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COV > SEC Filings for COV > Form 10-K on 15-Nov-2012All Recent SEC Filings

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Form 10-K for COVIDIEN PLC


15-Nov-2012

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our selected financial data and our consolidated financial statements and the accompanying notes included in this annual report. The following discussion may contain forward-looking statements that reflect our plans, estimates and beliefs and involve risks, uncertainties and assumptions. Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to these differences include those discussed under the headings "Risk Factors" and "Forward-Looking Statements." Overview
We develop, manufacture and sell healthcare products for use in clinical and home settings. Our mission is to create and deliver innovative healthcare solutions, developed in ethical collaboration with medical professionals, which enhance the quality of life for patients and improve outcomes for our customers and our shareholders. Our three reportable segments are as follows:
Medical Devices includes the development, manufacture and sale of endomechanical instruments, energy devices, soft tissue repair products, vascular products, oximetry and monitoring products, airway and ventilation products and other medical products.

Pharmaceuticals includes the development, manufacture and distribution of specialty pharmaceuticals, active pharmaceutical ingredients, contrast products and radiopharmaceuticals.

Medical Supplies includes the development, manufacture and sale of nursing care products, medical surgical products, SharpSafety products and original equipment manufacturer (OEM) products.

Effective June 29, 2007, Covidien became the parent company owning the former healthcare businesses of Tyco International Ltd. On June 29, 2007, Tyco International distributed all of our shares, as well as the shares of its former electronics businesses (TE Connectivity Ltd.), to Tyco International shareholders.
Our consolidated financial statements have been prepared in U.S. dollars, in accordance with accounting principles generally accepted in the United States of America.

Separation of Our Pharmaceuticals Business In December 2011, we announced a plan to spin off our pharmaceuticals business into a stand-alone public company. We anticipate that the transaction will be in the form of a distribution that will be tax-free to U.S. shareholders of a new publicly traded stock in the new pharmaceuticals company. Completion of the transaction is expected to be subject to certain conditions, including, among others, receipt of regulatory approvals, assurance as to the tax-free status of the spin-off of the pharmaceuticals business to our U.S. shareholders, the effectiveness of a Form 10 registration statement to be filed with the U.S. Securities and Exchange Commission and final approval by our Board of Directors. We currently expect to complete the transaction in June 2013; however, there can be no assurance regarding the ultimate timing of the proposed transaction or that the transaction will be completed. Subsequent to the separation, the historical results of our Pharmaceuticals segment will be presented as discontinued operations.
Healthcare Reform
In March 2010, the Patient Protection and Affordable Care Act was enacted in the United States. This legislation includes a provision that imposes a 2.3% excise tax on the sale of certain medical devices by a manufacturer, producer or importer of such devices in the United States starting after December 31, 2012. The legislation also includes a $28 billion fee on the branded pharmaceutical industry over nine years starting in 2011 and a $2.8 billion annual fee on branded pharmaceuticals thereafter. The amount of branded pharmaceutical fee payable by each company is based upon market share. Since our branded pharmaceutical sales currently represent a small portion of the total market, this annual assessment has not had a significant impact on our results of operations. We estimate that the medical devices tax, however, will increase our selling, general and administrative expenses by between $75 and $100 million annually, beginning in our second quarter of fiscal 2013. Strategic Acquisitions, Licensing Agreements and Divestitures We regularly engage in strategic reviews of our businesses to improve operations, financial returns and alignment between our businesses and our strategy. We have made strategic acquisitions and divestitures in the past and we will continue to explore strategic alternatives for our businesses, including licensing and distribution transactions and selective acquisitions, as well as divestitures of non-strategic and/or underperforming businesses.


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Acquisitions
In October 2012, our Pharmaceuticals segment acquired CNS Therapeutics, Inc., a pharmaceuticals company focused on developing and commercializing products for site-specific administration to the central nervous system to treat neurological disorders and chronic pain, for approximately $100 million. The acquisition of CNS Therapeutics complements and expands our branded pharmaceuticals portfolio.

During fiscal 2012, our Medical Devices segment acquired the following companies:
MindFrame, Inc.-a designer and manufacturer of devices designed to optimize rapid perfusion and clot removal in the treatment of patients suffering from ischemic stroke, for total consideration of $72 million, comprised of $70 million in cash (net of cash acquired) and $2 million of debt assumed, which we subsequently repaid;

Oridion Systems Ltd. (Oridion)-a developer of patient monitoring systems, for $327 million in cash (net of cash acquired);

superDimension, Ltd.-a developer of minimally invasive interventional pulmonology devices, for total consideration of $286 million, comprised of:
$243 million in cash (net of cash acquired); $21 million of debt assumed, which we subsequently repaid; and the fair value of contingent consideration of $22 million. The contingent consideration, which could total $50 million, consists of milestone payments related to the achievement of sales targets.

Newport Medical Instruments, Inc.-a designer and manufacturer of ventilators, for total consideration of $101 million, comprised of $92 million in cash (net of cash acquired) and $9 million of debt assumed, which we subsequently repaid;

Maya Medical-a developer of a treatment for hypertension, for total consideration of $106 million, comprised of: $49 million in cash; $10 million of debt assumed, which we subsequently repaid; and the fair value of contingent consideration of $47 million. The contingent consideration, which could total a maximum of $170 million, consists of $70 million in milestone payments related to the commercialization of a radiofrequency energy-based renal denervation device and $100 million in milestone payments related to a device that delivers a chemical agent to cause renal denervation.

BRRX Medical, Inc. (BRRX)-a developer of bipolar radiofrequency ablation devices used in the treatment of Barrett's esophagus syndrome, for total consideration of $393 million, comprised of $322 million in cash (net of cash acquired) and the fair value of contingent consideration of $71 million. During fiscal 2012, we recorded an additional $4 million of contingent consideration upon the achievement of health insurance coverage targets for procedures utilizing BRRX devices. We paid $50 million of this contingent consideration during fiscal 2012.

During fiscal 2010, our Medical Devices segment acquired the following companies:
ev3 Inc.-a developer of technologies for the endovascular treatment of peripheral vascular and neurovascular diseases, for approximately $2.5 billion in cash (net of cash acquired);

Somanetics Corporation-a developer of cerebral and somatic oximetry and monitoring systems, for $291 million in cash (net of cash acquired); and

Aspect Medical Systems, Inc. (Aspect)-a provider of brain monitoring technology, for total consideration of $208 million, comprised of $150 million in cash (net of cash acquired) and $58 million of debt assumed, which we subsequently repaid.

License Agreement
During fiscal 2012, our Medical Devices segment entered into an exclusive licensing agreement which grants us product rights for two medical device patent and product candidates that are designed to remove peripheral artery blockages. This licensing arrangement included an upfront cash payment of $12 million, which was included in research and development expenses. In addition, during fiscal 2012, we made regulatory-related milestone payments of $15 million, which were capitalized as an intangible asset. We may also be required to make additional payments of up to $50 million if certain regulatory and sales milestones are achieved.


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Divestitures
During fiscal 2010, we sold our sleep and oxygen therapy product lines, both of which were formerly included within our Medical Devices segment. In addition, in fiscal 2010, we sold our nuclear pharmacies in the United States, which was formerly included in our Pharmaceuticals segment. Selling, general and administrative expenses for fiscal 2010 includes a net loss on divestitures of $25 million, primarily related to the sale of our sleep therapy product line. During fiscal 2010, we also sold our Specialty Chemicals, which was formerly included in our Pharmaceuticals segment. This business met the criteria of a discontinued operation and, accordingly has been classified as a discontinued operation in our consolidated financial statements for all periods presented. See "Discontinued Operations" for further information. Covidien Business Factors Influencing the Results of Operations Fiscal Year
We report our results based on a "52-53 week" year ending on the last Friday of September. Fiscal 2012 and 2010 consisted of 52 weeks and ended on September 28, 2012 and September 24, 2010, respectively. Fiscal 2011 ended on September 30, 2011 and consisted of 53 weeks. The additional week in fiscal 2011 has been reflected in our fourth quarter.
Sales and Marketing Investment
Selling and marketing expenses increased $57 million and $304 million in fiscal 2012 and 2011, respectively. The increase in fiscal 2012 resulted largely from sales force expansion, primarily in the emerging markets, and increased costs resulting from current year acquisitions. The increase in fiscal 2011 was primarily due to increased costs resulting from acquisitions that occurred during the fourth quarter of fiscal 2010 and planned increases to support product launches. We expect sales and marketing expenses to continue to increase over the next several years as we make investments to drive our future growth, specifically in Asia.
Separation and Acquisition Transaction Costs During fiscal 2012, we incurred $36 million in costs related to the separation of our Pharmaceuticals segment. These costs, which are included in selling, general and administrative expenses, primarily relate to professional fees and duplicative costs incurred to build out the corporate infrastructure of the pharmaceuticals company. We expect to continue to incur costs related to the separation in fiscal 2013.
In addition, during fiscal 2012, we incurred net transaction costs associated with acquisitions of $31 million. These costs consist of $20 million of charges included in selling, general and administrative expenses and $17 million of charges in cost of goods sold related to the sale of acquired inventory that had been written up to fair value upon acquisition, partially offset by a $6 million gain on the sale of our non-controlling interest in superDimension, which is included in other income, net.
During fiscal 2011, we incurred $32 million of charges related to the sale of acquired inventory that had been written up to fair value upon acquisition, which was included in cost of goods sold. During fiscal 2010, we incurred $91 million of costs associated with acquisitions. These costs consisted of $39 million of charges in cost of goods sold related to the sale of acquired inventory that had been written up to fair value upon acquisition, $39 million of charges included in selling, general and administrative expenses and $13 million of financing fees included in interest expense.
Research and Development Investment
Our research and development expense increased $69 million and $107 million in fiscal 2012 and 2011, respectively. The increase in fiscal 2012 primarily resulted from current year acquisitions, increased spending to support our growth initiatives and entering into the license agreement discussed above. The increase in fiscal 2011 was primarily due to additional spending resulting from acquisitions that occurred during the fourth quarter of fiscal 2010. We expect research and development expenditures to continue to increase over the next several years as a result of our internal research and development initiatives. We intend to focus our research and development investments in those fields that we believe will offer the greatest opportunity for growth and profitability. We are committed to investing in products that have a demonstrable clinical impact and value to the healthcare system and through which we can benefit from our core competencies and global infrastructure.
Restructuring Initiatives
In fiscal 2011, we launched a restructuring program, designed to improve our cost structure. This program includes actions across all three segments as well as corporate. We expect to incur charges of approximately $275 million under this program as the specific actions required to execute on these initiatives are identified and approved, most of which are expected to be incurred by the end of fiscal 2014. Savings from this program are estimated to be $175 million to $225 million on an annualized basis once the program is completed. As of September 28, 2012, we had incurred $135 million of net restructuring


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and related charges under this program since its inception. During fiscal 2012, 2011 and 2010, we recorded net restructuring and related charges associated with all restructuring programs and acquisitions totaling $104 million, $131 million and $76 million, respectively.
Legal Charges
During fiscal 2012 and 2011, we recorded legal charges of $49 million and $46 million, respectively, related to our indemnification obligations for certain claims pertaining to all known pending and estimated future pelvic mesh product liability claims, net of insurance recoveries. The amount recorded in fiscal 2011 was partially offset by income of $11 million for the reversal of our portion of the remaining reserves that had been established in fiscal 2009 to settle Tyco International securities cases. In addition, during fiscal 2010, we recorded a $33 million charge to settle an antitrust case. These amounts were all included within selling, general and administrative expenses in the consolidated statements of income.
Product Recalls and Discontinuance
During fiscal 2012, net sales of our Duet TRSTM Universal Straight and Articulating Single Use Loading Units (Duet) declined approximately $85 million primarily as a result of recalls. These recalls also led to the discontinuance of the product, which resulted in $18 million of inventory and capital equipment impairments.
Currency Exchange Rates
Our results of operations are influenced by changes in the currency exchange rates. Increases or decreases in the value of the U.S. dollar, compared to other currencies, will directly affect our reported results as we translate those currencies into U.S. dollars at the end of each fiscal period. The percentage of net sales by major currencies for fiscal 2012 is as follows:

U.S. dollar   58 %
Euro          15
Japanese yen   9
All other     18
             100 %


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Results of Operations

Fiscal Years Ended 2012, 2011 and 2010
The following table presents results of operations, including percentage of net
sales:
                                                          Fiscal Year
(Dollars in Millions)              2012                      2011                      2010
Net sales                 $  11,852      100.0  %   $  11,574      100.0  %   $  10,429      100.0  %
Cost of goods sold            5,038       42.5          4,996       43.2          4,624       44.3
Gross profit                  6,814       57.5          6,578       56.8          5,805       55.7
Selling, general and
administrative expenses       3,686       31.1          3,527       30.5          3,219       30.9
Research and development
expenses                        623        5.3            554        4.8            447        4.3
Restructuring charges,
net                              91        0.8            122        1.1             76        0.7
Operating income              2,414       20.4          2,375       20.5          2,063       19.8
Interest expense               (206 )     (1.7 )         (203 )     (1.8 )         (199 )     (1.9 )
Interest income                  16        0.1             22        0.2             22        0.2
Other income, net                25        0.2             22        0.2             40        0.4
Income from continuing
operations before
income taxes                  2,249       19.0          2,216       19.1          1,926       18.5
Income tax expense              347        2.9            333        2.9            363        3.5
Income from continuing
operations                    1,902       16.0          1,883       16.3          1,563       15.0
Income (loss) from
discontinued operations,
net of tax                        3          -            (15 )     (0.1 )           69        0.7
Net income                $   1,905       16.1      $   1,868       16.1      $   1,632       15.6

Net sales-Our net sales for fiscal 2012 increased $278 million, or 2.4%, to $11.852 billion, compared with $11.574 billion in fiscal 2011. The increase in net sales was driven by sales growth within our Medical Devices segment, partially offset by unfavorable currency exchange rate fluctuations of $196 million. In addition, the extra selling week in fiscal 2011 had an unfavorable impact on our current fiscal year's net sales growth.
Our net sales for fiscal 2011 increased $1.145 billion, or 11.0%, to $11.574 billion, compared with $10.429 billion in fiscal 2010. Favorable currency exchange rate fluctuations resulted in a $269 million increase to net sales in fiscal 2011. The remaining increase in net sales was driven by sales growth within our Medical Devices segment, largely attributable to the acquisition of ev3 Inc. In addition, the extra selling week in fiscal 2011 had a favorable impact on our fiscal 2011 net sales growth. Additional information regarding our increases in net sales is provided in "Analysis of Operating Results by Segment."
Net sales generated by our businesses in the United States were $6.572 billion, $6.331 billion and $5.725 billion in fiscal 2012, 2011 and 2010, respectively. Our non-U.S. businesses generated net sales of $5.280 billion, $5.243 billion and $4.704 billion in fiscal 2012, 2011 and 2010, respectively. Our businesses outside the United States represented approximately 45% of our net sales in each of fiscal 2012, 2011 and 2010.


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Net sales by geographic area are shown in the following tables:

                           Fiscal Year        Percentage      Currency      Operational
(Dollars in Millions)   2012        2011          Change        Impact        Growth(2)
U.S.                  $  6,572    $  6,331             4  %          -  %             4 %
Other Americas             725         745            (3 )          (6 )              3
Europe                   2,637       2,746            (4 )          (7 )              3
Asia-Pacific             1,918       1,752             9             1                8
Net Sales(1)          $ 11,852    $ 11,574             2            (2 )              4



                           Fiscal Year        Percentage     Currency     Operational
(Dollars in Millions)   2011        2010          Change       Impact       Growth(2)
U.S.                  $  6,331    $  5,725            11 %          - %            11 %
Other Americas             745         653            14            6               8
Europe                   2,746       2,605             5            3               2
Asia-Pacific             1,752       1,446            21           10              11
Net Sales(1)          $ 11,574    $ 10,429            11            3               8

(1) Sales to external customers are reflected in the regions based on the reporting entity that records the transaction. U.S. sales include sales of neurovascular and peripheral products exported to customers outside the United States and invoiced in multiple currencies of approximately $302 million, $281 million and $206 million for fiscal 2012, 2011 and 2010, respectively. Accordingly, these U.S. sales are subject to the effects of changes in foreign currency exchange rates.

(2) Operational growth, a non-GAAP financial measure, measures the change in sales between current and prior year periods using a constant currency, the exchange rate in effect during the applicable prior year period. We have provided this non-GAAP financial measure because we believe it provides meaningful information regarding our results on a consistent and comparable basis for the periods presented. Management uses this non-GAAP financial measure, in addition to GAAP financial measures, to evaluate our operating results. It is also one of the performance metrics that determines management incentive compensation. This non-GAAP financial measure should be considered supplemental to and not a substitute for our reported financial results prepared in accordance with GAAP.

Cost of goods sold-Cost of goods sold was 42.5% of net sales in fiscal 2012, compared with 43.2% of net sales in fiscal 2011. The decrease in cost of goods sold as a percent of net sales in fiscal 2012 was primarily attributable to a more favorable mix of businesses and, to a lesser extent, manufacturing cost reductions.
Cost of goods sold was 43.2% of net sales in fiscal 2011, compared with 44.3% of net sales in fiscal 2010. The decrease in cost of goods sold as a percent of net sales in fiscal 2011 was primarily attributable to a more favorable mix of businesses resulting from fiscal 2010 acquisitions and divestitures, as well as, manufacturing cost reductions. These decreases were partially offset by increased raw materials prices.
Selling, general and administrative expenses-Selling, general and administrative expenses in fiscal 2012 increased $159 million, or 4.5%, to $3.686 billion, compared with $3.527 billion in fiscal 2011. The increase in selling, general and administrative expenses in fiscal 2012 was primarily due to increased selling and marketing expenses resulting from sales force expansion, primarily in the emerging markets, and acquisitions. Separation and transaction costs totaling $56 million in fiscal 2012 also contributed to the increase in selling, general and administrative expenses. We expect selling, general and administrative expenses to continue to increase as a result of our recent acquisitions, planned sales and marketing investments to drive our future growth, and the medical device excise tax, which becomes effective in January 2013. Selling, general and administrative expenses were 31.1% of net sales for fiscal 2012, compared with 30.5% of net sales for fiscal 2011. The increase in selling, general and administrative expenses as a percent of net sales primarily resulted from the extra selling week in fiscal 2011.
Selling, general and administrative expenses for fiscal 2011 increased $308 million, or 9.6%, to $3.527 billion, compared with $3.219 billion in fiscal 2010. The increase in selling, general and administrative expenses for fiscal 2011 was largely due to increased costs, primarily selling and marketing, resulting from prior year acquisitions within our Medical Devices segment. Selling, general and administrative expenses were 30.5% of net sales for fiscal 2011, compared with 30.9% of net sales for


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fiscal 2010. The decrease in selling, general and administrative expenses as a percent of net sales primarily resulted from the extra selling week in fiscal 2011.
Research and development expenses-Research and development expenses increased $69 million, or 12.5%, to $623 million in fiscal 2012, compared with $554 million in fiscal 2011. The increase primarily resulted from increased spending within our Medical Devices segment resulting from current year acquisitions and investments made to support our growth initiatives. In addition, fiscal 2012 includes a $12 million upfront payment made in connection with a license agreement entered into by our Medical Devices segment. During fiscal 2012, we achieved our goal of increasing research and development expenses as a percentage of net sales to within the range of 5% to 6%. As a percentage of our net sales, research and development expenses were 5.3% for fiscal 2012, compared with 4.8% for fiscal 2011.
Research and development expenses increased $107 million, or 23.9%, to $554 million in fiscal 2011, compared with $447 million in fiscal 2010. The increase was primarily due to additional spending within our Medical Devices segment, largely resulting from acquisitions in the fourth quarter of fiscal 2010 and, to a lesser extent, increased spending within our Pharmaceuticals segment. As a percentage of our net sales, research and development expenses were 4.8% for fiscal 2011, compared with 4.3% for fiscal 2010.
Restructuring charges, net-During fiscal 2012, we recorded net restructuring and related charges of $104 million, of which charges of $13 million related to accelerated depreciation and were included in cost of goods sold. The remaining $91 million primarily related to severance and employee benefit costs incurred under our 2011 program.
During fiscal 2011, we recorded net restructuring and related charges of $131 million, of which $9 million related to accelerated depreciation and was included in cost of goods sold. The remaining $122 million primarily related to severance and employee benefit costs incurred under our 2011 and 2009 programs and the cancellation of distributor and supplier agreements associated with prior year acquisitions by our Medical Devices segment. In addition, during fiscal 2011 we reversed $24 million of restructuring reserves, primarily under our 2009 program, $10 million of which resulted from the determination that one of the restructuring actions within our Medical Supplies segment was no longer cost effective.
During fiscal 2010, we recorded net restructuring charges of $76 million primarily related to severance costs within our Medical Supplies and Medical Devices segments.
Operating income-In fiscal 2012, operating income increased $39 million to $2.414 billion, compared with operating income of $2.375 billion in fiscal 2011. The increase in operating income was primarily due to the gross profit resulting from increased sales volume within our Medical Devices segment. This increase was partially offset by a $69 million increase in research and development expenses, increased selling and marketing expenses, primarily resulting from . . .

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