Medtronic Plc (MDT) — Q2 2015 Earnings Call Transcript

Thank you, Jackie. Good morning. And welcome to Medtronic's second quarter conference call and webcast. During the next hour, Omar Ishrak, Medtronic Chairman and Chief Executive Officer; and Gary Ellis, Medtronic Chief Financial Officer, will provide comments on the results of our fiscal year 2015 second quarter which ended October 24, 2014. After our prepared remarks, we’ll be happy to take your questions. First, a few logistical comments. Earlier this morning, we issued a press release containing our financial statements and our revenue by business summary. You should also note that some of the statements made during this call may be considered forward-looking statements and that actual results might differ materially from those projected in any forward-looking statement. Additional information concerning factors that could cause actual results to differ is contained in our periodic reports filed with the SEC. Therefore, we do not undertake to update any forward-looking statement. In addition, the reconciliations of any non-GAAP financial measures are available on the Investors portion of our website at medtronic.com. Also, unless we say otherwise, references to quarterly results increasing or decreasing are in comparison to the second quarter of fiscal year 2014 and all year-over-year revenue growth rates are given on a constant currency basis. And finally, today’s earnings call does not constitute an offer to sell or solicitation of an offer to buy any securities or solicitation of any vote or approval. In connection with the proposed Covidien transaction, Medtronic Holdings Limited has filed with the SEC a registration statement on Form S-4 that includes a preliminary joint proxy statement of Medtronic Inc. and Covidien plc that also constitutes preliminary perspectives of new Medtronic. The registration statement is not complete and will be further amended. After the registration statement has been declared effective by the SEC, the final joint proxy statement perspectives will be mailed to Medtronic shareholders and Covidien shareholders. You should review materials filed with the SEC carefully as they will include important information regarding the proposed transaction, including information about Medtronic and Covidien, the respective directors, executive officers and certain other members of management and employees who may be deemed to be participants in the solicitation of proxy in favor of the proposed transaction. Please also review the Disclaimer Page at globalmedtechleader.com for additional information on forward-looking statements and other important information on the proposed transaction. With that, I’m now pleased to turn the call over to Medtronic Chairman and Chief Executive Officer, Omar Ishrak.

Good morning. Thank you, Jeff, and everyone for joining us today. This morning we announced second quarter revenue of $4.4 billion, which reflects a growth of 5%, alongside non-GAAP diluted earnings per share of $0.96, also increasing by 5%. The second quarter was a strong period with revenue growth at the upper end of our outlook for the fiscal year and within our mid-single-digit baseline goal. Our performance was balanced across our three groups, with our two largest groups, CVG and RTG, both showing mid-single-digit revenue growth, while diabetes saw double-digit growth. Our results were geographically balanced, with growth of 5% in both the U.S. and international markets. Looking forward, we expect our three main strategies—therapy innovation, globalization, and economic value—combined with increased market diversification, will allow us to consistently achieve reliable growth in healthcare. We also believe our pending acquisition of Covidien will further enhance and balance our growth profile. As previously mentioned, we are actively quantifying, communicating, and executing our independent growth strategies. Our new therapies growth vector contributed 310 basis points to our overall growth in Q2, which is over 100 basis points higher than last quarter and at the upper end of our previously stated range of 150 to 350 basis points. Our organization continues to launch new products and services, which are receiving positive feedback from customers globally. Let me highlight some innovations that have contributed to our revenue growth by providing significant clinical and economic value. In our Cardiac and Vascular Group, we launched the Attain Performa quadripolar lead system in the U.S. in September. This advanced system, along with our Adaptive CRT response improvement algorithm and efficient VectorExpress programming technology, led to a substantial increase in our CRT-D implant volume during the quarter. Attain Performa has also continued to gain market share in Japan, adding nearly 20 points since its launch. In our low power business, the Reveal LINQ miniaturized cardiac diagnostic monitor has surpassed our expectations in terms of revenue growth. The business also introduced the SEEQ Mobile Cardiac Telemetry System, which is designed for patients needing up to 30 days of monitoring. The SEEQ sends vital cardiac data to the Medtronic monitoring center, staffed by certified technicians to facilitate early detection. In AF solutions, we are growing our market presence with the Arctic Front Advanced Cryo System, and we are initiating our redesigned phased RF product line. In structural heart, the U.S. launch of our CoreValve transcatheter valve continues to foster growth, with over 200 sites now equipped to implant this innovative technology. Looking ahead, our CVG pipeline is strong, with several significant therapies set to launch in the coming quarters, including our CoreValve Evolut R transcatheter valve and Resolut Onyx drug-eluting stent. In our Restorative Therapies group, innovation is also a growth driver. RTG is advancing its neuro science strategy, as shown by our recent acquisitions of Visualase and Sapiens. These technologies are expected to strengthen our leadership position in the growing field of neurosurgery. In spine, we are launching several new therapies, including the PRESTIGE LP artificial cervical disc and the Divergence Anterior Cervical Fusion System. We expect that the ongoing stability in BMP will result in modest growth in our spine business in FY ’15. In neuromodulation, our InterStim therapy for bladder and bowel control is contributing to growth, alongside the Activa DBS System. In our Diabetes Group, the successful U.S. launch of the MiniMed 530G System with the Enlite Sensor is driving strong growth in both insulin pumps and CGM. Our strategy of selling and supporting the pump and sensor as an integrated system continues to yield global share gains. The MiniMed 530G is unique as the only system that automatically halts insulin delivery if glucose levels drop below a certain threshold, a crucial step towards developing a fully automated artificial pancreas. Peer-reviewed studies have highlighted the benefits of our Threshold Suspend feature, including findings published in renowned medical journals. We have also completed user evaluations for our next-generation systems, the MiniMed 640G and 620G, and are ramping up manufacturing in anticipation of a broader international launch later this fiscal year. In Q2, we reorganized our Diabetes Group into three focused units aimed at transforming diabetes care. The first unit will concentrate on intensive insulin management for type 1 and intensive type 2 diabetes. The second will focus on non-intensive diabetes therapies for type 2 solutions. The third unit will enhance the customer experience through improved data management and support services. We believe these businesses can leverage Medtronic’s technology and services to expand care accessibility, integrate support, and improve outcomes. Emerging markets contributed 145 basis points to our overall growth, showing improvement from the previous quarter and aligning closely with our expectations. Greater China returned to double-digit growth, and we saw continued impressive growth in the Middle East and Africa for the ninth consecutive quarter. Latin America performed well, especially in Brazil, which exceeded 20% growth. We are optimistic about the rebound in Russia's growth profile and are focusing on optimizing our distribution in India to capitalize on this major market opportunity. We remain confident in the long-term prospects of emerging markets and continue to invest in these regions. Services and solutions contributed 45 basis points to our overall growth, fitting within our targeted annual range. Our cath lab managed services continue to grow in Europe, and we completed the acquisition of NGC Medical Institute to strengthen this business. NGC brings valuable expertise that enhances our managed services offering. We now have nearly 40 long-term agreements with hospital systems, amounting to over $900 million in committed revenue. Our Cardiocom business is also delivering strong results, serving over 80,000 patients, largely due to growth in government and hospital accounts. This platform supports our goal of offering more comprehensive healthcare solutions. Regarding our financials, non-GAAP EPS growth exceeded our actual revenue growth but fell short of our annual leverage expectation. Although our gross margin rates did not meet expectations, we achieved our EPS objectives with a sequential improvement in SG&A spending. We generated nearly $1 billion in free cash flow in Q2, returning over $850 million to shareholders through buybacks and dividends. We are disciplined in our capital deployment, pursuing acquisitions that align with our growth strategies while minimizing shareholder dilution. Our strategy of completing acquisitions since FY ’09 has generated $1.4 billion in revenue without net dilution, and we expect this trend to continue. We made three additional acquisitions this quarter, which align with our acquisition guidelines. We remain focused on achieving our financial model of mid-single-digit revenue growth, EPS growth outpacing revenue growth by 200 to 400 basis points, and returning half of our free cash flow to shareholders. To achieve these goals, we will continue to execute on our key strategies. We believe our acquisition of Covidien will greatly enhance our strategies and improve our market competitiveness. As we move through the integration planning and regulatory approvals, we are increasingly excited about the potential benefits of the Medtronic-Covidien combination and remain committed to this transaction, expected to close in early 2015. We view this acquisition as financially beneficial, identifying achievable cost synergies that could make the transaction accretive in the first year and neutral to accretive within three years on a GAAP basis. We anticipate significant free cash flow generation from the combined company. Our integration planning is progressing, guided by four main priorities: preserving our growth potential, optimizing for cost synergies, accelerating market presence, and transforming our innovation and partnerships in healthcare. We believe our industry-leading products, combined expertise, and global reach position us to be the partner of choice across healthcare sectors. Now, Gary will take you through a detailed overview of our second quarter results.

Thanks, Omar. Second quarter revenue of $4.366 billion increased 4% as reported, or 5% on a constant currency basis after adjusting for a $38 million unfavorable impact from foreign currency. Q2 revenue results on a geographic basis were as follows. Growth in the emerging markets was 12%, and represented 13% of our overall sales. The U.S. grew 5% and represented 56% of our overall sales, and growth in non-U.S. developed markets was 2% and represented 31% of our overall sales. Q2 diluted earnings per share on a non-GAAP basis were $0.96, an increase of 5%. Q2 GAAP diluted earnings per share were $0.83, a decrease of 7%. This quarter’s GAAP to non-GAAP adjustments on an after-tax basis included a $64 million multi-year donation to the Medtronic Foundation and a $60 million charge for acquisition-related items, primarily associated with transaction costs in connection with the pending Covidien acquisition. It is worth noting that on a cash basis, Q2 diluted earnings per share were $1.02, an increase of 5%. In our Cardiac and Vascular Group, revenue of $2.286 billion grew 5%. Results were driven by growth in Low Power, Structural Heart, and AF & Other, partially offset by declines in Coronary and High Power. In Cardiac Rhythm & Heart Failure, revenue of $1.320 billion grew 5% and included $18 million of combined revenue from our acquisitions of NGC Medical, Corventis, and TYRX. High Power revenue of $670 million declined 5% after difficult prior year comparison but sequentially grew 7%, as reported on the strength of the U.S. mid-quarter launch of our Attain Performa quadripolar CRT-D system. Our daily CRT-D implant volumes were flat prior to the launch but jumped to mid-teens growth post-launch. In fact, despite having Attain Performa available for only part of the quarter, our Q2 in total represented our highest level of average daily CRT-D implants in over three and a half years. As we have noted over the last several quarters, we believe the best way to view the High and Lower Power markets is on a rolling two quarter basis, given the variability in quarter-to-quarter dynamics. We estimate that global High Power market growth is flat to slightly down with low single-digit growth in international markets, offsetting low single digits declines in the United States. Last week, we announced the launch of our Revo MRI SureScan ICDs in Japan. We expect Revo MRI, which allows for full body MRI access to be well received by the Japanese market, given their preference for MRI technology. Low Power revenue of $524 million grew 11%, driven by the strong global launch of Reveal LINQ. In June, data from the CRYSTAL AF trial were published in the New England Journal, showing that in patients with recent cryptogenic strokes, our Reveal monitor detected AF better when compared to standard care. We continued to make progress on our global clinical trial for Micra and expect CE Mark by the end of this fiscal year, with U.S. approval in FY ’17. AF solutions grew over 30%, as we continue to take share and grow the AF market. Results were driven by robust growth of the Arctic Front Advance CryoAblation system which grew over 30%, as well as strong double-digit growth from the international launch of our PVAC Gold phased RF system. We continue to make progress in bringing our phased RF technologies to the U.S. market, as we are enrolling our VICTORY AF pivotal study for patients with persistent AF. In our Coronary & Structural Heart business, revenue of $743 million grew 6%. Coronary declined 2% percent, although our drug-eluting stent share remains stable in the United States and was up slightly in international markets. The business executed on a strong global launch of our NC Euphora Balloon, which gained market share in an area where share is usually very sticky. Our agreement with ACIST, where we co-promote their FFR technology in the United States also continues to go very well. We also just received CE Mark for our Resolute Onyx DES and are preparing to broadly launch in Q3. Resolute Onyx builds on a superior deliverability, improving clinical performance of Resolute Integrity, with thinner struts to enhance deliverability even further and is the first stent to feature our core wire technology, which markedly enhances visibility. Structural Heart grew 19%, on a continued strength of our U.S. CoreValve launch. Our global transcatheter valve revenue in the quarter was $131 million, representing growth of over 60%. We estimate that the global transcatheter valve market is now annualizing at over $1.5 billion. Our team is aggressively adding new centers, with a presence now in over 200 U.S. centers. We are executing to the launch as planned, with a focus on training and strong procedural results. Our share was stable in our experience accounts. In international, the launch of CoreValve Evolut R 23 millimeter valve is well underway with very strong customer reception to the platform. We are expecting to broaden this platform with the approval of our 26 and 29 millimeter valves in early calendar year ’15. Evolut R is our next-generation recapturable system, with a differentiated 14 French equivalent delivery system. In addition, our U.S. IDE study for Evolut R, our 250 patient single-arm study with a 30-day follow-up is now enrolling. In our Aortic & Peripheral Vascular business, revenue of $223 million grew 3%, or 5% after adjusting for the divestiture of our Pioneer Plus product line and the voluntary product recall of the below-the-knee DCB. This is the last quarter we faced the negative effect of these two discontinued product lines, which should lead to improved reported growth in this business going forward. Aortic revenue grew 3%, driven by double-digit growth in thoracic with Valiant Captivia stent grafts achieving strong share gains. In AAA, we received CE Mark and FDA approval for our Endurant IIs in the last week of Q2. Endurant IIs, a unique three-piece version of our market-leading Endurant platform, will launch in Q3. Revenues for our Peripheral business grew 4% in Q2. However, after adjusting for the discontinued product lines just mentioned, our Peripheral business grew in the mid-teens, with strong double-digit growth in SFA DCB products. Looking ahead, in the first calendar quarter of 2015, we are expecting U.S. approval for our IN.PACT Admiral drug-coated balloon as well as the major medical journal publication of IN.PACT SFA one year results. We expect our IN.PACT Admiral DCB to drive growth in Peripheral in the coming quarters. Now turning to our Restorative Therapies Group, revenue of $1.650 billion grew 4%. Results were driven by growth in Surgical Technologies, Neuromodulation, and BMP. Spine revenue of $746 million grew 1%. Core Spine growth was flat year-over-year, a modest improvement from last quarter. We are encouraged that both the global and U.S. Core Spine markets continue to stabilize and are beginning to show bias towards low-single-digit growth. Our Core Spine business is launched in a number of new products this fiscal year, which are expected to return our overall spine business to modest growth in FY '15. In addition to working with surgeons to develop the leading technology in spine, our business continues to focus on procedural innovation and our surgical synergy program, which integrates enabling technologies, surgical tools, spinal implants, and our expertise. Interventional Spine, which primarily consists of our balloon kyphoplasty product line, declined 5%. While we saw good underlying procedural volumes, we were affected by a product supply issue related to our Cement Delivery System. BMP sales of $120 million grew 9%, with stable underlying demand. While sales of BMP bounced round a bit, we do believe we have turned the corner and would expect BMP sales growth to be slightly positive going forward. Turning to Surgical Technologies, revenue of $410 million grew 10% and included $3 million of revenue from our acquisition in the quarter of Visualase. Surgical Technologies had balanced growth across Neurosurgery, ENT, and Advanced Energy. Neurosurgery grew in the upper-single digits, driven by growth in Midas Rex power equipment, capital equipment service revenue, as well as revenue from Visualase. ENT also grew in the upper-single digits, driven by solid results in ENT power systems due to the recent launch of the M5 Microdebrider and monitoring disposables. The recent launch of our NuVent sinus balloon also drove growth in ENT. In Advanced Energy, strong adoption of our proprietary Aquamantys tissue sealing and PEAK PlasmaBlade technologies drove solid double-digit growth. In Neuromodulation, revenue of $494 million increased 4%, led by upper-single digit growth in Gastro/Uro and DBS businesses. Gastro/Uro results were driven in part by the success of our Care Pathway program, resulting in solid new InterStim implant growth in the United States. We also received the FDA approval and launched the Verify Evaluation System, which is used to provide advanced filing of our InterStim system. In DBS, our global focus on neurologist referral programs and the strength of the early stim data in international markets, which shows DBS provides superior benefits for patients with early motor complications from Parkinson's disease, continues to drive solid new growth. Our DBS business also acquired Sapiens in Q2, a developer of advanced DBS lead technology that features 40 individually programmable stimulation points that can more easily stimulate the intended target in the brain. We expect to finalize development and initiate clinical studies to bring this technology to market. In Pain Stim, recent reimbursement changes have softened the U.S. market. However, we gained modest share globally on the strength of our SureScan MRI spinal cord stimulation system, with its proprietary adaptive stim automatic stimulation adjustment. In our Diabetes Group, revenue of $430 million grew 10%, driven by the ongoing U.S. launch of the MiniMed 530G system, which includes the Enlite CGM sensor, a smaller, more comfortable, and more accurate sensor. Globally, insulin pumps grew in the mid-single digits and CGM grew over 40%. Looking ahead, we are planning a limited launch of our next-generation MiniMed 640G system, with predictive low glucose management in international markets in Q3, followed by a broader Q4 launch. Likewise, our MiniMed 620G, the first integrated system optimized for the Japanese market has begun its limited rollout and will also broadly launch in Q4. In addition, we are making good progress on our sensor pipeline as we advance towards a closed-loop system. Last month we announced the first enrollment in our U.S. pivotal study of our predictive low glucose management technology, which includes the study of our new insulin pump design and fourth-generation CGM sensor. This sensor has new intelligent diagnostics that are expected to result in enhanced accuracy and is 80% smaller than the Enlite sensor currently sold in the United States. Looking ahead, it is worth noting that in Q3 diabetes will face difficult comparisons due to the $23 million in deferred revenue that was recognized in Q3 last year. Turning to the rest of the income statement, please note that all of my forward-looking outlook and guidance comments do not contemplate the effect from the expected closings and related financing of the Covidien transaction. The Q2 gross margin was 73.8%. This was below our expectations due to several factors, including a product mix shift in CVG, the outperformance in BMP sales, and our acquisition of NGC Medical. As we have noted in the past, BMP is one of our lowest gross margin products due to the profit-sharing arrangement with Pfizer. NGC Medical, which we acquired in the quarter, also has a gross margin that is significantly below our corporate average. However, both BMP and NGC have operating margins that are similar to the corporate average due to lower spend in SG&A and R&D. The gross margin also continues to include significant spending related to resources to address quality issues in neuromodulation and diabetes, which negatively affected the Q2 gross margin by approximately 40 basis points. Looking ahead, we would expect our gross margin to improve sequentially on an operational basis, driven in part by positive manufacturing variances that have already occurred flowing through in the back half of the fiscal year as well as continuing execution on our cost of goods sold reduction program, resulting in gross margins around 74.5% on an operational basis in the second half of FY '15. However, based on current exchange rates, we would expect to have a negative 50 to 60 basis points foreign exchange impact in Q3 and Q4, which would result in reported gross margins that are similar to our Q2 reported gross margin. Second quarter R&D spending of $374 million was 8.6% of revenue. We continue to invest in new technologies as well as to generate clinical and economic evidence to drive future growth. We expect R&D expense in FY '15 to around 8.5%. Second quarter SG&A expenditures of $1.507 billion represented 34.5% of sales, both on an as-reported and operational basis and in line with the outlook we provided. We continue to expect FY '15 SG&A to be in the range of 33.7% to 33.9%, implying leverage of 50 to 70 basis points on an operational basis. Amortization expense for the quarter was $89 million. In FY ‘15 we continued to expect amortization expense to remain around $90 million per quarter. Net other expense for the quarter was $63 million. This result was favorable to our prior expectations due in large part to changes in FX, which resulted in a $12 million gain in Q2 from our FX hedging program. We continue to hedge the majority of our operating results in developed market currencies to reduce volatility in our earnings from foreign exchange. However, it’s worth noting that there is a growing portion of our profits that are unhedged, especially emerging market currencies, which can create some volatility in our earnings. Based on current exchange rates, we expect FY ‘15 net other expense to be in the range of $180 million to $210 million, which includes an expected $120 million impact from the U.S. Medical Device Tax, as well as increased royalty expense from the Edwards agreement. In Q3, we expect net other expense to be in the range of $30 million to $40 million based on current exchange rates. Net interest expense for the quarter was $8 million. At the end of Q2, we had approximately $14.5 billion in cash and investments and $13.7 billion in debt. Based on current rates, we would expect Q3, net interest expense to be in the range of $5 million to $10 million. This forecast does not include any potential impact from the planned financing of the Covidien acquisition, which we would expect to exclude in our Q3 non-GAAP net interest expense. Our non-GAAP nominal tax rate in Q2 was 19.5%. For FY ‘15, we expect an adjusted non-GAAP nominal tax rate to be in the range of 18% to 20% and we expect to be at the higher end of this range until the presently expired U.S. R&D tax credit is reinstated. In Q2, we generated $951 million in free cash flow after adjusting for the Medtronic Foundation donation and certain litigation payments. We remain committed to returning 50% of our free cash flow, excluding one-time items to shareholders. In Q2, we paid $298 million in dividends and repurchased $555 million of our common stock. As of the end of Q2, we had remaining authorization to repurchase approximately 34 million shares. Second quarter average shares outstanding on a diluted basis were 993 million shares. It is important to note that we expect that the cash we received from stock option redemptions, which was $158 million in Q2, will also continue to be used to repurchase shares on the open market to partially offset the dilutive impact. These share repurchases are incremental to our commitment to return 50% of our free cash flow to shareholders. For FY ‘15, we would expect diluted weighted average shares outstanding to be approximately 998 million shares, including approximately 995 million shares in Q3. Let me conclude by providing our fiscal year 2015 revenue outlook and earnings per share guidance. We are tightening our constant currency revenue growth outlook to 4% to 5% for FY ‘15. And based upon our current forecast for the back half of the fiscal year, we would not be surprised to be at the upper end of this range. While we cannot predict the impact of currency movements to give you a sense of the FX impact if exchange rates were to remain similar to yesterday for the remainder of the fiscal year, then our FY ‘15 revenue would be negatively affected by approximately $280 million to $320 million, including a negative $130 million to $150 million impact in Q3. Turning to guidance on the bottom line, we continue to expect FY ‘15 non-GAAP diluted earnings per share in the range of $4 to $4.10. Based on current exchange rates, this implies earnings per share growth in the range of 7% to 10% on a constant currency basis after taking into account the currently expected $0.08 to $0.09 of negative foreign currency impact on earnings. While we don’t provide quarterly guidance, we would point out that Q3 typically has modestly lower revenue and similar earnings per share to Q2. Given this and the fact that the U.S. R&D tax credit has not yet been reinstated, we would not be surprised to see some model shift to a few pennies of earnings per share from Q3 to Q4. As in the past, my comments and guidance do not include any unusual charges or gains that might occur during the fiscal year. In addition, as I have mentioned earlier, our outlook and guidance do not contemplate the impact of the expected Covidien transaction. Before turning the call back to Omar, I would like to remind you that we will have an extra selling week in FY ’16, which will occur in the first quarter. This means that Q1 will have a total of 14 weeks, an anomaly due to the way our fiscal years are structured with this catch-up week occurring every six years. Omar?

Thanks, Gary. Before opening the lines for Q&A, let me briefly conclude by stating that Q2 was a strong balanced quarter. We continue to strive to reliably deliver on our baseline expectations. And looking ahead, we believe our three primary strategies, therapy innovation, globalization, and economic value, coupled with our increased market diversification will enable us to consistently deliver dependable growth in healthcare. And we believe our pending acquisition of Covidien will further strengthen and balance our growth profile. With that we will now open the phone lines for Q&A. In addition to Gary, I will ask Mike Coyle, President of our Cardiac & Vascular Group, Chris O'Connell, President of our Restorative Therapies Group; and Hooman Hakami, President of our Diabetes Group to join us. We are really able to get to everyone’s questions, so please limit yourself to only one question and if needed one related follow-up. If you have additional questions, please contact our Investor Relations team after the call. Operator, first question please?

Good morning. Thanks for taking the questions. Gary, I would like you to discuss a couple of items. First, regarding the upcoming Covidien closing, can you share your thoughts on your debt load after the closing in light of the borrowing in the U.S.? Also, what will your comp levels and debt ratios look like going forward? Secondly, I would like you to address your capital allocation strategy post-closing considering your access to Covidien’s cash flows and how that changes with the increased cash flow opportunities after the close.

Okay. Well, with respect to the debt levels, I think everyone’s well aware to finance the transaction at this point. We’ve changed instead of using our off-U.S. cash and bringing that we’re using that as part of the transaction, we will finance the entire cash component of the transaction, which is basically about $16 billion that we’re going to need to finance now. That will be both through some bank debt and obviously going to the capital markets. We’ve thoroughly had discussions with the rating agencies around that. We’ve taken a look at the finance and that’s well within our ability to do. We don’t think that should be any issue. Obviously, it will result in slightly lower ratings from the agencies but still well in line with our expectations. We expect over time that we’ve kind of committed to the fact that we want to maintain, get it done at kind of a three times leverage, which I think will occur over the first few years as we get the synergies and drive the growth in the business. We think the leverage levels will probably we can maintain those levels and be very, very comfortable going forward and give us the financial flexibility we need as an organization. So obviously, as much as we prefer to be using our own cash with the transaction, the ability to go and use outside debt to finance this transaction fits very well into the financials and our expectations moving ahead. So that we don’t think that’s going to have much of an impact on our overall cash flexibility. As far as the capital allocation goes, as we indicated, when we did the transaction, we still are committed to return the 50% free cash flow to shareholders, that’s where our commitment still remains. But as we indicated, when we talk about the transaction, just getting access to the Covidien of both U.S. and off-U.S. cash improves our cash availability in the U.S. dramatically from around 35% to 40% that we have right now to above 60% as we go forward. And so that clearly improves our flexibility and gives us the ability as we take a look at the combined companies going forward on what we might do with capital allocation or reinvesting back in the United States. And as we indicated, that was one of the key factors for the transaction and the structure we came up with is to improve that overall flexibility as we move ahead. So, we have not changed our capital allocation, but obviously we’ll have increased flexibility as we move forward after the transaction closes, and we’ll have to evaluate that as we get together as a combined company.

Let me ask you a question, Omar. This quarter, there was a 5% growth, marking the first time in four and a half years that the company has achieved this. This growth is largely due to new products and therapies in the U.S. market. Additionally, the emerging markets segment experienced a 12% growth this quarter, and it continues to grow, though it appears to be below your internal targets. Could you elaborate on how to boost emerging markets growth from 12% to over 15%, as this seems to be a key focus for you?

Well frankly I am targeting even higher than that Mike, but it’s true that we’ve said that mid-teens is our baseline expectations. And I think we’ve had a little bit of a tough couple of quarters in emerging markets in relative terms because of some changes we made in distribution and also some difficult comparisons as well. We expect to get to mid-teens in the emerging markets quite shortly because there is a balance here. Some of the emerging markets are doing very well, others are under pressure, and it so happened that Central and Eastern Europe, which was a big driver of growth had a lot of pressure in the past three or four quarters that’s coming back. China had to return to double-digit growth this quarter, and we expect China to continue in that range. India has been a problem, and it’s going to take a little while to sort out. It’s primarily around our distribution channels, but that has a fairly small impact right now on our overall numbers. And Latin America is coming pretty strong, growing well over 15% in fact so. This is a balance of different countries here, which have different profiles. I think it’s fair to look at this on an annual basis as opposed to a quarterly basis. And I think that’s the way we are looking at it, and we are pretty confident that on an annual basis getting around the mid-teens is a realistic objective. But as I have mentioned earlier in all seriousness, I’ll challenge the team that the opportunity there in terms of the under-penetrated market among people who can afford the care really deserves growth higher than that. So, it’s not quite that simple though to get all those different constituents together, and it’s going to take a little while. But the opportunity is clearly there. I think mid-teens is still a very realistic and achievable annual goal. We’ll have quarter-over-quarter fluctuations simply given the breadth of geographies we’re dealing with.

Yeah. Thank you, Omar. Congratulations on the quarter.

Good. Thanks. Mike.

Thanks Mike.

Good morning. Just a couple of quick questions, I guess the first question just talking about consistency of growth, Omar, has been a huge focus of the business and as you head into Covidien and you reiterated, you want to be a more consistent business, and certainly on the topline that looks like the case here in the quarter. Maybe for both of you, just thinking about gross margins, this is sort of in a third straight quarter where GMs have been a little soft and there have been one-time issues. But I think investors, I think are looking for sort of conviction around whether you really can deliver to 200 to 400 basis points of leverage to a much stronger topline number? I think based on the last three quarters, Gary or Omar, there is a view that maybe there are some structural forces weighing on gross margin. So can you talk about why you are still confident that you can deliver, from a Medtronic individual perspective, better leverage on that topline, which is obviously improving here in the last few years and then I have a quick follow-up?

You are correct in noting that the gross margin has faced pressure for various reasons over the past few quarters. While we maintain that our previously discussed range is realistic and achievable, I want to emphasize that, given our current product and business mix, the operating margin serves as a more relevant metric than the gross margin. The gross margin constitutes just a part of what impacts the overall operating margin. With the scale we're achieving in our services and solutions business, particularly at NGC, the resulting lower SG&A combined with a lower gross margin will lead to an increase in operating margins. Therefore, our focus is shifting more to operating margin. We will continue to monitor gross margin from a pricing standpoint, but the operating margin is likely to be a more significant indicator for us. Moving forward, as we assess the combined company with Covidien, we need to consider the implications of a higher growth rate on our leverage. The focus should be on absolute EPS leverage at this point, and while we remain committed to delivering consistent mid-single-digit growth and the associated leverage, we can only explore different leverage strategies once we have established reliable growth patterns. So, let’s prioritize the overall operating margin and deliver a few more quarters in line with our baseline expectations before contemplating potential changes, particularly as Covidien introduces additional mix.

Okay. Omar, very helpful. And then execution obviously is the second thing. I think you’ve been very focused on here in the last several quarters. Maybe just talk about two points of execution in the U.S. market in this quarter, one, the high-powered market has been softer for several quarters, how much of that is product mix for you guys? And how much do you think can really be improved through better execution, better management? And then just secondarily, TAVR rollout, obviously still a strong number but flattish sequentially based on your commentary. What do you think you share with TAVR market share and how happy were you with the results there this quarter? Thank you.

I am going to let, Mike Coyle talk about the dynamics. What I will say that from my perspective, when I look at the overall execution of our businesses in terms of this new product launches. I really, I'm encouraged and quite pleased. I think the team has by and large met their commitments, not only in terms of dates but in terms of the traction that these products have achieved. Their inter-quarter dynamics, there are other factors here which relate to the exact share position or the growth numbers on a short-term basis. But the real meaningful indicators that I looked at and the team has clearly executed so. But, Mike, may be you can give some more color to the market.

Just specifically on the two markets that you mentioned on the High Power side, obviously despite the fact that we have a year-over-year decline of 5% in the High Power number, that really has more to do with the prior year than it does in the current quarter from the standpoint that there were some unusual dynamics in the prior year second quarter. Because of the fact that we had this meaningful destocking in the first quarter a year ago, as we brought on the new what we call the Blackwell platform or the Evera Viva/Brava product lines. So if you look at the prior year number, it was an unusually high because of the quarter end dynamics in the second quarter. But when you now look at the actual performance on a run rate basis, especially since the second half introduction into the U.S. of the new quadripolar Attain Performa system, we are actually seeing very nice growth dynamics and I think in the text, you heard mid-teens kind of growth in implants for the second half of the quarter, which obviously reflects very good execution and matches frankly what we saw in other geographies like Japan for the differential performance of the product life. So we think there is very good execution going on there. In the TAVI product line, obviously from a performance perspective, the rollout is going just as we had envisioned it would in terms of new centers being opened and revenues generated. Obviously, what was a little different in the quarter was the fact that there were some positive competitive dynamics going on with new product introductions. And we have to remember this is the market that is in its infancy is going to respond to new technology introductions. So one of our competitors obviously brought in the product line that allowed them to compete in the larger valve sizes, which gave them an opportunity to differentially grow in the accounts where we are not there yet. And obviously there is also a reaction to new products coming into the market, where there is trialing and then accounts are going to decide what they are going to settle on in terms of overall share. Fortunately for us, we’re now heading into that cycle with the Evolut R product. We will have our CE Mark for that product. We have it for the 23-millimeter valve. We will be adding the 26 and 29 by the time we get into the fourth quarter of this fiscal year. And then by midyear next year, we will have that availability of product in the United States. So we think this is going to be a competitive market. The good news is it looks like it’s going to be growing faster than we had projected at the time of the Analyst Meeting, and we’re happy to participate in it. I think the important thing from a CVG perspective is no single product line dominates our growth profile. As you heard from the number of new product innovations, whether we’re talking about the diagnostics area, the new products in CRT-D, whether we’re talking about the drug-coated balloon, or the refresh on the Evolut R, or the additions of our new Onyx drug-eluting stent, we have a large number of therapy innovation growth drivers that are taking place throughout the world and will help us get and sustain balanced growth.

Okay. Thank you very much. Nice quarter.

Thank you.

Wondering if you could just focus on with the Covidien transaction, just with respect to accretion that you’re talking about, FX definitely has an impact on Covidien’s results. So I was wondering if you could just weigh in on how you guys are thinking about FX moving ahead as you bring that company into the Medtronic fold and how will hedging I guess look like?

I will clearly let Gary take this one.

As we indicated earlier, with the Medtronic and Covidien transaction, we expect it to be at least neutral to accretive in terms of cash earnings per share in the first year, and GAAP accretive by the third year, provided the anticipated synergies are realized. We're in the process of finalizing our detailed plans for fiscal year 2016 and are just beginning to assess the impact of foreign exchange on the combined entities. At this moment, I cannot provide specifics on how FX will affect us moving forward. However, it's true that foreign exchange poses a challenge for both Medtronic and Covidien, as it does for any company operating internationally. We have implemented a hedging program that is more extensive than what Covidien had done, and we will evaluate its effects as we progress. Unfortunately, I don't have detailed information to share regarding the potential FX impact for fiscal years 2015 or 2016 at this time.

Okay.

One comment that I can make on this is that look with Covidien, given the breadth of manufacturing facilities, again we don’t want to kind of just create one just for FX. But if it makes sense, given the diversity of manufacturing locations and the spread of cost globally, I think over the long-term, this is not a short-term, I mean over the long-term, we can plot, not a hedging, but a more balanced strategy on FX that will give us some protection. So I think the addition of Covidien actually gives us that added flexibility, which over the long-term if you plan it carefully might help us.

More of a natural hedge.

It provides more of a natural hedge.

Great. And then, just a clarification on the tax rate given the change in finance, you’ve talked about 2% lower, I guess, off the blended tax rate? Is that the blended tax rate as we see it from a non-GAAP basis today or should we be thinking about that as a blended tax rate, if we adjust both your tax rate and Covidien’s tax rate onto like more of cash earnings, so it would be certainly lower than what the non-GAAP number is today?

No. It should be on the non-GAAP number, is what you should base on. What we have done is, we’ve assumed that, based on what our non-GAAP normal tax rate is in there, if you blend those together and then assume, as we indicated approximately 2% benefit from the financing, that’s kind of roughly where we expect. But, obviously, there is a lot of moving parts there that are outside even our control. I mean, what happens if the R&D tax credit, all these different things will have impact on where their rate is. But generally just take our two rates and blend them together and it’s a 2 percentage point improvement on the top of that.

And that’s going to be on a new cash basis tax rate?

That’s on the non-GAAP rates.

Okay. All right. Thank you.

Thanks, Kristen. Next question.

Great. Thank you and good morning.

Hi.

I have two questions, one related to the product for Mike, but first I'd like to ask Omar or Gary. As we approach the conclusion of the Covidien deal, could you provide a more detailed update on the synergy target that you have mentioned, which is at least $850 million? As you get closer and begin planning, how confident are you in achieving that $850 million? Is there potential for additional gains, and if so, where might those come from? I'd appreciate your comments as we near the finalization.

I think the planning is progressing well. We now have a detailed list of when we expect to achieve some of these savings. We’ve assessed different levels of savings and feel comfortable with the $800 million figure. At this point, it’s too early to discuss potential upsides to that number. We do have a good pipeline of opportunities, but our main focus remains on preserving the two businesses, their growth profiles, R&D spending, and commercial presence, which is crucial for us to safeguard. As we move further from customer-facing areas, there are clearly opportunities, and we are compiling a list. However, some of these may take longer to materialize and carry more risk. We want to avoid anything that disrupts our product supply, so we need to proceed cautiously. In summary, it’s a bit early to delve into specifics about potential upsides, but we are confident about the baseline number we’ve committed to and are exploring further options. Gary, go ahead.

Great.

No. I think you made a good point. The teams are clearly focused on the details, unlike the high-level estimate we had earlier. We now have more detailed plans regarding that figure, as Omar mentioned. We remain confident in reaching the $850 million target, and there is potential for more, which we will share when the time is right. However, we see no reason for concern regarding the $850 million target at this moment.

Okay. Great. And then on the product side for Mike. Mike, I was wondering if you could comment on two things. First on, LINQ and then on your U.S. quad pole CRT-D lead launch and on LINQ, is that again over $100 million this quarter and could you give us any revised thoughts on how big you think that opportunity might be beside sort of the obvious comment that it could be bigger than you originally thought? And then just some qualitative comments on the quad pole launch would be great?

Sure. I think, the diagnostic area is one that we are particularly focused on as a potential growth driver, not only for the product revenue that come with LINQ and with the SEEQ patch that we have, but also because its sort of the door for improving diagnosis of patients and then also getting actively involved in patient management. And so, we see service revenue opportunity associated with those products, as well as obviously, the product revenue. So, I’m not prepared to give you a quantification of how fast we update the numbers that we talked about at the Analyst Meeting here earlier in the spring, but it clearly is going to have the potential to be a $1 billion market, we will talk about at what time period that is going to play out. I think the thing that is very interesting about it is, well, it’s not only obviously the revenues that we are getting off of this particular product, but the fact that by essentially more than doubling the number of patients who are getting diagnosed for syncope. We typically get 8% or 9% pull-through on devices, pacemakers that get diagnosed, because these patients are getting effectively diagnosed with the LINQ product. So it’s helping us in multiple ways creating service revenue, creating product revenue, and then actually driving devices revenue of which we get a differential share. And now on the quadripolar lead system, I think it’s important to sort of understand that this is a lead, but a device system that offers significant advantages over what was available in the market prior to its approvals from the standpoint that the Adaptive CRT algorithm, which minimizes biventricular pacing has been demonstrated to provide better outcomes in heart failure and now physicians no longer have to choose between having a quadripolar lead and being able to select that algorithm. Secondly, the design of the lead itself, where we have this narrow dipole that some have been referring to as a tripole system, actually that narrowed dipole, is limiting the dispersion of current which is lowering the amount of phrenic nerve stimulation, which has been a problem with prior generation quadripolar lead. In addition, the fact that we have a steroid on H1 gives us a much better patient threshold for improving or longevity of the overall product. And then our 16 vector selection process using the VectorExpress program, basically allows a high degree of efficiency to be brought into the procedure by in two minutes being able to tell what optimal vector is across 16 different options. So, it really is a better product and that’s why we have seen share movement that we have seen in Japan and why we expect to see share capture here in the United States.

Great. Thank you.

Thanks.

Thanks, Bob. Hey, we’re past the top of the hour too. We’ll take our two last questions.

Hi. Good morning. Can you guys hear me okay?

Yes, we can.

Okay. Thanks. First, for Omar, it looks like the Covidien deal is on track. And in the past quarter, Covidien announced divestiture of their drug-coated balloon. Do we anticipate any more divestitures going forward? And I had two follow-ups.

I don’t want to go into specifics on their regulatory process here other than to say that as far as we are concerned, they are all on track. We haven’t got an approval yet. So there are still steps to kind of go through. But the fact that we called the shareholders meeting, we’ve got a date for it, says that we’ve got some confidence that this will flow according to our original projections but it isn’t done yet. So we will have to kind of see how it progresses.

Okay. And then two quickies on the legislative front. It seems like there is some growing momentum in Congress to repeal the med dev tax, so your thoughts there and then any thoughts on the R&D tax credit? Thanks.

We clearly welcome the repeal of the medical device tax. We have been close to this before and there are several compounding factors that haven’t allowed that to happen. Although I agree that right now, at least from what we hear, there is a fair amount of momentum and consensus to get this one through. I mean, I really cannot comment any further than that on that aspect. As far as the R&D tax credit is concerned, we expect an extension but it has to happen. I mean, I think we are hearing all the noises that that should happen shortly. But again, I mean, these things until they are absolutely done you cannot really guarantee it. So that’s where we stand. And in both cases, we are optimistic, perhaps more confident on the R&D tax credit because that’s happened before. With the medical device tax, it looks better than before but we will see. There are still many variables left here.

Okay. Thank you.

Time for one last question.

Hi. Good morning guys. Thanks for taking the question. Gary, a quick one for you, just on the quality spend that’s hitting the gross margin line, that just seems like it’s dragging out a little bit further than you had anticipated. Can you talk about a resolution timeline there and how we should think about that going forward, then I have a follow-up for Omar on diabetes? Thanks.

Yeah. As we indicated, obviously, the biggest impact on the quality and it is basically obviously converting resources into the quality area to focus on it, from both in neuro and diabetes. We continue to make sure that we are making all the investment necessary to get that accomplished. It’s a high priority across the organization and so it’s top of mind. And as a result of that, my expectation right now is I would say diabetes, I think is probably getting closer to having theirs kind of resolved and completed. And so I think that will probably start to lessen, as we get in here probably even in Q3 and Q4. I think neuro will continue probably for the rest of the year as our expectation because then as we get into FY ’16, I think you will start to see that dropping as they continue to implement their various programs. But I think, Neuro will continue for a period of time at least for the rest of the fiscal year until we get into next year, but they’re making progress. I think the teams feel good about where they’re at but it has been costly and something that we give a high priority to as we move ahead. So I think you’ll see some improvement as you go in the back half of the year. But I think that headwind still needs to be part of this year and then obviously improvement as you get into FY ‘15.

Thanks. And then Jeff, can I ask a question, a follow-up on the diabetes there?

Okay. Go ahead.

Yeah. Okay. For Hooman, I thought the structural comments on the diabetes franchise were interesting. And I’m wondering how much of this is reorganization? How much of this might you need to build or acquire? And then specifically on the service and solutions, data management is interesting, is that Cardiocom? About how deep might you get into supplies and some of the other tertiary products that especially, type II diabetics might use? Thanks.

Sure. The genesis of the structure is really for us to become a much more holistic diabetes company, not just a type 1 pump and sensor company but a true global diabetes care organization. And that's really the impetus behind the organizational changes that Omar talked about in the text. If you take a look at the three business units that we’ve created, the first one the intensive insulin management, this is really our core business where we’re going after the type 1 patient and the intensive type 2 with product and solutions. The second one, the non-intensive diabetes therapy business is really our step into type 2 in a broad way. And this starts with the Sanofi partnership but I think you'll see from us that it’s going to extend. And with Sanofi, I think, we’ve got some really innovative things on the horizon that we’re both excited about. And then service and solution, this I think, absolutely can leverage Cardiocom. There are assets both within diabetes, with CareLink and across Medtronic with Cardiocom that can be leveraged as we think about patient management and data management. And you’ll see some additional activity from us along these lines later this year. But I think you can even extend beyond those types of things. So I think it’s going to be a mixture of both organic and inorganic activity as we look to build out particularly non-intensive and also service and solution.

Yes.

Okay. Well, thanks everyone for your questions. And with that and on behalf of our entire management team, I’d like to thank you again for your continued support and interest in Medtronic. And for those of you in the U.S., I want to wish you and your families a very happy Thanksgiving. We look forward to updating you on our progress in our Q3 call, which we anticipate holding on February the 17. Thank you and have a great day.