cash to our shareholders through payment of our dividend while managing our debt level to maintain a strong balance sheet. We were again active on the new product front, as we begin to reap the benefits from our increased R&D investments. In endomechanical, we introduced the SILS Procedure Kit to assist physicians in performing single incision laparoscopic surgery and other advanced laparoscopic procedures.

In soft tissue repair, our AbsorbaTack hernia fixation device, which has exceeded our expectations in the US, was recently rolled out across Europe. In energy, we completed the US rollout of the innovative LigaSure Advance multifunctional laparoscopic instrument.

In imaging, we launched the Optistar Elite contrast delivery system and a novel delivery system incorporating RFID technology to help reduce the risk of potentially life-threatening medical errors and infections during CT scan procedures. We also announced the acquisition of power injectors from Pinyons to complement our existing line of injector products.

We were pleased to receive approval from FDA for a generic version of OxyContin. As you know, there are still outstanding litigations surrounding the launch of a generic product, so we are limited in what we can say publicly. I will say, however, that we have a definitive plan in place and FDA approval was an important step for us. While we are not in a position to disclose specific details of our plan today, we will announce additional details when appropriate.

We are also awaiting word from FDA regarding the status of our ANDA filing for generic Sestamibi as the branded product on our patent on July 29th.

As noted on an earlier call, remember that the conversion to the generic product will result in a reduced sales growth rate but improved margins for this portion of our radiopharmaceutical business.

Our results this quarter reflect the challenging environment in the respiratory business where operational growth has been below expectations. As we have noted previously, we face strong competitive activity in this category, particularly in oximetry monitoring and ventilators. We continue our efforts to accelerate growth in respiratory but expect that turn around of this business will take some time as we ramp up R&D to accelerate the flow of new products and become more competitive in the marketplace.

Next, I would like to make a brief comment on guidance. We will not be updating 2008 guidance today. We remain comfortable with all of our prior statements regarding full-year 2008 guidance. We will initiate full-year 2009 guidance ranges at our investor meeting next month.

Over the last few weeks, I’ve had an opportunity to review the strategic plans of each of our businesses as part of our annual planning process. I came away from these reviews with an even stronger appreciation of the wide ranging growth opportunities that Covidien has.

Our new product pipeline is the best I have seen in my career as a leader of this healthcare business. We have a good combination of breakthrough products and line extensions to drive growth. Over time, we will look to complement this strong new product line up with selected technology acquisitions that can help us fill product gaps and expand into adjacencies. As you all know, Covidien just completed a successful first year as a public company. We made significant progress this year, implementing a number of strategic initiatives across the business and are confident that we are in an excellent position to achieve our future growth objectives.

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

Chuck Dockendorff

Thanks, Rich. Overall, we are very pleased with our third quarter results. Sales, gross margin, and operating income were all somewhat above our expectations, as we delivered broad-based growth, business growth and continue to benefit from favorable foreign exchange rates.

Looking at third quarter sales, net sales increased 14% to $2.6 billion led by medical devices, imaging solution, and pharmaceutical product segments, all of which reported double-digit gains. Favorable foreign currency contributed 5 percentage points to our sales growth rate.

Sales rose 9% in the United States and a very strong 22% outside the U.S. This is the highest U.S. growth rate in more than two years as all segments registered high single or low double-digit increases.

Turning to the results by segment, overall, it was another strong quarter for medical devices with sales up 15% to $1.8 billion, aided by favorable foreign exchange which contributed 7 percentage points to the sales advance. Increases were paced by strong double-digit gains in energy up 29%, endomechanical up 21%, and soft tissue repair also up 21%. These strong gains were coupled with 11% increases for both vascular and for clinical care products.

The excellent growth in energy resulted from further increases in sales of vessel sealing and hardware products in the U.S. and Europe. Also contributing was the broader market penetration by the Force Triad Generator and the related disposable products we’ve introduced including Impact and Hand Switching Atlas. In endomechanical, we registered a good performance for our laparoscopic instrumentation with the rollout of the AbsorbaTack into Europe and continued growth of products used in bariatric and hernia procedures.

Sales growth in soft tissue was paced by a strong performance for mesh products in both the U.S. and Europe and good growth for biosurgery. Performance was aided by our key growth initiatives as we have created specialized hernia and soft tissue repair sales teams in the U.S. and Europe over the past year.

In the respiratory category, sales of oximetry and monitoring products increased 6% while sales of airway and ventilation products rose 4% from a year ago. Looking next at imaging solutions, sales were up a strong 18% in the quarter to $319 million aided by favorable foreign exchange rates which contributed 5 percentage points to the increase. Growth was broad-based with double-digit gains for both radiopharmaceuticals up 20% and contrast products up16%. The radiopharmaceutical increase was driven by higher U.S. volume coupled with the benefit of the recently implemented price increase for technetium generators.

In contrast products, growth was led by international markets with particular strength in Europe, Latin America, and Asia Pacific which more than offset significantly lower pricing in the U.S. Going forward, we expect the international performance to return to more normalized levels, bringing growth back to low single-digits in this category.

In the pharmaceutical product segments, sales increased 13% to $257 million. Dosage sales grew at a strong double-digit pace with both branded and generic products well above a year ago. The generic increase was aided by a competitive supply constraint giving us opportunistic volume and some larger than expected wholesale orders. In active pharmaceutical ingredients, sales increased primarily due to higher peptide volumes. And finally in medical supplies, sales of $238 million were 8% above those of a year ago. This stronger-than-expected increase came largely in OEM and nursing care products. Going forward, we expect sales growth in this segment to moderate back to historical levels.

Now turning to the items below the sales line. For the fourth consecutive quarter, we made good year-over-year progress on gross margin. The third quarter increase of 150 basis points to 53.7% of sales came as benefits from favorable product mix, foreign exchange, and cost reductions more than countered higher raw material costs and increased freight expense. While we again made good progress this quarter, we are starting to see some significant pressure on product cost from rising raw material prices as increases in resins, pulp, and petrochemicals, for example, are depressing margins.

At current levels, this cost pressure would have a dampening effect on our gross margin increases. This pressure is being felt most significantly in our medical supplies and pharmaceutical segments, and in the Sharp Safety and respiratory product lines in our medical device segment.

The improvement in gross margin was partially offset by our planned investments in SG&A, and research and development. We continue to accelerate spending in these two areas to increase long-term revenue growth, through sales force expansion, more competitive marketing, and greater innovation. Foreign exchange impacts also increased our SG&A cost in the quarter.

R&D expense climbed 33% in the quarter to 3.3% of sales and we remain committed to further increases over time. As you saw in the release, we also had a couple of special items that affected our reported results. These included a $10 million charge for in-process research and development related to two recent acquisitions and $4 million in expense for our portion of the Tyco International shareholders’ settlement net of insurance recoveries. There was also a $4 million charge for restructuring.

Thus far, we have incurred restructuring program expense of $130 million and are on track to spend a total of about $150 million for the majority of the spending completed by the end of calendar 2008. This program is already delivering significant savings and once completed, we expect between $50 million and $75 million in savings on an annualized basis.

As reported, operating income was $545 million. Excluding the item just mentioned, the in-process R&D, net shareholder settlement, and restructuring, operating income would have been $563 million and the operating margin 21.7%.

Looking below operating income, net interest expense was on target at $38 million and other income was $13 million. Included in other income was a $9 million benefit related to the tax sharing agreement, with the remainder of the income primarily representing the interest on the tax liability related to the agreement.

Turning to income taxes, the third quarter effective tax rate was 36%. This rate reflected the impact of restructuring, and the shareholders settlement and other tax matters. Excluding these items, the third quarter tax rate was 31% and the year-to-date rate was 30%.

Next, let me take you through some cash flow highlights. We again generated strong cash flow for this quarter. On a reported basis, our operating cash flow for the year-to-date was approximately $90 million, as last quarter we reported the outflow of $1.26 billion related to the Tyco shareholder class action settlement announced in May 2007 prior to the separation. While the finalization of the settlement resulted in a decrease to the company’s cash flow from continuing operations, it did not affect our cash balance as we had previously funded our portion of the class action settlement into an escrow account used to settle the liability.

Excluding the $1.26 billion outflow related to the class action settlement, adjusted operating cash flow from continuing operations was about $1.34 billion for the year-to-date. The $1.34 billion adjusted operating cash flow from continuing operations plus capital spending of about $250 million resulted in adjusted free cash flow of approximately $1.1 billion.

For 2008 and beyond, we expect our business operations will continue to generate strong cash flow.

Now, we'd be happy be take any questions you may have. I will turn the call back to Cole who’ll explain the procedure for signaling if you do have a question.

Cole Lannum

Thanks, Chuck. For Q&A, I am going to ask that you to please limit yourself to one question and a follow-up if needed, then put yourself back in the queue. Operator, can you please review the process once again for signaling a question?

Question-and-Answer Session

Operator

(Operator instructions) Your first question will come from the line of Mr. Taylor Harris from JP Morgan. Please proceed.

Taylor Harris – JP Morgan

Thanks a lot. Rich, first question would just be on what’s going on, what you’re seeing in the surgical and energy market. You had a very nice sequential uptick. J&J did as well. So, maybe give us your thoughts on, is the market as a whole expanding? Do you think that we should look at this quarter's reported growth as a normalized number or do you think it’s more somewhere in between the previous two quarters? And then any comments on market share in those categories as well. Thanks.

Rich Meelia

Yes, sure Taylor. You’re probably somewhere between in terms of where we think the growth will settle out. We are benefiting from some good market dynamics, both us and our competitors, and I think you are seeing that especially in energy, it is a very strong segment right now. Bariatrics continues to drive a lot of growth I think for everybody.

In terms of actual share, if you go more specific product line by product line, I think we are getting some share in mesh and fixation within the hernia segment, might be some slight uptick in share in some of the other endomechanical pieces, but I think mostly we are benefiting from a good strong market growth with the exemption some of those areas that I mentioned previously.

And so going forward, we think the sales growth in these segments will be in that mid to upper single-digit numbers that we’ve been talking about from the beginning and that’s very good for Covidien because it really helps drive a lot of the value for our business.

Taylor Harris – JP Morgan

Great, thanks. And Chuck, just one for you. On the raw materials, cost of goods side of things, can you quantify at all what the potential impact would be in ’09 on gross margin, assuming some of these commodity prices stay where they are?

Chuck Dockendorff

Yes, it’s interesting. We are clearly beginning to see the increase in these raw material costs coming through and as we’ve mentioned, they are primarily in our patient care and safety division as well as the pharmaceutical piece of it and medical supplies. The ranges of it – it is following – you’ve seen the price of oil go up and down on these things, and the price of it has really come out from those increases and it is growing through our system now as we are beginning to get price increases from a lot of vendors and things like that, but we estimate the range of this to be in the 40 million to 50 million range at this point in time related to those specific things and may be another 15 to 20 pressure related around our freight and utilities from these higher costs. We’re still monitoring this and looking at it, and taking how this will impact our gross margins in the next year.

Taylor Harris – JP Morgan

Okay, but you are saying that what you would expect right now as annual increases in those spending items for next year?

Chuck Dockendorff

Yes, on an incremental basis, right, if you look at it today.

Taylor Harris – JP Morgan

Okay. Great.

Chuck Dockendorff

It is that kind of pressure we are seeing out there.

Taylor Harris – JP Morgan

Okay, thanks.

Operator

Your next question comes from the line of line Mr. Rick Wise from Leerink Swann. Please proceed.

Rick Wise – Leerink Swann

Good morning, Rich. Good morning, Chuck. Question on – if I could just push on the guidance front just a little bit here. I appreciate that you are anxious to forecast the fourth quarter and by updating the year, but you haven’t changed guidance despite a terrific quarter, maybe just give us some other perspective – Covidien (inaudible). Should we expect the fourth quarter to be seasonally slower, equal to the third quarter, I mean, how do we just think about the business from a funnel [ph] point of view, sort of directionally?

Rich Meelia

I think we’ve said this in the call. But the third quarter was an exceptional quarter. We had – our sales growth rate was higher than what we expected. We really had some really good improvements in gross margin and the operating margin, I think, was always higher than our guidance range.

But for the full year, as we look at our business, we’re still comfortable with the guidance that we gave, the 20% to 21% in the range of operating income. And I think sequentially, while we still have good growth in Q4, I think when you look at the sequential dollars on sales, it could be down slightly because Q3 was so strong. But again, I would just say that I think about our business at the high end of the guidance ranges we’ve given on sales and both operating income. I think that’s what will be reflected in Q4.

Rick Wise – Leerink Swann

Okay, and just to follow up on two small things. Rich, you mentioned that OxyContin had a definite plan and place, is it reasonable to expect some economic benefit not included in the guidance just as you resolve all this? And on respiratory, you talked about the challenges remaining, can you fix the issues without acquisitions and maybe help us understand what’s left to do? Thanks.

Rich Meelia

Yes, sure. There’s no economical benefit for OxyContin in our forecast and our guidance, so anything that we are able to commercialize from that standpoint would be above what we’ve predicted. And like I said in the opening comments, we believe the FDA approval was a huge step for us and this is a big opportunity and we are working as we speak to carry out plans in order to maximize the benefit to us and the shareholders for that specific opportunity.

Relative to respiratory, if you look at the monitoring business, it’s gotten better than where it was a couple of years ago, where we’re really trailing market growth rates, we continue to trail growth rates. It will require additional technological developments. Some of that will come internally, some will have to come externally; we’re working diligently to do that, to find technology that we will bring into that business. But if we look at all the different businesses then you can see it in the results. This one currently has the most challenges in terms of what needed to be done internally, and the quality of the competition that these businesses deal with externally.

So we love the space; it’s a strong, good strong growth. It’s a space we want to continue to be in. Its just going to take a little bit longer I think for us to begin to execute in that space like we have been in, for example, surgical and energy, and even imaging supplies. The others said that [ph] we are seeing much better execution from – at Covidien.

Cole Lannum

Let me add one more thing back on the oxycodone ER thing, I certainly appreciate the fact that this is a big item out there and the challenge that all of you may have in trying to understand what the impact it may have to us, that’s why we’ve not put it into guidance at this point because there continues to be question marks as to timing and magnitude. I would tell you this, though, that we’ve thought all along that this being a potential call option and I think that it continues to be the case. But if it changes so that we do see some specific economics accruing to us, we will be prepared to talk about that if and when that time happen.

Rick Wise – Leerink Swann

Thanks, Cole.

Operator

The next question comes from the line of Tao Levy of Deutsche Bank. Please proceed.

Tao Levy – Deutsche Bank

Good morning.

Rich Meelia

Good morning.

Tao Levy-Deutsche Bank

Just a few questions on my end. You’re showing some great growth out of endomechanical, soft tissue, energy. Is there some sort of a good sales synergy that you’re running into right now because all three of them seem to be growing in the sort of 20% range?

Rich Meelia

Clearly, when we began the separation plans there, we talked a lot back then about growth initiatives, specifically sales force expansion both in terms of generalists and specialists. And so if you look at the way that the surgical device team is structured today and being managed, it’s very different than just a couple of years ago and you’ve got people focusing on procedures like bariatrics or private areas like hernia as opposed to just a generalist representing the entire product line and so the combination of the focused selling effort as well as the new products that are coming both internally and externally, you’re seeing synthetic mesh coming from Florean and the AbsorbaTack launch of the absorbable tacking system. We just acquired the Tissue Science, so we now have a biologic mesh and so it’s just a combination I think of a lot of good execution by the surgical device management team with added resources and bringing really strong new products into the mix. So, yes, I don’t think it’s coincidental at all. For sure, it’s a nice market, but I think you’re seeing the benefit of a lot of resource allocation, a lot of focus, and some really good execution by that team.

Tao Levy – Deutsche Bank

And is this principally a U.S. base driven growth or how much of this –?

Rich Meelia

No, the more recent phenomenon is U.S. growth – just two or three years ago where our U.S. growth was fairly anemic. I think it might have been 1% or 2% and I think we announced 9% for this quarter and so I think that’s a reflection of both the new products and the recent sales emphasis. And outside the U.S., we put about 1,400 sales people into the mix outside U.S. beginning in 2004, 2005, in that timeframe and so we’ve been seeing very good growth and I think we mentioned in the call that we’ve had a double-digit growth in all regions of the world. We’re talking of all the emerging markets, and even Europe which is a very developed market – I think the growth was 6% or 7%; Japan 4% to 5%. But then you get to Eastern Europe, Latin America, Asia Pacific, it’s all double-digit growths. So outside the U.S. continues to be a real source of growth for us.

Tao Levy – Deutsche Bank

Okay, thanks. And on the oximetry front, how did the U.S. business do in the quarter? Did it growth or did it stay flat? Did it decline?

Rich Meelia

I think it was – I don’t have it right in front of me but I believe it was probably a percent or two, that’s total growth. Usually our outside the U.S. does better than inside the U.S. so it was probably flat to maybe slightly up or down.

Tao Levy – Deutsche Bank

Great. Thanks and just finally, looking at the fourth quarter, I know you don’t want to obviously talk about guidance, but are there any sort of one-time events related to the spin-off anywhere in the P&L that we should kind of just think about in the numbers sort of like what we saw in the third quarter?

Chuck Dockendorff

No, not really. I think there weren’t any spin-off-related type charges within the quarter. We had backed out the one – in other income, we had the $9 million related to some tax sharing liabilities which we pulled out in the GAAP to non-GAAP reconciliation but that was about it.

Rich Meelia

Were you asking about the fourth quarter?

Tao Levy – Deutsche Bank

Yes, sorry. On the fourth quarter just like in the third quarter you had some of these tax benefits or charges getting through that we pulled out and this time on an adjusted GAAP number, I was just wondering is there any similar kind of events coming up here in the fourth quarter?

Rich Meelia

I can say that there’s nothing that we can relate to you right now. Sometimes these events do happen intra quarter and it’s very possible by the time we report, there might be some small ones but there’s nothing of a material nature that’s happened thus for in the quarter that would affect things.

Tao Levy – Deutsche Bank

Great. Okay. Thanks a lot then and great job.

Rich Meelia

Thank you.

Operator

Your next question comes from the line of Mr. Matthew Dodds from Citigroup. Please proceed.

Matthew Dodds – Citigroup

Hey, good morning. A couple of questions. First, following up on the last set of questions, when you look at the surgical segment in particular, look into your organic growth, can you say if inside the U.S. or outside the U.S., which one is growing faster? Because my guess would be outside the U.S. but with the currency it’s hard to tell. So that’s the first question. Then Chuck, can you give us any more color on the generic benefits you’re getting in pharma, maybe what product that is or how long that might last?

Rich Meelia

Yes, this is Rich. In terms of surgical growth outside the U.S., the total percentage increase is probably stronger outside the U.S. than inside the U.S. But if you look at where the increased growth year-over-year is coming from, you're seeing much stronger results in the U.S. relative to where it was a couple of years ago. So I think the significance of the increased U.S. growth is pretty important and relevant to our overall success because we had been able to generate really good growth in surgical in all those other regions of the world that I talked about previously and we continue to struggle in the U.S., but we see and feel some real good momentum in the U.S. now as well, and that was important for us to demonstrate our ability to grow within this market and not just outside the U.S.

Cole Lannum

On the question on pharma, we prefer not to talk about which products (inaudible). I am comfortable saying that it's in some of our higher margin business. It has continued somewhat into the fourth quarter but at this point we don't think it will have nearly the impact as it did in the third quarter and it will tail off during this quarter.

Matthew Dodds – Citigroup

Okay. Thanks, Rich. Thanks, Cole.

Rich Meelia

Okay, Matt.

Operator

Your next question comes from the line of Mr. Bob Hopkins from Bank of America Securities. Please proceed.

Bob Hopkins – Bank of America Securities

All right. Thank you and good morning. Two questions, one for Chuck and then for Rich. Chuck, on the gross margin side, I want to go back to Taylor's question. I think you've suggested that there's an incremental $65 million to $70 million in expense that will affect the gross margin in 2009 versus 2008. And as we sit here in the third quarter, is it already – those incremental expenses, are they already running through the P&L at that kind of a run rate, in other words sort of $15 million to $17 million a quarter, or is it that things get a little bit – things still – you would expect those expenses to increase and get a little bit worse in Q4 and then end up to be $65 million and $70 million for the full year '09?

Chuck Dockendorff

Yes. We are just beginning to see the increased raw materials coming through now. That's what I was talking about the timing from the recent increases in the oil and all that. But we're beginning to see it come through. We expect it to grow within the fourth quarter and then get bigger of course in 2009, if everything stays at its current level. We're again trying to offset these things with our cost reduction programs. We've gone out and initiated a number of pricing programs around some of our products where we can. So, we have recognized this and taken actions to try to mitigate some of these exposures.

Bob Hopkins – Bank of America Securities

Okay. And then the impact in terms of basis points on the gross margin this quarter from those expenses, understanding they'll get worse, is it 20 or 30 basis points this quarter?

Chuck Dockendorff

Bob, I think you can do the math. It's hard to predict how fast this will come through our gross margin and the timing of it specifically, and where it finally ends up. And as I mentioned, we're offsetting price increases and we're still going through a lot of detailed planning for next year. So at this point, I don't want to give any specifics around that impact to gross margin specifics.

Rich Meelia

Additionally, there's a lot of mix changes. We continue to see the faster growing segments or the higher margin growing segments, Bob, and so there's just so many moving pieces. We're very pleased with what's been able to happen with gross margin to date. It's exceeded our expectations and so we'll continue to look at ways to take down costs. We're very aggressively eliminating SKUs and looking at pricing the way we did before. And quite honestly, our ability to offer higher value new products to our customers, also at a higher price, is helping support that gross margin as well. So, it's difficult to get real accurate at this point with respect to those gross margin numbers given all the moving parts.

Bob Hopkins – Bank of America Securities

Right. Clearly, doing better than I think anyone was expecting. And then on currency for gross margin, did that help out as it's helped out in previous quarters, maybe 70 or 80 basis points?

Chuck Dockendorff

Yes. That's actually a bigger piece of it, Bob. That really has – it's over half of the improvement that we incurred this quarter. So that's even a more significant piece of it and that's really the more careful thing to watch next year as we go through the year and what goes on with the Euro. I think if you just think of the year-over-year costs, we're still in a favorable position which would diminish as we go through fiscal year '09.

Bob Hopkins – Bank of America Securities

Right. And then, thank you for that, and just really quickly for Rich. Big picture question. If you adjust for the divestures that you've made, your organic constant currency top line growth over the last four quarters has gone from the three range to the four range to the five range, and now this quarter up to 9% which is obviously a significant jump sequentially from where it's been. I'm just wondering if you do want to give us some comments around how you think about your business going forward in terms of sustainable organic constant currency top line growth. Is 9% the new level that we should be thinking about or is it something lower than that?

Rich Meelia

Yes, I think if you go back to those original numbers as we consistently increased net sales growth as a result of a lot of good investments and hard work by the people at the divisions, we really anticipated, so we haven't been surprised with that steady sales growth. Now, what's happened in this quarter, we had some fairly significant one time supplies? That Christmas business grew I think 7% or 8% and we typically look at that as kind of a flattish-like or down kind of business, so that should get back to that area. And in pharma, we got the benefit of some dosage sales as a result of the profit from the competitors. So I think from a sustainability standpoint, we are more into that mid to upper single-digit – again, as we manage the portfolio, the whole objective is to create a portfolio that has greater opportunity and a lot of our growth plan honestly has come from our ability to not just grow in our markets but to expand into nice adjacencies like mesh and like biosurgery. Many of these businesses that started fairly and significantly a couple of years ago in the $20 million to $30 million are now anywhere from $50 million to $60 million to $100 million. And so the better we find continued findings adjacent to these stat, we can leverage with our presence in these overall franchises. That will dictate our ability to keep the sales growth rate as high as we possibly can.

Bob Hopkins – Bank of America Securities

Great. Thanks and congrats on your success.

Rich Meelia

Thank you.

Operator

Your next question comes from the line of Ms. Kristin Stewart from Credit Suisse. Please proceed.

Kristin Stewart – Credit Suisse

Good morning.

Rich Meelia

Good Morning.

Kristin Stewart – Credit Suisse

I just wanted to circle back on kind of Bob's commentary on the gross margin. Chuck, could you just help us reconcile the 150 basis points year-over-year? I know you said that a little bit more than I guess 70 basis points or 80 basis points of setbacks, maybe just help give us a sense or specifically what is moving with mix, productivity and then what the specific FX may be, to the best you can answer me?

Chuck Dockendorff

Yes. I think if you look at the components of the increase in the margin, clearly on the mix piece, we're getting some nice benefits from that. We see that up over 100 basis point increase for mix, just selling the higher margin products, the same with the kind of impact we get from the foreign exchange, so they're about equal as we see that increase. Clearly, we are seeing some negative increase in raw material costs over last year, as well as some variances that we've had which is driving that down a little bit. We are trying to offset that with cost reductions. But those are the major components, clearly would be the FX and the mix piece that's driving that increase into the improvement in the gross margin.

Kristin Stewart – Credit Suisse

Okay. And given kind of your focused on reducing (inaudible) and whatnot, it seems reasonable to assume that that mix piece is likely to continue going forward and obviously you'll work at increasing that sort of benefit.

Chuck Dockendorff

Yes, I think the mix piece will continue. I don't know if it will increase from where it is. We've had a very good year and really done a good job focusing on those higher margin products but we should still be in a good situation. But I think that we are going to have changes in the FX going forward clearly as the year-over-year comps change into next year, and this depends where the rate goes, whether if it stays where it is today, we'll have a lower impact going out into Q3 and Q4 next year.

Kristin Stewart – Credit Suisse

Okay. And then can you just expand a little on your commentary around pricing you had mentioned with raw material costs going up, are you looking to better GPOs and talk about higher prices on some of the more commodity-type businesses? You talked just more about pricing generally excluding what we have seen with the technetium.

Rich Meelia

Sure. This is Rich, Kristin. Without getting into specifics that could create a competitive problem for us, I would say that we – the answer is yes. We have gone to specific GPOs on some of our contracts where there were pricing escalation opportunities that typically you don't try and trigger, but in times like this you do. We've lost business because of our prices – price increases our customers didn't want to accept. We've also kept this and so it's been a little bit of both. And it's not just the GPOs and other big customers. We've actually asked for price increases and I think that some of the ones that we talked about previously would be with technetium generators. We're doing the same thing in other Mallinckrodt businesses, again, without getting into competitive detail.

And so, as you get pressures that we are seeing from raw materials, the bad news is you get all these negative headwinds. The good news is it tends to motivate your innovation to look for ways that otherwise they may not have as aggressively to mitigate that. And so at the end of the day, I think the business runs better as a result of some of the stimuli that gets you thinking about things that you otherwise weren't thinking about. So while we don't like these raw material increases, it's unavoidable. We can't control it and it's our responsibility just to make sure the business does everything we possibly can. And I think our history from an OpEx standpoint and always focused on cost reductions, while on the past, it was maybe what we did too much. I think having that as part of our core competency in this kind of environment is very good.

Kristin Stewart – Credit Suisse

Okay. And then last and real quick, any update on the specialty chemicals business in the sale of that?

Rich Meelia

No. I mean, the process continues. We've always been pretty quiet on these deals until we have something specifically to announce so just the process is ongoing.

Kristin Stewart – Credit Suisse

Great. Thanks.

Rich Meelia

Okay. You're welcome.

Operator

(Operator instructions) Your next question comes from the line of Mr. David Roman from Morgan Stanley. Please proceed.

David Roman – Morgan Stanley

Good morning everyone. I wanted to touch on the financials for a second. Chuck, it looks like share account is starting to creep up which is obviously due to the stock performance. Can you give us some sense to where those numbers are going and whether that has changed at all your priority with respect to use of cash?

Chuck Dockendorff

We've always given kind of a 1% number out there for dilution. Clearly the stock price will impact the number of shares that we do calculate for the EPS. That's impossible to predict at this point, so I wouldn't bring anything out there but I think we're comfortable with the 1%. Cash flow, we talked about clearly and just the majority of where we want this cash flow to go is back into the business. You can see that cash flow is very strong and we will look at a number of opportunities to deploy this cash that gives the best return to the shareholders. So we do have a number of opportunities to invest this in acquisitions and licensing and other deals that we think will – that have the highest returns and will really generate the best returns for the business. But clearly, the level of cash it was generating is one we'll going to begin to take a look beginning fiscal year ‘09 and reassess the needs of the business and where we invest this.

Rich Meelia

The only thing I'd like to just add to what Chuck said is that we track this very carefully and we recognize that where we are from many metric standpoints compared to our peers is we're just beginning to get to the kind of the middle of the pack relative to liquidity and cash positions. But we also recognize that based on our performance, we're going to get there pretty quickly in the next two or three quarters. We will likely be challenged to make some decisions relative to use of cash if in fact other ways to invest in the company don't materialize as we would expect.

David Roman – Morgan Stanley

Okay. But it's safe to say that priority remains investing the business either internal or external investments followed by a potential for dividend and maybe share buybacks?

Rich Meelia

Absolutely.

Chuck Dockendorff

Yes.

David Roman – Morgan Stanley

Okay. And then on the soft tissue repair business, that continues to do very well. You obviously were benefiting from some problems at your competitors but that issue seems have (inaudible). Can you maybe talk about some of the dynamics in that business, whether the growth we're seeing in your views were transient or whether this is sort of sustainable?

Rich Meelia

Well, we believe that's sustainable. Our share has increased pretty significantly since a couple of years ago. I think we're up – the latest time I stayed ahead from 17% or 18%, and we just got into the mesh business really with the acquisition of Floreane back in the end of 2005. I think what people probably don't fully appreciate with Floreane as an example has been the pipeline that was there when we acquired them and which has continued to expand and enrich based upon the added resources we've given them. And so, the number of new meshes that have come out of Floreane has been significant and that's really driving the hernia mesh growth that we're seeing. And it is significant, this is significant double-digit growth. We're very pleased with what's happened with AbsorbaTack, and again, we believe this has very little to do with our competitors situation as this is a whole new technology that we've offered to our customers where they can use absorbable tacking devices that are much more beneficial to the patient and this has far exceeded our expectations.

And then in the regular titanium fixation products, there you probably have seen some benefit for sure from competitive problems, but in terms of what's driving that growth, it's a new product, it's a specialist that we've got throughout the world, it's just the added focus. Again the fact that we're talking about a soft tissue repair business, soft tissue repair sales force system existed two years ago. It was a generalist at a US surgical division. So, we believe that there's still plenty of runway ahead of us. We got a lot of momentum and it's a – and we're significantly committed to that as you saw with that most recent acquisition of Tissue Science.

David Roman – Morgan Stanley

And then lastly on the bariatric surgery side, can you give us maybe an update as to where we stand on the co-promote with Allergan and Lap-Band? Has rep training been completed and are you seeing any sort of pull-through from being able to sell Lap-Band with the rest of your bariatric surgery products?

Rich Meelia

Yes, I would say that both parties just we don't speak specifically about these kinds of contracts, but I think both parties would agree it's been very successful. I think we've helped Allergan get into the operating room. I think they – the ability of us to offer a band to our surgical customers who want to use a band as opposed to do bariatric surgery because it's not (inaudible) one or the other. They tend to do both and we now can offer a competitive product that will prevent them from having to go to J&J as an example. So, financially it's not a big, big deal, David, but we're actually exceeding what we've anticipated from a financial standpoint and while we don't carve out bariatric sales due to a co-promote with an Allergan band as an example, bariatrics continues to be a real driver for us. So, clearly that has been a good deal.

David Roman – Morgan Stanley

Okay. Thank you very much.

Rich Meelia

Yes.

Operator

Your next question comes from the line of Mr. Jason Bedford from Raymond James. Please proceed.

Jason Bedford – Raymond James

Good morning and thanks for taking the questions. Is there any way you can quantify the impact of the increased wholesaler orders on the pharma side and then maybe the one-time orders on the med supply side?

Rich Meelia

Well, on the med supplies, I would say we're actually – we're doing better than we anticipated. It might have been a 2% to 3% growth without that one-timer that we got on the OEM side. On the dosage business –

Chuck Dockendorff

It's difficult, Jason, to quantify that. I would say, just to clarify on dosage, it was more us supplying as opposed to one-time inventory issues. There's more of us supplying market demand because some of our – one of our competitors was not able to satisfy that demand. But again, I think it's fair to say that business would not have been up double-digit had that not happened.

Rich Meelia

We've been saying that business would do three to six for the year despite the very challenging first half. Probably before this quarter, we were looking at closer to three and now we're probably looking closer to six in terms of where we'd be on that range.

Jason Bedford – Raymond James

Okay. That's helpful. And then just on the cost side and looking at your restructuring efforts, you guys have consistently noted that these efforts should lead to $50 million to $75 million in savings. Just wondering where are we with realizing these savings, meaning on a run rate basis, are you now realizing 75% of this or will the bulk of the benefit come next year?

Chuck Dockendorff

We're really realizing a big piece of this now as we go through the quarter. So we've been executing on this for a while. I'd say we're in that 60% to 70% range. It's already in our numbers and we'll complete the rest as we go forward. But it's mitigating some of the increases we see. It's part of our cost reduction programs that we have ongoing within the business.

Jason Bedford – Raymond James

Okay. And just lastly on the cost side, SG&A expense is still growing quite rapidly albeit at a little slower pace. Is this still a line item you feel you can leverage going forward?

Chuck Dockendorff

Yes. It is going to go up. These are planned increases. These are added sales forces and investments. So, these are increases we've made. Some of the increase is coming from acquisitions that we've done. We also have FX that's driving that up a bit as well. And I think our goal on SG&A clearly is to begin to leverage that next year and we've always said the amount of leverage next year would be modest because we still have the full-year impact of some these adds that we have in the current year. But clearly, we think we'll have the right kind of level now. If you look at our spending related to our peers and the investments that we have and the kind of programs we're putting forward, we feel very comfortable at the levels we're at now with the potential sales.

Jason Bedford – Raymond James

Okay, great. Thank you.

Operator

Your next question comes from the line of Taylor Harris from JP Morgan, please proceed.

Taylor Harris – JP Morgan

Thanks. A few follow-ups here. So, first of all, can you touch on Cardiolite and what the situation of the FDA is right now?

Rich Meelia

Yes, sure. As you know, we got approval for generic Sestamibi several months ago. There was a pediatric extension for the Cardiolite patent mix that extended to July 29. So, we're dealing with FDA in all the issues associated with that. There's a citizens' petition that they need to deal with, we believe, at sometime in the mid-August time frame. Our record experience with FDA would suggest that they should address that in a timely fashion. So, we're hoping to begin commercializing this end of August and September time frame.

Chuck Dockendorff

Let me just clarify one thing. The original approval we got back earlier this calendar year that was a tentative approval from the FDA and satisfied everything that the FDA had needed. All we're waiting for is final approval and we think that's relatively routine and we continue our dialog with the FDA, but obviously final decision there stands with the agency.

Taylor Harris – JP Morgan

Okay, but the sequence of events would be the FDA deals with the citizens' petition and then grants you final approval I assume?

Rich Meelia

That's what we would expect and that's what the dialog ongoing with FDA right now about.

Taylor Harris – JP Morgan

At this point, do you have an expectation on the number of other generics that will be on the market?

Chuck Dockendorff

We don't expect anyone when we launch. It is hard for us to predict 6 to 12 months from now. We imagine that there'll be other players for sure.

Rich Meelia

At least one or two other companies, Taylor, have hinted at being in this market. However, at this point, we are yet to see any official notation from the FDA or filing for any other player and that's part of a game theory that we've worked through in working through this market and trying to price it out, because it is highly dependent obviously as every incremental new generic gets on the market, you can have a material impact on what the ultimate pricing is.

Taylor Harris – JP Morgan

Okay, great. And then just a follow-up on a couple of SG&A questions. Chuck, how much of the SG&A increase this quarter was FX related?

Chuck Dockendorff

Probably about $25 million, something in that range.

Taylor Harris – JP Morgan

Okay. And then as you look at the fourth quarter, you said sales may be sequentially down slightly. Will SG&A be down sequentially or does that continue to increase with these investments?

Chuck Dockendorff

They will most likely increase for Q4.

Taylor Harris – JP Morgan

Okay.

Chuck Dockendorff

There will be a higher percentage of revenue in Q4 than it was in Q3.

Taylor Harris – JP Morgan

Okay. And that's continued primarily sales force investments or other?

Chuck Dockendorff

Yes, it's sales force investments that continue to add people in there, the growth initiatives as well as the continued FX impact.

Taylor Harris – JP Morgan

Okay, very good. Thank you very much.

Chuck Dockendorff

So, on a year-over-year comp –

Taylor Harris – JP Morgan

Sure.

Rich Meelia

Operator, we have time for maybe one more question.

Operator

Okay. Your final question is a follow-up question from Mr. Rick Wise from Leerink Swann. Please proceed.

Rick Wise – Leerink Swann

Thanks for taking my question. Two quick ones here, just a follow-up on the SG&A. Rich, you've said a couple of times publicly I think that this fourth fiscal quarter, the September quarter, would be the last of the sort of, I think you've used the phrase catchup spending quarters. Is that still accurate and obviously that's an important part of sort of seeing growth re-accelerate?

Rich Meelia

I think what we've said Rick within – in lieu of our context is that the – we will have positive leverage going forward in 2009. We are committed to double-digit earnings growth and that the majority of those investments will in fact be behind us. As you hire people, you're going to get them in. People hired in half a year in 2008 are going to be in portfolio year 2009. So there'll be some of that leak over effect. But in terms of our major strategies, we felt like '07 and '08 were the years where we had made those investments, and quite honestly, I think you're seeing the benefit of those investments in the increased sales growth, and that beginning in 2009, we'll start leveraging that.

Chuck Dockendorff

Rick, and consistent with what we've said in the past, and that's why I want to make sure everyone's clear on this, given what you said, we've never given a specific quarter as to when this affair may happen. We've never said that in any given quarter, we would or would not leverage SG&A. We've simply said that for 2009, we expect to leverage that number.

Rick Wise – Leerink Swann

Okay. And two other quick ones. The tax rate, Chuck, was that on the higher end, as you said, for the nine months. I would have thought some of your tax strategies would be kicking in by now, maybe just give us a little perspective on that. And last for Rich, maybe Rich you'll just give us a quick update on any updated thoughts you might have on your sort of business development outside the company? Are your priorities now in a particular segment for acquisitions or geographic, large, small, dilutive, just any updated thoughts would be welcome? Thank you so much.

Chuck Dockendorff

Rick, on the tax piece of it, the tax rate within the quarter was a little higher and it is going to fluctuate. The tax rate by quarter is going to fluctuate because of the way you account for some of the things with the declining interest over the course of the year or how FX charges hit us. We booked those in the quarter rather than annualize them, but they are built into our annual rate. As far as the annual rate on tax, I think we are very comfortable with the guidance that we've given, 28 to 31 and we should be well within that range, but we do have a lot of issues going around our tax. But I think in the Q3 it's at a little higher, but we feel it's going to be right within the range as we end up with the full year.

Rich Meelia

And Rick this is Rich. In terms of business development, I'll prep this by saying it's a very opportunistic area, so you just never say anything with certainty, but we anticipate it'd be more of the same. What you've seen in the past, very much technology focused, in places where we can leverage our presence in the franchise, smaller likely rather than larger. Likely, it will be dilutive. Everything and mostly once we've done have been diluted, but we look at impact and return in invested capital and what it does to our business, years three, four, and five, and you can look at whether it be Confluent Surgical, Erox [ph], Florean, all of which were diluted as we pro forma them out, are now just being real solid contributors to our success today. So, our strategy is to continue in the same path that we've been on in the past because it's actually been there, been working very well for us.

Chuck Dockendorff

Hey, Rick, this is Chuck. I just want to follow up on the tax thing because I want to explain and reiterate it but, again, we feel very comfortable with the tax planning we have out there that we're going to see some reductions in this rate going forward in the 200 to 300 basis points, so we'll begin to see that shortly.

Rick Wise – Leerink Swann

Thanks so much. I appreciate that.

Chuck Dockendorff

You're welcome.

Rich Meelia

Okay, given that that's the last question, thank you very much. Before I wrap up, I just want to give a quick word on next month's analyst day. As most of you are aware, it will be held on September 10 at the Pierre Hotel in New York. The format of the day will be focused on education about our products and our markets. Now, in addition to the usual format of presentations by senior management, we'll also have a number of our operating people there to discuss our products and more of a hands-on type of environment. In addition, as previously noted, we'll give much more detail about our fiscal 2009 guidance at that time.

As always, we'll reserve plenty of time for your questions and answers and hopefully it will you understand a little more about our markets and competitive positioning. Please refer to our website for instructions on how to register for the meeting and we look forward to seeing you at the event.

As for today's call, starting at noon Eastern time today, a replay of the call will be available. Additionally, the replay will be available on our corporate website, covidien.com a few hours from now. For members of the media who've listened to the call and have additional questions, please contact Erick Krauss, our head of Corporate Communications. And then for analysts having more detailed questions involving non-material information, Wayde and I will be available to take your calls. Thanks. Have a great day.

Operator

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

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