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COV > SEC Filings for COV > Form 10-K on 21-Nov-2013All Recent SEC Filings

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Form 10-K for COVIDIEN PLC


21-Nov-2013

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.
As discussed under "Recent Developments-Separation of Our Pharmaceuticals Business," the historical results of operations of our Pharmaceuticals business have been presented as discontinued operations. Accordingly, our segment data has been recast to exclude our former Pharmaceuticals segment and to reallocate certain allocations previously included within this segment. Following the separation, our 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.

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 (the 2007 separation).
Our consolidated financial statements have been prepared in U.S. dollars, in accordance with accounting principles generally accepted in the United States of America (U.S. GAAP).

Recent Developments

Separation of Our Pharmaceuticals Business-On May 23, 2013, our board of directors declared a special dividend distribution of all of the outstanding ordinary shares of Mallinckrodt plc, the company formed to hold our Pharmaceuticals business. On June 28, 2013, our shareholders received one ordinary share of Mallinckrodt for every eight ordinary shares of Covidien held at the close of business on June 19, 2013 (the 2013 separation). We have received a ruling from the U.S. Internal Revenue Service (IRS) that the separation qualifies as a tax-free distribution to us and our shareholders for U.S. federal income tax purposes. See "Discontinued Operations" for additional information.
Change in Segment Reporting Structure-Effective October 1, 2013, we realigned our operating segments such that the Medical Supplies business in Western Europe is now managed by our Medical Devices segment. Integrating these businesses allows us to better utilize internal resources and achieve cost synergies. The segment information presented herein does not reflect this change as the change was not effected internally until our first quarter of fiscal 2014. Healthcare Reform
In March 2010, the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Affordability Reconciliation Act, was enacted into law in the United States. This legislation imposes a 2.3% excise tax on the sale in the United States of certain medical devices by a manufacturer, producer or importer of such devices starting after December 31, 2012. During fiscal 2013, our medical device tax, which began in our second fiscal quarter, was $46 million and was included in selling, general and administrative expenses. We estimate this tax will be between $60 million and $65 million in fiscal 2014.


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Strategic Acquisitions, License 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. Acquisitions

During fiscal 2013, we acquired the following companies:
Nfocus Neuromedical, Inc. (Nfocus)-a developer of neurovascular intrasaccular devices, for total consideration of $72 million ($71 million, net of cash acquired), comprised of cash of $51 million ($50 million, net of cash acquired) and the fair value of contingent consideration of $21 million. As of September 27, 2013, our maximum future contingent consideration payments associated with Nfocus totaled $45 million;

CV Ingenuity (CVI)-a developer of a treatment for peripheral arterial disease, for total consideration of $216 million ($211 million, net of cash acquired), comprised of cash of $115 million ($110 million, net of cash acquired) and the fair value of contingent consideration of $101 million, of which $65 million was paid during fiscal 2013. As of September 27, 2013, our maximum future contingent consideration payments associated with CVI totaled $82 million, for which we had recorded a liability of $41 million.

During fiscal 2012, we 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 $76 million ($72 million, net of cash acquired), comprised of cash of $74 million ($70 million, net of cash acquired) and debt assumed of $2 million, which we subsequently repaid;

Oridion Systems Ltd. (Oridion)-a developer of patient monitoring systems, for $337 million of cash ($327 million, net of cash acquired);

superDimension, Ltd.-a developer of minimally invasive interventional pulmonology devices, for total consideration of $292 million ($284 million, net of cash acquired), comprised of cash of $249 million ($241 million, net of cash acquired); debt assumed of $21 million, which we subsequently repaid; and the fair value of contingent consideration of $22 million, of which $8 million was paid during fiscal 2013. As of September 27, 2013, our maximum future contingent consideration payments associated with superDimension totaled $42 million, for which we had recorded a liability of $9 million;

Newport Medical Instruments, Inc.-a designer and manufacturer of ventilators, for total consideration of $103 million ($101 million, net of cash acquired), comprised of cash of $94 million ($92 million, net of cash acquired) and debt assumed of $9 million, which we subsequently repaid;

Maya Medical (Maya)-a developer of a treatment for hypertension, for total consideration of $106 million, comprised of an upfront cash payment of $49 million; debt assumed of $10 million, which we subsequently repaid; and the fair value of contingent consideration of $47 million, of which $17 million was paid during fiscal 2013. As of September 27, 2013, our maximum future contingent consideration payments associated with Maya totaled $150 million, for which we had recorded a liability of $27 million;

BRRX Medical, Inc. (BRRX)-a developer of bipolar radiofrequency ablation devices used in the treatment of Barrett's esophagus syndrome, for total consideration of $409 million ($393 million, net of cash acquired), comprised of cash of $338 million ($322 million, 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 $10 million and $50 million of this contingent consideration during fiscal 2013 and 2012, respectively. We expect to pay the remaining $15 million in fiscal 2014.

License Agreements
During fiscal 2013, we entered into an exclusive license agreement for intellectual property. As a result, we recorded research and development charges totaling $16 million, comprised of an upfront cash payment and a milestone payment. We will be required to make an additional payment under this agreement of approximately 8 million ($11 million as of


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September 27, 2013) upon the first commercial sale of a product using the intellectual property. In connection with this agreement, we also committed to hiring a certain number of research and development personnel within a specified time frame.
During fiscal 2012, we entered into an exclusive license agreement which grants us product rights for two medical device patent and product candidates that are designed to remove peripheral artery blockages. This license arrangement included an upfront cash payment of $12 million, which was included in research and development expenses. During fiscal 2012, we made regulatory-related milestone payments of $15 million, which were capitalized as an intangible asset. In addition, during fiscal 2013, we made a sales milestone payment of $11 million, which was also capitalized as an intangible asset. We may be required to make additional payments of up to $39 million if certain sales milestones are achieved.
Divestiture
In October 2013, we entered into a definitive agreement to sell our biosurgery sealants product line within our Medical Devices segment for approximately $235 million in cash. In addition, we may receive up to $30 million, contingent upon the achievement of certain performance measures. This product line generated approximately $65 million of sales in fiscal 2013. We decided to sell this product line because it was not aligned with our long-term strategic objectives. The transaction is subject to customary closing conditions and is expected to close in the first half of fiscal 2014.
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 2013 and 2012 consisted of 52 weeks and ended on September 27, 2013 and September 28, 2012, respectively. Fiscal 2011 ended on September 30, 2011 and consisted of 53 weeks. For fiscal years in which there are 53 weeks, the fourth quarter reporting period will include 14 weeks, with the next such occurrence taking place in fiscal 2016.
Sales and Marketing Investment
Selling and marketing expenses increased $36 million and $67 million in fiscal 2013 and 2012, respectively. These increases resulted largely from sales force expansion in the emerging markets and increased costs resulting from acquisitions. We expect sales and marketing expenses to continue to increase over the next several years as we make investments to drive our future growth in the emerging markets.
Research and Development Investment
Our research and development expenses increased $29 million and $67 million in fiscal 2013 and 2012, respectively. These increases primarily resulted from acquisitions, increased spending to support our growth initiatives and entering into the license agreements discussed above. 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 2013, we launched a restructuring program designed to improve our cost structure. This program includes actions across our segments and corporate. Such actions include, among other things, reducing corporate expenses, expanding the use of shared services in low-cost locations, outsourcing services where appropriate, streamlining our organizational structure, consolidating manufacturing locations, consolidating and optimizing distribution centers and expanding low-cost country sourcing. We expect to incur aggregate charges between $350 million and $450 million associated with these actions. These charges, which are recorded as the specific actions required to execute on these initiatives are identified and approved, are expected to be incurred through fiscal 2018. Management is targeting savings from this program of $250 million to $300 million on an annualized basis once the program is completed. During fiscal 2013, we incurred $23 million of restructuring and related charges under this program. This program excludes restructuring actions associated with acquisitions.
In fiscal 2011, we launched a $275 million restructuring program designed to improve our cost structure. This program includes actions across all segments and corporate and excludes restructuring actions associated with acquisitions. Charges totaling approximately $50 million recorded under this program by our former Pharmaceuticals segment have been reclassified to discontinued operations. Accordingly, aggregate charges of approximately $225 million are expected to relate to our continuing operations. These charges, which are recorded as the specific actions required to execute on these initiatives are identified and approved, are expected to be incurred by the end of fiscal 2014. Savings from this program are estimated to be


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approximately $205 million on an annualized basis once the program is completed. As of September 27, 2013, we had incurred $176 million of net restructuring and related charges under this program since its inception.
During fiscal 2013, 2012 and 2011, we recorded net restructuring and related charges associated with all restructuring programs and acquisitions totaling $109 million, $87 million and $121 million, respectively. Additional information regarding restructuring and related charges is provided in "Results of Operations-Restructuring and related charges, net." 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. These amounts were all included within selling, general and administrative expenses in the consolidated statements of income.
Acquisition Transaction Costs
During fiscal 2013, we recorded $21 million of income associated with acquisitions, primarily related to an $18 million gain associated with our acquisition of CVI, which was included in other income, net. The remaining amount resulted from adjustments to contingent consideration. 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, primarily related to advisory and legal fees, 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. These costs were partially offset by a $6 million gain associated with our acquisition of superDimension, which was 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. 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 inventory and capital equipment impairments totaling $18 million.
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 2013 is as follows:

U.S. dollar   55 %
Euro          17
Japanese yen   9
All other     19
             100 %


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Results of Operations

Fiscal Years Ended 2013, 2012 and 2011
The following table presents results of operations, including percentage of net
sales:
(Dollars in Millions)              2013                      2012                      2011
Net sales                 $  10,235      100.0  %   $   9,851      100.0  %   $   9,607      100.0  %
Cost of goods sold            4,150       40.5          3,944       40.0          3,886       40.4
Gross profit                  6,085       59.5          5,907       60.0          5,721       59.6
Selling, general and
administrative expenses       3,340       32.6          3,261       33.1          3,153       32.8
Research and development
expenses                        508        5.0            479        4.9            412        4.3
Restructuring charges,
net                             105        1.0             82        0.8            114        1.2
Operating income              2,132       20.8          2,085       21.2          2,042       21.3
Interest expense               (208 )     (2.0 )         (206 )     (2.1 )         (203 )     (2.1 )
Interest income                  16        0.2             15        0.2             19        0.2
Other income, net                89        0.9             25        0.3             22        0.2
Income from continuing
operations before
income taxes                  2,029       19.8          1,919       19.5          1,880       19.6
Income tax expense              429        4.2            282        2.9            299        3.1
Income from continuing
operations                    1,600       15.6          1,637       16.6          1,581       16.5
Income from discontinued
operations, net of income
taxes                           100        1.0            268        2.7            287        3.0
Net income                $   1,700       16.6      $   1,905       19.3      $   1,868       19.4

Net sales-Our net sales for fiscal 2013 increased $384 million, or 3.9%, to $10.235 billion, compared with $9.851 billion in fiscal 2012. The increase in net sales was driven by sales growth within our Medical Devices segment, partially offset by unfavorable currency exchange rate fluctuations of $175 million. Additional information regarding our increases in net sales is provided in "Analysis of Operating Results by Segment." Our net sales for fiscal 2012 increased $244 million, or 2.5%, to $9.851 billion, compared with $9.607 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 $165 million. In addition, the extra selling week in fiscal 2011 had an unfavorable impact on our fiscal 2012 net sales growth.
Net sales generated by our businesses in the United States were $5.209 billion, $5.226 billion and $5.043 billion in fiscal 2013, 2012 and 2011, respectively. Our non-U.S. businesses generated net sales of $5.026 billion, $4.625 billion and $4.564 billion in fiscal 2013, 2012 and 2011, respectively. Our businesses outside the United States represented 49% of our net sales in fiscal 2013 and 47% of our net sales in both fiscal 2012 and 2011.
Sales to external customers are reflected in the regions based on the reporting entity that records the sales transaction. During fiscal 2013, our supply chain for neurovascular and peripheral products in certain regions changed such that these products are now sold through reporting entities in the respective regions rather than through a U.S. entity. Accordingly, non-U.S. sales for our Medical Devices segment for fiscal 2013 include $202 million of sales for which the corresponding sales in the prior years were included in U.S. sales.


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

                          Fiscal Year        Percentage    Currency     Operational
(Dollars in Millions)   2013        2012       Change       Impact       Growth(3)
United States         $  5,209    $ 5,226        -  %         -  %          -  %
Other Americas             661        610        8           (4 )          12
Europe                   2,463      2,226       11            1            10
Asia-Pacific(1)          1,902      1,789        6           (9 )          15
Net Sales(2)          $ 10,235    $ 9,851        4           (2 )           6



                          Fiscal Year       Percentage    Currency     Operational
(Dollars in Millions)   2012       2011       Change       Impact       Growth(3)
United States         $ 5,226    $ 5,043        4  %         -  %          4 %
Other Americas            610        609        -           (6 )           6
Europe                  2,226      2,326       (4 )         (6 )           2
Asia-Pacific(1)         1,789      1,629       10            2             8
Net Sales(2)          $ 9,851    $ 9,607        3           (1 )           4

(1) Includes sales to Japan which represented 10%, 11% and 10% of total net sales in fiscal 2013, 2012 and 2011, respectively.

(2) 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 $115 million, $302 million and $281 million for fiscal 2013, 2012 and 2011, respectively. Accordingly, these U.S. sales are subject to the effects of changes in foreign currency exchange rates.

(3) Operational growth is a non-GAAP financial measure, which should be considered supplemental to and not a substitute for our reported financial results prepared in accordance with U.S. GAAP. See "Management's Use of Non-GAAP Measures."

Cost of goods sold-Cost of goods sold was 40.5% of net sales in fiscal 2013, compared with 40.0% of net sales in fiscal 2012. The increase in cost of goods sold as a percent of net sales in fiscal 2013 primarily resulted from unfavorable currency exchange fluctuations and pricing, partially offset by a more favorable mix of businesses.
Cost of goods sold was 40.0% of net sales in fiscal 2012, compared with 40.4% 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.
Selling, general and administrative expenses-Selling, general and administrative expenses in fiscal 2013 increased $79 million, or 2.4%, to $3.340 billion, compared with $3.261 billion in fiscal 2012. The increase in selling, general and administrative expenses in fiscal 2013 was largely attributable to sales force expansion, primarily in the emerging markets, as well as acquisitions, partially offset by cost savings initiatives. In addition, the medical device tax, which began during our second quarter of fiscal 2013, increased selling, general and administrative expenses by $46 million. These increases were partially offset by the absence of $49 million in legal charges related to indemnification obligations for certain claims pertaining to all known pending and estimated future pelvic mesh products liability cases, which was recorded during the prior year and a decrease in transaction costs associated with acquisitions. Selling, general and administrative expenses were 32.6% of net sales in fiscal 2013, compared with 33.1% of net sales in fiscal 2012. The decrease in selling, general and administrative expenses as a percent of net sales primarily resulted from the overall increase in sales coupled with cost savings initiatives in fiscal 2013.
Selling, general and administrative expenses in fiscal 2012 increased $108 million, or 3.4%, to $3.261 billion, compared with $3.153 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. Selling, general and administrative expenses were 33.1% of net sales in fiscal 2012, compared with 32.8% of net sales in 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.
Research and development expenses-Research and development expenses increased $29 million, or 6.1%, to $508 million in fiscal 2013, compared with $479 million in fiscal 2012. This increase primarily resulted from increased spending within our Medical Devices segment largely resulting from acquisitions and, to a lesser extent, increased expenses resulting


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from license agreements. As a percentage of our net sales, research and development expenses were 5.0% in fiscal 2013, compared with 4.9% in fiscal 2012.
Research and development expenses increased $67 million, or 16.3%, to $479 million in fiscal 2012, compared with $412 million in fiscal 2011. The increase primarily resulted from increased spending within our Medical Devices segment resulting from 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. As a percentage of our net sales, research and development expenses were 4.9% in fiscal 2012, compared with 4.3% in fiscal 2011.
Restructuring and related charges, net-During fiscal 2013, we recorded net restructuring and related charges of $109 million, of which charges of $4 million related to accelerated depreciation and were included in cost of goods sold. The remaining $105 million primarily related to severance and employee benefit costs incurred under our 2011 program.
During fiscal 2012, we recorded net restructuring and related charges of $87 million, of which charges of $5 million related to accelerated depreciation and were included in cost of goods sold. The remaining $82 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 $121 million, of which charges of $7 million related to accelerated depreciation and . . .

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