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Inc. See Note B - Business Combinations to our unaudited condensed consolidated financial statements contained in this Quarterly Report for the estimated maximum potential amount of future contingent consideration we could be required to pay associated with our business combinations.

We made capital expenditures of $273 million in the first nine months of 2007, as compared to $231 million during the first nine months of 2006. The increase was primarily a result of capital expenditures associated with our CRM division. In addition, during the third quarter of 2007, we received cash proceeds of $28 million for the sale of one of our manufacturing facilities, as compared to proceeds of $18 million for the first nine months of 2006. We expect to incur capital expenditures of approximately $125 million for the remainder of 2007, including capital expenditures to continue to upgrade our quality systems, to continue to enhance our manufacturing capabilities in order to support our second drug-eluting stent platform, and to support future growth in our core business units.

 

We received cash proceeds of $149 million during the first nine months of 2007 and $20 million during the first nine months of 2006 from sales of equity investments in and collections of notes receivable from certain of our portfolio companies. In addition, our 2006 cash flows from investing activities included $159 million of net proceeds from maturities of marketable securities.

Financing Activities

 

Our cash flows from financing activities reflect issuances and repayments of debt and proceeds from stock issuances related to our equity incentive programs.

Debt

We had outstanding borrowings of $8.157 billion at September 30, 2007 at a weighted average interest rate of 6.34 percent, as compared to outstanding borrowings of $8.902 billion at December 31, 2006 at a weighted average interest rate of 6.03 percent. Our borrowings at September 30, 2007 consisted of unsecured subsidiary indebtedness including $4.0 billion under our senior term loan, $900 million in our subordinated loan from Abbott, unsecured senior corporate notes of $3.050 billion and $250 million in borrowings against our credit and security facility secured by our U.S. trade receivables. Our borrowings as of December 31, 2006 consisted of unsecured subsidiary indebtedness including $5.0 billion under our senior term loan, $900 million in our subordinated loan from Abbott and unsecured corporate notes of $3.050 billion. There were no amounts outstanding under our $2.0 billion revolving credit facility as of September 30, 2007 and December 31, 2006. 

Our revolving credit facility and term loan agreement requires that we maintain certain financial covenants. In the third quarter of 2007, we amended our $2.0 billion revolving line of credit and $5.0 billion term loan agreements. Among other items, the amendment extends a step-down in the maximum permitted ratio of debt to consolidated EBITDA, as defined by the agreement, as follows:

 

	From:		To:
	4.5 times to 3.5 times on March 31, 2008		4.5 times to 4.0 times on March 31, 2009, and
			4.0 times to 3.5 times on September 30, 2009

                                                                                                                                                                                                                                                    

The amendment also provides for an exclusion from the calculation of consolidated EBITDA, as defined by the agreement, of up to $300 million of restructuring charges incurred through June 30, 2009 and up to $500 million of litigation and settlement expenses incurred (net of any litigation or settlement income received) in any period of four fiscal quarters through June 30, 2009, not to exceed $1 billion in the aggregate. There

 

 

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was no change in our minimum required ratio of consolidated EBITDA, as defined by the agreement, to interest expense of greater than or equal to 3.0 to 1.0. In connection with the amended agreement, we prepaid $1.0 billion against the outstanding principal under the term loan, using $750 million of cash on hand and $250 million in borrowings against our credit and security facility secured by our U.S. trade receivables. The amendment changes the application of any term loan prepayments from pro-rata across maturities to the chronological order of maturities. Accordingly, the prepayment satisfied the first scheduled repayment under our term loan of $650 million in April 2008 and reduces our April 2009 obligation by $350 million. As a result, the next maturity under our term loan will be in April 2009 for $300 million.

As of September 30, 2007, we were in compliance with the required financial covenants. Exiting the quarter, our ratio of debt to consolidated EBITDA was approximately 3.6 to 1.0 and our ratio of consolidated EBITDA to interest expense was approximately 3.9 to 1.0. Any inability to maintain compliance with these covenants would require us to either amend the terms of our credit facilities or obtain waivers from our lenders, and there can be no assurance that our lenders would renegotiate the terms or grant such waivers. Our inability to obtain any necessary waivers, or to obtain them on reasonable terms, could have a material adverse impact on our operations.

During the third quarter of 2007, our credit ratings from Standard & Poor’s Rating Services (S&P) and Fitch Ratings were downgraded to BB+, and our credit rating from Moody’s Investor Service was downgraded to Ba1. All of these are non-investment grade ratings and the ratings outlook by all three agencies is currently negative. Credit rating changes may impact our borrowing cost, but do not require the repayment of any borrowings. These credit rating changes have not materially increased the cost of our existing borrowings.

 

Equity

During the first nine months of 2007, we received $130 million in proceeds from stock issuances related to our stock option and employee stock purchase plans, as compared to $137 million for the same period in the prior year.

On May 22, 2007, we extended an offer to our non-director and non-executive employees to exchange certain outstanding stock options for deferred stock units (DSUs). Stock options previously granted under our stock plans with an exercise price of $25 or more per share were exchangeable for a smaller number of DSUs, based on exchange ratios derived from the exercise prices of the surrendered options.  On June 20, 2007, following the expiration of the offer, our employees exchanged approximately 6.6 million options for approximately 1.1 million DSUs, which were subject to additional vesting restrictions. We did not record incremental stock compensation expense as a result of these exchanges because the fair values of the options exchanged equaled the fair values of the DSUs issued.

Contractual Obligations and Commitments

Certain of our business combinations involve the payment of contingent consideration. Prior to the amendment of our merger agreement with Advanced Bionics, we were obligated to pay future consideration contingent primarily on the achievement of future performance milestones, with certain milestone payments tied to profitability. We estimated that these payments could amount to as much as $2.0 billion through 2013. The amended agreement provides a new schedule of consolidated, fixed earnout payments that we are required to make, consisting of $650 million payable upon closing, expected in January 2008, and $500 million payable in March 2009.  These payments will be the final earnout payments made to Advanced Bionics. See Note B – Business Combinations to our unaudited condensed consolidated financial statements contained in this Quarterly Report for the estimated potential amount of future contingent consideration we could be required to pay associated with our other business combinations.

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Refer also to the Tax Rate discussion above for changes to our contractual obligations and commitments that resulted from the adoption of Interpretation No. 48. There have been no other material changes to our contractual obligations and commitments as reported in our 2006 Annual Report on Form 10-K.

In connection with our acquisition of Guidant and concurrent transaction with Abbott Laboratories, Abbott purchased from us approximately 65 million shares of our common stock for $1.4 billion, or $21.66 per share. We agreed to issue Abbott additional shares of our common stock having an aggregate value of up to $60 million eighteen months following the Abbott transaction closing to reimburse Abbott for a portion of its cost of borrowing $1.4 billion to purchase the shares of our common stock. We recorded the $60 million as a liability assumed in connection with the sale of Guidant’s vascular intervention and endovascular solutions businesses to Abbott. In October 2007, we modified our agreement with Abbott, and paid this obligation in cash, rather than in shares of our common stock.

Legal Matters

 

The medical device market in which we primarily participate is largely technology driven. Physician customers, particularly in interventional cardiology, have historically moved quickly to new products and new technologies. As a result, intellectual property rights, particularly patents and trade secrets, play a significant role in product development and differentiation. However, intellectual property litigation to defend or create market advantage is inherently complex and unpredictable. Furthermore, appellate courts frequently overturn lower court patent decisions.

 

In addition, competing parties frequently file multiple suits to leverage patent portfolios across product lines, technologies and geographies and to balance risk and exposure between the parties. In some cases, several competitors are parties in the same proceeding, or in a series of related proceedings, or litigate multiple features of a single class of devices. These forces frequently drive settlement not only of individual cases, but also of a series of pending and potentially related and unrelated cases. In addition, although monetary and injunctive relief is typically sought, remedies and restitution are generally not determined until the conclusion of the proceedings and are frequently modified on appeal. Accordingly, the outcomes of individual cases are difficult to time, predict or quantify and are often dependent upon the outcomes of other cases in other geographies.

 

Several third parties have asserted that our current and former stent systems infringe patents owned or licensed by them. We have similarly asserted that stent systems or other products sold by these companies infringe patents owned or licensed by us. Adverse outcomes in one or more of these proceedings could limit our ability to sell certain stent products in certain jurisdictions, or reduce our operating margin on the sale of these products and could have a material adverse effect on our financial position, results of operations or liquidity.

We are substantially self-insured with respect to general, product liability and securities litigation claims. In the normal course of business, product liability and securities litigation claims are asserted against us. Product liability and securities litigation claims against us may be asserted in the future related to events not known to management at the present time. The absence of significant third-party insurance coverage increases our potential exposure to unanticipated claims or adverse decisions. Product liability claims, product recalls, securities litigation and other litigation in the future, regardless of their outcome, could have a material adverse effect on our financial position, results of operations or liquidity. 

We accrue anticipated costs of settlement and damages and, under certain conditions, costs of defense, based on historical experience or to the extent specific losses are probable and estimable. We record losses for claims in excess of the limits of purchased insurance in earnings at the time and to the extent they are

 

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probable and estimable. If the estimate of a probable loss is a range and no amount within the range is more likely, we accrue the minimum amount of the range.

In connection with our acquisition of Guidant, the number of legal claims against us, including product liability, private securities and shareholder derivative claims, significantly increased. Our accrual for legal matters that are probable and estimable was $680 million at September 30, 2007 and $485 million at December 31, 2006, and includes costs of settlement, damages and defense. The amounts accrued relate primarily to Guidant litigation and claims recorded as part of the purchase price. We continue to assess certain litigation and claims to determine the amounts that management believes will be paid as a result of such claims and litigation and, therefore, additional losses may be accrued in the future, which could adversely impact our operating results, cash flows and our ability to comply with our debt covenants.

In July 2007, we reached an agreement to settle certain claims related to CRM product liability claims. Under the terms of the settlement, we agreed to pay a total of $195 million to resolve approximately 4,900 claims of individuals that have been consolidated in the U.S. District Court for the District of Minnesota in a Multi-District Litigation. In addition, the agreement includes an undetermined number, but not all, of additional similar claims throughout the country. To date, Guidant has also been informed of over 3,900 other claims of individuals that may or may not mature into filed suits. Refer to Note J - Commitments and Contingencies to our unaudited condensed consolidated financial statements contained in this Quarterly Report which identifies all material developments with regard to any matters of litigation disclosed in our 2006 Annual Report on Form 10-K or instituted since December 31, 2006.

Recent Accounting Pronouncements

Statement No. 159

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115, which allows an entity to elect to record financial assets and liabilities at fair value upon their initial recognition on a contract-by-contract basis. Subsequent changes in fair value would be recognized in earnings as the changes occur. Statement No. 159 also establishes additional disclosure requirements for these items stated at fair value. Statement No. 159 is effective for our 2008 fiscal year, with early adoption permitted, provided that we also adopt Statement No. 157, Fair Value Measurements. We are currently evaluating the impact that the adoption of Statement No. 159 will have on our consolidated financial statements.

Statement No. 157

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. Statement No. 157 defines fair value, establishes a framework for measuring fair value in accordance with U.S. GAAP, and expands disclosures about fair value measurements. Statement No. 157 does not require any new fair value measurements; rather, it applies to other accounting pronouncements that require or permit fair value measurements. We are required to apply the provisions of Statement No. 157 prospectively as of January 1, 2008, and recognize any transition adjustment as a cumulative-effect adjustment to the opening balance of retained earnings. We are in the process of determining the effect of adoption of Statement No. 157, but we do not believe such adoption will materially impact our future results of operations or financial position.

Issue No. 06-3

In June 2006, the FASB ratified EITF Issue No. 06−3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation). The scope of this consensus includes any taxes assessed by a governmental authority that are directly imposed on a revenue producing transaction between a seller and a customer and may include, but are not

 

 

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limited to, sales, use, value-added, and some excise taxes. Per the consensus, the presentation of these taxes on either a gross (included in revenues and costs) or a net (excluded from revenues) basis is an accounting policy decision that should be disclosed. We present sales net of sales taxes in our unaudited condensed consolidated statements of operations. Issue No. 06−3 is effective for interim and annual reporting periods beginning after December 15, 2006. No change of presentation has resulted from our adoption of Issue No. 06−3. 

Cautionary Statement Regarding Forward Looking Statements

Certain statements that we may make from time to time, including statements contained in this report and information incorporated by reference into this report, constitute “forward-looking statements” within the meaning of Section 27E of the Securities Exchange Act of 1934. Forward-looking statements may be identified by words like “anticipate,” “expect,” “project,” “believe,” “plan,” “estimate,” “intend” and similar words and include, among other things, statements regarding our financial performance, our growth strategy, timing of regulatory approvals and our regulatory and quality compliance, expected research and development efforts, product development and new product launches, our market position and competitive changes in the marketplace for our products, the effect of new accounting pronouncements, the outcome of matters before taxing authorities, intellectual property and litigation matters, our  capital needs and expenditures, our ability to meet the financial covenants required by our credit facilities or to renegotiate the terms of our credit facilities or obtain waivers for compliance with those covenants, and potential acquisitions and divestitures. These forward-looking statements are based on our beliefs, assumptions and estimates using information available to us at the time and are not intended to be guarantees of future events or performance. If our underlying assumptions turn out to be incorrect, or if certain risks or uncertainties materialize, actual results could vary materially from the expectations and projections expressed or implied by our forward-looking statements. As a result, investors are cautioned not to place undue reliance on any of our forward-looking statements.

 

We do not intend to update the forward-looking statements below even if new information becomes available or other events occur in the future. We have identified these forward-looking statements below in order to take advantage of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Certain factors that could cause actual results to differ materially from those expressed in forward-looking statements are contained below.

 

Coronary Stent Business

·	Volatility in the coronary stent market, competitive offerings and the timing of receipt of regulatory approvals to market existing and anticipated drug-eluting stent technology and other stent platforms;

·	Our ability to launch our next-generation drug-eluting stent system, the TAXUS® Liberté coronary stent system, in the U.S., subject to regulatory approval, and to maintain or expand our worldwide market positions through reinvestment in our drug-eluting stent program;

·

Our share of the worldwide drug-eluting stent market, the impact of concerns relating to late stent thrombosis on the size of the coronary stent market, the distribution of share within the coronary stent market in the U.S. and around the world, the average number of stents used per procedure and average selling prices;

·

The overall performance of, and continued physician confidence in, our and other drug-eluting stents, our ability to adequately address concerns regarding the risk of late stent thrombosis, and the results of drug-eluting stent clinical trials undertaken by us, our competitors or other third parties;

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·	The penetration rate of drug-eluting stent technology in the U.S. and our International markets;

·	Our ability to leverage our position as one of two early entrants in the U.S. drug-eluting stent market, to anticipate competitor products as they enter the market and to respond to the challenges presented as additional competitors enter the U.S. drug-eluting stent market;

·	Changes in FDA clinical trial and post-market surveillance requirements and the associated impact on new product launch schedules and the cost of compliance;

·	Our ability to manage inventory levels, accounts receivable, gross margins and operating expenses and to react effectively to worldwide economic and political conditions;

·	Our ability to retain key members of our cardiology sales force; and

·	Our ability to manage the mix of our PROMUS stent system revenue relative to our total drug-eluting stent revenue and maintain our overall profitability as a percentage of revenue.

CRM Business

·	Our estimate for the worldwide CRM market, the recovery of the CRM market to historical growth rates and our ability to increase CRM net sales;

·	The overall performance of, and referring physician, implanting physician and patient confidence in, our and our competitors’ CRM products and technologies, including our LATITUDE® Patient Management System and next-generation pulse generator platform;

·	Our continued ability to minimize or eliminate future field actions relating to our CRM technology;

·	The results of CRM clinical trials undertaken by us, our competitors or other third parties;

·	Our continued ability to launch various products utilizing our next-generation CRM pulse generator platform in the U.S. over the next 27 months and to expand our CRM market position through reinvestment in our CRM products and technologies;

·	Our ability to retain key members of our CRM sales force;

·	Competitive offerings in the CRM market and the timing of receipt of regulatory approvals to market existing and anticipated CRM products and technologies;

·	Our ability to move quickly and effectively implement a direct sales model for our CRM products in Japan; and

·	Our ability to avoid disruption in the supply of certain components or materials or to quickly secure additional or replacement components or materials on a timely basis.

 

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Litigation and Regulatory Compliance

·	Any conditions imposed in resolving, or any inability to resolve, our corporate warning letter or other FDA matters, as well as risks generally associated with our regulatory compliance and quality systems;

·	The effect of our litigation, risk management practices, including self-insurance, and compliance activities on our loss contingency, legal provision and cash flow;

·	The impact of our stockholder derivative and class action, patent, product liability, contract and other litigation and legal proceedings;

·	The ongoing, inherent risk of potential physician communications or field actions related to medical devices;

·	Costs associated with our incremental compliance and quality initiatives, including Project Horizon; and

·	The availability and rate of third-party reimbursement for our products and procedures.

Innovation

·	Our ability to complete planned clinical trials successfully, to obtain regulatory approvals and to develop and launch products on a timely basis within cost estimates, including the successful completion of in-process projects from purchased research and development;

·	Our ability to manage research and development and other operating expenses consistent with our expected revenue growth;

·	Our ability to develop products and technologies successfully in addition to our drug-eluting stent and CRM technologies;

·	Our ability to fund and achieve benefits from our focus on internal research and development and external alliances as well as our ability to capitalize on opportunities across our businesses;

·	Our ability to develop next-generation products and technologies within our drug-eluting stent and CRM business;

·	Our failure to succeed at, or our decision to discontinue, any of our growth initiatives;

·	Our ability to integrate the acquisitions and other strategic alliances we have consummated, including Guidant;

·	Our decision to exercise, or not to exercise, options to purchase certain companies party to our strategic alliances and our ability to fund with cash or common stock these and other acquisitions, or to fund contingent payments associated with these alliances;

·	The timing, size and nature of strategic initiatives, market opportunities and research and development platforms available to us and the ultimate cost and success of these initiatives; and

·	Our ability to successfully identify, develop and market new products or the ability of others to develop products or technologies that render our products or technologies noncompetitive or obsolete.

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International Markets

·	Dependency on international net sales to achieve growth;

·	Risks associated with international operations, including compliance with local legal and regulatory requirements as well as reimbursement practices and policies; and

·	The potential effect of foreign currency fluctuations and interest rate fluctuations on our net sales, expenses and resulting margins.

Liquidity

·	Our ability to generate sufficient cash flow to fund operations, capital expenditures, and strategic investments, as well as debt reduction over the next twelve months and beyond;

·	Our ability to maintain positive operating cash flow for the remainder of 2007;

·	Our ability to recover substantially all of our deferred tax assets;

·	Our ability to access the public and private capital markets and to issue debt or equity securities on terms reasonably acceptable to us;

·	Our ability to regain investment-grade credit ratings and to remain in compliance with our financial covenants;

·	Our ability to generate sufficient cash flow to effectively manage our debt levels and minimize the impact of interest rate fluctuations on our earnings and cash flows; and

·

Our ability to implement, fund, and achieve sustainable cost improvement measures, including expense and head count reduction initiatives and potential divestitures of non-strategic assets, that will better align operating expenses with expected revenue levels and reallocate resources to better support growth initiatives.

Other

·	Risks associated with significant changes made or to be made to our organizational structure, or to the membership of our executive committee;

·	Risks associated with our acquisition of Guidant, including, among other things, the indebtedness we have incurred and the integration costs and challenges we will continue to face;

·	Our ability to retain our key employees and avoid business disruption and employee distraction as we execute our expense and head count reduction initiatives; and

·

Our ability to maintain management focus on core business activities while also concentrating on resolving the corporate warning letter and implementing strategic initiatives, including expense and head count reduction initiatives and potential divestitures of non-strategic assets, in order to streamline our operations and reduce our debt obligations.

 

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Several important factors, in addition to the specific factors discussed in connection with each forward-looking statement individually could affect our future results and growth rates and could cause those results and rates to differ materially from those expressed in the forward-looking statements and the risk factors contained in this report. These additional factors include, among other things, future economic, competitive, reimbursement and regulatory conditions, new product introductions, demographic trends, intellectual property, financial market conditions and future business decisions made by us and our competitors, all of which are difficult or impossible to predict accurately and many of which are beyond our control. We discuss those and other important risks and uncertainties that may affect our future operations in Part I, Item IA- Risk Factors in our most recent Annual Report on Form 10-K and may update that discussion in Part II, Item 1A – Risk Factors in this or another Quarterly Report on Form 10-Q we file hereafter. Therefore, we wish to caution each reader of this report to consider carefully these factors as well as the specific factors discussed with each forward-looking statement and risk factor in this report and as disclosed in our filings with the SEC. These factors, in some cases, have affected and in the future (together with other factors) could affect our ability to implement our business strategy and may cause actual results to differ materially from those contemplated by the statements expressed in this report.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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We develop, manufacture and sell medical devices globally and our earnings and cash flows are exposed to market risk from changes in currency exchange rates and interest rates. We address these risks through a risk management program that includes the use of derivative financial instruments. We operate the program pursuant to documented corporate risk management policies. We do not enter derivative transactions for speculative purposes. Gains and losses on derivative financial instruments substantially offset losses and gains on underlying hedged exposures. Furthermore, we manage our exposure to counterparty risk on derivative instruments by entering into contracts with a diversified group of major financial institutions and by monitoring outstanding positions.

 

Our currency risk consists primarily of foreign currency denominated firm commitments, forecasted foreign currency denominated intercompany and third party transactions and net investments in certain subsidiaries. We use both nonderivative (primarily European manufacturing operations) and derivative instruments to manage our earnings and cash flow exposure to changes in currency exchange rates. We had currency derivative instruments outstanding in the contract amount of $4.409 billion at September 30, 2007 and $3.413 billion at December 31, 2006. We recorded $20 million of other assets and $110 million of other liabilities to recognize the fair value of these derivative instruments at September 30, 2007 as compared to $71 million of other assets and $27 million of other liabilities recorded at December 31, 2006. A ten percent appreciation in the U.S. dollar’s value relative to the hedged currencies would increase the derivative instruments’ fair value by $285 million at September 30, 2007 and $112 million at December 31, 2006. A ten percent depreciation in the U.S. dollar’s value relative to the hedged currencies would decrease the derivative instruments’ fair value by $346 million at September 30, 2007 and $134 million at December 31, 2006. Any increase or decrease in the fair value of our currency exchange rate sensitive derivative instruments would be substantially offset by a corresponding decrease or increase in the fair value of the hedged underlying asset, liability or forecasted transaction.

 

ITEM 1.

LEGAL PROCEEDINGS

Note J - Commitments and Contingencies to our unaudited condensed consolidated financial statements contained elsewhere in this Quarterly Report is incorporated herein by reference.

 

 

ITEM 1A.

RISK FACTORS

In addition to the risk factors set forth below and the other information set forth in this report, you should carefully consider the factors discussed in “Part I, Item 1A. Risk Factors” in our 2006 Annual Report filed on Form 10-K, which could materially affect our business, financial condition or future results. 

We may not realize the expected benefits from our expense reduction measures; our long-term expense reduction programs may result in an increase in short-term expense; and our head count reductions may lead to additional unintended consequences.

As part of our efforts to reduce expenses, improve our operating cost structure and better position ourselves competitively, we are implementing several expense reduction measures. These cost reduction initiatives include cost improvement measures designed to better align operating expenses with expected revenue levels, resource reallocations, head count reductions, the sale of certain non-strategic assets and efforts to streamline our business, among other actions.  These measures could yield unintended consequences, such as distraction of our management and employees, business disruption, attrition beyond our planned reduction in workforce and reduced employee productivity.  We may be unable to attract or retain key personnel.  Attrition beyond our planned reduction in workforce or a material decrease in employee morale or productivity could negatively affect our business, financial condition and results of operations.  In addition, our head count reductions my subject us to the risk of litigation, which could result in substantial cost.

Moreover, expense reduction programs could result in current period charges and expenses that could impact our operating results.  We cannot guarantee that these measures, or other expense reduction measures we take in the future, will result in the expected cost savings.

 

We have decided to divest certain non-strategic assets.  These divestitures could pose significant risks and may materially adversely affect our business, financial condition and operating results.