10-Q 1 stjude014545_10q.txt ST. JUDE MEDICAL, INC. FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Quarter Ended September 30, 2001 Commission File Number 0-8672 ------------------ ------ ST. JUDE MEDICAL, INC. ----------------------- (Exact name of Registrant as specified in its charter) MINNESOTA 41-1276891 --------- -------------------------- (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) One Lillehei Plaza, St. Paul, Minnesota 55117 ---------------------------------------------- (Address of principal executive offices) (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 ___ The number of shares of common stock, par value $.10 per share, outstanding on November 2, 2001 was 87,054,512. Page 1 of 19 PART I FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS ST. JUDE MEDICAL, INC. CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 2001 2000 2001 2000 ================================================================================================== Net sales $ 337,029 $ 286,969 $ 999,156 $ 883,407 Cost of sales: Cost of sales before special charges 108,322 93,008 325,622 293,562 Special charges 21,667 -- 21,667 -- -------------------------------------------------------------------------------------------------- Total cost of sales 129,989 93,008 347,289 293,562 -------------------------------------------------------------------------------------------------- Gross profit 207,040 193,961 651,867 589,845 Selling, general and administrative expense 116,684 102,688 347,385 313,753 Research and development expense 41,141 34,657 121,772 101,947 Purchased in-process research and development charges -- -- 5,000 5,000 Special charges 11,167 -- 11,167 26,101 -------------------------------------------------------------------------------------------------- Operating profit 38,048 56,616 166,543 143,044 Other income (expense) (1,614) (5,950) (7,251) (20,599) -------------------------------------------------------------------------------------------------- Earnings before income taxes 36,434 50,666 159,292 122,445 Income tax expense 5,000 12,667 36,965 34,499 -------------------------------------------------------------------------------------------------- Net earnings $ 31,434 $ 37,999 $ 122,327 $ 87,946 ================================================================================================== ================================================================================================== Net earnings per share: Basic $ 0.36 $ 0.45 $ 1.42 $ 1.05 Diluted $ 0.35 $ 0.44 $ 1.37 $ 1.03 Weighted average shares outstanding: Basic 86,510 84,269 85,945 83,970 Diluted 89,832 86,494 89,012 85,136 ==================================================================================================
See notes to condensed consolidated financial statements. Page 2 of 19 ST. JUDE MEDICAL, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 2001 (UNAUDITED) 2000 (SEE NOTE) ========================================================================================= ASSETS Current assets Cash and equivalents $ 82,190 $ 50,439 Marketable securities 54,156 57,423 Accounts receivable, less allowances of $18,182 in 2001 and $13,831 in 2000 329,136 303,307 Inventories 235,182 222,238 Other current assets 79,526 71,235 --------------------------------------------------------------------------------------- Total current assets 780,190 704,642 Property, plant and equipment - at cost 645,343 619,392 Less accumulated depreciation (345,760) (302,213) --------------------------------------------------------------------------------------- Net property, plant and equipment 299,583 317,179 Other assets Goodwill and other intangible assets, net 429,567 430,896 Other 78,122 79,999 --------------------------------------------------------------------------------------- Total other assets 507,689 510,895 --------------------------------------------------------------------------------------- TOTAL ASSETS $ 1,587,462 $ 1,532,716 ======================================================================================= LIABILITIES & SHAREHOLDERS' EQUITY Current liabilities Accounts payable $ 88,528 $ 81,340 Accrued expenses 174,665 157,803 Incomes taxes payable 61,376 58,224 --------------------------------------------------------------------------------------- Total current liabilities 324,569 297,367 Long-term debt 162,400 294,500 Commitments and contingencies -- -- Shareholders' equity Preferred stock -- -- Common stock 8,677 8,534 Additional paid-in capital 115,424 55,723 Retained earnings 1,084,644 962,317 Accumulated other comprehensive income: Cumulative translation adjustment (112,065) (93,380) Unrealized gain on available-for-sale securities 3,813 7,655 --------------------------------------------------------------------------------------- Total shareholders' equity 1,100,493 940,849 --------------------------------------------------------------------------------------- TOTAL LIABILITIES & SHAREHOLDERS' EQUITY $ 1,587,462 $ 1,532,716 =======================================================================================
NOTE: THE BALANCE SHEET AT DECEMBER 31, 2000 HAS BEEN DERIVED FROM THE AUDITED FINANCIAL STATEMENTS AT THAT DATE. SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. Page 3 of 19 ST. JUDE MEDICAL, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)
NINE MONTHS ENDED SEPTEMBER 30, 2001 2000 ============================================================================================= Operating Activities Net earnings $ 122,327 $ 87,946 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 66,396 69,919 Purchased in-process research and development charges 5,000 5,000 Special charges 32,834 26,101 Net investment gain -- (2,056) Working capital change and other (23,783) (61,300) --------------------------------------------------------------------------------------------- Net cash provided by operating activities 202,774 125,610 Investing Activities Purchase of property, plant and equipment (51,682) (23,042) Proceeds from sale or maturity of marketable securities -- 7,871 Business acquisition payments (10,919) (7,864) Other (19,705) (1,048) --------------------------------------------------------------------------------------------- Net cash used in investing activities (82,306) (24,083) Financing Activities Proceeds from exercise of stock options and employee stock purchase plan 44,377 20,662 Borrowings under debt facilities 1,691,700 3,478,537 Payments under debt facilities (1,823,800) (3,572,937) Repurchase of convertible subordinated debentures -- (19,320) --------------------------------------------------------------------------------------------- Net cash used in financing activities (87,723) (93,058) Effect of currency exchange rate changes on cash (994) (1,026) --------------------------------------------------------------------------------------------- Net increase in cash and equivalents 31,751 7,443 Cash and equivalents at beginning of period 50,439 9,655 --------------------------------------------------------------------------------------------- Cash and equivalents at end of period $ 82,190 $ 17,098 =============================================================================================
See notes to condensed consolidated financial statements. Page 4 of 19 ST. JUDE MEDICAL, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) NOTE 1 - BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles 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 generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the interim periods are not necessarily indicative of the results that may be expected for the full year. For further information, refer to the consolidated financial statements and footnotes included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. NOTE 2 - INVENTORIES Inventories consist of the following: SEPTEMBER 30, DECEMBER 31, 2001 2000 ================================================================================ Finished goods $127,776 $ 123,696 Work in process 40,151 35,640 Raw materials 67,255 62,902 -------------------------------------------------------------------------------- $235,182 $ 222,238 ================================================================================ NOTE 3 - LONG-TERM DEBT Long-term debt consists of the following: SEPTEMBER 30, DECEMBER 31, 2001 2000 ================================================================================ Commercial paper borrowings $162,400 $ 223,000 Uncommitted credit facility borrowings -- 71,500 -------------------------------------------------------------------------------- Total long-term debt $162,400 $ 294,500 ================================================================================ The Company issues commercial paper with maturities up to 270 days. These commercial paper borrowings are fully backed by committed credit facilities. The Company has committed revolving credit facilities of $350,000 and $150,000 that expire in March 2003 and March 2002, respectively. The Company also borrows from time to time under uncommitted, due-on-demand credit facilities with various banks. Page 5 of 19 The Company classifies all of its commercial paper and credit facility borrowings as long-term on its balance sheet as the Company has the ability to repay any short-term obligations with available cash from its existing long-term, committed credit facility. Management continually reviews the Company's cash flow projections and may from time to time repay a portion of the Company's borrowings. NOTE 4 - COMMITMENTS AND CONTINGENCIES SILZONE(R) LITIGATION: The Company has been sued by patients alleging defects in the Company's mechanical heart valves and valve repair products with Silzone(R) coating. The Company recalled products with Silzone(R) coating on January 21, 2000, and sent a Recall Notice and Advisory concerning the recall to physicians and others. Some of these cases are seeking monitoring of patients implanted with Silzone(R)-coated valves and repair products who allege no injury to date. Some of these cases are seeking class action status. The Company intends to vigorously defend these cases. See also Note 6 regarding the 2000 special charge for the Silzone(R) recall. On April 18, 2001, the U.S. Judicial Panel on Multi-Litigation ruled that certain lawsuits filed in U.S. federal district court involving products with Silzone(R) coating should be part of M.D.L. proceedings, which will take place under the supervision of U.S. District court Judge John Tunheim in Minnesota. As a result, a number of actions involving products with Silzone(R) coating are being transferred to Judge Tunheim's court in Minnesota for coordinated or consolidated pretrial proceedings. While it is not possible to predict the outcome of these cases, the Company believes that it has adequate product liability insurance to cover the costs associated with them. The Company further believes that any costs not covered by product liability insurance will not have a material adverse impact on the Company's financial position or liquidity, but may be material to the consolidated results of operations of any one period. GUIDANT LITIGATION: On November 26, 1996, Guidant Corporation (a competitor of St. Jude Medical) ("Guidant") and related parties filed two lawsuits against St. Jude Medical, Inc. and certain affiliates ("St. Jude Medical"). The first lawsuit, filed in State Superior Court in Marion County, Indiana, alleged, among other things, that the license agreement between CPI (Guidant) and members of the Telectronics Group did not pass to St. Jude Medical upon St. Jude Medical's acquisition of substantially all the assets of the Telectronics cardiac stimulation device business. This lawsuit was stayed by the court in 1998 pending a ruling on the transferability of the CPI/Telectronics license by an arbitrator, as required by the license agreement. On July 10, 2000, the arbitrator ruled that the CPI/Telectronics license agreement did not transfer to St. Jude Medical in connection with St. Jude Medical's acquisition of the Telectronics cardiac stimulation device business. Pursuant to an earlier ruling by the arbitrator, St. Jude Medical was not allowed to participate in the arbitration proceeding. The second case Guidant initiated against St. Jude Medical in November 1996 was filed in the United States District Court for the Southern District of Indiana. In this lawsuit, Guidant originally alleged infringement by St. Jude Medical of four patents. Guidant later dismissed its claims on one patent Page 6 of 19 (the '678 patent). In addition, in response to a stipulation by the parties, the court ruled that a second patent (the '191 patent) was invalid. Guidant has appealed the ruling of invalidity concerning the '191 patent. The judge in the U.S. District court action issued a pre-trial ruling in May 2001 which determined that the CPI/Telectronics license did not transfer to St. Jude Medical. Based on the ruling of the arbitrator and the judge in the federal court case, the Indiana State court action discussed above has no further significance. A jury trial involving the two remaining patents asserted by Guidant (the '288 and '472 patents) commenced in June 2001. The jury issued its verdict on July 3, 2001, finding that both the '472 and '288 patents were valid and that St. Jude Medical did not infringe the '288 patent. The jury also found that St. Jude did infringe the '472 patent, which expired on March 4, 2001, but that the infringement was not willful. The jury awarded damages of $140 million to Guidant. The jury's verdict in this case has not yet been entered as a judgment by the judge overseeing the trial pending any post-trial motions filed by St. Jude Medical or Guidant. St. Jude Medical has filed various post-trial motions which would effectively eliminate any damage award on the '472 patent if these motions were ruled upon favorably by the trial judge. The Company has also filed alternative post-trial motions seeking to reduce the damage amount, and the Guidant parties have filed motions seeking a new trial on certain issues and also an award of interest. Rulings on the post trial motions filed by the parties are expected in the fourth quarter of 2001 or the first quarter of 2002. Under these circumstances, the Company is unable to determine the amount of a loss, if any, that may be incurred in connection with this case, and consequently has not recorded any liability for this lawsuit in its financial statements. Since the date of St. Jude Medical's acquisition of Ventritex in May 1997 and the inception of the Company's sales of implantable cardioverter defibrillator (ICD) products, St. Jude Medical has accrued a 3% royalty on its ICD sales under a license it believed it had acquired as part of its purchase of the Telectronics cardiac stimulation device business. As a result of the jury's verdict that St. Jude Medical's ICD products do not infringe Guidant's '288 patent, future royalty accruals are no longer necessary. The historical accruals under this license, which total approximately $15 million, will remain on the Company's balance sheet pending future developments in this case. OTHER LITIGATION MATTERS: The Company is involved in various other product liability lawsuits, claims and proceedings of a nature considered normal to its business. Subject to self-insured retentions, the Company believes it has product liability insurance sufficient to cover such claims and suits. NOTE 5 - SHAREHOLDERS' EQUITY CAPITAL STOCK: The Company's authorized capital consists of 25,000 shares of $1.00 per share par value preferred stock and 250,000 shares of $0.10 per share par value common stock. There were no shares of preferred stock issued or outstanding during 2000 or 2001. There were 86,770 and 85,336 shares of common stock outstanding at September 30, 2001 and December 31, 2000. Page 7 of 19 SHARE REPURCHASES: In 1999, the Company's Board of Directors authorized the repurchase of up to $250,000 of the Company's outstanding common stock over a three-year period at the discretion of the Company's management. Since the authorization in 1999, the Company has repurchased 978 shares of its common stock for $29,826. NOTE 6 - SPECIAL CHARGES In July 2001, the Company initiated efforts to streamline its heart valve operations, consolidate its U.S. sales activities and restructure its international sales organization. As a result of these activities, the Company recorded pre-tax special charges of $20,657 in the third quarter of 2001, consisting of employee severance costs resulting from the elimination of approximately 90 production and administrative positions ($5,293), inventory write-offs ($9,490), capital equipment write-offs ($3,379) and other costs related primarily to lease terminations and other facility exit costs due to the closing and consolidation of sales offices ($2,495). The Company has utilized $13,987 of these special charge accruals through September 30, 2001. During the third quarter of 2001, the Company also wrote-off $12,177 of certain diagnostic equipment deemed obsolete due to the overwhelming acceptance of newer technology equipment that was launched earlier in the year. The charges relating to employee severance costs, heart valve operations equipment write-offs and other costs have been recorded in operating expenses as special charges. The inventory and diagnostic equipment write-offs are included in cost of sales as special charges. On January 21, 2000, the Company initiated a worldwide voluntary recall of all field inventory of heart valve replacement and repair products incorporating a Silzone(R) coating on the sewing cuff fabric. The Company concluded that it will no longer utilize a Silzone(R) coating. The Company recorded a special charge accrual totaling $26,101 during the first quarter of 2000 relating to asset write-downs ($9,465) and other costs ($16,636), including monitoring expenses, associated with this recall and product discontinuance. The Company has utilized $19,707 of this special charge accrual through September 30, 2001. There can be no assurance that the final costs associated with this recall, including litigation-related costs, will not exceed management's estimates. NOTE 7 - PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES The Company recorded purchased in-process research and development charges totaling $5,000 during each of the second quarters of 2001 and 2000 relating to performance-based milestone payments associated with the 1999 acquisition of Vascular Science, Inc. (VSI). The Company will also record an additional $5,000 of purchased in-process research and development charges in the fourth quarter of 2001 based on an additional milestone that was achieved in October 2001. See Note 2 of the "Notes to Consolidated Financial Statements" in the Company's 2000 Annual Report on Form 10-K for additional discussion on the VSI acquisition and related accounting. Page 8 of 19 NOTE 8 - NET EARNINGS PER SHARE The table below sets forth the computation of basic and diluted net earnings per share:
THREE MONTHS NINE MONTHS ENDED SEPTEMBER 30, ENDED SEPTEMBER 30, 2001 2000 2001 2000 ================================================================================================= Numerator: Net earnings $ 31,434 $ 37,999 $122,327 $ 87,946 Convertible debenture interest, net of taxes -- 95 -- 95 ------------------------------------------------------------------------------------------------- Adjusted net earnings $ 31,434 $ 38,094 $122,327 $ 88,041 Denominator: Basic-weighted average shares outstanding 86,510 84,269 85,945 83,970 Effect of dilutive securities: Employee stock options 3,280 1,882 3,026 1,023 Restricted shares 42 32 41 40 Convertible debentures -- 311 -- 103 ------------------------------------------------------------------------------------------------- Diluted-weighted average shares outstanding 89,832 86,494 89,012 85,136 ================================================================================================= Basic net earnings per share $ .36 $ .45 $ 1.42 $ 1.05 ================================================================================================= Diluted net earnings per share $ .35 $ .44 $ 1.37 $ 1.03 =================================================================================================
Diluted-weighted average shares outstanding for 2000 have not been adjusted for certain employee stock options and awards since the effect of those securities would have been anti-dilutive. NOTE 9 - COMPREHENSIVE INCOME (LOSS) Other comprehensive income (loss) consists of unrealized gains or losses on available-for-sale marketable securities, net of taxes, and foreign currency translation adjustments. Other comprehensive income (loss) was $7,077 and $(1,743) for the three months ended September 30, 2001 and 2000, and $(22,527) and $(13,887) for the first nine months of 2001 and 2000. Total comprehensive income (loss) combines reported net earnings and other comprehensive income (loss). Total comprehensive income was $38,511 and $36,256 for the three months ended September 30, 2001 and 2000, and $99,800 and $74,059 for the first nine months of 2001 and 2000. Page 9 of 19 NOTE 10 - OTHER INCOME (EXPENSE) Other income (expense) consists of the following: THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 2001 2000 2001 2000 ------------------------------------------------------------------------------ Interest expense, net $ (1,585) $ (6,663) $ (8,767) $ (21,019) Other (29) 713 1,516 420 ------------------------------------------------------------------------------ Other income (expense) $ (1,614) $ (5,950) $ (7,251) $ (20,599) ------------------------------------------------------------------------------ NOTE 11 - SEGMENT INFORMATION The Company has two reportable segments: Cardiac Rhythm Management (CRM) and Cardiac Surgery (CS). The CRM segment, which includes the results from the Company's Cardiac Rhythm Management Division and Daig Division, develops, manufactures and distributes bradycardia pulse generator and tachycardia implantable cardioverter defibrillator systems, electrophysiology and interventional cardiology catheters and vascular closure devices. The CS segment develops, manufactures and distributes mechanical and tissue heart valves and valve repair products, and suture-free devices to facilitate coronary artery bypass graft anastomoses. The following table presents certain financial information about the Company's reportable segments:
ALL CRM CS OTHER (a) TOTAL --------------------------------------------------------------------------------------- QUARTER ENDED SEPTEMBER 30, 2001 External net sales $ 279,074 $ 57,955 $ -- $ 337,029 Operating profit (loss)(b) 53,821 25,153 (40,926) 38,048 QUARTER ENDED SEPTEMBER 30, 2000 External net sales 226,016 60,953 -- 286,969 Operating profit (loss) 32,430 32,039 (7,853) 56,616 NINE MONTHS ENDED SEPTEMBER 30, 2001 External net sales 811,707 187,449 -- 999,156 Operating profit (loss)(b) 144,111 87,335 (64,903) 166,543 NINE MONTHS ENDED SEPTEMBER 30, 2000 External net sales 685,562 197,845 -- 883,407 Operating profit (loss)(b) 97,512 100,838 (55,306) 143,044 =======================================================================================
Page 10 of 19 (a) AMOUNTS RELATE PRIMARILY TO CORPORATE ACTIVITIES, PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES AND SPECIAL CHARGES. (b) ALL OTHER OPERATING PROFIT (LOSS) AMOUNTS INCLUDE PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES OF $5,000 IN EACH OF THE SECOND QUARTERS OF 2001 AND 2000, AND SPECIAL CHARGES TOTALING$32,834 IN THE THIRD QUARTER OF 2001 AND $26,101 IN THE FIRST QUARTER OF 2000. NOTE 12 - NEW ACCOUNTING PRONOUNCEMENTS In July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations (Statement 141), and No. 142, Goodwill and Other Intangible Assets (Statement 142). These Statements change the accounting for business combinations, goodwill, and intangible assets. Statement 141 eliminates the pooling-of-interests method of accounting for business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. Statement 141 further clarifies the criteria to recognize intangible assets separately from goodwill. The requirements of Statement of 141 are effective for any business combination accounted for by the purchase method that is completed after June 30, 2001. Under Statement 142, goodwill and indefinite lived intangible assets are no longer amortized but are reviewed annually (or more frequently if impairment indicators arise) for impairment. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The amortization provisions of Statement 142 apply to goodwill and intangible assets acquired after June 30, 2001. Goodwill and intangible assets acquired prior to July 1, 2001 will continue to be amortized through December 31, 2001 for all calendar year companies. After December 31, 2001, such goodwill and indefinite lived intangible assets will cease being amortized. Management is reviewing the impact of these two statements on the Company's financial statements. Page 11 of 19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) RESULTS OF OPERATIONS NET SALES: Net sales for the third quarter of 2001 totaled $337,029, a 17.4% increase over the $286,969 reported in the third quarter of 2000. For the first nine months of 2001, net sales totaled $999,156, a 13.1% increase over the $883,407 reported in 2000. Unfavorable foreign currency effects due to a stronger U.S. dollar primarily against the major Western European currencies reduced 2001 net sales as compared with 2000 by approximately $5,300 for the third quarter and $16,900 for the first nine months. Cardiac rhythm management (CRM) net sales for the second quarter of 2001 were $279,074, a 23.5% increase over the $226,016 recorded in the third quarter of 2000. CRM net sales for the first nine months of 2001 were $811,707, an 18.4% increase over the $685,562 recorded in 2000. The increase in CRM net sales for the third quarter and first nine months of 2001 was primarily attributable to increased bradycardia, tachycardia, Angio-Seal(TM), and electrophysiology (EP) catheter unit sales, offset in part by negative foreign currency effects. Cardiac surgery (CS) net sales for the third quarter of 2001 were $57,955, a 4.9% decrease from the $60,953 recorded in 2000. CS net sales for the first nine months of 2001 were $187,449 compared with $197,845 recorded in 2000. The decrease in CS net sales in 2001 was attributable to the effects of the stronger U.S. dollar and a slight clinical preference shift from mechanical valves to tissue valves in the U.S. market where CS holds significant mechanical valve market share and a smaller share of the tissue valve market, offset in part by an increase in aortic connector sales in the U.S. market. GROSS PROFIT: Gross profit for the third quarter of 2001 totaled $207,040 or 61.4% of net sales, as compared with $193,961, or 67.6% of net sales, during the third quarter of 2000. For the first nine months of 2001 and 2000, gross profit was $651,867, or 65.2% of net sales, and $589,845, or 66.8% of net sales. The reduction in gross profit percentage for the third quarter and first nine months of 2001 was due to the $21,667 of special charges recorded in the third quarter of 2001 relating to inventory and diagnostic equipment write-offs (see further details under the discussion of Special Charges). Excluding these special charges, the gross profit percentage was 67.9% for the third quarter of 2001 and 67.4% for the first nine months of 2001, up from the prior year due to higher CRM unit volumes and improved CRM manufacturing efficiencies. SELLING, GENERAL AND ADMINISTRATIVE (SG&A) EXPENSE: SG&A expense for the third quarter of 2001 totaled $116,684, a 13.6% increase over the $102,688 reported in the third quarter of 2000. For the first nine months of 2001, SG&A expense totaled $347,385, a 10.7% increase over the $313,753 recorded in 2000. The increase in SG&A expense in the third quarter and first nine months of 2001 was primarily attributable to increased sales activities. Page 12 of 19 RESEARCH AND DEVELOPMENT (R&D) EXPENSE: R&D expense in the third quarter of 2001 totaled $41,141, or 12.2% of net sales, compared with $34,657, or 12.1 % of net sales, for the third quarter of 2000. For the first nine months of 2001, R&D expense totaled $121,772 or 12.2% of net sales, compared with $101,947, or 11.5% of net sales, for the first nine months of 2000. The increase in R&D expenses and as a percentage of net sales was primarily attributable to increased CRM activities relating primarily to ICDs and products treating emerging indications in atrial fibrillation and congestive heart failure. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT CHARGES: The Company recorded purchased in-process research and development charges totaling $5,000 during each of the second quarters of 2001 and 2000 relating to performance-based milestone payments associated with the 1999 acquisition of Vascular Science, Inc. (VSI). The Company will also record an additional $5,000 of purchased in-process research and development charges in the fourth quarter of 2001 based on an additional milestone that was achieved in October 2001. The Company anticipates additional in-process research and development charges related to the VSI acquisition as additional milestones are achieved. See "Purchased in-process research and development charges" in the Company's 2000 Annual Report on Form 10-K for additional discussion on the VSI acquisition and related accounting. SPECIAL CHARGES: In July 2001, the Company initiated efforts to streamline its heart valve operations, consolidate its U.S. sales activities and restructure its international sales organization. As a result of these activities, the Company recorded pre-tax special charges of $20,657 in the third quarter of 2001, consisting of employee severance costs resulting from the elimination of approximately 90 production and administrative positions ($5,293), inventory write-offs ($9,490), capital equipment write-offs ($3,379) and other costs related primarily to lease terminations and other facility exit costs due to the closing and consolidation of sales offices ($2,495). The Company has utilized $13,987 of these special charge accruals through September 30, 2001. During the third quarter of 2001, the Company also wrote-off $12,177 of certain diagnostic equipment deemed obsolete due to the overwhelming acceptance of newer technology equipment that was launched earlier in the year. The charges relating to employee severance costs, heart valve operations equipment write-offs and other costs have been recorded in operating expenses as special charges. The inventory and diagnostic equipment write-offs are included in cost of sales as special charges. On January 21, 2000, the Company initiated a worldwide voluntary recall of all field inventory of heart valve replacement and repair products incorporating a Silzone(R) coating on the sewing cuff fabric. The Company concluded that it would no longer utilize a Silzone(R) coating. The Company recorded a special charge accrual totaling $26,101 during the first quarter of 2000 relating to asset write-downs ($9,465) and other costs ($16,636), including monitoring expenses, associated with this recall and product discontinuance. The Company has utilized $19,707 of this special charge accrual through September 30, 2001. There can be no assurance that the final costs associated with this recall, including litigation-related costs, will not exceed management's estimates. Page 13 of 19 OTHER INCOME (EXPENSE): Net interest expense was $1,585 during the third quarter of 2001, as compared with $6,663 in 2000. Net interest expense was $8,767 for the first nine months of 2001, compared with $21,019 for 2000. The decrease in net interest expense is due to lower debt levels resulting from debt repayments, as well as lower interest rates in 2001 as compared with 2000. INCOME TAXES: The Company's reported effective income tax rates were 13.7% and 25.0% for the third quarters of 2001 and 2000, and 23.2% and 28.2% for the first nine months of 2001 and 2000. Exclusive of the purchased in-process research and development and special charges, the Company's effective income tax rate was 25% for each of these periods. The purchased in-process research and development charges were not deductible for tax purposes, and the special charges were recorded in taxing jurisdictions where income tax rates vary from the Company's blended 25% effective tax rate. OUTLOOK: The Company expects that market demand, government regulation and societal pressures will continue to change the worldwide health care industry resulting in further business consolidations and alliances. The Company participates with industry groups to promote the use of advanced medical device technology in a cost conscious environment. Customer service in the form of cost-effective clinical outcomes will continue to be a primary focus for the Company. The Company's CS business is in a highly competitive market. The market is segmented between mechanical heart valves, tissue heart valves, and repair products. Since 1999, the U.S. market has shifted slightly to tissue valve and repair products from mechanical heart valves, resulting in a small overall CS market share loss for the Company. Competition is anticipated to continue to place pressure on pricing and terms. The Company's CRM business is also in a highly competitive industry that has undergone consolidation. There are currently three principal suppliers, including the Company, and the Company's two principal competitors each have substantially more assets and sales than the Company. Rapid technological change is expected to continue, requiring the Company to invest heavily in R&D and to effectively market its products. The global medical technology market is highly competitive. Competitors have historically employed litigation to gain a competitive advantage. In addition, the Company's products must continually improve technologically and provide improved clinical outcomes due to the competitive nature of the industry. Group purchasing organizations (GPOs) in the U.S. continue to consolidate the purchasing for some of the Company's customers. A few GPOs have executed contracts with the Company's CRM market competitors, which exclude the Company. These contracts, if enforced, may adversely affect the Company's sales of CRM products to members of these GPOs. FINANCIAL CONDITION The Company's liquidity and cash flows remained strong in 2001. Cash provided by operating activities was $202,774 for the nine months ended September 30, 2001, a $77,164 increase over the same period one year ago reflecting increased earnings and improved working capital management. The Company's current assets to current liabilities ratio was 2.4 to 1 at September 30, 2001 and December 31, 2000. Page 14 of 19 Total interest bearing debt at September 30, 2001 decreased $132,100 from December 31, 2000 due to debt repayments primarily using cash generated from operations and proceeds from employee stock option exercises. The Company classifies all of its credit facility and commercial paper borrowings as long-term on its balance sheet as the Company has the ability to repay any short-term maturity with available cash from its existing long-term, committed credit facility. Management continually reviews the Company's cash flow projections and may from time to time repay a portion of the Company's borrowings. In 1999, the Company's Board of Directors authorized the repurchase of up to $250,000 of the Company's outstanding common stock over a three-year period at the discretion of the Company's management. Since the authorization in 1999, the Company has repurchased 978 shares of its common stock for $29,826. Management believes that cash generated from operations and cash available under its credit facilities will be sufficient to meet the Company's working capital and share repurchase plan needs in the near term. Should suitable investment opportunities arise, management believes that the Company's earnings, cash flows and balance sheet will permit the Company to obtain additional debt or equity financing, if necessary. CAUTIONARY STATEMENTS In this discussion and in other written or oral statements made from time to time, we have included and may include statements that may constitute "forward-looking statements" within the meaning of the safe harbor provisions of the Private Litigation Securities Reform Act of 1995. These forward-looking statements are not historical facts but instead represent our belief regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements relate to our future plans and objectives, among other things. By identifying these statements for you in this manner, we are alerting you to the possibility that our 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. Various factors contained in the previous discussion and those described below may affect the Company's operations and results. 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. Risk factors include the following: o Administrative or legislative reforms to the U.S. Medicare and Medicaid systems or similar reforms of foreign reimbursement systems in a manner that significantly reduces reimbursement for procedures using the Company's medical devices or denies coverage for such procedures. o Acquisition of key patents by others that have the affect of excluding the Company from market segments or require the Company to pay royalties. Page 15 of 19 o Economic factors, including inflation, changes in interest rates and changes in foreign currency exchange rates. o Product introductions by competitors which have advanced technology, better features or lower pricing. o Price increases by suppliers of key components, some of which are sole-sourced. o A reduction in the number of procedures using the Company's devices caused by cost containment pressures or preferences for alternate therapies. o Safety, performance or efficacy concerns about the Company's marketed products, many of which are expected to be implanted for many years, leading to recalls and advisories with the attendant expenses and declining sales. o Changes in laws, regulations or administrative practices affecting government regulation of the Company's products, such as FDA laws and regulations, that increase pre-approval testing requirements for products or impose additional burdens on the manufacture and sale of medical devices. o Difficulties obtaining, or the inability to obtain, appropriate levels of product liability insurance. o A serious earthquake affecting the Company's facilities in Sunnyvale or Sylmar, California. o Health care industry consolidation leading to demands for price concessions or the exclusion of some suppliers from significant market segments. o Adverse developments in litigation including product liability litigation and patent litigation or other intellectual property litigation including that arising from the Telectronics and Ventritex acquisitions. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes from December 31, 2000 in the Company's market risk. For further information on market risk, refer to Item 7A in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. Page 16 of 19 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS SILZONE(R) LITIGATION: The Company has been sued by patients alleging defects in the Company's mechanical heart valves and valve repair products with Silzone(R) coating. The Company recalled products with Silzone(R) coating on January 21, 2000 (see Note 6), and sent a Recall Notice and Advisory concerning the recall to physicians and others. Some of these cases are seeking monitoring of patients implanted with Silzone(R)-coated valves and repair products who allege no injury to date. Some of these cases are seeking class action status. The Company intends to vigorously defend these cases. On April 18, 2001, the U.S. Judicial Panel on Multi-Litigation ruled that certain lawsuits filed in U.S. federal district court involving products with Silzone(R) coating should be part of M.D.L. proceedings, which will take place under the supervision of U.S. District court Judge John Tunheim in Minnesota. As a result, a number of actions involving products with Silzone(R) coating are being transferred to Judge Tunheim's court in Minnesota for coordinated or consolidated pretrial proceedings. While it is not possible to predict the outcome of these cases, the Company believes that it has adequate product liability insurance to cover the costs associated with them. The Company further believes that any costs not covered by product liability insurance will not have a material adverse impact on the Company's financial position or liquidity, but may be material to the consolidated results of operations of any one period. GUIDANT LITIGATION: On November 26, 1996, Guidant Corporation (a competitor of St. Jude Medical) ("Guidant") and related parties filed two lawsuits against St. Jude Medical, Inc. and certain affiliates ("St. Jude Medical"). The first lawsuit, filed in State Superior Court in Marion County, Indiana, alleged, among other things, that the license agreement between CPI (Guidant) and members of the Telectronics Group did not pass to St. Jude Medical upon St. Jude Medical's acquisition of substantially all the assets of the Telectronics cardiac stimulation device business. This lawsuit was stayed by the court in 1998 pending a ruling on the transferability of the CPI/Telectronics license by an arbitrator, as required by the license agreement. On July 10, 2000, the arbitrator ruled that the CPI/Telectronics license agreement did not transfer to St. Jude Medical in connection with St. Jude Medical's acquisition of the Telectronics cardiac stimulation device business. Pursuant to an earlier ruling by the arbitrator, St. Jude Medical was not allowed to participate in the arbitration proceeding. The second case Guidant initiated against St. Jude Medical in November 1996 was filed in the United States District Court for the Southern District of Indiana. In this lawsuit, Guidant originally alleged infringement by St. Jude Medical of four patents. Guidant later dismissed its claims on one patent (the '678 patent). In addition, in response to a stipulation by the parties, the court ruled that a second patent (the '191 patent) was invalid. Guidant has appealed the ruling of invalidity concerning the '191 patent. Page 17 of 19 The judge in the U.S. District court action issued a pre-trial ruling in May 2001 which determined that the CPI/Telectronics license did not transfer to St. Jude Medical. Based on the ruling of the arbitrator and the judge in the federal court case, the Indiana State court action discussed above has no further significance. A jury trial involving the two remaining patents asserted by Guidant (the '288 and '472 patents) commenced in June 2001. The jury issued its verdict on July 3, 2001, finding that both the '472 and '288 patents were valid and that St. Jude Medical did not infringe the '288 patent. The jury also found that St. Jude did infringe the '472 patent, which expired on March 4, 2001, but that the infringement was not willful. The jury awarded damages of $140 million to Guidant. The jury's verdict in this case has not yet been entered as a judgment by the judge overseeing the trial pending any post-trial motions filed by St. Jude Medical or Guidant. St. Jude Medical has filed various post-trial motions which would effectively eliminate any damage award on the '472 patent if these motions were ruled upon favorably by the trial judge. The Company has also filed alternative post-trial motions seeking to reduce the damage amount, and the Guidant parties have filed motions seeking a new trial on certain issues and also an award of interest. Rulings on the post trial motions filed by the parties are expected in the fourth quarter of 2001 or the first quarter of 2002. Under these circumstances, the Company is unable to determine the amount of a loss, if any, that may be incurred in connection with this case, and consequently has not recorded any liability for this lawsuit in its financial statements. Since the date of St. Jude Medical's acquisition of Ventritex in May 1997 and the inception of the Company's sales of implantable cardioverter defibrillator (ICD) products, St. Jude Medical has accrued a 3% royalty on its ICD sales under a license it believed it had acquired as part of its purchase of the Telectronics cardiac stimulation device business. As a result of the jury's verdict that St. Jude Medical's ICD products do not infringe Guidant's '288 patent, future royalty accruals are no longer necessary. The historical accruals under this license, which total approximately $15 million, will remain on the Company's balance sheet pending future developments in this case. OTHER LITIGATION AND PROCEEDINGS The Company is unaware of any other pending legal proceedings which it regards as likely to have a material adverse effect on its business. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits None (b) Reports on Form 8-K A Form 8-K was filed on July 5, 2001, announcing the jury's verdict in a lawsuit brought by Guidant Corporation against the Company and its subsidiaries. Page 18 of 19 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. ST. JUDE MEDICAL, INC. November 9, 2001 /s/ John C. Heinmiller ---------------- ---------------------- DATE JOHN C. HEINMILLER Vice President - Finance and Chief Financial Officer (Principal Financial and Accounting Officer) Page 19 of 19