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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_________________

FORM 10-Q

Commission File Number 0-8672

___________________________

ST. JUDE MEDICAL, INC.

(Exact name of registrant as specified in its charter)

Minnesota (State or other jurisdiction of incorporation or organization)

41-1276891 (I.R.S. Employer Identification No.)

One Lillehei Plaza, St. Paul, Minnesota 55117

(Address of principal executive offices, including zip code)

(651) 483-2000

(Registrant’s telephone number, including area code)

_________________

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer x    Accelerated filer o    Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o No x   

The number of shares of common stock, par value $.10 per share, outstanding on October 31, 2006 was 353,469,239.

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TABLE OF CONTENTS

ITEM

DESCRIPTION

PAGE

PART I  – FINANCIAL INFORMATION
1.			Financial Statements				1
			Condensed Consolidated Statements of Earnings				1
			Condensed Consolidated Balance Sheets				2
			Condensed Consolidated Statements of Cash Flows				3
			Notes to Condensed Consolidated Financial Statements				4
			Note 1 – Basis of Presentation				4
			Note 2 – New Accounting Pronouncement				4
			Note 3 – Stock-Based Compensation				4
			Note 4 – Acquisitions and Minority Investment				8
			Note 5 – Goodwill and Other Intangible Assets				9
			Note 6 – Inventories				9
			Note 7 – Commitments and Contingencies				9
			Note 8 – Purchased In-Process Research and Development (IPR&D) Charges and Special Charges (Credits)				15
			Note 9 – Debt				16
			Note 10 – Shareholders’ Equity				17
			Note 11 – Net Earnings Per Share				17
			Note 12 – Comprehensive Income				18
			Note 13 – Other (Expense) Income				18
			Note 14 – Segment and Geographic Information				18
2.			Management’s Discussion and Analysis of Financial Condition and Results of Operations				21
			Overview				21
			New Accounting Pronouncement				22
			Critical Accounting Policies and Estimates				22
			Minority Investment				23
			Segment Performance				23
			Results of Operations				26
			Liquidity				29
			Share Repurchase Program				30
			Debt and Credit Facilities				31
			Commitments and Contingencies				31
			Cautionary Statements				31
3.			Quantitative and Qualitative Disclosures About Market Risk				32
4.			Controls and Procedures				32
PART II – OTHER INFORMATION
1.			Legal Proceedings				33
1A.			Risk Factors				33
6.			Exhibits				33
			Signature				34
			Index to Exhibits				35

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ST. JUDE MEDICAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(In thousands, except per share amounts)

(Unaudited)

 

See notes to condensed consolidated financial statements.

 

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ST. JUDE MEDICAL, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

See notes to condensed consolidated financial statements.

 

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ST. JUDE MEDICAL, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

See notes to condensed consolidated financial statements.

 

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ST. JUDE MEDICAL, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1 – BASIS OF PRESENTATION

 

The accompanying unaudited condensed consolidated financial statements of St. Jude Medical, Inc. (St. Jude Medical or the Company) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, these statements include all adjustments (consisting of normal recurring adjustments) considered necessary to present a fair statement of our consolidated results of operations, financial position and cash flows. Operating results for any interim period are not necessarily indicative of the results that may be expected for the full year. Preparation of the Company’s financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts in the financial statements and footnotes. Actual results could differ from those estimates. This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s consolidated financial statements and footnotes included in its Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (2005 Annual Report on Form 10-K).

 

NOTE 2 – NEW ACCOUNTING PRONOUNCEMENT

 

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN No. 48) which clarifies the accounting for uncertainty in income taxes recognized in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure. FIN No. 48 is effective for fiscal years beginning after December 15, 2006 and is required to be adopted by the Company effective January 1, 2007. The Company is currently evaluating the impact of this standard on its financial statements.

 

NOTE 3 – STOCK-BASED COMPENSATION

 

Effective January 1, 2006, the Company adopted the provisions of, and accounts for stock-based compensation in accordance with, SFAS No. 123 (revised 2004), Share-Based Payment (SFAS No. 123(R)) which replaced SFAS No. 123, Accounting for Stock-Based Compensation (SFAS No. 123) and supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees (APB Opinion No. 25). Under the fair value recognition provisions of SFAS No. 123(R), the Company measures stock-based compensation cost at the grant date based on the fair value of the award and recognizes the compensation expense over the requisite service period, which is the vesting period. The Company elected the modified-prospective method of adopting SFAS No. 123(R), under which prior periods are not retroactively revised. For the Company, the valuation provisions of SFAS No. 123(R) apply to awards granted after the January 1, 2006 effective date. Stock-based compensation expense for awards granted prior to the effective date but that remain unvested on the effective date is being recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123 pro forma disclosures. The adoption of SFAS No. 123(R) had a material impact on the Company’s consolidated results of operations and statement of cash flows.

 

Stock Options and Stock Appreciation Rights

Stock option awards are generally granted to officers and key employees at exercise prices equal to the fair market value of the Company’s common stock on the grant date. The majority of the Company’s stock option awards are non-qualified stock options with an eight-year life and a four-year ratable vesting term. The Company currently grants stock options under the 1997 Stock Option Plan, the 2000 Stock Plan (as amended), the 2002 Stock Plan (as amended) and the 2006 Stock Plan. At September 30, 2006, approximately 7.4 million shares were available for stock option grants under these plans.

 

On May 10, 2006, the Company’s shareholders approved the 2006 Stock Plan, authorizing the issuance of an aggregate of 5.0 million shares of the Company’s common stock through grants of stock options and stock appreciation rights (SARs). Similar to stock options, SARs reward holders if the fair market value of the Company’s common stock rises above the price on the SAR grant date. Upon exercise of the SAR, the holder receives cash or stock equivalent to the excess of the fair market value of the Company’s common stock on the exercise date over the grant price of the SAR. The Company did not have any SARs outstanding as of September 30, 2006.

 

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Restricted Stock

Restricted stock awards are granted to officers and key employees. Restricted stock awards are independent of stock option awards and are subject to forfeiture if employment terminates prior to the release of the restrictions. The Company grants restricted stock which generally vests ratably over a four-year period. Directors can elect to receive half or all of their annual retainer in the form of a restricted stock grant with six-month vesting terms. During the vesting period, ownership of the shares cannot be transferred. Restricted stock is considered issued and outstanding at the grant date and has the same dividend and voting rights as other common stock. The Company grants restricted stock under the 2000 Stock Plan. At September 30, 2006, 108,439 shares were available for restricted stock grants under this plan.

 

Employee Stock Purchase Savings Plan

The Company’s 2000 Employee Stock Purchase Savings Plan (ESPP) allows participating employees to purchase newly issued shares of the Company’s common stock at a discount through payroll deductions. The ESPP consists of a 12-month offering period. Employees can purchase shares at 85% of the market value at either the beginning of the offering period or the end of the offering period, whichever price is lower. The maximum number of shares that employees can purchase is established at the beginning of the offering period, which is on or around August 1 of each year. At September 30, 2006, approximately 0.8 million shares of additional common stock were available for purchase under the ESPP.

 

Valuation Assumptions

The Company uses the Black-Scholes standard option pricing model (Black-Scholes model) to determine the fair value of stock options and ESPP share options. The determination of the fair value of the awards on the date of grant using the Black-Scholes model is affected by the Company’s stock price as well as assumptions of other variables, including projected employee stock option exercise behaviors, risk-free interest rate, expected volatility of the Company’s stock price in future periods and expected dividends. The fair value of restricted stock awards is based on the Company’s closing stock price on the date of grant.

 

The following table provides the weighted average fair value of stock options granted to employees and the related assumptions used in the Black-Scholes model:

 

 

The following table provides the weighted average assumptions used in the Black-Scholes model to estimate the fair value of ESPP share options at the beginning of the respective 12-month offering periods:

 

 

Expected life: The Company analyzes historical employee exercise and termination data to estimate the expected life assumption. The Company believes that historical data currently represents the best estimate of the expected life of a new employee stock option. For determining the fair value of stock options under SFAS No. 123(R), the Company uses different expected lives for the general employee population and officers and directors. In preparing to adopt SFAS No. 123(R), the Company examined its historical pattern of stock option exercises to determine if there was a discernable pattern as to how different classes of employees exercised their stock options. The Company’s analysis showed that officers and directors held their stock options for a longer period of time before exercising compared to the rest of the employee population. Prior to adopting SFAS No. 123(R), the Company used the entire employee population for estimating the expected life assumptions. The expected life for ESPP share options is the offering period of 12 months.

 

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Risk-free interest rate: The rate is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected life of the options.

 

Volatility: The Company estimates the expected volatility of its common stock by using the implied volatility in market traded options in accordance with Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which expressed the views of the SEC staff regarding the application of SFAS No. 123(R). The Company’s decision to use implied volatility was based on the availability of actively traded options for the Company’s common stock and the Company’s assessment that implied volatility is more representative of future stock price trends than the historical volatility of the Company’s common stock. Prior to adopting SFAS No. 123(R), the Company used historical volatility to determine the expected volatility.

 

Dividend yield: The Company does not anticipate paying any cash dividends in the foreseeable future and therefore a dividend yield of zero is assumed.

 

Stock-Based Compensation Expense

Prior to adopting SFAS No. 123(R) on January 1, 2006, the Company used a graded attribution method, as described in FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, to recognize its pro forma stock-based compensation expense. Unrecognized stock-based compensation expense for awards granted prior to the adoption of SFAS No. 123(R) will continue to be recognized under the graded attribution method. Stock-based compensation expense for awards granted after the adoption of SFAS No. 123(R) will be recognized under a straight-line attribution method.

 

SFAS No. 123(R) requires compensation cost for share-based awards to be recognized over the requisite service period, which, for the Company, is the award’s vesting term. The Company’s awards are not eligible to vest early in the event of retirement, however, the majority of the Company’s awards vest early in the event of death, disability or change in control.

 

The amount of stock-based compensation expense recognized during a period is based on the portion of the awards that are ultimately expected to vest. The Company estimates pre-vesting option forfeitures at the time of grant by analyzing historical data and revises those estimates in subsequent periods if actual forfeitures differ from those estimates. Ultimately, the total expense recognized over the vesting period will only be for those awards that vest.

 

The following tables present the statement of earnings classification of pre-tax stock-based compensation expense recognized during the three and nine months ended September 30, 2006 (in thousands):

 

 

In connection with the acquisition of Advanced Neuromodulation Systems, Inc. (ANS) in November 2005, the Company granted replacement unvested stock options and replacement unvested restricted stock to ANS employees who had unvested stock options and unvested restricted stock outstanding at the date of acquisition. ANS employees are required to render future service in order to vest in the replacement stock options and restricted stock. The Company issued 790,737 replacement St. Jude Medical stock options having a weighted average exercise price of $24.00, which vest over one to four year periods. The fair values of the replacement stock options were determined on the replacement grant date using the Black-Scholes model. The weighted average fair value of the replacement stock options was $27.79. Additionally, the Company issued 209,364 shares of replacement St. Jude Medical restricted stock at a weighted average grant price of $48.17, which vest over a four year period. Included in the $17.7 million and $53.2 million of total pre-tax stock-based compensation expense recognized for the three and nine months ended September 30, 2006, respectively, is $2.2 million and $7.4 million of expense relating to these ANS replacement awards, respectively.

 

At September 30, 2006, there was $68.5 million of total unrecognized stock-based compensation expense, adjusted for estimated forfeitures which is expected to be recognized over a weighted average period of 1.1 years and will be adjusted for any future changes in estimated forfeitures. Included in total unrecognized stock-based compensation expense is approximately $3.0 million related to replacement stock options and $5.8 million related to replacement restricted stock that the Company issued in connection with the acquisition of ANS, which is expected to be recognized over weighted average periods of 0.9 years and 1.6 years, respectively.

 

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Prior to January 1, 2006, the Company accounted for its stock-based employee compensation plans under the recognition and measurement principles of APB Opinion No. 25 and related interpretations. The following table illustrates the effect on net earnings and net earnings per share for the three and nine months ended September 30, 2005 if the Company had applied the fair value recognition provisions of SFAS No. 123 to its stock-based employee compensation (in thousands, except per share amounts):

 

 

Statement of Cash Flows Change in Classification

Prior to the adoption of SFAS No. 123(R), benefits of tax deductions in excess of recognized stock-based compensation expense were reported as operating cash flows. Under SFAS No. 123(R), such excess tax benefits are reported as financing cash flows. Although total cash flows under SFAS No. 123(R) remain unchanged from what would have been reported under prior accounting standards, net operating cash flows are reduced and net financing cash flows are increased due to the adoption of SFAS No. 123(R). For the nine months ended September 30, 2006, there were excess tax benefits of $26.5 million, which are classified as financing cash flows. For the nine months ended September 30, 2005, there were excess tax benefits of $62.2 million, which are classified as operating cash flows as part of the change in income taxes payable.

 

General Stock Option and Restricted Stock Information

The following table summarizes stock option activity during the nine months ended September 30, 2006:

 

 

The following tables summarize information concerning stock options outstanding and exercisable at September 30, 2006:

 

 

The total intrinsic value of options exercised during the nine months ended September 30, 2006 was $94.1 million. At September 30, 2006, the total intrinsic value of options outstanding and options exercisable was $573.4 million and $524.7 million, respectively. The total intrinsic value at September 30, 2006 is based on the Company’s closing stock price on the last trading day of the quarter for in-the-money options.

 

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The following table summarizes restricted stock activity during the nine months ended September 30, 2006:

 

 

NOTE 4 – ACQUISITIONS AND MINORITY INVESTMENT

 

Acquisitions

The results of operations of businesses acquired are included in the Company’s consolidated results of operations from the dates of acquisition. Refer to Note 2 to the Consolidated Financial Statements included in the Company’s 2005 Annual Report on Form 10-K for additional information regarding the Company’s acquisitions. Other than the acquisition of ANS, pro forma results of operations have not been presented for these acquisitions since the effects of these business acquisitions were not material to the Company either individually or in the aggregate.

 

Advanced Neuromodulation Systems, Inc.:   On November 29, 2005, the Company completed its acquisition of ANS. ANS designs, develops, manufactures and markets implantable neuromodulation devices used primarily to manage chronic severe pain. The ANS acquisition expanded the Company’s implantable microelectronics technology programs and provided the Company an immediate presence in the neuromodulation segment of the medical device industry.

 

The aggregate ANS purchase price was allocated on a preliminary basis to the assets acquired and liabilities assumed based on their estimated fair values at the date of acquisition. The purchase price allocation is preliminary as a result of uncertainty surrounding the estimation of probable and future legal costs relating to legal proceedings outstanding on the acquisition date (see Note 7). Upon finalization, there could be a change in the current liabilities and goodwill. See Note 2 of the Consolidated Financial Statements included in the Company’s 2005 Annual Report on Form 10-K for the preliminary ANS purchase price allocation.

 

The following unaudited pro forma information presents the consolidated results of operations of the Company and ANS as if the acquisition of ANS had occurred as of the beginning of the periods presented (in thousands, except per share amounts):

 

 

Pro forma adjustments relate to amortization of identified intangible assets, interest expense resulting from acquisition financing and certain other adjustments together with related income tax effects. Pro forma net earnings for the nine months ended September 30, 2005 include an $85.2 million pre-tax gain on the sale of ANS’s investment in common stock of Cyberonics, Inc., which was recorded by ANS in its historical results of operations for the nine months ended September 30, 2005. The above unaudited pro forma consolidated results of operations are for comparative purposes only and are not necessarily indicative of results that would have occurred had the acquisition occurred as of the beginning of the period presented, nor are they necessarily indicative of future results.

 

Other Acquisitions: During the nine months ended September 30, 2006, the Company also acquired various businesses involved in the distribution of the Company’s products for aggregate cash consideration of $21.6 million.

 

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Minority Investment

The Company made an initial $12.5 million investment in ProRhythm, Inc. (ProRhythm) in January 2005, which approximated a 9% ownership interest. In January 2006, the Company made a second $12.5 million investment in ProRhythm, increasing its total ownership interest to approximately 18%. ProRhythm is a privately-held company that is focused on the development of a high intensity focused ultrasound catheter-based ablation system for the treatment of atrial fibrillation. In connection with making the initial equity investment, the Company also entered into a purchase agreement under which the Company has the exclusive right, but not the obligation, through the later of three months after the date ProRhythm delivers certain clinical trial data or March 31, 2007, to acquire the remaining capital stock of ProRhythm for $125.0 million in cash, with additional cash consideration payable to the non-St. Jude Medical shareholders after the consummation of the acquisition if ProRhythm achieves certain performance-related milestones. The ProRhythm investment is being accounted for under the cost method of accounting.

 

NOTE 5 – GOODWILL AND OTHER INTANGIBLE ASSETS

 

The changes in the carrying amount of goodwill for each of the Company’s reportable segments (see Note 14) for the nine months ended September 30, 2006 are as follows (in thousands):

 

 

The following table provides the gross carrying amount of other intangible assets and related accumulated amortization (in thousands):

 

 

NOTE 6 – INVENTORIES

 

The Company’s inventories consisted of the following (in thousands):

 

		September 30, 2006			December 31, 2005
Finished goods		$	307,015		$	262,640
Work in process			38,557			34,531
Raw materials			92,829			81,285
		$	438,401		$	378,456

 

NOTE 7 – COMMITMENTS AND CONTINGENCIES

 

Silzone® Litigation and Insurance Receivables:  In July 1997, the Company began marketing mechanical heart valves which incorporated Silzone® coating. The Company later began marketing heart valve repair products incorporating Silzone® coating. Silzone® coating was intended to reduce the risk of endocarditis, a bacterial infection affecting heart tissue, which is associated with replacement heart valve surgery. In January 2000, the Company initiated a voluntary field action for products incorporating Silzone® coating after receiving information from a clinical study that patients with a Silzone®-coated heart valve had a small, but statistically significant, increased incidence of explant due to paravalvular leak compared to patients in that clinical study with heart valves that did not incorporate Silzone® coating.

 

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Subsequent to the Company’s voluntary field action, the Company has been sued in various jurisdictions by some patients who received a product with Silzone® coating and, as of October 24, 2006, such cases are pending in the United States, Canada, United Kingdom, Ireland and France. Some of these claimants allege bodily injuries as a result of an explant or other complications, which they attribute to Silzone®-coated products. Others, who have not had their Silzone®-coated heart valve explanted, seek compensation for past and future costs of special monitoring they allege they need over and above the medical monitoring all replacement heart valve patients receive. Some of the lawsuits seeking the cost of monitoring have been initiated by patients who are asymptomatic and who have no apparent clinical injury to date. The Company has vigorously defended against the claims that have been asserted and expects to continue to do so with respect to any remaining claims.

 

In 2001, the U.S. Judicial Panel on Multi-District Litigation (MDL) ruled that certain lawsuits filed in U.S. federal district court involving products with Silzone® coating should be part of MDL proceedings under the supervision of U.S. District Court Judge John Tunheim in Minnesota (the District Court). As a result, actions in federal court involving products with Silzone® coating have been and will likely continue to be transferred to Judge Tunheim for coordinated or consolidated pretrial proceedings.

 

The District Court ruled against the Company on the issue of preemption and found that the plaintiffs’ causes of action were not preempted by the U.S. Food and Drug Act. The Company sought to appeal this ruling, but the appellate court determined that it would not review the ruling at that point in the proceedings.

 

Certain plaintiffs requested the District Court to allow some cases to proceed as class actions. The first complaint seeking class-action status was served upon the Company on April 27, 2000 and all eight original class-action complaints were consolidated into one case by the District Court on October 22, 2001. One proposed class in the consolidated complaint seeks injunctive relief in the form of medical monitoring. A second class in the consolidated complaint seeks an unspecified amount of monetary damages. In response to the requests of the claimants in these cases, the District Court issued several rulings concerning class action certification. The Company requested the Eighth Circuit Court of Appeals (the Eighth Circuit) to review the District Court’s class certification orders.

 

On October 12, 2005, the Eighth Circuit issued a decision reversing the District Court’s class certification rulings. More specifically, the Eighth Circuit ruled that the District Court erred in certifying a consumer protection class seeking damages based on Minnesota’s consumer protection statutes, and required the District Court in further proceedings to conduct a thorough conflicts-of-law analysis as to each plaintiff class member before applying Minnesota law. In addition, in its October 12, 2005 opinion, the Eighth Circuit also ruled that the District Court’s certification of a medical monitoring class was an abuse of discretion and thus reversed the District Court’s certification of a medical monitoring class involving the products with Silzone® coating.

 

After briefing and oral argument by the parties, the District Court issued its further ruling on class certification issues on October 13, 2006. The District Court granted plaintiffs’ renewed motion to certify a nationwide consumer protection class under Minnesota’s consumer protection statutes and the Private Attorney General Act. The Company plans to seek appellate review of the District Court’s October 13, 2006 decision.

 

In addition to the purported class action before the District Court, as of October 24, 2006, there were 16 individual Silzone® cases initiated in various federal courts which were pending before the District Court. Plaintiffs in those cases are requesting damages ranging from $10 thousand to $120.5 million and, in some cases, seeking an unspecified amount. The first individual complaint that was transferred to the MDL court was served upon the Company on November 28, 2000, and the most recent individual complaint that was transferred to the MDL court was served upon the Company on February 10, 2006. These cases, which are consolidated before the District Court, are proceeding in accordance with the scheduling orders the District Court has rendered. Actions involving products with Silzone® coating in various state courts in the United States may or may not be coordinated with the matters presently before the District Court.

 

There are 25 individual state court suits concerning Silzone®-coated products pending as of October 24, 2006, involving 33 patients. These cases are venued in Florida, Minnesota, Missouri, Nevada, Pennsylvania and Texas. There is also a case in Texas which has been dismissed but remains on appeal. The first individual state court complaint was served upon the Company on March 1, 2000, and the most recent individual state court complaint was served upon the Company on August 6, 2006. The complaints in these state court cases request damages ranging from $10 thousand to $100 thousand and, in some cases, seek an unspecified amount. These state court cases are proceeding in accordance with the orders issued by the judges in those matters.

 

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In addition, a lawsuit seeking a class action for all persons residing in the European Economic Union member jurisdictions who have had a heart valve replacement and/or repair procedure using a product with Silzone® coating was filed in Minnesota state court and served upon the Company on February 11, 2004, by two European citizens who now live in Canada. The complaint seeks damages in an unspecified amount for the class, and in excess of $50 thousand for each plaintiff. The complaint also seeks injunctive relief in the form of medical monitoring. The Company is opposing the plaintiffs’ pursuit of this case on jurisdictional, procedural and substantive grounds.

 

There are also four class-action cases and one individual case pending against the Company in Canada. In one such case in Ontario, the court certified that a class action may proceed involving Silzone® patients. The Company’s request for leave to appeal the rulings on certification was rejected, and the trial of the initial phase of this matter is now scheduled for September 2007. A second case seeking class action in Ontario has been stayed pending resolution of the other Ontario action, and a case seeking class action in British Columbia is also proceeding but is in its early stages. A court in the Province of Quebec has certified a class action, and that matter is proceeding in accordance with the orders in that court. Additionally, on December 22, 2005, the Company was served with a lawsuit by the Quebec Provincial health insurer. The lawsuit asserts a subrogation right to recover the cost of insured services furnished or to be furnished to class members in the class action pending in Quebec. The complaints in these cases each request damages ranging from 1.5 million to 2.0 billion Canadian dollars (the equivalent to $1.4 million to $1.8 billion at September 30, 2006).

 

In the United Kingdom, one case involving one plaintiff is pending as of October 24, 2006. The Particulars of Claim in this case were served on July 13, 2004. The plaintiff in this case requests damages of approximately 0.2 million British pounds (the equivalent to approximately $0.4 million at September 30, 2006).

 

In Ireland, one case involving one plaintiff was withdrawn in the third quarter of 2006. The complaint in this case had been originally served on December 30, 2004, and had sought an unspecified amount in damages.

 

In France, one case involving one plaintiff is pending as of October 24, 2006. It was initiated by way of an Injunctive Summons to Appear that was served on November 8, 2004, and requests damages in excess of 3 million Euros (the equivalent to $3.8 million at September 30, 2006).

 

The Company is not aware of any unasserted claims related to Silzone®-coated products. Company management believes that the final resolution of the Silzone® cases will take several years.

 

The Company has recorded an accrual for probable legal costs that it will incur to defend the various cases involving Silzone®-coated products, and the Company has recorded a receivable from its product liability insurance carriers for amounts expected to be recovered. The Company has not accrued for any amounts associated with settlements or judgments because management cannot reasonably estimate such amounts. Any Silzone® litigation settlement or judgment reserve established by the Company is not based on the amount of the claims because, based on the Company’s experience in these types of cases, the amount ultimately paid, if any, often does not bear any relationship to the amount claimed by the plaintiffs and is often significantly less than the amount claimed. Furthermore, management expects that no significant claims will ultimately be allowed to proceed as class actions in the United States and, therefore, that all settlements and judgments will be covered under the Company’s product liability insurance, subject to the insurance companies’ performance under the policies, which is discussed below. As such, management expects that any costs (the material components of which are settlements, judgments, legal fees and other related defense costs) not covered by the Company’s product liability insurance policies or existing reserves will not have a material adverse effect on the Company’s consolidated financial position, although such costs may be material to the Company’s consolidated earnings and cash flows of a future period.

 

A summary of the activity relating to the Silzone® litigation reserve is as follows (in thousands):

 

 

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The Company records insurance receivables for amounts related to probable future legal costs associated with the Silzone® litigation that are expected to be reimbursable by the Company’s insurance carriers. In 2005, the Company determined that the Silzone® reserves should be increased by $9.8 million as a result of an increase in management’s estimate of the probable future legal costs that would be incurred. The Company also increased the receivable from the Company’s insurance carriers as the Company expects such costs to be reimbursable by the Company’s insurance carriers. At September 30, 2006 and December 31, 2005, the Company’s receivables from insurance carriers were $23.6 million and $24.1 million, respectively.

 

The Company’s remaining product liability insurance (approximately $125.5 million at October 24, 2006) for Silzone® claims consists of a number of layers, each of which is covered by one or more insurance companies. Part of the Company’s final layer of insurance ($20 million of the final $50 million layer) is covered by Lumberman’s Mutual Casualty Insurance, a unit of the Kemper Insurance Companies (collectively referred to as Kemper). Prior to being no longer rated by A.M. Best, Kemper’s financial strength rating was downgraded to a “D” (poor). Kemper is currently in “run off,” which means that it is not issuing new policies and is, therefore, not generating any new revenue that could be used to cover claims made under previously-issued policies. In the event Kemper is unable to pay claims directed to it, the Company believes the other insurance carriers in the final layer of insurance will take the position that the Company will be directly liable for any claims and costs that Kemper is unable to pay. It is possible that Silzone® costs and expenses will reach the limit of the final Kemper layer of insurance coverage, and it is possible that Kemper will be unable to meet its full obligations to the Company. If this were to happen, the Company could incur expense of up to approximately $20 million. The Company has not accrued for any such losses as potential losses are possible, but not estimable, at this time.

 

Symmetry™ Bypass System Aortic Connector Litigation:  The Company has been sued in various jurisdictions by claimants who allege that the Company’s Symmetry™ device caused bodily injury or might cause bodily injury. The Company’s Symmetry™ device was cleared through a 510(K) submission to the U.S. Food and Drug Administration (FDA), and therefore, the Company is unable to rely on a defense under the doctrine of federal preemption that such suits are prohibited. Given the Company’s self-insured retention levels under its product liability insurance policies, the Company expects that it will be solely responsible for these lawsuits, including any costs of defense, settlements and judgments.

 

Although four cases asserted against the Company involving the Symmetry™ device sought class-action status, no class actions were certified in those cases, and all four cases have now been dismissed. In one of those matters seeking class action status, the case was dismissed by the court, and the plaintiff appealed the dismissal. In another, a Magistrate Judge recommended that the case not proceed as a class action. In the third case, the trial judge denied class certification in a July 26, 2005 decision that was not appealed. No motion requesting the court to certify a class action was ever pursued in the fourth case. Therefore, as of October 24, 2006, no class actions have been certified in cases involving the Symmetry™ device, and all four cases where class actions were initially sought have now been resolved, including the case where the plaintiff appealed the court’s dismissal of the case.

 

Since August 2003, when the first lawsuit involving the Symmetry™ device was filed against the Company, through October 24, 2006, the Company has resolved the claims involving over 94% of the plaintiffs that have initiated lawsuits against the Company involving the Symmetry™ device. As of October 24, 2006, all but four of the lawsuits which allege that the Symmetry™ device caused bodily injury or might cause bodily injury have been resolved. Three of the four unresolved lawsuits were initiated in the second quarter of 2006. Three of the four unresolved cases involving the Symmetry™ device are pending in state court in Minnesota and one is pending in federal court in South Carolina. The first of the unresolved cases involving the Symmetry™ device was commenced against the Company on June 17, 2004, and the most recently initiated unresolved case was commenced against the Company on June 12, 2006. Each of the complaints in these unresolved cases request damages in excess of $50 thousand. In addition to this litigation, some persons have made claims against the Company involving the Symmetry™ device without filing a lawsuit, although, as with the lawsuits, the vast majority of the claims that the Company has been made aware of as of October 24, 2006 have been resolved.

 

Potential losses arising from future settlements or judgments of unresolved cases and claims are possible, but not estimable, at this time. Moreover, the Company currently expects that any costs (the material components of which are settlements, judgments, legal fees and other related defense costs) not covered by any remaining reserve will not have a material adverse effect on the Company’s consolidated financial position, although such costs may be material to the Company’s consolidated earnings and cash flows of a future period.

 

Guidant 1996 Patent Litigation:  In November 1996, Guidant, a subsidiary of Boston Scientific Corporation, sued the Company in federal district court for the Southern District of Indiana alleging that the Company did not have a license to certain patents controlled by Guidant covering tachycardia implantable cardioverter defibrillator system (ICD) products and alleging that the Company was infringing those patents. The Company’s contention was that it had obtained a license from Guidant to the patents at issue when it acquired certain assets of Telectronics in November 1996. In July 2000, an arbitrator rejected the Company’s position, and in May 2001, a federal district court judge also ruled that the Guidant patent license with Telectronics had not transferred to the Company.

 

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Guidant’s suit originally alleged infringement of four patents by the Company. Guidant later dismissed its claim on one patent and a court ruled that a second patent was invalid. This determination of invalidity was appealed by Guidant, and the Court of Appeals upheld the lower court’s invalidity determination. In a jury trial involving the two remaining patents (the ‘288 and ‘472 patents), the jury found that these patents were valid and that the Company did not infringe the ‘288 patent. The jury also found that the Company did infringe the ‘472 patent, though such infringement was not willful. The jury awarded damages of $140.0 million to Guidant. In post-trial rulings, however, the judge overseeing the jury trial ruled that the ‘472 patent was invalid and also was not infringed by the Company, thereby eliminating the $140.0 million verdict against the Company. The trial court also made other rulings as part of the post-trial order, including a ruling that the ‘288 patent was invalid on several grounds.

 

In August 2002, Guidant commenced an appeal of certain of the trial judge’s post-trial decisions pertaining to the ‘288 patent. Guidant did not appeal the trial court’s finding of invalidity and non-infringement of the ‘472 patent. As part of its appeal, Guidant requested that the monetary damages awarded by the jury pertaining to the ‘472 patent ($140.0 million) be transferred to the ‘288 patent infringement claim.

 

On August 31, 2004, a three judge panel of the Court of Appeals for the Federal Circuit (CAFC) issued a ruling on Guidant’s appeal of the trial court decision concerning the ‘288 patent. The CAFC reversed the decision of the trial court judge that the ‘288 patent was invalid. The court also ruled that the trial judge’s claim construction of the ‘288 patent was incorrect and, therefore, the jury’s verdict of non-infringement was set aside. Guidant’s request to transfer the $140.0 million to the ‘288 patent was rejected. The court also ruled on other issues that were raised by the parties. The Company’s request for re-hearing of the matter by the panel and the entire CAFC court was rejected.

 

The case was returned to the district court in Indiana in November 2004, but since that time, further appellate activity has occurred. In this regard, the U.S. Supreme Court rejected the Company’s request that it review certain aspects of the CAFC decision. In addition, further appellate review has occurred after Guidant brought motion in the district court seeking to have a new judge assigned to handle the case in lieu of the judge that oversaw the prior trial. On a motion reconsideration, the judge reversed his initial decision in response to Guidant’s motion and agreed to have the case reassigned to a new judge but also certified the issue to the CAFC. On July 20, 2005, the CAFC ruled that the original judge should continue with the case. A hearing on claims construction issues and various motions for summary judgment brought by both parties was held on December 20, 2005, and the district court issued rulings on claims construction and in response to some of the motions for summary judgment on March 1, 2006. In response to the district court ruling, on March 21, 2006, Guidant filed a special request with the CAFC to appeal certain of the March 1, 2006 rulings, or to clarify the August 31, 2005 CAFC decision. The Company filed responses to these filings on April 7, 2006, and, on June 2, 2006, the CAFC rejected Guidant’s special request for an appeal. On July 30, 2006, the parties agreed to jointly approach the court to request a new schedule for the case, and in September 2006, the Court issued a new schedule for the case which kept the previously announced April 30, 2007 trial date.

 

The ‘288 patent expired in December 2003. Accordingly, the final outcome of the lawsuit involving the ‘288 patent cannot result in an injunction precluding the Company from selling ICD products in the future. Sales of the Company’s ICD products which Guidant asserts infringed the ‘288 patent were approximately 18% and 16% of the Company’s consolidated net sales during the fiscal years ended December 31, 2003 and 2002, respectively.

 

On July 30, 2006, in exchange for the Company agreeing not to pursue the recovery of attorneys’ fees or assert certain claims and defenses, Guidant agreed that it would not seek to recover lost profits in the case, that the maximum royalty rate that it would seek for any patents found to be infringed by the Company would not exceed 3% of net sales, and that it would not seek prejudgment interest. These agreements have the effect of limiting the Company’s financial exposure. However, any potential losses arising from any legal settlements or judgments could be material to the Company’s consolidated earnings, financial position and cash flows. The Company has not accrued any amounts for legal settlements or judgments related to the Guidant 1996 patent litigation. Although the Company believes that the assertions and claims in these matters are without merit, potential losses arising from any legal settlements or judgments are possible, but not estimable, at this time.

 

Guidant 2004 Patent Litigation:  In February 2004, Guidant sued the Company in federal district court in Delaware alleging that the Company’s Epic® HF ICD, Atlas®+ HF ICD and Frontier™ devices infringe U.S Patent No. RE 38,119E (the ‘119 patent). A competitor of the Company, Medtronic, Inc., which has a license to the ‘119 patent, is contending in a separate lawsuit with Guidant in the same court that the ‘119 patent is invalid. In July 2005, the court ruled against Medtronic’s claim of invalidity, and Medtronic appealed that decision. In October 2006, the CAFC upheld the district court’s ruling against Medtronic’s claim of invalidity. By agreement with Guidant, Medtronic had presented limited arguments of invalidity in its case and did not address infringement. On January 6, 2006, the Court ruled against the Company in response to a motion for summary judgment it had filed in June 2005. The Company expects to assert invalidity arguments that were not made by Medtronic and also defend against Guidant’s claims of infringement. Pursuant to a recent order of the Court, this matter is presently set for trial in August 2007, and it is otherwise proceeding in accordance with deadlines established by the Court.

 

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On July 30, 2006, in exchange for the Company agreeing not to pursue the recovery of attorneys’ fees or assert certain defenses, Guidant agreed that it would not seek to recover lost profits in the case, that the maximum royalty rate that it would seek for any patents found to be infringed by the Company would not exceed 3% of net sales, that it would not seek prejudgment interest, and that it would not pursue an injunction against the Company until all appeals have been exhausted and any judgment of infringement is final and no longer can be appealed. These agreements have the effect of limiting the Company’s financial and operational exposure. However, any potential losses arising from any legal settlements or judgments could be material to the Company’s consolidated earnings, financial position and cash flows. The Company has not accrued any amounts for legal settlements or judgments related to the outstanding Guidant 2004 patent litigation. Although the Company believes that the assertions and claims in the outstanding Guidant 2004 patent litigation are without merit, potential losses arising from any legal settlements or judgments are possible, but not estimable, at this time.

 

Guidant also sued the Company in February 2004 alleging that the Company’s QuickSite® 1056K pacing lead infringes U.S. Patent No. 5,755,766 (the ‘766 patent). This second suit was initiated in federal district court in Minnesota. Guidant later amended its complaint to allege that the QuickSite® 1056K and the QuickSite® 1056T pacing leads infringe U.S. Patent No. 6,901,288, as well as the ‘766 patent. The parties settled this suit on July 30, 2006 and agreed to a patent cross-license involving the parties’ cardiac rhythm management patent portfolio.

 

Advanced Bionics Patent Litigation:  On July 30, 2006, the Company settled the litigation between its recently acquired subsidiary, ANS, and Advanced Bionics, a subsidiary of Boston Scientific Corporation. That litigation had involved patent infringement claims by both parties. In connection with the settlement, the parties agreed to a cross-license of certain patents related to neuromodulation.

 

Securities Class Action Litigation:  In April and May 2006, five shareholders, each purporting to act on behalf of a class of purchasers during the period January 25 through April 4, 2006 (the Class Period), separately sued the Company and certain officers in federal district court in Minnesota alleging that the Company made materially false and misleading statements during the Class Period relating to financial performance, projected earnings guidance and projected sales of ICDs. The complaints, which all seek unspecified damages and other relief, as well as attorneys’ fees, have all been consolidated. In an August 24, 2006 ruling, lead plaintiffs were appointed by the district court. The plaintiffs filed their amended complaint on October 24, 2006. The Company intends to vigorously defend against the claims asserted in these actions. The Company’s directors and officers liability insurance provide $75 million of insurance coverage for the Company, the officers and the directors, after a $15 million self-insured retention level has been reached.

Additionally, the Company’s recently acquired subsidiary, ANS, has outstanding securities class action legal proceedings. In late May 2005, the U.S. District Court for the Eastern District of Texas, Sherman Division, granted an order consolidating three previously filed cases which sought class action status for claims asserted against ANS and certain of the individuals who were serving as ANS’s officers and directors at that time (the ANS Class Action Litigation), on behalf of purchasers of ANS securities between April 24, 2003 and February 16, 2005. On October 6, 2006, the parties entered into a settlement agreement that would resolve the ANS Class Action Litigation. That settlement is subject to the district court’s review and final approval. On October 18, 2006, the district court issued a preliminary order providing notice to the class, addressing certain procedural matters and setting a final Settlement Fairness Hearing for January 19, 2007. ANS’s directors and officers liability insurance policy provides coverage of up to $10 million. As of June 30, 2006, ANS had met its deductible under this policy, and from that point, it is expected that the insurance policy will cover costs of defense, settlements and judgments up to $10 million. Accordingly, once the district court grants final approval of the settlement, the insurance policy is expected to cover the amount of the settlement agreed to by the parties.

Other Litigation and Governmental Investigation Matters:  The Company has been named in the report of the Independent Inquiry Committee into the United Nations (U.N.) Oil-For-Food Programme as having made payments to the Iraqi government in connection with certain product sales made by the Company to Iraq under the U.N. Oil-For-Food Programme in 2001, 2002 and 2003. The Company is investigating the allegations. In February 2006, the Company received a subpoena from the SEC requesting the Company to produce documents concerning transactions under the U.N. Oil-for-Food Programme. The Company is cooperating with the SEC’s request.

 

In late January 2005, ANS received a subpoena from the Office of the Inspector General, Department of Health and Human Services (OIG) requesting documents related to certain of its sales and marketing, reimbursement, Medicare and Medicaid billings, and other business practices of ANS. The Company is cooperating with the OIG’s request for documents.

 

In October 2005, the Company received a subpoena for documents relating to business practices in its cardiac rhythm management business from the U.S. Attorney’s Office in Boston as part of an industry-wide investigation. The Company is cooperating with the investigation.

 

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The Company is also involved in various other product liability lawsuits, claims and proceedings that arise in the ordinary course of business.

 

Product Warranties: The Company offers a warranty on various products, the most significant of which relates to its bradycardia pacemaker systems (pacemakers) and ICDs. The Company estimates the costs that may be incurred under its warranties and records a liability in the amount of such costs at the time the product is sold. Factors that affect the Company’s warranty liability include the number of units sold, historical and anticipated rates of warranty claims and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary.

 

Changes in the Company’s product warranty liability during the three and nine months ended September 30, 2006 and 2005 were as follows (in thousands):

 

 

Other Commitments: The Company has certain contingent commitments to acquire various businesses involved in the distribution of the Company’s products and other contingent acquisition consideration payments. While it is not certain if and/or when these payments will be made, as of September 30, 2006, the Company estimates it could be required to pay approximately $292 million in future periods to satisfy such commitments. Refer to Part II, Item 7A, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Off-Balance Sheet Arrangements and Contractual Obligations of the Company’s 2005 Annual Report on Form 10-K for additional information.

 

NOTE 8 – PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT (IPR&D) CHARGES AND SPECIAL CHARGES (CREDITS)

IPR&D Charges

Refer to Note 7 to the Consolidated Financial Statements included in the Company’s 2005 Annual Report on Form 10-K for additional information regarding IPR&D acquired as part of the Company’s recent acquisitions. There has been no material changes in the completion status of IPR&D projects acquired and the estimated total cost to complete each project, as estimated on the acquisition dates, from that previously disclosed in our 2005 Annual Report on Form 10-K.

 

Velocimed, LLC (Velocimed): In April 2005, the Company acquired Velocimed to further enhance the Company’s portfolio of products in the interventional cardiology market. At the date of acquisition, $13.7 million of the purchase price was expensed as IPR&D related to projects for the Proxis™ embolic protection device that had not yet reached technological feasibility in the United States and other geographies and had no future alternative use. The device is used to help minimize the risk of heart attack or stroke if plaque or other debris is dislodged into the blood stream during interventional cardiology procedures. In 2005, the Company incurred $3.4 million in costs related to these projects. The Company has incurred $2.8 million in the first nine months of 2006 and expects to incur up to an additional $2 million through 2007 to bring this acquired technology to commercial viability.

 

Endocardial Solutions, Inc. (ESI): In January 2005, the Company acquired ESI to further enhance the Company’s portfolio of products used to treat heart rhythm disorders. At the date of acquisition, $12.4 million of the purchase price was expensed as IPR&D related to system upgrades that had not yet reached technological feasibility and had no future alternative use. These major system upgrades are part of the EnSite® system which is used for the navigation and localization of diagnostic and therapeutic catheters used in atrial fibrillation ablation and other electrophysiology (EP) catheterization procedures. During 2005, the Company incurred $0.7 million in costs related to these projects and in the third quarter of 2005, the Company achieved commercial viability and launched EnSite® system version 5.1 and the EnSite® Verismo™ segmentation tool.

Special Charges (Credits)

Restructuring Activities: During the third quarter of 2006, Company management performed a review of the organizational structure of the Company’s Cardiac Surgery and Cardiology divisions and its international selling organization. In August 2006, Company management approved restructuring plans to streamline its operations within its Cardiac Surgery and Cardiology divisions and combine them into one new Cardiovascular division, effective January 1, 2007, and also to implement changes in its international selling organization to enhance the efficiency and effectiveness of sales and customer service operations in certain international geographies. This strategic reorganization and operational restructuring will allow the Company to enhance operating efficiencies and increase investment in product development.

 

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As a result of these restructuring plans, the Company recorded pre-tax special charges totaling $34.8 million in the third quarter of 2006 consisting of employee termination costs ($14.7 million), inventory write-downs ($8.7 million), asset write-downs ($7.3 million) and other exit costs ($4.1 million). Of the total $34.8 million special charge, $15.1 million was recorded in cost of sales and $19.7 million was recorded in operating expenses. In order to enhance segment comparability and reflect management’s focus on the ongoing operations of the Company, the restructuring special charges have not been recorded in the individual reportable segments.

 

Employee termination costs relate to severance and benefits costs for approximately 140 individuals. The charges for employee termination costs were recorded after management determined that such postemployment severance and benefits were probable and estimable, in accordance with SFAS No. 112, Employers’ Accounting for Postemployment Benefits. Inventory write-downs represent the net carrying value of inventory relating to product lines discontinued in connection with the reorganization. Asset write-downs represent the net book value of assets that will no longer be utilized as a result of the reorganization and restructuring, including $4.2 million of trademarks acquired in connection with the Company’s 2003 acquisition of Getz Bros. Co. Ltd. as well as other assets relating to product lines discontinued in connection with the reorganization. Other exit costs primarily represent contract termination costs.

 

A summary of the activity relating to the restructuring accrual (classified as other current liabilities) for the nine months ended September 30, 2006 is as follows (in thousands):

 

 

Symmetry™ Bypass System Aortic Connector Litigation: During the third quarter of 2005, over 90% of the cases and claims asserted involving the Symmetry™ device were resolved. As a result, the Company reversed $14.8 million of the pre-tax $21.0 million special charge that was recorded in the third quarter of 2004 to accrue for legal fees in connection with claims involving the Symmetry™ device. Additionally, the Company recorded a pre-tax charge of $3.3 million in the third quarter of 2005 to accrue for settlement costs negotiated in these related cases. These adjustments resulted in a net pre-tax benefit of $11.5 million that the Company recorded in the third quarter of 2005 related to Symmetry™ device product liability litigation. See Note 7 for further details on the outstanding litigation against the Company relating to the Symmetry™ device.

 

NOTE 9 – DEBT

 

The Company’s long-term debt consisted of the following (in thousands):

 

 

 

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The 2.80% Convertible Senior Debentures have been classified as current portion of long-term debt as the Company may be required to redeem these obligations on December 15, 2006. The Company’s commercial paper borrowings are classified as long-term debt at September 30, 2006. The Company normally classifies all of its commercial paper borrowings as long-term debt as the Company has the ability to repay any short-term maturity with available cash from its existing long-term, committed credit facilities. Because the Company repaid all of its outstanding commercial paper borrowings in January 2006, the Company classified the December 31, 2005 balance as current portion of long-term debt.

 

NOTE 10 – SHAREHOLDERS’ EQUITY

 

Capital Stock

The Company’s authorized capital consists of 25 million shares of $1.00 per share par value preferred stock and 500 million shares of $0.10 per share par value common stock. The Company has designated 1.1 million of the authorized preferred shares as a Series B Junior Preferred Stock for its shareholder rights plan. The rights related to this plan expire in July 2007. There were no shares of preferred stock issued or outstanding at September 30, 2006 or December 31, 2005.

 

Share Repurchase Program

On April 18, 2006, the Company’s Board of Directors authorized a new share repurchase program of up to $700 million of the Company’s outstanding common stock. The $700 million share repurchase program replaced an earlier share repurchase program, under which the Company was authorized to repurchase up to $300 million of its outstanding common stock. No stock had been repurchased under the earlier program. On April 21, 2006, the Company began making share repurchases through transactions in the open market in accordance with applicable securities laws. On May 26, 2006, the Company had repurchased the maximum amount authorized by the Board of Directors under the repurchase program. Approximately 18.6 million shares were repurchased for a total of $700 million, which was financed through cash from operations and proceeds from the issuance of commercial paper. The $700 million share repurchase was recorded as a $593.5 million aggregate reduction of common stock and additional paid-in capital and a $106.5 million reduction in retained earnings.

 

NOTE 11 – NET EARNINGS PER SHARE

 

The table below sets forth the computation of basic and diluted net earnings per share (in thousands, except per share amounts):

 

Diluted-weighted average shares outstanding have not been adjusted for certain stock options and restricted stock where the effect of those securities would not have been dilutive. Approximately 9.5 million and 24,000 shares of common stock subject to stock options and restricted stock were excluded from the diluted net earnings per share computation for the three months ended September 30, 2006 and 2005, respectively, because they were anti-dilutive. Approximately 7.9 million and 4.1 million shares of common stock subject to stock options and restricted stock were excluded from the diluted net earnings per share computation for the nine months ended September 30, 2006 and 2005, respectively, because they were anti-dilutive.

 

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NOTE 12 – COMPREHENSIVE INCOME

 

The amounts in other comprehensive income (loss) are presented below, net of the related income tax impact:

 

NOTE 13 – OTHER (EXPENSE) INCOME

 

NOTE 14 – SEGMENT AND GEOGRAPHIC INFORMATION

 

Segment Information

The Company develops, manufactures and distributes cardiovascular medical devices for the global cardiac rhythm management, cardiac surgery, cardiology and atrial fibrillation therapy areas and implantable neuromodulation devices. The Company’s five operating segments are Cardiac Rhythm Management (CRM), Cardiac Surgery (CS), Neuromodulation (NEURO), Cardiology (CD) and Atrial Fibrillation (AF). The Company formed the NEURO operating segment in November 2005 in connection with the acquisition of ANS. Each operating segment focuses on developing and manufacturing products for its respective therapy area. The primary products produced by each operating segment are: CRM – ICDs and pacemakers; CS – mechanical and tissue heart valves and valve repair products; NEURO – neurostimulation devices; CD – vascular closure devices, hemostasis introducers, patent foramen ovale closure devices, guidewires, embolic protection devices and other cardiology products; and AF – EP catheters, advanced cardiac mapping systems and ablation systems.

 

The Company has aggregated the five operating segments into two reportable segments based upon their similar operational and economic characteristics: CRM/CS/NEURO and CD/AF. Net sales of the Company’s reportable segments include end-customer revenue from the sale of products they each develop and manufacture or distribute. The costs included in each of the reportable segments’ operating results include the direct costs of the products sold to end-customers and operating expenses managed by each of the reportable segments. Certain operating expenses managed by the Company’s selling and corporate functions, including all stock-based compensation expense, are not included in the reportable segments’ operating profit. Because of this, reportable segment operating profit is not representative of the operating profit of the products in these reportable segments. Additionally, certain assets are managed by the Company’s selling and corporate functions, principally including end-customer receivables, inventory, corporate cash and cash equivalents and deferred income taxes. For management reporting purposes, the Company does not compile capital expenditures by reportable segment and, therefore, this information has not been presented as it is impracticable to do so.

 

As discussed in Note 8, the Company is combining the Cardiac Surgery and Cardiology divisions into a new Cardiovascular division which will incorporate all activities currently managed by the Cardiac Surgery division and by the Cardiology division. A transitional period was provided to combine the existing divisions into the new division. Internal management reporting for the new reportable segments will commence January 1, 2007. Segment information will be reclassified effective January 1, 2007 to reflect the new Cardiovascular division. In order to enhance segment comparability and reflect management’s focus on the ongoing operations of the Company, the related special charges have not been recorded in the individual reportable segments.

 

 

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The following table presents net sales and operating profit by reportable segment (in thousands):

 

 

 

The following table presents the Company’s total assets by reportable segment (in thousands):

 

 

Geographic Information

The following tables present certain geographical financial information (in thousands):

 

 

 

 

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OVERVIEW

 

Our business is focused on the development, manufacturing and distribution of cardiovascular medical devices for the global cardiac rhythm management, cardiac surgery, cardiology and atrial fibrillation therapy areas and implantable neuromodulation devices. We sell our products in more than 100 countries around the world. Our largest geographic markets are the United States, Europe and Japan. Our five operating segments are Cardiac Rhythm Management (CRM), Cardiac Surgery (CS), Neuromodulation (NEURO), Cardiology (CD) and Atrial Fibrillation (AF). Each operating segment focuses on developing and manufacturing products for its respective therapy area. Our principal products in each operating segment are as follows: CRM – tachycardia implantable cardioverter defibrillator systems (ICDs) and bradycardia pacemaker systems (pacemakers); CS – mechanical and tissue heart valves and valve repair products; NEURO – neurostimulation devices; CD – vascular closure devices, hemostasis introducers, patent foramen ovale closure devices, guidewires, embolic protection devices and other cardiology products; and AF – electrophysiology (EP) catheters, advanced cardiac mapping systems and ablation systems. References to “St. Jude Medical,” “St. Jude,” “the Company,” “we,” “us” and “our” are to St. Jude Medical, Inc. and its subsidiaries.

 

In August 2006, we announced that we are combining the Cardiac Surgery and Cardiology divisions into a new Cardiovascular division, effective January 1, 2007. This combination is expected to enhance operating efficiencies and thereby enable us to increase investment in product development. The Cardiovascular division will incorporate all activities currently managed by the Cardiac Surgery division and by the Cardiology division. A transitional period was provided to combine the existing divisions into the new division. Internal management reporting for the new reportable segments will commence January 1, 2007. We also have implemented changes in our international selling organization to enhance the efficiency and effectiveness of sales and customer service operations in certain international geographies. The strategic reorganization and operational restructuring will allow us to enhance operating efficiencies and increase our investment in product development.

 

Net sales in the third quarter and first nine months of 2006 were $821.3 million and $2,438.6 million, respectively, an increase of approximately 11% and 15% over the third quarter and first nine months of 2005, respectively, led by growth in sales of atrial fibrillation products as well as neuromodulation product sales from the acquisition of Advanced Neuromodulation Systems, Inc. (ANS). AF net sales increased approximately 29% to $81.2 million in the third quarter of 2006 and approximately 29% to $235.1 million in the first nine months of 2006. The acquisition of ANS in the fourth quarter of 2005 contributed $43.3 million and $128.8 million to our sales growth in the third quarter and first nine months of 2006, respectively. Foreign currency translation comparisons positively impacted third quarter 2006 sales by $6.6 million and negatively impacted sales for the first nine months of 2006 by $21.1 million. Refer to the Segment Performance section below for a more detailed discussion of the sales results for the respective segments.

 

The global ICD market grew at an estimated compounded annual growth rate of approximately 28% from 2001 to 2005. We believe the rate of growth declined significantly in the second half of 2005 and first nine months of 2006 due to a number of factors, including adverse publicity relating to product recalls of a competitor during 2005 and 2006. We forecast that the overall ICD market will remain depressed in the near term but eventually will rebound. This is because data indicates the potential patient populations remain significantly underpenetrated. We also expect that we can continue to increase our ICD market share. In order to help accomplish this objective, we plan to continue to expand our United States selling organization and to continue to introduce new CRM products.

 

Net earnings and diluted net earnings per share for the third quarter of 2006 were $115.5 million and $0.32 per diluted share, which includes an after-tax $22.0 million special charge, or $0.06 per diluted share, related to restructuring activities in the Company’s Cardiac Surgery and Cardiology divisions and international selling organization. Net earnings for the third quarter of 2006 also include after-tax stock-based compensation expense of $12.3 million, or $0.03 per diluted share, resulting from the adoption of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (SFAS No. 123(R)), on January 1, 2006. Net earnings and diluted net earnings per share for the third quarter of 2005 were $167.8 million and $0.44 per diluted share, which benefited from an after-tax $7.1 million special credit, or $0.02 per diluted share, relating to a reversal of a portion of the Symmetry™ Bypass System Aortic Connector (Symmetry™ device) product liability litigation accrual, net of settlement costs, as well as a $13.7 million reversal, or $0.04 per diluted share, of previously recorded income tax expense due to the finalization of certain tax examinations. Net earnings and diluted net earnings per share for the first nine months of 2006 were $393.6 million and $1.05 per diluted share. Net earnings for the first nine months of 2006 include the aforementioned after-tax $22.0 million special charge, or $0.06 per diluted share, related to restructuring activities as well as after-tax stock-based compensation expense of $37.1 million, or $0.10 per diluted share. Net earnings and diluted net earnings per share for the first nine months of 2005 were $388.6 million and $1.03 per diluted share. Purchased in-process research and development (IPR&D) charges from the acquisitions of the businesses of Velocimed, LLC (Velocimed) and Endocardial Solutions, Inc. (ESI) reduced 2005 year-to-date net earnings by an aggregate of $26.1 million, or $0.07 per diluted share. Income tax expense of $27.0 million resulting from the repatriation of $500 million under the American Jobs Creation Act of 2004 reduced 2005 year-to-date diluted net earnings per share by $0.07. The aforementioned Symmetry™ device after-tax special credit of $7.1 million and $13.7 million reversal of previously recorded income tax expense benefited 2005 year-to-date diluted net earnings per share by $0.02 and $0.04, respectively.

 

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We generated $409.8 million of operating cash flows for the first nine months of 2006, which was a decrease compared to the first nine months of 2005, but primarily resulted from a change in classification of excess tax benefits from the exercise of stock options resulting from our adoption of SFAS No. 123(R) on January 1, 2006. In the second quarter of 2006, we repurchased $700 million, or approximately 18.6 million shares, of our outstanding common stock, which was primarily financed through the issuance of commercial paper. We are focused on repaying our outstanding debt. Refer to the Debt and Credit Facilities section below for a more detailed discussion of our outstanding debt. We ended the quarter with $70.3 million of cash and cash equivalents and $1,018.2 million of total debt. We have short-term credit ratings of A2 from Standard & Poor’s and P2 from Moody’s.

 

NEW ACCOUNTING PRONOUNCEMENT

 

Information regarding new accounting pronouncement is included in Note 2 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

 

We have adopted various accounting policies in preparing the consolidated financial statements in accordance with accounting principles generally accepted in the United States. Our significant accounting policies are disclosed in Note 1 to the Consolidated Financial Statements included in our 2005 Annual Report on Form 10-K.

 

Preparation of our consolidated financial statements in conformity with accounting principles generally accepted in the United States requires us to adopt various accounting policies and to make estimates and assumptions that affect the reported amounts in the financial statements and accompanying notes. On an ongoing basis, we evaluate our estimates and assumptions, including those related to accounts receivable allowance for doubtful accounts; estimated useful lives of diagnostic equipment; valuation of IPR&D, other intangible assets and goodwill; income taxes; and legal reserves and insurance receivables. We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, and the results form the basis for making judgments about the reported values of assets, liabilities, revenue and expenses. Actual results may differ from these estimates. Other than the inclusion of stock-based compensation as a significant accounting policy (see Note 3 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q) and critical accounting estimate effective with our adoption of SFAS No. 123(R) on January 1, 2006, there have been no material changes to our critical accounting policies and estimates from the information provided in Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2005 Annual Report on Form 10-K.

 

Stock-Based Compensation

Effective January 1, 2006, we adopted the provisions of, and account for stock-based compensation in accordance with, SFAS No. 123(R). Under the fair value recognition provisions of SFAS No. 123(R), we measure stock-based compensation cost at the grant date based on the fair value of the award and recognize the compensation expense over the requisite service period, which is the vesting period. We elected the modified-prospective method of adopting SFAS No. 123(R), under which prior periods are not retroactively revised. For the Company, the valuation provisions of SFAS No. 123(R) apply to awards granted after the January 1, 2006 effective date. Estimated stock-based compensation expense for awards granted prior to the effective date but that remain unvested on the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123, Accounting for Stock-Based Compensation pro forma disclosures.

 

The adoption of SFAS No. 123(R) had a material impact on our consolidated results of operations and operating cash flows. However, we believe that stock-based compensation aligns the interests of managers and non-employee directors with the interests of shareholders. As a result, we do not currently expect to significantly change our various stock-based compensation programs. See Note 3 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for further information regarding our stock-based compensation programs.

 

We use the Black-Scholes standard option pricing model (Black-Scholes model) to determine the fair value of stock options and employee stock purchase plan shares. The determination of the fair value of the awards on the date of grant using the Black-Scholes model is affected by our stock price as well as assumptions of other variables, including projected employee stock option exercise behaviors, risk-free interest rate, expected volatility of our stock price in future periods and expected dividends.

 

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We analyze historical employee exercise and termination data to estimate the expected life assumption. We believe that historical data currently represents the best estimate of the expected life of a new employee option. We also stratify our employee population based upon distinctive exercise behavior patterns. The risk-free interest rate we use is based on the U.S. Treasury zero-coupon yield curve on the grant date for a maturity similar to the expected life of the options. We estimate the expected volatility of our common stock by using the implied volatility in market traded options. Our decision to use implied volatility was based on the availability of actively traded options for our common stock and our assessment that implied volatility is more representative of future stock price trends than the historical volatility of our common stock. Because we do not anticipate paying any cash dividends in the foreseeable future, we use an expected dividend yield of zero. The amount of stock-based compensation expense we recognize during a period is based on the portion of the awards that are ultimately expected to vest. We estimate pre-vesting option forfeitures at the time of grant by analyzing historical data and revise those estimates in subsequent periods if actual forfeitures differ from those estimates.

 

If factors change and we employ different assumptions for estimating stock-based compensation expense in future periods or if we decide to use a different valuation model, the expense in future periods may differ significantly from what we have recorded in the current period and could materially affect our net earnings and net earnings per share of a future period.

 

The Black-Scholes model was developed for use in estimating the fair value of market traded options that have no vesting restrictions and are fully transferable, characteristics not present in our option grants and employee stock purchase plan shares. There is a risk that our estimates of the fair values of our stock-based awards on the grant dates as determined using the Black-Scholes model may bear little resemblance to the actual values realized upon the exercise or forfeiture of those stock-based awards in the future. Some employee stock options may expire without value, or only realize minimal intrinsic value, as compared to the fair values originally estimated on the grant date and recognized in our financial statements. Alternatively, some employee stock options may realize significantly more value than the fair values originally estimated on the grant date and recognized in our financial statements.

 

The guidance in SFAS No. 123(R) is relatively new. The application of these principles may be subject to further interpretation and refinement over time. There are significant differences among valuation models, and there is a possibility that we may adopt a different valuation model in the future. This may result in a lack of consistency in future periods and materially affect the fair value estimate of stock-based awards. It may also result in a lack of comparability with other companies that use different models, methods and assumptions.

 

MINORITY INVESTMENT

 

We made an initial $12.5 million investment in ProRhythm, Inc. (ProRhythm) in January 2005, which approximated a 9% ownership interest. In January 2006, we made a second $12.5 million investment in ProRhythm, increasing our total ownership interest to approximately 18%. ProRhythm is a privately-held company that is focused on the development of a high intensity focused ultrasound catheter-based ablation system for the treatment of atrial fibrillation. In connection with making the initial equity investment, we also entered into a purchase agreement, under which we have the exclusive right, but not the obligation, through the later of three months after the date ProRhythm delivers certain clinical trial data or March 31, 2007, to acquire the remaining capital stock of ProRhythm for $125.0 million in cash, with additional cash consideration payable to the non-St. Jude Medical shareholders after the consummation of the acquisition if ProRhythm achieves certain performance-related milestones. The ProRhythm investment is being accounted for under the cost method of accounting.

 

SEGMENT PERFORMANCE

 

Our five operating segments are Cardiac Rhythm Management (CRM), Cardiac Surgery (CS), Neuromodulation (NEURO), Cardiology (CD) and Atrial Fibrillation (AF). We formed our NEURO operating segment in November 2005 in connection with the acquisition of ANS. Each operating segment focuses on developing and manufacturing products for its respective therapy area. The primary products produced by each operating segment are: CRM – ICDs and pacemakers; CS – mechanical and tissue heart valves and valve repair products; NEURO – neurostimulation devices; CD – vascular closure devices, hemostasis introducers, patent foramen ovale closure devices, guidewires, embolic protection devices and other cardiology products; and AF – EP catheters, advanced cardiac mapping systems and ablation systems.

 

We aggregate our five operating segments into two reportable segments based upon their similar operational and economic characteristics: CRM/CS/NEURO and CD/AF. Net sales of our reportable segments include end-customer revenue from the sale of products they each develop and manufacture or distribute. The costs included in each of the reportable segments’ operating results include the direct costs of the products sold to end-customers and operating expenses managed by each of the reportable segments. Certain operating expenses managed by our selling and corporate functions, including all stock-based compensation expense, are not included in our reportable segments’ operating profit. Because of this, reportable segment operating profit is not representative of the operating profit of the products in these reportable segments.

 

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We are combining the Cardiac Surgery and Cardiology divisions into a new Cardiovascular division which will incorporate all activities currently managed by the Cardiac Surgery division and by the Cardiology division. A transitional period was provided to combine the existing divisions into the new division. Internal management reporting for the new reportable segments will commence January 1, 2007. Segment information will be reclassified effective January 1, 2007 to reflect the new Cardiovascular division. In order to enhance segment comparability and reflect management’s focus on our ongoing operations, the related special charges have not been recorded in the individual reportable segments.

 

The following table presents net sales and operating profit by reportable segment (in thousands):

 

 

 

The following discussion of the changes in our net sales is provided by class of similar products within our five operating segments, which is the primary focus of our sales activities. This analysis sufficiently describes the changes in our sales results for our two reportable segments.

 

Cardiac Rhythm Management

 

 

Cardiac Rhythm Management net sales increased 2% in the third quarter of 2006 over the third quarter of 2005 and increased 8% in the first nine months of 2006 over the same period one year ago. Foreign currency translation had a $5.0 million favorable impact on CRM net sales in the third quarter of 2006 when compared to the third quarter of 2005. Foreign currency translation unfavorably impacted CRM net sales for the first nine months of 2006 by $8.8 million when compared to the first nine months of 2005. Net sales of ICD systems decreased 2% in the third quarter of 2006. Slight declines in average selling price, primarily driven by a change in geographic mix in sales, were offset by a $2.5 million favorable impact from foreign currency translation and slight growth in unit sales. Net sales of ICD systems increased 12% in the first nine months of 2006, due to a 16% increase in ICD unit sales that was partially offset by $2.4 million of unfavorable impact from foreign currency translation as well as a slight decline in average selling price. Net sales of pacemaker systems increased 8% during the third quarter of 2006 due to an 11% increase in pacemaker unit sales and $2.5 million of favorable impact from foreign currency translation which were partially offset by a slight decline in average selling price. Net sales of pacemaker systems increased 4% during the first nine months of 2006 due to a 9% increase in pacemaker unit sales that was partially offset by $6.5 million of unfavorable impact from foreign currency translation as well as a slight decline in average selling price.

 

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Cardiac Surgery

 

 

Cardiac Surgery net sales increased 10% in the third quarter 2006 over the third quarter of 2005 and increased 7% in the first nine months of 2006 over the same period one year ago. CS net sales for both the third quarter and first nine months of 2006 were favorably impacted by growth in unit volume driven by increased sales of tissue heart valves. Foreign currency translation had a negligible impact on CS net sales in the third quarter of 2006 when compared to the third quarter of 2005. However, foreign currency translation did have a $3.7 million unfavorable impact on CS net sales in the first nine months of 2006 as compared with the same period in 2005. Heart valve net sales increased 10% during the third quarter of 2006, due primarily to an increase in unit volume of 19% which was partially offset by a decline in average selling price. Foreign currency translation had a favorable impact of $0.6 million. For the first nine months of 2006, heart valve net sales increased approximately 8%, due primarily to an increase in unit volume of approximately 15%. Foreign currency translation had an unfavorable impact of $2.6 million while average selling price slightly declined. For both the third quarter and first nine months of 2006, sales growth in tissue heart valves continues to be partially offset by declines in mechanical heart valves net sales. Net sales of other cardiac surgery products remained relatively flat during the third quarter and first nine months of 2006, respectively, when compared to the same periods in 2005.

 

Neuromodulation

 

 

St. Jude Medical did not have neuromodulation product sales prior to our acquisition of ANS in November 2005. Third quarter 2006 net sales of $43.4 million represent a 10% increase over ANS’s third quarter 2005 sales of $39.3 million as a stand-alone company. Net sales of $128.8 million for the first nine months of 2006 represent a 17% increase over ANS’s net sales of $110.4 million as a stand-alone company for the first nine months of 2005.

 

Cardiology

 

 

Cardiology net sales increased over 4% in the third quarter 2006 over the third quarter of 2005 and increased approximately 3% in the first nine months of 2006 over the same period one year ago. CD net sales for both the third quarter and first nine months of 2006 were favorably impacted by growth in unit volume driven by increased sales of vascular closure devices. Foreign currency translation had a negligible impact on CD net sales in the third quarter of 2006 when compared to the third quarter of 2005. However, foreign currency translation did have a $5.6 million unfavorable impact on CD net sales in the first nine months of 2006 as compared with the same period in 2005. Net sales of vascular closure devices increased approximately 6% during the third quarter of 2006 due to a 6% increase in unit sales. Impacts from foreign currency translation and changes in average selling price were negligible. For the first nine months of 2006, net sales of vascular closure devices increased 3%, due primarily to an increase in unit volume of approximately 6%. Foreign currency translation had an unfavorable impact of $2.0 million while average selling price slightly declined. Net sales of other cardiology products were relatively flat during the third quarter and first nine months of 2006, respectively, when compared to the same periods in 2005.

 

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Atrial Fibrillation

 

 

Atrial Fibrillation net sales increased over 29% during both the third quarter and first nine months of 2006 when compared to the same periods one year ago. The increases in AF net sales are due to sales of products related to recent acquisitions and an increase in unit volume of existing products. Foreign currency translation impact on AF net sales for the third quarter of 2006 was negligible; however, foreign currency translation did have an unfavorable impact of $2.9 million in the first nine months of 2006.

 

RESULTS OF OPERATIONS

 

Net Sales

 

 

Overall, net sales increased over 11% in the third quarter of 2006 over the third quarter of 2005. For the first nine months of 2006, net sales increased approximately 15% over the same period one year ago. Incremental revenue resulting from the acquisition of ANS benefited net sales for the third quarter and first nine months of 2006 by approximately $43.3 million and $128.8 million, respectively. Foreign currency translation was favorable in the third quarter of 2006, with sales growth benefiting from a $6.6 million impact from foreign currency translation, primarily resulting from the strengthening of the Euro and Yen against the U.S. Dollar. Sales growth for the first nine months of 2006, however, was partially offset by a $21.1 million unfavorable impact from foreign currency translation, primarily resulting from the strengthening of the U.S. Dollar against the Euro and Yen. The impact of foreign currency translation on net sales is not indicative of the net earnings impact for the respective periods of 2006 due to partially offsetting foreign currency translation impacts on cost of sales and operating expenses.

 

Net sales by geographic markets were as follows (in thousands):

 

 

 

 

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Gross Profit

 

 

Gross profit for the third quarter of 2006 totaled $581.0 million, or 70.7% of net sales, compared to $537.0 million, or 72.8% of net sales, for the third quarter of 2005. Restructuring special charges negatively impacted our gross profit percentage for the third quarter of 2006 by 1.9 percentage points. Stock-based compensation expense also resulted in an unfavorable 0.2 percentage point impact on our gross profit percentage for the third quarter of 2006. Gross profit for the first nine months of 2006 totaled $1,762.9 million, or 72.3% of net sales, compared to $1,535.7 million, or 72.3% of net sales, for the first nine months of 2005. Restructuring special charges negatively impacted our gross profit percentage for the first nine months of 2006 by 0.6 percentage points. Stock-based compensation expense also resulted in an unfavorable 0.2 percentage point impact on our gross profit percentage for the first nine months of 2006. Gross profit percentage for the first nine months of 2006 also reflects increased manufacturing efficiencies partially offset by unfavorable changes in product mix for our higher margin products and a slight decrease in the average selling price for these products.

 

Selling, General and Administrative (SG&A) Expense

 

 

SG&A expense for the third quarter of 2006 totaled $290.4 million, or 35.4% of net sales, compared to $243.6 million, or 33.0% of net sales, for the third quarter of 2005. Approximately 1.5 percentage points of the third quarter 2006 SG&A expense as a percent of net sales relates to $11.8 million of stock-based compensation expense. The remaining 0.9 percentage point increase in SG&A expense as a percent of net sales primarily relates to higher amortization expense resulting from intangible assets acquired as part of fiscal year 2005 acquisitions and higher costs related to the continued expansion of our selling organization infrastructure. SG&A expense for the first nine months of 2006 totaled $875.7 million, or 35.9% of net sales, compared to $700.2 million, or 32.9% of net sales, for the first nine months of 2005. Approximately 1.5 percentage points of the SG&A expense for the first nine months of 2006 as a percent of net sales relates to $35.8 million of stock-based compensation expense. The remaining 1.5 percentage point increase in SG&A expense as a percent of net sales primarily relates to higher amortization expense resulting from intangible assets acquired as part of fiscal year 2005 acquisitions and higher costs related to the continued expansion of our selling organization infrastructure.

 

Research and Development (R&D) Expense

 

 

R&D expense in the third quarter of 2006 totaled $108.7 million, or 13.2% of net sales, compared to $97.5 million, or 13.2% of net sales, for the third quarter of 2005. R&D expense in the first nine months of 2006 totaled $322.8 million, or 13.2% of net sales, compared to $264.3 million, or 12.4% of net sales, for the first nine months of 2005. Stock-based compensation expense accounted for approximately 0.5 percentage points of R&D expense for both the third quarter of 2006 and for the first nine months of 2006 as a percent of net sales.

Purchased In-Process Research and Development Charges

Velocimed, LLC (Velocimed): In April 2005, we acquired Velocimed to further enhance our portfolio of products in the interventional cardiology market. At the date of acquisition, $13.7 million of the purchase price was expensed as IPR&D related to projects for the Proxis™ embolic protection device that had not yet reached technological feasibility in the United States and other geographies and had no future alternative use. The device is used to help minimize the risk of heart attack or stroke if plaque or other debris is dislodged into the blood stream during interventional cardiology procedures. In 2005, we incurred $3.4 million in costs related to these projects. We have incurred $2.8 million in the first nine months of 2006 and expect to incur up to an additional $2 million through 2007 to bring this acquired technology to commercial viability.

 

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Endocardial Solutions, Inc. (ESI): In January 2005, we acquired ESI to further enhance our portfolio of products used to treat heart rhythm disorders. At the date of acquisition, $12.4 million of the purchase price was expensed as IPR&D related to system upgrades that had not yet reached technological feasibility and had no future alternative use. These major system upgrades are part of the EnSite® system which is used for the navigation and localization of diagnostic and therapeutic catheters used in atrial fibrillation ablation and other EP catheterization procedures. During 2005, we incurred an additional $0.7 million in costs related to these projects and in the third quarter of 2005, we achieved commercial viability and launched EnSite® system version 5.1 and the EnSite® Verismo™ segmentation tool.

Special Charges (Credits)

Restructuring Activities: During the third quarter of 2006, management performed a review of the organizational structure of our Cardiac Surgery and Cardiology divisions and our international selling organization. In August 2006, management approved restructuring plans to streamline its operations within its Cardiac Surgery and Cardiology divisions by combining them into one new Cardiovascular division and also to implement changes in our international selling organization by enhancing the efficiency and effectiveness of sales and customer service operations in certain international geographies. This strategic reorganization and operational restructuring will allow us to enhance operating efficiencies and increase our investment in product development.

 

As a result of these restructuring plans, we recorded pre-tax special charges totaling $34.8 million in the third quarter of 2006 consisting of employee termination costs ($14.7 million), inventory write-downs ($8.7 million), asset write-downs ($7.3 million) and other exit costs ($4.1 million). Of the total $34.8 million special charge, $15.1 million was recorded in cost of sales and $19.7 million was recorded in operating expenses. See Note 8 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for further detail on these charges. We expect that total cash expenditures for the restructuring special charge will be approximately $19 million and will be funded by cash from operations.

 

In connection with these restructuring plans, approximately 140 individuals were identified for employment termination, of which approximately 28 have been terminated as of September 30, 2006. In addition, in connection with these restructuring plans, management made the commitment to discontinue certain product lines and dispose of related assets. We have also decided to discontinue the use of the Getz Bros. Co. Ltd. (Getz Japan) trademarks in Japan, and therefore have written off the $4.2 million intangible asset that we acquired in connection with our 2003 acquisition of Getz Japan.

 

We do not anticipate any material short-term or long-term net cost savings resulting from these restructuring activities as we intend to use the immediate savings to increase our investment in research and development and in productivity improvement. We also do not anticipate any material short-term or long-term impact on future revenue or gross profit percentage as a result of the product lines that we exited in connection with this reorganization because the associated products did not materially contribute to our revenue or gross profit percentage.

 

A summary of the activity relating to the restructuring accrual for the nine months ended September 30, 2006 is as follows (in thousands):

 

 

Symmetry™ Bypass System Aortic Connector Litigation: During the third quarter of 2005, over 90% of the cases and claims asserted involving the Symmetry™ device were resolved. As a result, we reversed $14.8 million of the pre-tax $21.0 million special charge that was recorded in the third quarter of 2004 to accrue for legal fees in connection with claims involving the Symmetry™ device. Additionally, we recorded a pre-tax charge of $3.3 million in the third quarter of 2005 to accrue for settlement costs negotiated in these related cases. These adjustments resulted in a net pre-tax special credit of $11.5 million that was recorded in the third quarter of 2005 related to Symmetry™ device product liability litigation.

 

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Other (Expense) Income

 

The unfavorable changes in other (expense) income during the third quarter of 2006 and the first nine months of 2006 as compared to the same periods in the prior year were due primarily to higher interest expense resulting from the issuance of our 2.8% Convertible Senior Debentures in the fourth quarter of 2005 to fund a portion of the acquisition of ANS as well as higher commercial paper borrowings to finance the majority of the repurchase of $700 million of our common stock in the second quarter of 2006.

 

Income Taxes

 

 

Our effective income tax rate was 24.5% and 20.6% for the third quarter of 2006 and third quarter of 2005, respectively. In the third quarter of 2005, we reversed $13.7 million of previously recorded income tax expense due to the finalization of certain tax examinations, which positively impacted the effective tax rate for the third quarter of 2005 by 6.5 percentage points.

 

Our effective income tax rate was 25.7% and 31.1% for the first nine months of 2006 and 2005, respectively. The $27.0 million income tax expense recorded as a result of the repatriation of $500 million under the American Jobs Creation Act of 2004 negatively impacted the effective tax rate for the first nine months of 2005 by 4.8 percentage points. Non-deductible aggregate IPR&D charges of $26.1 million from the acquisitions of ESI and Velocimed also negatively impacted the effective tax rate for the first nine months of 2005 by 1.4 percentage points. These negative impacts were partially offset by the reversal of $13.7 million of previously recorded income tax expense due to the finalization of certain tax examinations which positively impacted the effective tax rate for the third quarter of 2005 by 2.4 percentage points.

 

The Federal Research and Development tax credit (R&D tax credit), which provides a tax benefit on certain incremental R&D expenditures, expired on December 31, 2005. Legislation to retroactively reinstate the R&D tax credit is pending in the U.S. Congress, however, it was not enacted and signed into law as of September 30, 2006. Accordingly, no benefit from the R&D tax credit was included in our 2006 effective tax rate. The benefit of the R&D tax credit will be recorded in the period the legislation is enacted and signed into law.

 

LIQUIDITY

 

We believe that our existing cash balances, available borrowings under our committed credit facilities and future cash generated from operations will be sufficient to meet our working capital and capital investment needs over the next twelve months and in the foreseeable future thereafter. Should suitable investment opportunities arise, we believe that our earnings, cash flows and balance sheet position will permit us to obtain additional debt financing or equity capital, if necessary. We have short-term credit ratings of A2 from Standard & Poor’s and P2 from Moody’s.

 

In December 2005, we issued $660.0 million aggregate principal amount of 2.80% Convertible Senior Debentures (Convertible Debentures) which permit the holders of the Convertible Debentures to require us to repurchase some or all of the Convertible Debentures for cash on December 15, 2006. It is likely that we will be required to repurchase some or all of the Convertible Debentures on that date; we believe that we will be able to finance such repurchase through cash from operations, proceeds from the issuance of commercial paper or additional debt financing. Refer to the Debt and Credit Facilities section below for further details on the Convertible Debentures.

 

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Cash Flows from Operating Activities

Cash provided by operating activities was $409.8 million for the first nine months of 2006, a $64.5 million decrease from the same period one year ago. The decrease in operating cash flow during the first nine months of 2006 when compared to the first nine months of 2005 results from changes in operating assets and liabilities as well as a required change in classification of excess tax benefits from the exercise of stock options.

 

Operating cash flows decreased approximately $207.8 million due to changes in operating assets and liabilities, principally accounts receivable and inventory, which increased $51.7 million and $64.4 million, respectively. We use two primary measures that focus on accounts receivable and inventory – days sales outstanding (DSO) and days inventory on hand (DIOH). These measures are not defined under U.S. generally accepted accounting principles and may not be computed the same as similarly titled measures used by other companies. Accounts receivable increased in the first nine months of 2006, and our DSO (calculated as average quarterly daily sales divided by ending net accounts receivable) correspondingly increased to 96 days at September 30, 2006 from 91 days at December 31, 2005. Our DSO normally increases in the third quarter of each fiscal year due to the seasonality of our international business and impact of summer holidays, particularly in Europe. We use DSO as a measure that places emphasis on how quickly we collect our accounts receivable balances from customers. Inventory increased to support new CRM and CD product introductions as well as to support our increased sales volumes. As a result, DIOH (calculated as average year-to-date daily cost of sales divided by ending net inventory) increased to 176 days at September 30, 2006 from 159 days at December 31, 2005. We use DIOH, which can also be expressed as a measure of the estimated number of days of cost of sales on hand, as a measure that places emphasis on how efficiently we are managing our inventory levels.

 

The required change in classification of excess tax benefits from the exercise of stock options resulted from our adoption of SFAS No. 123(R) on January 1, 2006. For the first nine months of 2005, these excess tax benefits were classified as operating cash flows as part of the change in income taxes payable, however, for the first nine months of 2006, such benefits are now classified as financing cash flows. These excess tax benefits had positively impacted our operating cash flows for the first nine months of 2005 by $62.2 million. See Note 3 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q for additional discussion of how adopting SFAS No. 123(R) affected our consolidated results of operations and statement of cash flows.

 

Cash Flows from Investing Activities

Cash used in investing activities was $238.3 million in the first nine months of 2006 compared to $490.3 million in the same period last year. Because we did not make any significant acquisitions in the first nine months of 2006, cash used in investing activities decreased when compared to the first nine months of 2005, when we acquired ESI for $279.4 million and Velocimed for $70.9 million, less cash acquired. If strategic opportunities arise, we have sufficient short-term liquidity sources to fund internal development opportunities and invest in acquisitions and minority investments. In January 2006, we made an additional $12.5 million investment in ProRhythm. Refer to the Minority Investment section above for more detail on our investment in ProRhythm. Our investing cash flows in the first nine months of 2006 have been focused on increasing our investments in property, plant and equipment, including next-generation diagnostic equipment such as our Merlin™ Patient Care System which is used by physicians and healthcare professionals to program and analyze data from ICDs and pacemakers. As a result, capital expenditures totaled $198.5 million in the first nine months of 2006, an 85% increase over the first nine months of 2005.

 

Cash Flows from Financing Activities

Cash used in financing activities was $642.2 million in the first nine months of 2006 compared to cash provided by financing activities of $63.0 million in the same period last year. We repurchased $700 million of our common stock in the second quarter of 2006, which was primarily financed through proceeds from the issuance of commercial paper. As discussed previously, excess tax benefits from the exercise of stock options are now classified as financing cash flows, and this amount can fluctuate significantly in future periods as it is dependent upon, among other things, the level of stock option exercises by our employees as well as the fair market value of our common stock on the exercise dates.

 

SHARE REPURCHASE PROGRAM

 

On April 18, 2006, our Board of Directors authorized a new share repurchase program of up to $700 million of our outstanding common stock. The $700 million share repurchase program replaced our earlier share repurchase program, under which we were authorized to repurchase up to $300 million of our outstanding common stock. No stock had been repurchased under this earlier program. On April 21, 2006, we began making share repurchases through transactions in the open market in accordance with applicable securities laws. On May 26, 2006, we had repurchased the maximum amount authorized by the Board of Directors under the repurchase program. Approximately 18.6 million shares were repurchased for a total of $700 million, which was financed through cash from operations and proceeds from the issuance of commercial paper.

 

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DEBT AND CREDIT FACILITIES

 

Total debt decreased slightly to $1.0 billion at September 30, 2006 from $1.1 billion at December 31, 2005. Although we issued approximately $535 million of commercial paper in the second quarter of 2006 primarily to fund the repurchase of $700 million of our common stock, we have repaid approximately $355 million as of September 30, 2006. Our commercial paper program provides for the issuance of short-term, unsecured commercial paper with maturities up to 270 days. At September 30, 2006 we had $180.6 million of commercial paper outstanding which bears interest at a weighted average effective interest rate of 5.4% and has a weighted average original maturity of 15 days.

 

In December 2005, we issued $660.0 million aggregate principal amount of 2.80% Convertible Debentures that mature on December 15, 2035. Interest payments are required on a semi-annual basis. Contingent interest is payable in certain circumstances after December 15, 2006. We have the right to redeem some or all of the Convertible Debentures for cash at any time on or after December 15, 2006. We also may be required to repurchase some or all of the Convertible Debentures for cash upon the occurrence of certain events as well as on December 15 in the years 2006, 2008, 2010, 2015, 2020, 2025 and 2030. The Convertible Debentures are convertible under certain circumstances for cash and shares of our common stock, if any, at a conversion rate of 15.5009 shares (or an initial conversion price of approximately $64.51 per share of common stock). Upon conversion, we would be required to satisfy up to 100% of the principal amount of the Convertible Debentures solely in cash, with any amounts above the principal amount to be satisfied in shares of our common stock.

 

In May 2003, we issued 7-year, 1.02% unsecured notes totaling 20.9 billion Yen, or $177.6 million and $176.9 million at September 30, 2006 and December 31, 2005, respectively. Interest payments are required on a semi-annual basis and the entire principal balance is due in May 2010.

 

On September 30, 2006, we had up to $750.0 million of available borrowings under our committed credit facilities in the United States, consisting of a $350 million revolving credit agreement that expires in September 2008 and a $400 million revolving credit agreement that expires in September 2009. Borrowings under these credit facilities bear interest at variable rates tied to the London InterBank Offered Rate and can be used for general corporate purposes or to support our commercial paper program. In June 2006, we renewed a 1.0 billion Yen (equivalent to approximately $8.5 million at September 30, 2006) credit facility that expires in June 2007. Borrowings under the credit facility bear interest at the floating Tokyo InterBank Offered Rate plus 0.50% per annum. This credit facility replaced a 1.0 billion Yen credit facility that expired in June 2006. There were no outstanding borrowings under our credit facilities at September 30, 2006 or December 31, 2005.

 

Our 1.02% unsecured notes and revolving credit facilities contain various operating and financial covenants. Specifically, we must have a ratio of total debt to total capitalization not exceeding 55%, have a leverage ratio (defined as the ratio of total debt to EBIT (net earnings before interest and income taxes) or total debt to EBITDA (net earnings before interest, income taxes, depreciation and amortization)) not exceeding 3.0 to 1.0, and an interest coverage ratio (defined as the ratio of EBIT to interest expense or the ratio of EBITDA to interest expense) not less than 3.0 to 1.0 or 3.5 to 1.0, as applicable. We also have limitations on additional liens or indebtedness and limitations on certain acquisitions, investments and dispositions of assets. However, these agreements do not include provisions for the termination of the agreements or acceleration of repayment due to changes in our debt ratings. We were in compliance with all of our debt covenants at September 30, 2006.

 

COMMITMENTS AND CONTINGENCIES

 

A description of our contractual obligations and other commitments is contained in Part II, Item 7A, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Off-Balance Sheet Arrangements and Contractual Obligations, included in our 2005 Annual Report on Form 10-K. There have been no significant changes in our contractual obligations and other commitments disclosed in our 2005 Annual Report on Form 10-K. We have no off-balance sheet financing arrangements other than that previously disclosed in our 2005 Annual Report on Form 10-K. Our significant legal proceedings are discussed in Note 7 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q.

 

CAUTIONARY STATEMENTS

 

In this Quarterly Report on Form 10-Q and in other written or oral statements made from time to time, we have included and may include statements that constitute “forward-looking statements” with respect to the financial condition, results of operations, plans, objectives, new products, future performance and business of St. Jude Medical, Inc. and its subsidiaries. Statements preceded by, followed by or that include words such as “may,” “will,” “expect,” “anticipate,” “continue,” “estimate,” “forecast,” “project,” “believe” or similar expressions are intended to identify some of the forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are included, along with this statement, for purposes of complying with the safe harbor provisions of that Act. These forward-looking statements involve risks and uncertainties. By identifying these statements for you in this manner, we are alerting you to the possibility that

 

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actual results may differ, possibly materially, from the results indicated by these forward-looking statements. We undertake no obligation to update any forward-looking statements. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the risks and uncertainties discussed in Part I, Item 1A, Risk Factors of our 2005 Annual Report on Form 10-K and in Part II, Item 1A, Risk Factors of our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006, as well as the various factors described below. Since it is not possible to foresee all such factors, you should not consider these factors to be a complete list of all risks or uncertainties. We believe the most significant factors that could affect our future operations and results are set forth in the list below.

 

 

 

There have been no material changes since December 31, 2005 in our market risk. For further information on market risk, refer to Part II, Item 7A, Quantitative and Qualitative Disclosures About Market Risk in our 2005 Annual Report on Form 10-K.

 

 

As of September 30, 2006, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2006.

 

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During the fiscal quarter ended September 30, 2006, there were no changes in the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

 

We are the subject of various pending or threatened legal actions and proceedings, including those that arise in the ordinary course of our business. Such matters are subject to many uncertainties and to outcomes that are not predictable with assurance and that may not be known for extended periods of time. We record a liability in our consolidated financial statements for costs related to claims, including future legal costs, settlements and judgments, where we have assessed that a loss is probable and an amount can be reasonably estimated. Our significant legal proceedings are discussed in Note 7 to the Condensed Consolidated Financial Statements in this Quarterly Report on Form 10-Q and are incorporated herein by reference. While it is not possible to predict the outcome for most of the legal proceedings discussed in Note 7, the costs associated with such proceedings could have a material adverse effect on our consolidated earnings, financial position or cash flows of a future period.

 

 

The discussion of our business and operations should be read together with the risk factors contained in Part I, Item 1A, Risk Factors in our 2005 Annual Report on Form 10-K and in Part II, Item 1A, Risk Factors in our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006, which describe various risks and uncertainties to which we are or may become subject. These risks and uncertainties have the potential to materially impact our business, financial condition or results of operations.

 

 

 

 

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SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

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INDEX TO EXHIBITS

 

 

 

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