Covidien - Back on Top: An Interview with Richard Meelia

Is there a medical device company today doing better than Covidien? The company is making a huge splash building new businesses and shoring up existing ones. But Covidien, formerly Tyco, hasn't always had it so good. A corporate scandal in the early 2000s brought Tyco's corporate management down and scuttled the healthcare business' strategic plan. After years of sitting on the sidelines, Covidien is back, stronger than ever.

Over the past 15 years, Covidien has seen more than its share of ups and downs: a forced bankruptcy and the shadow of corporate scandal during the worst of times, and, on the positive, the creation of a hospital-supplies powerhouse. More recently, the company has used an aggressive M&A strategy to establish itself as one of the device industry's leaders.

by David Cassak

Is there a medical device company today that, by any measure, is doing as well as Mansfield, MA-based Covidien Ltd.? Over the last three years, the company has been one of the industry's best performing companies and most active deal-makers, building major franchises in totally new target markets, such as peripheral vasculature, while securing a leadership position in its surgical devices/instrument business, one of its core franchises. Indeed, only Medtronic PLC and St. Jude Medical Inc. have done more deals since 2008 than has Covidien, which has scooped up a number of companies, most recently peripheral vascular specialist ev3 Inc. [See Deal] (Accounting for the large general stock market sell-offs of 2008 and midyear 2010, Covidien's stock has also outperformed most of the offerings of other large cap medical device companies since its spin-off IPO of early 2007.) [See Deal]

But Covidien's current streak raises an even more interesting question: is there a top device company today that has come as far as Covidien in reaching its current prominence? In fact, there isn't one Covidien, but really four or five (under a variety of different names) and each of the company's iterations has had its own story to tell. Beginning as Kendall, the wound care giant, the company has gone through a leveraged buyout and forced bankruptcy, a buyout by a large industrial conglomerate, Tyco International, which ushered in a period of extraordinary M&A activity in the late 1990s – activity that enabled the company build a powerhouse in hospital supplies – only to be brought low just a couple of years later by the financial scandals that roiled its parent company. [See Deal] But where most companies might have just given up, Covidien persevered, under the leadership of CEO Richard Meelia, a former American Hospital Supply Corp. executive who took the reins just before the scandal hit.

So bad was it at Covidien in the early 2000s that, as he confesses in the following interview, Meelia himself almost quit, worn out by the pressures of the scandal and feeling as if Covidien had few hands left to play. But a strong financial performance backed by a deep operational discipline enabled Covidien to ride out the troubles brought by the scandal, which in causing Tyco's stock price to plummet, effectively ended the growth-through-acquisition strategy that had driven the company just a few years earlier. A spin-out from Tyco and accompanying IPO three years ago helped put Covidien on a growth path again and enabled the company to return to its very active M&A agenda – albeit with an important shift in the strategy behind its acquisitions, as Meelia points out.

In the following interview, conducted as part of the Innovator's Workbench series sponsored by Stanford University's Biodesign program, Meelia tells Covidien's story – or should we say stories – beginning with the forced bankruptcy, through the scandal and eventual IPO, and talks about Covidien's strategy today and its plans for the future.

David Cassak: I know you started at American Hospital Supply. What did you do for AHSC?

Rich Meelia: I worked for the PharmaSeal division. I started as a sales rep and then moved into sales and marketing [management] through the nursing products division of PharmaSeal.

Q: What kinds of products were those?

Hospital supplies like urology and syringes and needles, gloves, basic floor-use products primarily. From there, I went to American's McGaw [IV solutions] division, where I was vice president of sales and marketing, and was there at one of the craziest times I can remember. I got there just when American Hospital Supply announced it was going to merge with HCA [HCA Inc., formerly Hospital Corp. of America] in a new company to be called Curon. Most of the people I knew at American were in disbelief; we couldn't figure out how we were going to be part of a hospital system. Dick Gilleland had been at McGaw before he went to Intermedics and then to AMI. He moved on to Kendall in 1990 and about six months after he got there, he brought me over to Kendall. That's how I got to what is today Covidien.

But Kendall at the time wasn't in much better shape than American had been. It was a privately held company that had been the object of an LBO but it was failing. What we needed to do was to take the company through a pre-packaged bankruptcy. It wasn't a lot of fun doing that, but it was an incredible educational experience, and, more importantly, I think it really did establish a kind of foundation for the Kendall culture. Today, we're very rigorous in how we invest our capital. We always review our capital investments for paybacks. The one difference is today, we're looking at three to five year paybacks; back then, during the bankruptcy proceedings, we were looking at months. If something didn't generate a return in 60 days, we didn't do it because cash was so important. We really learned what it meant to appreciate and sacredly guard cash. Within about a year, by early 1992, we emerged from bankruptcy and had gone public at $10.30 a share. And soon after that, in 1994, Tyco bought the company for $60 a share. They had been an industrial conglomerate and they decided they wanted to expand into health care.

Q: The LBO fund was Clayton, Dubilier and Rice. At $60 a share, they obviously got some money back. But did they ever make money on the deal, because there was a widespread belief at the time that they had overpaid for Kendall when they bought it [from Colgate Palmolive Co.]?

When they sold to Kendall, they made up for their losses on the original buyout. In fact, the price they got was something like $60.12, which was exactly the amount necessary to offset their losses on Kendall Part One. That was significant because it was important for them to be able to say that they'd never done a deal that lost money.

Q: So you were acquired by Tyco and became an operating unit with a large, publicly traded company.

Correct.

Q: We tend to think of Covidien's track record today as one of the industry's most aggressive deal-makers as something of a change in strategy. But it's actually deeply engrained in your history. It was just a couple of years after you were acquired by Tyco that Kendall went on one of the most amazing acquisition sprees that anybody has seen in the medical device space. The late 1990s were an incredible time for M&A in the device world. Companies like Medtronic and J&J were buying a lot of companies. But even those companies didn't match what Tyco was doing at the time.

Right.

Q: Take us through some of those deals. Was there a strategic rationale behind them -- a vision for what Tyco wanted to become?

I don't know how many people remember the name, but at the time, Dennis Kozlowski was running Tyco. And yes, he did some things that he shouldn't have done, and he's paying the price now for that. But he also deserves credit for having the vision to create a great health care company. That was really the vision; there wasn't any particular strategy in terms of the kinds of companies that Tyco was pursuing. The whole idea was to get more into health care because health care was considered much more stable, particularly when compared to the kinds of cyclical businesses that Tyco was in: fire and security and construction projects. Kozlowski just liked the idea of being in health care.

Our initial deals were primarily in what might be called Kendall-like products. So we acquired Professional Medical Products and InBrand, and then in 1998 we did our first really big deal when we acquired Sherwood-Davis & Geck [from American Home Products], which was about a billion dollars in sales, and cost a couple of billion in purchase price. We then acquired Graphic Control, which made electrodes, for about $600 million, and US Surgical, which included Valley Lab [electro-surgical devices]. At the time, United States Surgical was around $1.5 billion in sales and we paid $3 billion. The final piece was the baby diaper company, Confab, for which we paid about $800 million. And that was all within one year. We did four major deals in 12 months, and the key behind them all was just to create a company of a certain size. We weren't necessarily after growth; what we wanted to do was to build a company that was immediately profitable and to drive the profit through very aggressive integration of all of the companies, leveraging them all to strip out redundant costs. [See Deal] [See Deal] [See Deal] [See Deal]

Q: I don't know how familiar those names are today, but one of the interesting things about Tyco's acquisition spree is that you didn't just buy critical mass, you also acquired some of the most important brands in hospital supply at the time. How much of this was about getting the right mix of brands, so that when you went to customers, you could offer a package of products that included Kendall wound care, US Surgical surgical devices, Davis & Geck wound closure, and Sherwood products?

In the early days, that was the strategy. In particular, the Sherwood, InBrand, and ProMed products were all strong hospital supply lines, what I called the Kendall-like products. Once we bought US Surgical, and followed with Mallinckrodt in 2000, we moved beyond just hospital supplies and into what might be called medical devices, higher tech, more physician preference items. And that was a critical point for us. The good news about being part of Tyco at the time was that they allowed us to build a very big business and acquire some very good franchises in medical devices spaces we had never been in: surgical devices, energy-based devices, pulse oxymetry, critical care ventilation. These were important lines to be in. The bad news was that top line growth was inconsequential to what we were doing. It was not part of the model. We were focused on immediate earnings and cash flow. The entire strategy behind the acquisition effort was to bring these companies in, and I should say that by and large, they were bigger, underperforming companies, whose management teams, in some cases, may have lost their edge. Well, the one thing we had was edge. So we would bring these companies in and would integrate back-office systems and manufacturing plants. But those were tough to do, so we also wound up cutting sales and marketing and R&D and justified that because growth wasn't part of the equation. And so from around 1995 to 2000, just after the Mallinckrodt acquisition, we grew our health care business from $600 million to around $9 billion, but our organic growth rate was only 1-2% and that would become a problem later. [See Deal]

Q: And it became a problem because suddenly around 2002, the dealmaking stopped. You noted you had an edge and that was because in an industry full of sleepy, tired, non-growing companies, Tyco's style was extremely aggressive, take-no-prisoners, no-holds-barred. In fact, executives at many of the companies you acquired clearly weren't happy with the new situation. And all of that worked well, until about 2002 when the wheels came off, precisely because of, some would argue, Tyco's aggressive approach.

Well, yes.

Q: So let's talk about what happened in 2002. Few companies in this industry have ever gone through what you went through as a result of what was going on at Tyco's corporate headquarters. Describe what happened next, but as you do, I have to ask: do you still have the dog umbrella stand in your office?

Yes, I do. That first phase at Tyco was very successful because we were using a fast-growing and quickly appreciating Tyco stock to do most of the acquisitions. Dennis took the equity value of Tyco from about $3 billion in 1994 to around $90 billion at its peak, if I remember correctly. He created a lot of value, and with the appreciated stock, we were buying a lot of companies. Then the scandal hit. [ Editor's note: Kozlowski and some other Tyco officials were accused and later convicted of financial irregularities and defrauding shareholders.] The scandal was a big issue for us, but I think even without the scandal, we would have run into trouble. It was like having a drug habit: eventually, we were going to choke on the model because we just couldn't keep it up. We were getting EPS accretion, but the return on invested capital for the company just kept going lower and lower. No one paid attention to it until too late, and then it became a problem. But simultaneous with this was the scandal involving Dennis Kozlowski, and his abuse of corporate assets, which was summed up with the $15,000 dog-shaped umbrella stand.

Q: Well, yours didn't cost $15,000.

No, mine was only $15. Dennis' cost $15,000. It was a gag gift from someone. It's just a small ceramic umbrella stand.

Q: What was it like going through all of that? You once told me that at Tyco Healthcare, you didn't even find out about the problems swirling around Kozlowski and the others until you read it in the paper. At Tyco Healthcare itself, there was nothing like that going on, but it must have seemed both irrelevant to you and distracting at the same time.

Yes, we knew nothing about it. Most of what went on was invisible to the divisions. It started in February of 2002 when the Tyco board discovered that one of their board members had received a $20 million fee for connecting Tyco to a company, CIT, that Tyco eventually acquired. The fee was never disclosed to the board and it was totally inappropriate. That's when the board started looking into what exactly was going on, asking whether there were other instances of malfeasance. They hired David Boise, of the Boise, Schiller law firm, who then hired a forensic accounting firm. First, they focused on Tyco corporate, and as a result of that investigation, Dennis Kozlowski, Mark Schwartz, the CFO at the time, and the general counsel were all indicted and all left the company. It was around that time that we began to hear about all of the apartments that they had bought, all of the loans that had been forgiven, and all of the unreported bonus programs. But it was all at the corporate level. They finished their investigation and issued their report in September of 2002, and we thought it was all over. But then the same lawyers and forensic accountants showed up at all of the divisions, looking to see if anything similar had taken place at that level. It was hellacious. In all my years, I have never had a problem sleeping at night – despite all of the pressures that come up from running a business or from things going on in your family, I could always fall asleep. Suddenly, I had trouble sleeping, because we had all of these people running around, looking for things that we had done wrong.

Fortunately, Kendall had been a public company and so we had established good controls and policies and practices; becoming part of Tyco didn't change that at all. We had always been subjected to intense review and scrutiny and had always passed muster. So on that level, we weren't worried. But the whole process was very unsettling, to say the least, because we were dealing with people just dying to find problems where none existed. Just to give one example: several years before we had been at a Tyco fundraiser for some charity in Boston, and one of the raffle items was a weekend in Bermuda, using the Tyco jet to get us there. Three of us from Tyco Healthcare won it, and we were going to go down with our wives. So we all flew down, and we asked Corporate how to handle it and were told to just expense it, which is what we did. Three years later, these forensic accountants come across documents saying that Rich Meelia and two other colleagues flew on the Tyco jet with their wives, and suddenly they're trying to read all kinds of abuses into this. Fortunately, none existed, and we got through it. But that was a very difficult time. Soon after Ed Breen came in and what he brought was some stability and an effort to turn Tyco around. But Tyco's stock price went, over a three-month period, from something like $60 down to $7, and Tyco went from being a highly successful company with a soaring stock to a company mentioned in the same breath with WorldCom and Enron. ( See "Tyco Healthcare: Surviving Scandal," IN VIVO , April 2004 (Also see "Tyco Healthcare: Surviving Scandal" - In Vivo, 1 Apr, 2004.).)

Q: And what must have been worse for you was that it wasn't that there were any suggestions that you had done bad things, it was that everyone was looking for the next Enron.

Correct. To everyone else, the story was clear: here was Tyco, a Bermuda-based company that was one more example of corporate greed run amok. That was bad enough. But even when Dennis had left and Ed had come in, it wasn't an end to our problems because what became clear very quickly was that with our stock price at $7 instead of $60, the strategy of growth through acquisition was gone. If we were going to grow, we'd have to do so organically, and that was going to be impossible given the way we had been funding sales and marketing and R&D. It was a real challenge. Breen understood; he wanted to give us the opportunity to invest more, to change the paradigm, but he couldn't do it. He was under immense pressure. He came in and immediately cleaned up the governance issues, totally changed the board, and put in new controls and procedures. Sarbanes-Oxley followed soon thereafter, and those procedures and controls got even more intense. But it soon became clear we couldn't run a health care business given what Tyco was going through. To his credit, Ed was the kind of guy who ran the company with the shareholder in mind. It wasn't particularly a goal of his to take a big company and make it bigger for reasons of ego and prestige. He realized that there was just no way these health care businesses could flourish under Tyco. It just wasn't going to happen. And that's when he began, with our prompting, to think about spinning off the health care business. We had been saying to him that if you look at Tyco's other businesses – electronics, fire and security, those kinds of things – those are different businesses with different investor bases and different expectations. He brought in Goldman Sachs to offer the financial perspective and McKinsey to look at whether this would work strategically, and then decided to spin off Healthcare.

Q: Was there any downside, any argument for not doing the spin-off at that point?

I think just the cost to shareholders, because it was very expensive to do. And then there was always the risk that we wouldn't be able to execute on the strategy. Shareholders who had a share of Tyco stock were going to get three shares of stock, one in each of three companies, that would be worth the same as the one Tyco share. There was always the risk that if any of the companies couldn't execute on its strategic plan, we'd have some disappointed shareholders because their three shares of stock wouldn't be worth what their one share had been worth.

Q: Out of that spin-off came the new Covidien in 2007. Before we get to Covidien and its strategy today, let me ask you two questions about the period just following the scandal. First, was there any fallout among your customers? Did anybody respond to the scandal by saying, "Oh, we'd better not buy stuff from Tyco because it's a tainted company," either because they had qualms about partnering with such a company or because they feared being tainted by association?

It's a great question. The taint was felt by the employees tremendously. Tyco hats, Tyco T-shirts, Tyco sweatshirts – they were all put way in the back of the closet and they never came out. But the customers, and especially clinicians, saw Nellcor, US Surgical, Mallinckrodt, Kendall and Curity, and they didn't connect any of that with Tyco. Buying groups did, but the fact that hospitals and physicians really didn't, saved us. The bigger issue was that there were skeptics who wondered whether a company that had been managed as we had been managed for so long could survive independent of a mother ship like Tyco. There were a lot of skeptics who questioned whether we could pull this off. But we never really ran into a problem that customers wouldn't continue to buy products because of the scandal.

Q: I want to get to the point the skeptics were making. Before I do, let me ask one more question. So much of your strategy in the late 1990s was built on aggressive M&A. Your last major deal was the 2000 acquisition of Mallinckrodt, but soon after, you had another major deal lined up with CR Bard that fell apart at the last minute because of all of the problems. [W200110110]

Correct.

Q: Was the inability to pick up CR Bard an issue for you? Was there any feeling that in 2002, as you looked at going forward, having to grow organically with no currency to continue to buy any more companies, that you had gotten halfway through your strategy, but had to stop before you were done? Had you put enough of a portfolio together with the acquisitions closed to that point? Or were there more deals that the strategy was predicated upon, and suddenly having to stop undermined the whole strategy? When you failed to bring in CR Bard, was that a major problem, both in fact and symbolically, for what it said about the earlier strategy?

From 2002 to 2005 we didn't do a single deal. That's a really bad thing in the device space, particularly considering we had probably done 50 or 60 deals in the previous eight years. But we just couldn't continue to do deals. There was no currency to do them and no appetite – our investors didn't want to make the investment. They wanted to see what we could do to grow organically. It was a very difficult time. From a financial position, we were doing great, generating a ton of cash, very profitable, with operating margins comparable to some of the best companies in the device industry. But the problem was we weren't growing, and had no capability to grow. Bard was an opportunity to bring some growth in, but that deal actually fell apart before the scandal hit. As you say, we had signed a letter of intent in June of 2001, and we would normally have closed, after all the regulatory requirements, three months later. But the Federal Trade Commission came in and saw some overlap issues and it took us four to five months to address those issues.

By the time we were finally ready to close the deal, the scandal hit in 2002, the stock was down and we couldn't make the deal work financially. When Tyco decided to spin the company off, we all knew it was the right thing to do, but we weren't sure if we could deliver value very quickly or effectively. In fact, for a while it looked as if I wasn't going to be part of the spin-off. By 2004, I had been at Tyco for 10 years. I had been through the dramatic growth of Tyco Healthcare and also been through the scandals, and I had been through the period after Ed Breen had come on and the message was, "No more deals, just manage the best you can." At that point, I decided I was going to retire because I had basically been doing this for 10 years and didn't know that I wanted to keep doing it.

Q: You'd simply had it.

I'd had it. And then Breen came to me in the summer of 2005 and said, "We're thinking about splitting up the company and spinning Healthcare off. If we do that, will you stay?" And I said, "Yes," because that would be a totally different situation. I can remember meeting in the fall of 2005 – this is before the decision had been made by the board – and we were trying to understand the Healthcare business and someone put up a PowerPoint presentation about what it was going to take for us to create growth and, at the same time, have really robust quality and regulatory systems and strong clinical programs. We figured it would cost between $400-$500 million. I remember going to Bill Huyett [a lead director at McKinsey & Co.] and asking, "How do we go to our investors and say, we need to take away $500 million in earnings?" And he said, "The only way to do it is by spinning off the company. If we do that, each of the businesses will get a whole slew of new investors and they'll be re-establishing their investor base. The [existing] Tyco investors will be upset, but they're going to stay with the industrial businesses" – which they did. That's why for Healthcare, a spin-off was our only option.

Q: So who was going to fund all of the regulatory and clinical programs? Was the $400 million going to come from new investors? From existing operations?

Oh, we had the cash. But as part of Tyco, we just took the cash and sent it down to Tyco every quarter. We generated operating income as a percent of sales of around 22%-23%, which is where Bard and BD [Becton Dickinson & Co.] are. We were going to have to take it down to 18%-19% to afford these new programs, which would mean that our EPS would drop and our market value would shrink. But it was the only way to put the resources in Covidien to make it something other than Tyco Healthcare with a different name – it was the only thing that could have saved the company.

Q: For those of us who've been around long enough, there really have been three or four different versions of Kendall/Tyco/Covidien. There was the Covidien of the late 1990s, an aggressive, omnivorous acquirer of companies; there was the Covidien of the 2002-2005 period, in which the scandal hit and you basically had to kind of hunker down and do the best you could with limited options; and then there's been the Covidien of, say, 2008-2010, once again an aggressive acquirer of companies. I think you told me once that in the last three years, only St. Jude and Medtronic had done more deals than Covidien.

Right. And remember, we did no deals between 2002 and 2005; as of a few months ago, we had done 11 in the last three years. But it's important to keep in mind that the deals we're doing now are very different from the deals we did in the late 1990s. When we acquired a company like Mallinckrodt, we did a lot of good, but we also did a lot of bad as well. We cut unnecessary costs to make them much more productive – that's how we took operating margins at Mallinckrodt from 12% to 26% and from US Surgical from 13% to 25%. We were able to do a lot of really smart, six-sigma, lean-manufacturing types of things. But we also cut things that drive growth, like R&D and sales and marketing.

Q: That raises an important issue. You mentioned earlier that, even if the scandal hadn't hit Tyco, the strategy upon which Tyco Healthcare was built wasn't sustainable because you weren't really generating organic growth. I knew a lot of people in some of the companies Tyco acquired who were frustrated because sales and marketing were slashed, R&D was cut, valuable projects were put on back burners – all of which led to the perception that Tyco was engaging in a kind of slash-and-burn approach: drive immediate cost reductions whatever the long-term implications, which must have been an issue particularly as, as you say, you were moving from low tech hospital supply products to more physician-preferred medical devices.

There's no question we were cutting those kinds of expenses, though they weren't eliminated altogether. Still, they were cut more than they should have been. It was interesting. I remember our first investor meeting. It was the first day of our road show [as Covidien prepared to be a publicly traded spin-off of Tyco]. In the meeting was the senior management team – all of our business heads, our CFO and me, laying out for the new investors what we were going to do. Now, these were health care investors, not historic Tyco investors. They were meeting the management team for the first time, trying to assess the company and us. We put together a vision that really made sense and you could really feel a lot of excitement and enthusiasm, and then our CFO stands up – this was the week before we were going public in June of 2007 – and he tells everyone that our 2008 earnings would be lower than our 2007 earnings would be, and they were going to be lower by several hundred millions of dollars because we needed to make investments in areas like R&D, clinical, sales and marketing, and business development. We literally took our operating margins from that 22%-23% range down to 18%-19%. And obviously there was a lot of disappointment, a lot of questions, among the investors. But we told them if we do this, we can make the kinds of investments we need to find good technologies and create growth, to foster a real spirit of innovation. We outlined the different parts of our business: a supplies business, which we were going to run a certain way, a pharma business that we were going to run a certain way, and a device business, built upon innovative medical devices, which we were going to run in yet another way. As a result of those investments, our organic growth went from 1%-2% to 5%-7%, and has increased consistently over the past three years. Our gross margins went from 47% to 55%, as of our last quarter. And what is most interesting, we said that we'd get our operating margins from 18%-19% back up to 21%-22%, and in our most recent quarter, our operating margin was 22.1%. So the vision proved pretty accurate, and over the past three years, the management team has really established a lot of credibility with investors because the value of the company has increased – despite, or because of, the fact that we took earnings way down in order to do things like hiring 2,000 more salespeople or funding R&D at a $200 million incremental clip in 2008 versus 2004.

Q: Obviously, the investors who stuck with you were rewarded. But did you lose a lot of investors? Do you have a different investor base today than Tyco had?

We lost virtually every Tyco investor. But in came Fidelity, Wellington, and Dodge & Cox Capital just recently came back. These are people who understand medical devices, who understand the value of investment and the value of top line growth. They understand the importance of funding a strong R&D program and that you need to see R&D not as an expense, but as an investment. When you talk to industrial conglomerate analysts, they don't see it that way. They're very short-term focused, very different. The new investors enabled us to do what we needed to do. I've spent time meeting with people like Mike Mussalem, who spun Edwards [Edwards Lifesciences Corp.] out of Baxter [Baxter International Inc.] and Chris Begley who took Hospira [Hospira Inc.] out of Abbott [Abbott Laboratories Inc.] We wanted to find out what lessons they had learned, what mistakes we could avoid. And even then, I think we only had an appreciation of 20%, 30% max, of what we were going to face. [See Deal]

The key was changing the culture. When we spun out, we started paying people for driving innovation, rather than simply for driving dollars to the bottom line. We have always given stock options to people for achieving operational excellence targets and cost reduction targets at our plants. And that's fine; that's an important part of our model. But we started also giving options to people who didn't qualify for those other stock options, people in the R&D programs throughout Covidien who come up with the best innovative products.

Q: When you look at the deals Tyco had done in the 1990s, it was very easy to see quickly whether those deals paid off. You'd integrate the back offices, cut some other costs, and it was clear right away whether you were getting the kind of returns on them that you wanted.

Right.

Q: But as you say, the deals you're doing now are different. They're posited on growth and continuing to generate innovative products and building franchises that physicians will continue to show loyalty to. Do you worry that seeing a payoff for those deals is less easy? Vnus Medical Technologies looked like a great deal for Covidien, same with Bacchus Vascular and even Aspect Medical Systems, though that was a more mature technology. But you're not going to be able to generate the kinds of immediate returns you saw when you integrated ProMed or Sherwood Medical, where you could go in and immediately cut costs and integrate operations. [See Deal] [See Deal] [See Deal]

That's right, though I should point out that all of those deals were immediately accretive. Today, every deal we do has to have a strategic fit. We also model based on financial criteria tied to an internal rate of return, a return on invested capital in years three and five. We know that some of these deals aren't going to pay off for five years, and that's OK. But we also like to do deals that are accretive from a sales growth and margin standpoint, and fortunately all of the deals we've done in the past three years have been accretive. We do post-mortems on our deals every six months and we do them for the board once a year. People want to know if we're getting the returns we expected, and though they're not all performing as anticipated in the original pro formas, I'm glad to say almost all of them have turned out to be very, very good deals. You mentioned Vnus and Bacchus. Those two deals have turned out to be good deals, and I think if you talk with the employees of those companies, they'll tell you that the experience has been positive.

We're not naïve; we know that a lot of people who work for small companies have experienced that being part of a big company can be a real pain in the butt. But there's a world of difference in how we treat the companies we acquire now and how we treated the companies we acquired in the late 1990s. Today, we're not looking to uproot the scientific knowledge located in these companies or cut the R&D or clinical programs. We did consolidate the Bacchus people in with the Vnus people and put them in the same building. But in the old days, we would have closed both facilities and moved everyone to our Mansfield office. Today, it's a totally different world. So, we'd like to have deals that pay off in three to five years, but if they don't, hopefully we're attracting the kind of investors who have a long-term view and are buying into what we're doing to create long-term sustainable value. Thus far, it looks as if we are.

Q: I've asked this question of a lot of senior executives over the years: what percentage of deals do you think wind up, ultimately, to have been deemed successful? The highest estimate I've ever gotten was 50%, but I've talked with some very successful companies, whose executives put the figure closer to 33%. As the CEO of a company that does a lot of deals, are you comfortable with that kind of a success rate?

No.

Q: You expect that Covidien will have a higher success rate?

As I said before, the Kendall LBO days gave us a real foundation and made a huge cultural impact in terms of how we look at these things and how we spend every nickel. Later, at Tyco, one of the things we learned was how to identify, value, negotiate, and integrate deals. That's a very strong background to our dealmaking, and I would be disappointed, given our history and the capabilities and competencies that exist, if we weren't above the average. Our number's more like 70%-75%.

Q: Over the past several years, Covidien has done one of the most impressive jobs in the device industry in building its business and technology portfolio. Where do you go from here? And let me give you one example to start. You're one of the most diversified companies, and a leader, either number-one or -two, in many of the markets you're in. But you're not, for example, in a major area like interventional cardiology.

Right.

Q: With VNUS and Bacchus, and later ev3, you have built a major position in peripherals. Could you see Covidien getting into interventional cardiology? Could you see yourself getting into major markets in orthopedics, for example? In the 1990s, you moved into a lot of spaces, like sutures and wound closure and electro-surgical devices, by buying whole franchises. How do you decide strategically where you go next?

It has to have a strategic connection to our existing businesses or we don't do the deal, no matter what the financial payoff. Under Tyco, financial returns were the sole determinant of whether we did a deal. But at Covidien today, we see our job as managers to create shareholder value, long-term, sustainable shareholder value. Acquisitions and licensing deals have to be part of creating value or we won't do that, and I think, by definition, the further away from your core you get, the more expensive, uncertain, unfamiliar, and therefore riskier the deals become. If you think M&A is important, and you want to use it to grow value, I believe you have to stay as close to your strengths and competencies as you possibly can. We have the luxury right now of having created some really nice franchises, and there's still some low-hanging fruit out there that we can add to those franchises. At US Surgical, they had launched a metal hernia tacking business; since we've spun out as Covidien, we've added through acquisition a resorbable tacking product, including both synthetic and biological mesh. When we acquired Confluent Surgical, one of the things we wanted to do was to use that acquisition to get into biologics. Those are the kinds of successful deals that move us into what we call strategic adjacencies – same call point, more or less, same channels of distribution. We understand the customers, the competitors, the clinical issues, and reimbursement. [See Deal]

Soon after we spun out, we organized Covidien into three groups. There's a Pharma group and that's managed the way a Pharma business has to be managed, differently than we manage our device businesses. We separated our other products into two groups: one contains all of our supplies and commodities. We manage that business for cash, not growth. All we really want them to do is to generate cash and improve profitability. In the other group, we put our medical device businesses, which we manage for growth. You mentioned our peripheral business. Early on we overestimated the growth potential of one our businesses – a line of products in urology, enteral feeding, and temperature that we thought could grow. But after a year and a half, we raised the white flag and said they belong in the supplies category. We're not going to put any more effort into those lines to make them grow. Back then, within that GBU were our vascular products, which at the time included dialysis catheters and compression products. As we looked at those, we saw not so much an interventional business, but a peripheral business and concluded that that was a space we could make grow if we added to it. So when Vnus and then Bacchus became available, we acquired them and we're building up very aggressively in that space even now.

Q: And obviously, your recent acquisition of ev3, which is one of the leaders in peripherals, builds on that. How do you see that shaping your peripheral business going forward? Is it the capping piece, the last piece in the strategy? Or does it give you a platform for doing more deals? Also, what are your plans for ev3's neuro business? Does Covidien have any other product lines in neuro?

As you know, the ev3 acquisition was by far the largest that we've undertaken since the spin-off. But we do not consider this will be our last acquisition in the vascular space. Obviously, we'll be working hard to integrate ev3 into our ongoing operations, looking for call point synergies and other opportunities to accelerate growth in both our existing business and in ev3's categories. We were not previously in neurovascular, but it is a large, growing market where we see a number of excellent growth opportunities.

Q: In the late 1990s, a lot of Tyco's deals were critical mass deals – you suddenly bought huge franchises in wound closure, electro-surgical instruments, pulse oxymetry. Are those kinds of deals still attractive to you? Obviously, the ev3 deal brings you critical mass, but it could also be deemed a technology play, filling out the pipeline in peripherals, a business you were already in. Does the notion of a 1990s style critical mass play where you, in effect, buy your way into a space have any appeal? Or is that not really the way you want to approach building out a new device space?

It's always dangerous to speculate, but let me answer that theoretically. As I said earlier, the first hurdle is strategic connection. There is that for sure in large deals like that. Obviously, we wanted to be bigger in peripheral vascular. But the next question is, can you make those kinds of deals work for your shareholders? I think some companies do better than others at bringing value to their shareholders as opposed to simply bringing value to the shareholders of the company they're acquiring. That's critical.

We clearly have confidence in our ability to integrate ev3 in such a way that we create real value out of what is for us a very large deal. But generally speaking, sometimes the bigger deals don't wind up delivering value to your shareholders, particularly if you're trying to buy a platform. That's why we really don't have an interest in getting into interventional cardiology, diagnostics, or orthopedics and spine. The only way to get into those areas is to buy one of the big players, and then after you pay the premium to do that and find out that you really don't understand the business you've bought and as a result, it becomes very hard to create value for your shareholders. Right now and for the foreseeable future, our strategic plan would not include buying a platform in one of those areas. We'd rather focus on the areas we're now in, and there's plenty of very interesting technology development going on in those areas.

Q: So you believe you can keep adding to your existing bases.

We can keep adding to them without taking those bigger bets that have less certainty and greater risk.

Q: That's a convincing argument for sticking to your knitting. How, then, do you deal with white space opportunities at Covidien? I think it's an interesting issue particularly since you've recently launched a venture capital arm. There's no better indication of the commitment you've made to innovation than forming a venture group.

Right, and we did that for a number of reasons, but part of it was that if you look at the leading medical device companies, they all have a venture arm of some sort. Ours is modest; it's our toe in the water, but we've got some really good people there and they've already made some great investments. More importantly, they're really well connected to people in the start-up, venture-backed community. They're also able to help us identify clinical issues associated with certain technologies we're evaluating within our business units. It's important that, as a venture fund, they generate good financial returns. But they also serve us in those other capacities as well, which includes identifying white spaces. We also look to the individual businesses, not so much to identify the white spaces but to run models to see whether it makes sense or not to be in those spaces.

Q: Do you anticipate that the companies that your venture group makes an investment in will be acquisition candidates for Covidien, if not outright acquisitions?

They haven't been [acquisitions] so far, but they should be.

Q: To the extent that both the venture arm and your internal business development are now given the mandate of reaching out to or making connections with the venture-backed start-up community, what's the best way for those smaller companies to interact with Covidien?

I hope we've made the process easier by putting business development people in the divisions because when those small companies come to see us, they need to talk with the people who understand the businesses, the markets, and the clinical issues associated with whatever idea they're promoting. Back in the Tyco days when we did all of those deals, we didn't have a dedicated business development function within each business. We had four people in our headquarters managing the deals, and all of those deals were top-down driven. Those deals were all about execution and integration. Now, as I say, we have business development, portfolio management, and strategy people at every medical device business – energy, surgical, respiratory, and vascular. We may have over-clubbed; sometimes the pendulum swings a little too far when you try to move a company culturally. But there are now people at the individual businesses who are in a position to weigh in on proposed deals and make a decision.

I do worry about how we're perceived in the start-up community. We were sitting with someone from a start-up recently who had developed an idea that was being evaluated by our surgical device business, and I was very curious to hear how that went because I worry about that. I worry that we're so big, a not-invented-here mentality could creep in, and we'd miss out on a great idea. If we establish a reputation of being hard to deal with by the people who drive innovation, then we're going to deny ourselves huge opportunities.

Q: One group that you must be talking to now that you hadn't in the past is physicians, who in the past would have gone to Boston Scientific [Boston Scientific Corp.] or J&J [Johnson & Johnson] with an idea for a device or device improvement. More of those doctors must be coming to Covidien now.

That's true. If you went to SAGES [Society of American Gastrointestinal and Endoscopic Surgeons; the clinical meeting for minimally invasive surgery] three or four years ago, the only way any physicians would have known us was as US Surgical. Today, it's all about Covidien. It's Covidien that is out there talking to them and listening to them about NOTES [ Natural Orifice Translumenal Endoscopic Surgery] and SILS [ Single Incision Laparoscopic Surgery]. In fact, they're more likely to call the trend toward single-port surgery by SILS, which is our name for it. I think we're in very good shape when it comes to creating relationships with physicians.

Q: If you can, talk a bit about SILS. What are some of the technological innovations you're bringing to surgery? And how much of an issue is it in growing that business that surgeons, unlike interventional cardiologists, for example, tend to be slow to adopt new technology?

I'm not sure surgeons are necessarily slow adopters of new technology. But they have to be comfortable using new technology and so one of the key issues is how quickly we can train surgeons on the new system. At SAGES this year, we had our new hand instruments on display, and surgeons could actually try them out. We had a line at our booth for three days straight. In our formal training sites, all of the training sessions for the next several months are booked solid. We developed a mobile training van in response to this issue because we cannot get surgeons trained fast enough.

One challenge we do find is follow-up. Surgeons will use some new technology a couple of times and then simply stop using it. Again, we see that as our responsibility. To be fair to the surgeons, the launch of our SILS system was the first time surgeons were given instruments designed specifically for single-incision laparoscopic surgery, with greater capability and reticulation and articulation at the working end. That's a great technology, but it's our responsibility to make sure that they continue to be comfortable with the system and that they're getting good outcomes – reduced infections, less pain, and better cosmesis. That's why I say it's all about the training. We think we're at a point where we'll start to see greater uptake of SILS. The demand is clearly there. Patients want less pain and fewer scars, which is why we're confident this will take off and we'll be in a very good position to take advantage. But we have to help drive it.

Q: You mentioned before how you've changed your organizational structure to put business development people into the individual businesses. Expanding on that, how much time and energy do you spend generally on Covidien's organizational structure? You talked before about splitting Pharma, Supplies, and Medical Devices into separate units and managing each according to its specific needs. Is organizational structure a changing dynamic for you? Or do you believe you've found the right model? Do you spend a lot of time thinking about whether you've got the right structure at Covidien?

The way I would put it is that we spend as much time assessing whether we have the right pieces in the portfolio as we do anything else. When we were part of Tyco, our poorest performing businesses was a baby diaper business that we had acquired when we bought Confab. The day we spun out, we put the business up for sale. When we bought Mallinckrodt, we got a specialty chemical business. Day one, for sale. Those are no-brainers because they weren't really health care product lines. The harder decisions come when you have to divest businesses that once made sense. We used to be in the sleep business, and sleep apnea is a huge market, with growth of around 15%, and very profitable. We spent a lot of money investing in CPAP devices, diagnostic equipment, and interfaces. But we were constantly running up against the two Rs: ResMed [ResMed Inc.] and Respironics [Philips Respironics; a division of Royal Philips Electronics NV], and we decided that if we can't be number-one or -two in that business, we didn't want to be in it. Plus we looked at our return on invested capital, and because of all of the effort we had put into it to, the returns were in the low single digits. So we divested our sleep business. We had a European needle and syringe business, but it was only doing $50 million a year and had operating margins of 5%, so we pulled out of that. We had a $180 million nuclear pharmacy network through which we sold Mallinckrodt's nuclear medicine products. But it made little money, so we divested it.

What makes this difficult is that, as a publicly traded company, we're seen as a growth stock and so we're judged on our sales growth. When you lose a $180 million business, you don't put those sales into a restructuring column, you just eat them in the P&L. The various moves I mentioned probably represented $1.5 billion in total revenue that went away, and investors want to know what you're doing to make up for that. Unless they understand your strategy and are confident in your ability to execute, you can really get penalized for divesting businesses. We've been able to do it, but you have to look at the long-term. Once you get past the anniversary date of the divestiture, suddenly your business is much more profitable, with better operating and gross margins and better returns on invested capital. That's when everyone says, "Wow, that was a great move getting rid of those underperforming businesses." But at the time you're doing it, you're going to have some heartburn.

Q: You mentioned that because you couldn't be number-one or -two in sleep, you divested the business. That's a critical issue in hospital supplies. Karl Bays of American Hospital Supply, where you got started, used to talk all the time about how important it was for AHSC to be first or second, in part because they had this huge distribution business that supported their manufacturing lines. But is the same goal as relevant in medical devices? When he was running Guidant, Ron Dollens used to say that he never worried about whether Guidant was the market leader because technology changes so quickly – what was a leading technology today could be obsolete tomorrow. As you begin to invest more in medical devices, do you still think it's important to be number-one or -two? When you buy companies like Confluent or Bacchus, can you have the same expectations of them that you have of a supplies business?

I still think that for the majority of our businesses, it is important to be number-one or -two for a lot of reasons, perhaps the most important being that it really helps you understand your customers. As we've begun to shift our focus to innovative technologies, one of the things we did was to make sure that no project, whether an acquisition and certainly no internally developed product, goes forward or gets any funding unless we have the input of customers. We called it our "voice of the customer" protocol. We make sure there's an unmet clinical need that we're trying to address with this technology. But we don't really see ourselves as high-tech the way an interventional cardiology company like Guidant is. We think of ourselves as more mid-tech – the same technology space that Bard, Baxter, Becton Dickinson play in. We're more about singles and doubles than home runs; in mid-tech, technology doesn't become obsolete by the introduction of something new as quickly. For Guidant, a new drug-eluting stent comes along and the market flips. Our markets don't move that fast. But they're markets that do move and we try to make technology bets that can move the needle.

Q: It seems to me that one of the keys to the Tyco strategy of the 90s was to assemble all of these major brands in hospital supplies so that you could leverage your relationship with national buying groups like Premier, Novation, and AmeriNet. As you invest more in medical devices, does that strategy apply in those product lines? Will you use the same relationships to position product lines from Bacchus and Aspect Medical? Or do you keep those discussions within the hospital supplies part of Covidien? Does that historic strength with buying groups deliver value to this new medical device strategy? Or is it really irrelevant to it?

That's a sensitive area for us. But I definitely think there's a role for buying groups to play with us going forward. Now, I think that role is less as you get into clinician preference items. But it's obviously relevant to our supplies businesses. In terms of what we need to do to grow our medical device business, it's clearly not as important as it is for our hospital supplies products. For companies like Vnus or Confluent, our marketing people will look at the opportunity to contract and pursue it if it makes sense and not pursue it if it doesn't.

Q: I guess the question is, does a national accounts strategy ever make sense for those kind of niche, physician preference items?

For some it does, others it doesn't. Frankly, I don't know that we'll ever have a contract for Vnus. But that's not to say we won't on other product lines.

Q: Do you ever get the sense that the buying groups get frustrated at that approach – that their view is, "Hey, we have contracts on all of your other products. Why can't we have contracts on those as well?"

There are a lot of benefits to being a broadly diversified medical products and pharmaceutical company – lots of benefits. One of the few negatives is that you sometimes face these kinds of situations. Do we run into customers who try to leverage their relationship with us – "If you don't give us a deal here, we're going to squeeze you on the surgical contract award later"? Sure, that comes with the territory. We've found the best way to approach that is to have the surgical folks have their discussions with those customers, vascular have theirs, and make it clear that no one can speak for another business unit. On the rare occasions it bubbles up, we try to push it right back down. But we can only do that because we're very business unit-driven. We consolidate as much of the back-office as we can – we don't think it should matter much where someone gets an invoice from or to whom someone pays a bill or submits an order. But in terms of developing products, and making and selling them, that's driven by our businesses, not by Corporate.

Q: Obviously, to a lot of folks in the start-up community, Covidien's re-emergence, if I can put it that way, as an acquirer is good news. But what's happening to your R&D spending? I know it's going up. But is it where it needs to be as far as you're concerned?

Almost. It's getting there. We were at 2% of sales, which I'm almost embarrassed to say. But that was the model.

Q: Though that's 2% on a large sales base.

Well, yes, but we didn't spend anywhere near what we should have on R&D. We're now around 4.2%. And we think for our space, that's pretty close to where we should be. Factored into our R&D spend as a percent of sales is a $2 billion supplies business that requires very little investment; that means our other businesses are probably closer to 6%. I think surgical is around 7%-8% and so is energy. That's where we should be. If you look at Bard and BD, that's where they are. We don't need to be spending at the level of Medtronic or St. Jude or Zimmer [Zimmer Biomet Holdings Inc.]

Q: We're getting close to the end of our time. Let's begin to wrap up. In the 1990s, Tyco very consciously had the feeling that it had an edge, that it was an aggressive company scooping up companies that had kind of lost their way or were underperforming and with some of the Tyco juice and some cost cutting, you could turn them around. Then Tyco itself went through a very quiet period from 2002 to 2007 when it was virtually sitting on the sidelines. Did it ever haunt you that you had become the kind of company that would have been a Tyco target just a few years earlier?

Oh, yes. It was a very difficult time; that was a large part of the reason I wanted to retire. And there was no way out, given the model Tyco had adopted. If we had gone to Tyco investors and said, "We need to take $500 million in earnings out in order to develop a growth engine," they would have told us to forget it. It never would have happened. That's why the spin-out was so important and why I was willing to stay. The old investors would never have bought into the growth strategy. But the new investors would.

Q: Covidien has clearly in the last four years or so put itself squarely on the map among leading medical device companies. I know a lot of companies now see you as a major player, a major competitive target in their specific product areas. It seems to me that as Tyco looked at the marketplace a decade ago, you competed with a lot of companies, but the one that came to the fore most often was Johnson & Johnson, with whom you competed in surgical instruments, wound care, and wound closure, just to mention three key product lines. You still compete with them in a lot of areas, but as you were going through your transition, over the last decade J&J has gone through a transition of its own. Through its own M&A program, it's become a major player in areas like orthopedics, interventional cardiology, and diabetes care, where you don't play. And some of those historic businesses have become less central – operating companies like Patient Care and J&J Medical don't even exist anymore. How much does J&J resonate for you as a model and/or as a competitor for Covidien as it's positioned in 2010?

From a model perspective, as part of my due diligence when we spun off, I spent some time with Jim Lenehan [former head of J&J's medical device businesses], who's with Cerberus Capital now, and asked him about some of the things he did, and the one thing he stressed was getting rid of underperforming assets as fast as you possibly can. Take the hit on the sales growth, and get it behind you. People will accept it. That was a very important piece of advice and a real influence on our strategy.

From a competitive perspective, they're still our biggest competitor, and they're very good at what they do. But I think we can more than hold our own against companies like J&J. When the Tyco split-up was announced, I remember one of the sell side analysts issued a report that said that the spin-off could be really bad news for companies like Bard and J&J because for the first time, they're going to have a competitor in their space who's really acting like a medical device company. I don't want to sit here and pretend that we're rocket scientists, that we thought of things no one else thought of. For us, the key was to transform the company culturally – to have people who would run Covidien like a true medical device company.

Q: Did you have to turn over a lot of senior executives?

Oh, yes. We lost a lot of people, people I had worked with for many, many years. But they understood – they understood what we were doing and that it was different from what they had been doing.

Q: As we were saying before, if you go back to the mid-1990s, to the time when Tyco acquired Kendall, there have been three or four distinct periods: a very aggressive acquisition spree of mostly hospital supply companies in the late 1990s; the time of the scandal and the subsequent period of sitting back and kind of re-grouping; and then, most recently, a kind of resurgent Covidien, re-positioning yourself as a company with a strong medical device culture, with more dealmaking and a greater spend on R&D. As you look at the near- to mid-term future for Covidien, are you still in that last phase? Is there a next phase to come? How sustainable is Covidien's current strategy? Or will it have to evolve into something else?

I think we're still benefiting from the separation phenomenon; there's still a lot of excitement about the new medtech strategy. Part of that is because we're executing on our plan; if we had spun out and failed to deliver on our promises, then we would be in a very different place. You'd be interviewing someone else, I'm sure. But the fact that we were able to deliver increased sales, increased profitability, increased returns on invested capital, and increased shareholder value means there's still a buzz about Covidien. And that has real benefits for us. Coming to work for Covidien today is not like going to work for Tyco a decade ago – it's night and day. We're getting some really talented people, and we need them because that's what drives success. In that sense, the model is sustainable. We're also benefiting from a higher profile among people outside of Covidien. A decade ago, I don't think the venture community or the start-ups they invest in thought for a nanosecond about Tyco Healthcare. I don't think we could have done the kinds of deals we're doing today. But the people with great technology understand that we're serious. We don't take a long time to make a decision, and I don't think we necessarily overpay, but we pay a fair price.

Q: And at least you get the deals done.

We get the deal done and we get it done quickly. And we've got a very supportive board, and I think it's because the numbers have been good.

Q: So there's no residual caution from the Tyco days. It seems to me that in the device world, the biggest issue with Tyco of a decade ago wasn't Dennis Kozlowski's financial shenanigans, but his reputation for buying companies and then stripping them bare, eliminating all that was best about them. It's probably more likely that a lot of the small companies you talk to don't even remember the Tyco of the late 1990s.

That's right. You know, I remember coming out here the day we announced the Vnus acquisition, and meeting with the management team and the employees. And I said to them, "Do me a favor. Call some of the people at the small companies we've acquired, like Tissue Science Laboratories [Tissue Science Laboratories PLC] or Floreane [Floreane Medical Implants SA]. Ask them how they were treated." They not only kept their jobs, they had more resources to work with and a worldwide platform from which they'd be able to market and sell the products they were developing. Rather than disemboweling those companies, we were empowering them. It's just a very different reality from what had happened in the past. [See Deal]