TMCnet News
COVIDIEN PLC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the accompanying notes included in this Quarterly 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" in both our Annual Report on Form 10-K for the fiscal year ended September 24, 2010 and in this Quarterly Report. 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. We manage and operate our business through the following three segments: • Medical Devices includes the development, manufacture and sale of endomechanical instruments, soft tissue repair products, energy devices, oximetry and monitoring products, airway and ventilation products, products used in vascular therapies 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. Healthcare Reform In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act were enacted in the United States, which includes provisions that would impose a 2.3% excise tax on the sale of certain of our medical device and supply products in the United States starting in 2013. In addition, the new legislation 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, we do not expect this annual assessment to have a significant impact on Covidien. The medical devices tax, however, may have a significant impact on our results of operations. We are still evaluating the potential impact that this tax may have on our overall business. This new legislation increases our cost of doing business. If this cost is not offset by increased demand for our products, cost reductions or price increases, we could experience lower margins and profitability and our business and results of operations could be materially and adversely affected. In addition to the excise tax and annual fee described above, the new legislation contains numerous other provisions, many of which pertain to health insurance plans, which could impact our financial results in future periods. Restructuring Initiatives During the third quarter of 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 total charges of approximately $275 million 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. In fiscal 2009, 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 total charges of approximately $200 million under this program, which are recorded as the specific actions required to execute on these 29 -------------------------------------------------------------------------------- Table of Contents initiatives are identified and approved. The anticipated expenditures primarily relate to employee severance and benefits. As of June 24, 2011, we had incurred $158 million of net restructuring charges under the 2009 program since its inception and expect to incur most of the remaining charges by the end of 2011. This program excludes restructuring actions associated with acquisitions. In addition to continuing to incur charges under the 2009 program, we also expect to incur additional charges as restructuring actions stemming from our recent acquisitions are implemented. Results of Operations Quarters and Nine Months Ended June 24, 2011 and June 25, 2010 The following table presents results of operations, including percentage of net sales: Quarters Ended Nine Months Ended (Dollars in Millions) June 24, 2011 June 25, 2010 June 24, 2011 June 25, 2010 Net sales $ 2,926 100.0 % $ 2,564 100.0 % $ 8,496 100.0 % $ 7,759 100.0 % Cost of goods sold 1,255 42.9 1,138 44.4 3,658 43.1 3,421 44.1 Gross profit 1,671 57.1 1,426 55.6 4,838 56.9 4,338 55.9 Selling, general and administrative expenses 886 30.3 753 29.4 2,600 30.6 2,341 30.2 Research and development expenses 138 4.7 109 4.3 387 4.6 321 4.1 Restructuring charges, net 32 1.1 25 1.0 83 1.0 56 0.7 Shareholder settlement income - - - - (11 ) (0.1 ) - - Operating income 615 21.0 539 21.0 1,779 20.9 1,620 20.9 Interest expense (51 ) (1.7 ) (54 ) (2.1 ) (153 ) (1.8 ) (140 ) (1.8 ) Interest income 6 0.2 6 0.2 17 0.2 17 0.2 Other (expense) income, net (12 ) (0.4 ) 21 0.8 - - 49 0.6 Income from continuing operations before income taxes 558 19.1 512 20.0 1,643 19.3 1,546 19.9 Income tax expense 26 0.9 160 6.2 220 2.6 371 4.8 Income from continuing operations 532 18.2 352 13.7 1,423 16.7 1,175 15.1 Income (loss) from discontinued operations, net of income taxes 3 0.1 12 0.5 (6 ) (0.1 ) 14 0.2 Net income $ 535 18.3 $ 364 14.2 $ 1,417 16.7 $ 1,189 15.3 Net sales-Our net sales in the third quarter of fiscal 2011 increased $362 million, or 14%, to $2.926 billion, compared with $2.564 billion in the third quarter of fiscal 2010. Our net sales in the first nine months of fiscal 2011 increased $737 million, or 9%, to $8.496 billion, compared with $7.759 billion in the first nine months of fiscal 2010. Favorable currency exchange rate fluctuations resulted in increases in net sales of $132 million and $156 million for the third quarter and first nine months of fiscal 2011, respectively. The remaining increase in net sales for both periods were driven by sales growth within our Medical Devices segment, largely attributable to the acquisition of ev3 Inc., partially offset by decreased sales within our Pharmaceuticals segment, primarily resulting from the divestiture of our nuclear pharmacies within the United States during the third quarter of fiscal 2010. Net sales generated by our businesses in the United States were $1.580 billion and $1.413 billion for the third quarter of fiscal 2011 and 2010, respectively, and $4.653 billion and $4.222 billion for the first nine months of fiscal 2011 and 2010, respectively. Our non-U.S. businesses generated net sales of $1.346 billion and $1.151 billion for the third quarter of fiscal 2011 and 2010, respectively, and $3.843 billion and $3.537 billion for the 30-------------------------------------------------------------------------------- Table of Contents first nine months of fiscal 2011 and 2010, respectively. Our business outside the United States accounted for approximately 46% and 45% of our net sales for the third quarter of fiscal 2011 and 2010, respectively, and 45% and 46% for the first nine months of fiscal 2011 and 2010, respectively. Japan represented approximately 8% of our net sales for both the third quarter and first nine months of fiscal 2011. Our results of operations for these periods were not adversely impacted by the natural disasters that occurred during the second quarter of fiscal 2011 in Japan. Net sales by geographic area are shown in the following tables: Quarters Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth (1) U.S. $ 1,580 $ 1,413 12 % - % 12 % Other Americas 191 160 19 7 12 Europe 721 637 13 12 1 Asia-Pacific 434 354 23 13 10 $ 2,926 $ 2,564 14 5 9 Nine Months Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth (1) U.S. $ 4,653 $ 4,222 10 % - % 10 % Other Americas 537 483 11 5 6 Europe 2,048 2,007 2 2 - Asia-Pacific 1,258 1,047 20 9 11 $ 8,496 $ 7,759 9 2 7 (1) 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 42.9% and 43.1% of net sales in the third quarter and first nine months of fiscal 2011, respectively, compared with 44.4% and 44.1% of net sales in the third quarter and first nine months of fiscal 2010, respectively. The decrease in cost of goods sold as a percent of net sales for the first nine months of fiscal 2011 compared to the comparative prior year period was primarily attributable to a more favorable mix of businesses resulting primarily from acquisitions and divestitures in the prior year, as well as manufacturing cost reductions. The decrease for the first nine months of fiscal 2011 was partially offset by $32 million of charges in cost of goods sold related to the sale of acquired inventory that had been written up to fair value upon the acquisition of ev3 and increased raw material prices. Selling, general and administrative expenses-Selling, general and administrative expenses in the third quarter of fiscal 2011 increased $133 million, or 18%, to $886 million, compared with $753 million in the third quarter of fiscal 2010. Selling, general and administrative expenses in the first nine months of fiscal 2011 increased $259 million, or 11%, to $2.600 billion, compared with $2.341 billion in the first nine months of fiscal 2010. The increases in selling, general and administrative expenses for both fiscal 2011 periods were largely due to increased costs, primarily selling and marketing, resulting from recent acquisitions within our Medical Devices segment. 31-------------------------------------------------------------------------------- Table of Contents Research and development expenses-Research and development expenses increased $29 million, or 27%, to $138 million in the third quarter of fiscal 2011, compared with the third quarter of fiscal 2010, and increased $66 million, or 21%, to $387 million in the first nine months of fiscal 2011, compared with the same prior year period. These increases resulted from additional spending within our Medical Devices segment, primarily resulting from recent acquisitions and, to a lesser extent, increased spending within our Pharmaceuticals segment. As a percentage of our net sales, research and development expenses was 4.7% and 4.6% for the third quarter and first nine months of fiscal 2011, respectively, compared with 4.3% and 4.1% for the third quarter and first nine months of fiscal 2010, respectively. Restructuring charges, net-During the third quarter and first nine months of fiscal 2011, we recorded net restructuring charges of $32 million and $83 million, respectively. The charges recorded during the first nine months of fiscal 2011 primarily related to severance and employee benefit costs incurred under our 2009 and 2011 programs and the cancellation of distributor and supplier agreements associated with recent acquisitions by our Medical Devices segment. In addition, during the first nine months of fiscal 2011, we reversed $16 million of restructuring reserves 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 the third quarter and first nine months of fiscal 2010, we recorded restructuring charges of $25 million and $56 million, respectively, primarily related to severance costs across all segments. Shareholder settlement income-During fiscal 2011, the remaining securities lawsuits were resolved. Accordingly, during the first nine months of fiscal 2011, we recorded income of $11 million related to the reversal of our portion of the remaining reserves that had previously been established. Operating income-In the third quarter of fiscal 2011, operating income increased $76 million to $615 million, compared with operating income of $539 million in the third quarter of fiscal 2010. The increase in operating income for the third quarter of fiscal 2011 compared to the third quarter of fiscal 2010 was primarily due to increased sales volume within our Medical Devices segment, largely attributable to the acquisition of ev3. The current year period also benefitted from the absence of a $19 million charge related to the write-down of accounts receivable associated with the national healthcare system in Greece. These increases to operating income were partially offset by increased costs resulting from acquisitions. In the first nine months of fiscal 2011, operating income increased $159 million to $1.779 billion, compared with operating income of $1.620 billion in the first nine months of fiscal 2010. The increase in operating income for the first nine months of fiscal 2011 compared to the comparative prior year period was primarily due to increased sales volume within our Medical Devices segment, largely attributable to the acquisition of ev3. The current year period also benefitted from the absence of a $33 million legal charge incurred in the prior year to settle an antitrust case. These increases in operating income were partially offset by increased costs resulting from acquisitions and $27 million of incremental net restructuring charges. Analysis of Operating Results by Segment Net sales by segment are shown in the following tables: Quarters Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Medical Devices $ 1,985 $ 1,630 22 % 7 % 15 % Pharmaceuticals 500 507 (1 ) 3 (4 ) Medical Supplies 441 427 3 1 2 $ 2,926 $ 2,564 14 5 9 32 -------------------------------------------------------------------------------- Table of Contents Nine Months Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Medical Devices $ 5,739 $ 4,942 16 % 3 % 13 % Pharmaceuticals 1,460 1,526 (4 ) 1 (5 ) Medical Supplies 1,297 1,291 - - - $ 8,496 $ 7,759 9 2 7 Operating income by segment and as a percentage of segment net sales is shown in the following table: Quarters Ended Nine Months Ended June 24, June 25, June 24, June 25,(Dollars in Millions) 2011 2010 2011 2010 Medical Devices $ 613 30.9 % $ 512 31.4 % $ 1,777 31.0 % $ 1,549 31.3 % Pharmaceuticals 80 16.0 83 16.4 237 16.2 268 17.6 Medical Supplies 59 13.4 70 16.4 181 14.0 208 16.1 Operating income of reportable segments 752 25.7 665 25.9 2,195 25.8 2,025 26.1 Unallocated amounts: Corporate expenses (105 ) (96 ) (312 ) (311 ) Restructuring charges, net (32 ) (25 ) (83 ) (56 ) Acquisition-related charges(1) - (5 ) (32 ) (5 ) Shareholder settlement income and legal charge - - 11 (33 ) Consolidated operating income $ 615 $ 539 $ 1,779 $ 1,620 (1) Amounts for the quarter and nine months ended June 24, 2011 represent charges included in cost of goods sold related to the sale of acquired inventory that had been written up to fair value upon acquisition. Medical Devices Net sales for Medical Devices by groups of products and by geography for the third quarter of fiscal 2011 and 2010 were as follows: Quarters Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Endomechanical Instruments $ 593 $ 533 11 % 7 % 4 % Soft Tissue Repair Products 229 209 10 7 3 Energy Devices 301 252 19 6 13 Oximetry & Monitoring Products 211 189 12 5 7 Airway & Ventilation Products 183 178 3 7 (4 ) Vascular Products 368 175 110 6 104 Other Products 100 94 6 8 (2 ) $ 1,985 $ 1,630 22 7 15 U.S. $ 874 $ 685 28 % - % 28 % Non-U.S. 1,111 945 18 12 6 $ 1,985 $ 1,630 22 7 15 Net sales for the third quarter of fiscal 2011 increased $355 million, or 22%, to $1.985 billion, compared with $1.630 billion for the third quarter of fiscal 2010. Favorable currency exchange fluctuations positively impacted net 33-------------------------------------------------------------------------------- Table of Contents sales for the segment by $110 million. The remaining increase in net sales for the segment was driven by increased sales of Vascular Products, Energy Devices and Endomechanical Instruments. The increase in sales for Vascular Products was primarily due to the acquisition of ev3, which resulted in an additional $171 million in net sales for the segment. The increase in Energy Devices sales resulted primarily from higher sales volume of vessel sealing products in the United States and Europe. Finally, the increase in sales of Endomechanical Instruments primarily resulted from higher sales volume of stapling devices in the United States. Operating income for the third quarter of fiscal 2011 increased $101 million to $613 million, compared with $512 million for the third quarter of fiscal 2010. Our operating margin was 30.9% for the third quarter of fiscal 2011, compared with 31.4% for the third quarter of fiscal 2010. The increase in our operating income was primarily attributable to increased gross profit on the favorable sales performance for the overall segment discussed above, as well as the absence of a $19 million charge related to the write-down of accounts receivable associated with the national healthcare system in Greece. These increases to operating income were partially offset by increased costs related to acquisitions, particularly selling, general and administrative expenses. Net sales for Medical Devices by groups of products and by geography for the first nine months of fiscal 2011 and 2010 were as follows: Nine Months Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Endomechanical Instruments $ 1,718 $ 1,604 7 % 3 % 4 % Soft Tissue Repair Products 670 641 5 3 2 Energy Devices 854 733 17 3 14 Oximetry & Monitoring Products 627 563 11 1 10 Airway & Ventilation Products 554 585 (5 ) 3 (8 ) Vascular Products 1,033 521 98 3 95 Other Products 283 295 (4 ) 6 (10 ) $ 5,739 $ 4,942 16 3 13 U.S. $ 2,562 $ 2,035 26 % - % 26 % Non-U.S. 3,177 2,907 9 5 4 $ 5,739 $ 4,942 16 3 13 Net sales for the first nine months of fiscal 2011 increased $797 million, or 16%, to $5.739 billion, compared with $4.942 billion for the first nine months of fiscal 2010. Favorable currency exchange rate fluctuations positively impacted net sales for the segment by $139 million. The remaining increase in net sales for the segment was driven by increased sales of Vascular Products, Energy Devices, Endomechanical Instruments and Oximetry & Monitoring Products. The increase in Vascular Products sales was primarily due to the acquisition of ev3, which resulted in an additional $462 million in net sales for the segment. The increase in net sales for Energy Devices and Endomechanical Instruments resulted primarily from higher sales volume of vessel sealing products and stapling devices, respectively, largely attributable to sales of new products. Finally, the increase in sales for Oximetry & Monitoring Products was primarily driven by higher sales volume of sensors resulting from the prior year acquisition of Somanetics Corporation. These increases in net sales were somewhat offset by a decrease in sales of Airway & Ventilation Products resulting from strong sales in the prior year due to the H1N1 pandemic. Operating income for the first nine months of fiscal 2011 increased $228 million to $1.777 billion, compared with $1.549 billion for the first nine months of fiscal 2010. Our operating margin was 31.0% for the first nine months of fiscal 2011, compared with 31.3% for the first nine months of fiscal 2010. The increase in our operating income was primarily attributable to increased gross profit on the favorable sales performance for the overall segment discussed above, partially offset by increased costs related to acquisitions, particularly selling, general and administrative expenses. 34-------------------------------------------------------------------------------- Table of Contents Pharmaceuticals Net sales for Pharmaceuticals by groups of products and by geography for the third quarter of fiscal 2011 and 2010 were as follows: Quarters Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Specialty Pharmaceuticals $ 120 $ 127 (6 )% - % (6 )% Active Pharmaceutical Ingredients 107 103 4 3 1 Contrast Products 157 150 5 5 - Radiopharmaceuticals 116 127 (9 ) 3 (12 ) $ 500 $ 507 (1 ) 3 (4 ) U.S. $ 322 $ 352 (9 )% - % (9 )% Non-U.S. 178 155 15 10 5 $ 500 $ 507 (1 ) 3 (4 ) Net sales for the third quarter of fiscal 2011 decreased $7 million to $500 million, compared with $507 million for the third quarter of fiscal 2010. This decrease was driven by a decline in Radiopharmaceuticals net sales resulting from the divestiture of our nuclear pharmacies within the United States during the third quarter of fiscal 2010 and a decline in sales of our branded products, which stemmed primarily from the inventory stocking for PENNSAID® and EXALGO® launched in the third quarter of fiscal 2010. These decreases were partially offset by increased sales of generic pharmaceuticals, primarily the fentanyl lozenge and patch. Operating income for the third quarter of fiscal 2011 decreased $3 million to $80 million, compared with $83 million for the third quarter of fiscal 2010. Our operating margin was 16.0% for the third quarter of fiscal 2011, compared with 16.4% for the third quarter of fiscal 2010. The decrease in operating income was primarily due to increased research and development and environmental expenses, partially offset by a decrease in selling and marketing spending. Net sales for Pharmaceuticals by groups of products and by geography for the first nine months of fiscal 2011 and 2010 were as follows: Nine Months Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Specialty Pharmaceuticals $ 357 $ 373 (4 )% - % (4 )% Active Pharmaceutical Ingredients 312 302 3 1 2 Contrast Products 454 437 4 2 2 Radiopharmaceuticals 337 414 (19 ) - (19 ) $ 1,460 $ 1,526 (4 ) 1 (5 ) U.S. $ 956 $ 1,057 (10 )% - % (10 )% Non-U.S. 504 469 7 3 4 $ 1,460 $ 1,526 (4 ) 1 (5 ) Net sales for the first nine months of fiscal 2011 decreased $66 million, or 4%, to $1.460 billion, compared with $1.526 billion for the first nine months of fiscal 2010. This decrease primarily resulted from a decline in Radiopharmaceuticals and, to a much lesser extent, Specialty Pharmaceuticals net sales. The decrease in Radiopharmaceuticals sales resulted from the divestiture of our nuclear pharmacies within the United States 35-------------------------------------------------------------------------------- Table of Contents during the third quarter of fiscal 2010. The decrease in Specialty Pharmaceuticals sales was attributable to a decline in sales of our older branded products, primarily resulting from generic competition, partially offset by sales of PENNSAID® and EXALGO®. Operating income for the first nine months of fiscal 2011 decreased $31 million to $237 million, compared with $268 million for the first nine months of fiscal 2010. Our operating margin was 16.2% for the first nine months of fiscal 2011, compared with 17.6% for the first nine months of fiscal 2010. The decrease in operating income was primarily due to the decrease in gross profit resulting from the overall segment sales decline discussed above. In addition, the decline in operating income and margin resulted from increased research and development expenses and increased selling and marketing expenses to support our recent product launches, partially offset by decreased legal costs. Medical Supplies Net sales for Medical Supplies by groups of products and by geography for the third quarter of fiscal 2011 and 2010 were as follows: Quarters Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Nursing Care Products $ 199 $ 194 3 % 2 % 1 % Medical Surgical Products 110 102 8 4 4 SharpSafety Products 77 77 - (1 ) 1 Original Equipment Manufacturer (OEM) Products 55 54 2 1 1 $ 441 $ 427 3 1 2 U.S. $ 384 $ 376 2 % - % 2 % Non-U.S. 57 51 12 13 (1 ) $ 441 $ 427 3 1 2 Net sales for the third quarter of fiscal 2011 increased $14 million, or 3%, to $441 million, compared with $427 million for the third quarter of fiscal 2010. The increase in net sales for the segment was driven by increased sales of Medical Surgical Products and, to a lesser extent, Nursing Care Products. The increase in sales of Medical Surgical Products was largely attributable to sales of a new disposable lead wire system, while the sales increase in Nursing Care Products resulted from higher sales of incontinence and enteral feeding products. Operating income for the third quarter of fiscal 2011 decreased $11 million to $59 million, compared with $70 million for the third quarter of fiscal 2010. Our operating margin was 13.4% for the third quarter of fiscal 2011, compared with 16.4% for the third quarter of fiscal 2010. The decrease in operating income and margin primarily resulted from increased raw material costs, partially offset by the overall segment sales performance discussed above. 36-------------------------------------------------------------------------------- Table of Contents Net sales for Medical Supplies by groups of products and by geography for the first nine months of fiscal 2011 and 2010 were as follows: Nine Months Ended June 24, June 25, Percentage Currency Operational (Dollars in Millions) 2011 2010 Change Impact Growth Nursing Care Products $ 589 $ 586 1 % 1 % - % Medical Surgical Products 323 311 4 1 3 SharpSafety Products 226 240 (6 ) - (6 ) Original Equipment Manufacturer (OEM) Products 159 154 3 - 3 $ 1,297 $ 1,291 - - - U.S. $ 1,135 $ 1,130 - % - % - % Non-U.S. 162 161 1 2 (1 ) $ 1,297 $ 1,291 - - - Net sales for the first nine months of fiscal 2011 increased $6 million to $1.297 billion, compared with $1.291 billion for the first nine months of fiscal 2010. The increase in net sales for the segment was primarily driven by increased sales of Medical Surgical Products largely attributable to sales of a new disposable lead wire system. This increase was partially offset by a decline in sales of SharpSafety Products primarily resulting from stronger sales in the comparative prior year period due to the H1N1 flu pandemic. Operating income for the first nine months of fiscal 2011 decreased $27 million to $181 million, compared with $208 million for the first nine months of fiscal 2010. Our operating margin was 14.0% for the first nine months of fiscal 2011, compared with 16.1% for the first nine months of fiscal 2010. The decrease in operating income and margin resulted from increased raw material costs. Corporate Corporate expense was $105 million for the third quarter of fiscal 2011, compared with $96 million for the third quarter of fiscal 2010 and $312 million for the first nine months of fiscal 2011, compared with $311 million for the comparative prior year period. Non-Operating Items Interest Expense and Interest Income During the third quarters of fiscal 2011 and 2010, interest expense was $51 million and $54 million, respectively, and interest income was $6 million in each period. During the first nine months of fiscal 2011 and 2010, interest expense was $153 million and $140 million, respectively, and interest income was $17 million in each period. The increase in interest expense during the first nine months of fiscal 2011, compared with the comparative prior year periods was due to the issuance of $1.5 billion in senior notes during the fourth quarter of fiscal 2010, partially offset by the repayment of our $250 million 5.2% senior notes upon maturity. These increases were more than offset by the favorable impact of interest rate swaps entered into in 2011, resulting in an overall decrease in interest expense for the third quarter of fiscal 2011 compared to the comparative prior year quarter. Other (Expense) Income, net During the third quarter of fiscal 2011, we recorded other expense, net of $12 million, which includes expense of $13 million and a corresponding decrease to our receivable from Tyco International Ltd. and TE Connectivity Ltd. (formerly Tyco Electronics Ltd.). During the first nine months of fiscal 2011, we recorded 37 -------------------------------------------------------------------------------- Table of Contents other income of $7 million and a corresponding increase to our receivable from Tyco International and TE Connectivity. These amounts reflect 58% of interest and other income taxes payable recorded and/or released during each period that will be subject to the Tax Sharing Agreement. The $7 million of income recorded during the first nine months of fiscal 2011 was offset by a $7 million net loss on investments. During the third quarter and first nine months of fiscal 2010, we recorded other income of $21 million and $49 million, respectively. These amounts include income of $22 million and $48 million and corresponding increases to our receivable from Tyco International and TE Connectivity, for the third quarter and first nine months of fiscal 2010, respectively. Income Taxes Income tax expense was $26 million and $160 million on income from continuing operations before income taxes of $558 million and $512 million for the third quarters of fiscal 2011 and 2010, respectively. This resulted in effective tax rates of 4.7% and 31.3% for the third quarters of fiscal 2011 and 2010, respectively. Income tax expense was $220 million and $371 million on income from continuing operations before income taxes of $1.643 billion and $1.546 billion for the first nine months of fiscal 2011 and 2010, respectively. This resulted in effective tax rates of 13.4% and 24.0% for the first nine months of fiscal 2011 and 2010, respectively. The decrease in the effective tax rate for the third quarter and first nine months of fiscal 2011, compared to the comparative prior year periods resulted primarily from a favorable settlement reached with certain non-U.S. taxing authorities and, to a lesser extent, the release of certain U.S. and non-U.S. uncertain tax positions due to statute expirations. In addition, the decrease in the effective tax rate in both current year periods resulted from an increase in earnings in lower tax jurisdictions, the retroactive reenactment of the U.S. research and development tax credit and the implementation of our tax planning strategies. Discontinued Operations In fiscal 2010, we sold our Specialty Chemicals business within our Pharmaceuticals segment, which was included in discontinued operations. Liquidity and Capital Resources Our ability to fund our capital needs will be affected by our ongoing ability to generate cash from operations and access to the capital markets. We believe, however, that our cash balances and other sources of liquidity, primarily our committed credit facility, will be sufficient to allow us to fund operations for the foreseeable future and continue to invest in growth opportunities. Nine Months Ended June 24, 2011 Cash Flow Activity The net cash provided by operating activities of $1.609 billion was primarily attributable to income from continuing operations, as adjusted for depreciation and amortization, partially offset by an increase in inventory of $175 million. We estimate that within the next 12 months we will make a net payment of $327 million in connection with the settlements of U.S. tax audits for the years 1997 through 2004 and other non-U.S. audits, of which approximately $220 is expected to occur in fiscal 2011. These amounts include the net payments expected to be made under the Tax Sharing Agreement. The net cash used in investing activities of $315 million was primarily due to capital expenditures of $303 million. The net cash used in financing activities of $1.130 billion was primarily the result of the repayment of $307 million under our commercial paper program and the repayment of our $250 million 5.2% senior notes upon maturity. In addition, we paid $378 million to repurchase shares and made dividend payments of $297 million. 38 -------------------------------------------------------------------------------- Table of Contents Capitalization Shareholders' equity was $10.243 billion, or $20.78 per share, at June 24, 2011, compared with $8.974 billion, or $18.13 per share, at September 24, 2010. Net income of $1.417 billion, favorable changes in currency exchange rates of $174 million and proceeds from the exercise of options of $164 million, were partially offset by the repurchase of shares of $378 million and dividends declared of $198 million during the first nine months of fiscal 2011. At June 24, 2011, total debt was $4.166 billion and cash was $1.755 billion, compared with total debt of $4.706 billion and cash of $1.565 billion at September 24, 2010. The decrease in our total debt primarily resulted from the partial repayment of amounts outstanding under our commercial paper program and the repayment of our $250 million 5.2% senior notes upon maturity. Total debt as a percentage of total capitalization (total debt and shareholders' equity) was 29% at June 24, 2011, compared with 34% at September 24, 2010. We are required to maintain an available unused balance under our $1.425 billion revolving credit facility sufficient to support amounts outstanding under our commercial paper program. At June 24, 2011, we had $90 million of commercial paper outstanding and no amount outstanding under the credit facility. Our credit facility agreement contains a covenant limiting our ratio of debt to earnings before interest, income taxes, depreciation and amortization. In addition, the agreement contains other customary covenants, none of which we consider restrictive to our operations. We are currently in compliance with all of our debt covenants. Dividends Dividend payments totaled $297 million for the first nine months of fiscal 2011. On July 20, 2011, the Board of Directors declared a quarterly cash dividend of $0.20 per share to shareholders of record at the close of business on August 1, 2011. The dividend is payable on August 19, 2011. Share Repurchases During the first nine months of fiscal 2011, we purchased approximately 7.3 million shares for $375 million under our $1.0 billion share repurchase program. Since inception of the share repurchase program, we have purchased approximately 13.8 million shares for $625 million. We also repurchase shares from certain employees in order to satisfy employee tax withholding requirements in connection with the vesting of restricted shares and to settle certain option exercises. During the first nine months of fiscal 2011, we spent $3 million to acquire shares in connection with such share-based awards. Commitments and Contingencies Legal Proceedings We are subject to various legal proceedings and claims, including patent infringement claims, product liability matters, environmental matters, employment disputes, disputes on agreements and other commercial disputes, as described in our Annual Report on Form 10-K for the fiscal year ended September 24, 2010. We believe that these legal proceedings and claims likely will be resolved over an extended period of time. Although it is not feasible to predict the outcome of these proceedings, based upon our experience, current information and applicable law, we do not expect that these proceedings will have a material adverse effect on our financial condition. However, one or more of the proceedings could have a material adverse effect on our results of operations or cash flows for a future period. Further information regarding our legal proceedings is provided in note 14 to our consolidated financial statements and in Part II, Item 1 of this 10-Q. Income Taxes Our income tax returns are periodically examined by various tax authorities. The U.S. Internal Revenue Service (IRS) has commenced its examination of our U.S. federal income tax returns for the years 2008 and 39-------------------------------------------------------------------------------- Table of Contents 2009. Open periods for examination also include certain periods during which we were a subsidiary of Tyco International. The resolution of the matters arising during periods during which we were a Tyco International subsidiary is subject to the conditions set forth in the Tax Sharing Agreement discussed in note 13 to our consolidated financial statements. Tyco International has the right to administer, control and settle all U.S. income tax audits for periods prior to the separation. We have potential liabilities related to these income tax returns and have included our best estimate of potential liabilities for these years within our current and non-current taxes payable. With respect to these potential income tax liabilities from all of these years, we believe that the amounts recorded in our consolidated financial statements as current or non-current taxes payable are adequate. In accordance with the Tax Sharing Agreement, we share certain contingent liabilities relating to unresolved tax matters of Tyco International for periods prior to the separation, with Covidien assuming 42%, Tyco International 27% and TE Connectivity 31% of the total amount. We are the primary obligor to the taxing authorities for $1.936 billion of contingent tax liabilities that are recorded on the consolidated balance sheet at June 24, 2011, $1.426 billion of which relates to periods prior to the separation and which is shared with Tyco International and TE Connectivity pursuant to the Tax Sharing Agreement. The actual amounts that we may be required to ultimately accrue or pay under the Tax Sharing Agreement could vary depending upon the outcome of the unresolved tax matters, some of which may not be resolved for several years. In addition, pursuant to the terms of the Tax Sharing Agreement, we have recorded a current and long-term receivable from Tyco International and TE Connectivity of $149 million and $609 million, respectively, which are classified as due from former parent and affiliate on our consolidated balance sheet at June 24, 2011. These receivables primarily reflect 58% of our contingent tax liabilities that are subject to the Tax Sharing Agreement. If Tyco International and TE Connectivity default on their obligations to us under the Tax Sharing Agreement, however, we would be liable for the entire amount of such liabilities. The IRS has concluded its field examination of certain of Tyco International's U.S. federal income tax returns for the years 1997 through 2000 and proposed tax adjustments, several of which also affect our income tax returns for years after 2000. Tyco International has appealed certain of the tax adjustments proposed by the IRS and we believe that some of these adjustments are likely to be resolved within the next 12 months. With respect to other adjustments, Tyco International has indicated that settlement is unlikely. In the event that Tyco International is unable to resolve these issues in the IRS administrative process, Tyco International will likely contest certain adjustments related to disallowed deductions through litigation. While we believe that the amounts recorded as non-current taxes payable or guaranteed contingent tax liabilities related to these adjustments are adequate, the timing and outcome of such litigation is highly uncertain and could have a significant effect on our consolidated financial statements. The IRS continues to audit certain of Tyco International's U.S. federal income tax returns for the years 2001 through 2004. Tyco International and the IRS have entered into settlements related to certain outstanding tax matters arising in this audit cycle, which otherwise remains open and subject to examination and resolution of other matters. In addition, the IRS has commenced its examination of certain of Tyco International's U.S. federal income tax returns for the years 2005 through 2007. In connection with the settlements of the 1997 through 2000 and 2001 through 2004 U.S. audit cycles and other non-U.S. audits, we estimate that we will be required to make a payment of approximately $314 million, net of refunds, within the next 12 months, which is included in current income taxes payable on the consolidated balance sheet. Pursuant to the Tax Sharing Agreement, we will receive net payments totaling approximately $149 million from Tyco International and TE Connectivity, which is classified as the current portion of due from former parent and affiliate on the consolidated balance sheet. We will also be required to reimburse Tyco International and TE Connectivity $162 million for our portion of their settlements. This amount is classified as the current portion of guaranteed contingent tax liabilities on the consolidated balance sheet. 40 -------------------------------------------------------------------------------- Table of Contents The resolution of issues arising from the 1997 through 2000, 2001 through 2004 and 2005 through 2007 U.S. audit cycles and other non-U.S. audits, as well as other settlements or statute of limitations expirations, could result in a significant change in our unrecognized tax benefits. We estimate that within the next 12 months, our gross uncertain tax positions, exclusive of interest could decrease by as much as $412 million, as a result of such settlements or expirations. At September 24, 2010, our estimate of the decrease in the amount of gross uncertain tax positions, exclusive of interest, as a result of settlements or statute expirations in the upcoming 12 months was $745 million. The decrease in this amount was primarily due to changes in the estimated timing of our expected settlements. These estimates of changes to unrecognized tax benefits may not be representative of actual outcomes. Finalizing audits with the relevant taxing authorities can include formal administrative and legal proceedings, and, as a result, it is difficult to estimate the timing and range of possible change related to our unrecognized tax benefits. Guarantees Pursuant to the Separation and Distribution Agreement and Tax Sharing Agreement, we entered into certain guarantee commitments and indemnifications with Tyco International and TE Connectivity. These guarantee arrangements and indemnifications primarily relate to certain contingent tax liabilities; we assumed and are responsible for 42% of these liabilities. Regarding the guarantees, if any of the companies responsible for all or a portion of such liabilities were to default in its payment of costs related to any such liability, we would be responsible for a portion of the defaulting party or parties' obligation. These arrangements were valued upon our separation from Tyco International using appraisals and a liability related to these guarantees was recorded on our balance sheet, the offset of which was reflected as a reduction in shareholders' equity. Each reporting period, we evaluate the potential loss which we believe is probable as a result of our commitments under the Agreements. To the extent such potential loss exceeds the amount recorded on our balance sheet, an adjustment will be required to increase the recorded liability to the amount of such potential loss. This guarantee is not amortized because no predictable pattern of performance currently exists. As a result, the liability generally will be reduced upon release from our obligations under the Agreements, which may not occur for some years. In addition, as payments are made to indemnified parties, such payments are recorded as reductions to the liability and the impact of such payments is considered in the periodic evaluation of the sufficiency of the liability. A current and non-current liability totaling $716 million relating to these guarantees was included on our consolidated balance sheet at both June 24, 2011 and September 24, 2010. In disposing of assets or businesses, we often provide representations, warranties and indemnities to cover various risks, including unknown damage to the assets, environmental risks involved in the sale of real estate, liability to investigate and remediate environmental contamination at waste disposal sites and manufacturing facilities, and unidentified tax liabilities and legal fees related to periods prior to disposition. Except as discussed below, we generally do not have the ability to estimate the potential liability from such indemnities because they relate to unknown conditions. However, we have no reason to believe that these uncertainties would have a material adverse effect on our results of operations, financial condition or cash flows. In connection with the sale of our Specialty Chemicals business, we provided the purchaser with an indemnification for various risks, including environmental, health, safety, tax and other matters, some of which have an indefinite term. However, the most significant portion of this indemnification relates to environmental, health and safety matters, which has a term of 17 years. A liability of $22 million relating to this indemnification was included on our consolidated balance sheet as of June 24, 2011. The value of the environmental, health and safety guarantee was measured based on the probability-weighted present value of the costs expected to be incurred to address environmental claims proposed under the indemnity. The maximum future payments we could be required to make under the indemnification provided to the purchaser is $82 million. In addition, we were required to pay $30 million into an escrow account as collateral, which is included in other assets on the consolidated balance sheet. 41 -------------------------------------------------------------------------------- Table of Contents We have recorded liabilities for known indemnifications included as part of environmental liabilities, which are discussed in note 14 to our consolidated financial statements. In addition, we are liable for product performance; however in the opinion of management, such obligations will not significantly affect our results of operations, financial condition or cash flows. Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to use judgment in making estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. We believe that our accounting policies for revenue recognition, inventories, property, plant and equipment, intangible assets, business combinations, goodwill, contingencies, pension and postretirement benefits, guarantees and income taxes are based on, among other things, judgments and assumptions made by management that include inherent risks and uncertainties. There have been no significant changes to the above critical accounting policies or in the underlying accounting assumptions and estimates used in such policies from those disclosed in our annual consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the fiscal year ended September 24, 2010. 42 -------------------------------------------------------------------------------- Table of Contents FORWARD-LOOKING STATEMENTS We have made forward-looking statements in this report that are based on our management's beliefs and assumptions and on information currently available to our management. Forward-looking statements include information concerning our possible or assumed future results of operations, business strategies, financing plans, competitive position, potential growth opportunities, potential operating performance improvements, the effects of competition, and the effects of future legislation or regulations. Forward-looking statements include all statements that are not historical facts and can be identified by the use of forward-looking terminology such as the words "believe," "expect," "plan," "intend," "anticipate," "estimate," "predict," "potential," "continue," "may," "should" or the negative of these terms or similar expressions. Forward-looking statements involve risks, uncertainties and assumptions. Actual results may differ materially from those expressed in these forward-looking statements. You should not put undue reliance on any forward-looking statements. The risk factors discussed in "Risk Factors" in our Annual Report on Form 10-K for the fiscal year ended September 24, 2010 and in this Quarterly Report could cause our results to differ materially from those expressed in forward-looking statements. There may be other risks and uncertainties that we are unable to predict at this time or that we currently do not expect to have a material adverse effect on our business. We expressly disclaim any obligation to update these forward-looking statements other than as required by law. |