BOSTON SCIENTIFIC CORP quarterly report, Q2 FY2011

Boston Scientific Corporation — Q2 2011 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2011. Amounts are in millions of dollars, except per-share data. The company develops and sells medical devices worldwide across cardiovascular, endoscopy, urology/women’s health and neuromodulation markets.

Financial performance

Metric	Q2 2011	Q2 2010	Six months 2011	Six months 2010
Net sales	$1,975	$1,928	$3,900	$3,888
Gross profit	$1,287	$1,274	$2,581	$2,572
Gross margin	65.2%	66.1%	66.2%	66.2%
Operating income (loss)	$237	$231	$560	$(1,255)
Net income (loss)	$146	$98	$192	$(1,491)
Diluted earnings (loss) per share	$0.10	$0.06	$0.12	$(0.98)
Interest expense	$73	$103	$148	$195

Q2 reported sales rose 2%, but declined 2% on a constant-currency basis; excluding currency and divested-business sales, management reported a decline of less than 1%. First-half reported sales were nearly flat, while constant-currency sales declined 3%; excluding currency and divested businesses, the decline was less than 1%. Foreign exchange added $96 million to Q2 sales and $129 million to first-half sales versus the prior year.

Management reported adjusted net income of $262 million, or $0.17 per share, for Q2, compared with $190 million, or $0.12, in Q2 2010. For the first half, adjusted net income was $598 million, or $0.39 per share, versus $441 million, or $0.29. These are non-GAAP measures that exclude specified impairment, acquisition/divestiture, restructuring, tax and amortization items; they should be considered alongside GAAP results.

Cash flow, balance sheet and debt

Cash from operations was $293 million for the first half, compared with $2 million in the prior-year period. Q2 operating cash flow was $390 million, versus $286 million.
First-half investing cash flow was positive $886 million, principally reflecting $1.417 billion of net proceeds from the Neurovascular divestiture; financing cash flow was negative $1.241 billion, including debt repayments. Cash declined $59 million to $154 million.
At June 30, cash and cash equivalents were $154 million; working capital was $1.257 billion; total debt was $4.201 billion, down from $5.438 billion at December 31, 2010. Long-term debt was $4.197 billion and current debt obligations were $4 million.
The company prepaid its remaining $1.0 billion term loan and repaid $250 million of senior notes during the first half. It had no borrowings under its $2.0 billion revolving credit facility and was in compliance with its covenants: leverage ratio 1.4x against a 3.5x maximum, and interest coverage 8.5x against a 3.0x minimum.
In July 2011, Fitch upgraded the company to BBB−, investment grade, and Moody’s revised its Ba1 outlook to positive from stable.

Material changes and unusual items

In January 2011, Boston Scientific sold its Neurovascular business to Stryker for $1.5 billion cash consideration. It recorded a $760 million pretax gain ($530 million after tax); $27 million of gain was deferred pending escrow release and transition-related activities. Neurovascular generated $340 million of 2010 sales. Ongoing supply sales to Stryker are expected at materially lower levels and margins.
The company recorded a $697 million non-deductible goodwill impairment in Q1 related to its U.S. Cardiac Rhythm Management (CRM) business, reflecting a smaller projected U.S. ICD market and lower CRM growth assumptions. A further $12 million intangible-asset impairment was recorded in Q2.
Q2 gross margin fell 0.9 percentage points, primarily due to the Neurovascular divestiture and lower-margin transition supply arrangements. First-half margin was supported by a $50 million retroactive pricing credit under the Abbott PROMUS stent supply arrangement.
Interest expense declined as debt and average borrowing rates fell. The reported first-half tax rate was unusually high at 55.5%, affected by the mix and tax treatment of the divestiture gain, impairment and other items.
First-half operating cash flow comparisons were affected by litigation payments: $296 million in 2011 versus approximately $1.0 billion in 2010. The 2010 period also included a $250 million Abbott milestone receipt and a $163 million federal tax refund.
First-quarter acquisitions included Sadra Medical, Intelect Medical, ReVascular Therapeutics and Atritech. The company paid $370 million net of cash acquired and recorded $287 million of acquisition-date contingent consideration liabilities. Maximum undiscounted contingent consideration for post-2008 acquisitions was approximately $760 million.

Outlook, management commentary and risks

No consolidated revenue or earnings guidance is provided in the filing. Management expected R&D spending to increase in the remainder of 2011 and planned higher SG&A investment to support product launches, acquisitions and emerging-market expansion.
A new restructuring plan approved July 26, 2011 is expected to produce $225 million to $275 million of annual pretax expense reductions exiting 2013. Estimated charges are $155 million to $210 million, mostly involving future cash outlays; implementation is expected to be substantially complete by the end of 2013.
Management estimated 2011 capital expenditures of $300 million to $350 million and planned $30 million to $40 million of 2011 investment in emerging markets. It also described an additional $150 million investment to expand commercial, manufacturing, training, R&D and clinical capabilities in China.
CRM remains pressured by contraction in the U.S. ICD market, physician and hospital practices, audits, competition and pricing. Management expected U.S. approval of next-generation defibrillators in late 2011 or early 2012 and a U.S. pacemaker launch in early 2012.
Key product and supply risks include timing of PROMUS Element launches (U.S. and Japan expected in mid-2012) and reliance on Abbott for PROMUS supply in those markets through June 2012. Delays, supply disruptions or weaker market acceptance could affect sales and margins.
Goodwill impairment sensitivity remains elevated: the U.S. CRM reporting unit’s carrying value exceeded fair value after the impairment; other identified higher-risk units had estimated fair-value cushions of about 8% to 15%. Changes in growth, profitability or discount-rate assumptions could trigger further impairment.
Legal accruals were $278 million at June 30, down from $588 million at year-end, mainly after a $296 million DOJ payment. The company remains exposed to patent, product-liability, securities and governmental matters, and is substantially self-insured for product liability and intellectual-property claims.
The IRS asserted an additional $525 million plus interest for Guidant’s 2001–2003 transfer-pricing tax years. The company disputes the position and expects further proposed adjustments for other years; it believes reserves are adequate but states that resolution could materially affect financial condition or results.

Important facts for investors to verify

Whether underlying sales and margins improve after separating currency effects, divested-business sales and the Abbott PROMUS pricing credit.
U.S. ICD/CRM market trends, CRM market-share recovery and the assumptions supporting the $697 million goodwill impairment and remaining CRM asset values.
Progress, costs and realized savings from restructuring, and whether planned R&D and emerging-market investments yield profitable growth.
Debt reduction, cash generation, covenant headroom and the cash demands of litigation, taxes, acquisitions and contingent consideration.
Timing and commercial performance of major product launches, including PROMUS Element, next-generation CRM products and acquired technologies.
Developments in the IRS transfer-pricing disputes, patent litigation, product-liability claims and other proceedings that could affect earnings, cash flow or product access.