EQUITY RESEARCH
Health Care
MEDTRONIC, INC.
Medical Appliances & Equipment
May 31, 2011
Recommendation
BUY
Medtronic, Inc. (Medtronic or the Company) is the world’s largest pureplay medical device company and the market leader in several key
segments including Cardiac Rhythm Disease Management, Spinal,
Neuromodulation and Diabetes. The Company develops, manufactures
and markets devices to alleviate pain, restore health and extend life for
people with chronic illnesses.
Ticker
MDT
Price Target (USD)
55.00
Price (May 25, 2011, USD)
40.23
Potential Upside/Downside
36.7%
Projected Total Return
38.9%
Investment Thesis
Market Data
Medtronic has a proven track record of revenue growth and has
consistently generated some of the highest margins in the industry.
Recent initiatives have left the Company stronger and better positioned
to maintain its spot as the market leader in the industry. Medtronic has
reorganized its resources to better capitalize on global growth
opportunities, and the Company has recognized approximately $600
million of $1 billion identified cost savings through its “One Medtronic”
initiative. It also is an attractive investment for the following reasons:
Market Capitalization (USD)
43.02B
Shares Outstanding
1.07B
Dividend Yield
2.2%
Dividend (USD)
0.90
52 Week Price Range (USD)
30.80-43.33
Medtronic 12-Month Price Performance
(USD)
44
•
•
•
•
•
Mr. Ishrak, the incoming Chief Executive Officer, is a potential
catalyst from growth. He has a proven track record for driving sales
growth organically and is very experienced with emerging markets.
An established pipeline of new products will offset pricing pressure
in key markets and contribute to sales growth in the years ahead.
The Company offers an attractive total return on investment with a
dividend yield of 2.2% and through its share repurchase programs.
Weakening growth fundamentals in its key markets may be
negatively impacting the valuation of the stronger divisions.
Valuation metrics demonstrate that shares are relatively inexpensive
compared the market and based on historical performance.
Risks
•
•
•
•
•
Medtronic’s key business segments are experiencing pricing pressure
due to market saturation and increasing competition.
The Company is dependent on the innovation of new products and
acquisitions to drive continued revenue growth.
There is uncertainty surrounding health care reform in the U.S. and
there are new taxes being imposed on medical device manufacturers.
The Health Care sector is subject to rigorous regulation by various
U.S. and foreign government entities and compliance can be costly.
The industry is characterized by extensive patent litigation and is
susceptible to significant product liability claims.
42
40
38
36
34
32
30
Financial Data (FY 2011)
Revenue (USD)
Revenue Growth (YOY)
15.93B
0.7%
Gross Margin
75.5%
Operating Margin
25.1%
Earnings Per Share
Price to Earnings
Tracy Shoemaker
216.210.3209
shoemaker_158@fisher.osu.edu
Columbus, Ohio
2.8
14.4
Medtronic, Inc.
May 31, 2011
TABLE OF CONTENTS
Company Overview .......................................................................................................................3
Business Segments .....................................................................................................................3
Business Strategy and Competitive Advantage .........................................................................4
Recent Developments ................................................................................................................5
Investment Thesis...........................................................................................................................6
Fundamental Drivers ..................................................................................................................6
Macro Environment ...................................................................................................................7
Financial Analysis ......................................................................................................................9
Valuation Analysis ...................................................................................................................11
Risks and Considerations ............................................................................................................15
Conclusions ...................................................................................................................................16
Appendices ....................................................................................................................................17
Appendix I: Medtronic New Product Pipeline .......................................................................17
Appendix II: Discounted Cash Flow Analysis .......................................................................18
Appendix III: Analyst Information .......................................................................................19
Appendix IV: Sources ............................................................................................................20
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Medtronic, Inc.
May 31, 2011
COMPANY OVERVIEW
Medtronic, Inc. (Medtronic or the Company), founded in 1949, is the global leader in medical technology
with products designed to alleviate pain, restore health and extend life for millions of people around the
world. Headquartered in Minneapolis, Minnesota, Medtronic develops, manufactures and markets its
technologies in over 120 countries with approximately 40,000 employees. Its primary customers include
hospitals, clinics, third-party health care providers, distributors, government health care programs and
group purchasing organizations. For fiscal year 2011, the Company generated revenue and EBITDA of
approximately $15.9 billion and $4.8 billion, respectively.
Business Segments
During fiscal year 2010, Medtronic consolidated its businesses into two operating segments: the Cardiac
and Vascular Group and the Restorative Therapies Group. The purpose of this new structure is further the
Company’s goal of operating as “One Medtronic” by allowing it to capitalize on existing synergies
related to customers and technologies across each business unit.
The Cardio and Vascular Group is comprised of the Cardiac Rhythm Disease Management
(CRDM), CardioVascular and Physio-Control businesses. The primary products sold by this
operating segment include those for cardiac rhythm disorders, cardiovascular disease, and
external defibrillation.
The Restorative Therapies Group is comprised of the Spinal, Neuromodulation, Diabetes, and
Surgical Technologies businesses. The primary products sold by this operating segment include
those for spinal conditions and musculoskeletal trauma, neurological disorders, urological and
digestive disorders, diabetes, and ear, nose and throat conditions.
Fiscal 2011 Sales Mix By Business Segment
($ in Millions)
Physio-Control
$425
3%
Cardio and
Vascular
Group
$8,544
54%
CardioVascular
$3,109
20%
CRDM
$5,010
31%
Consolidated 2011 Net Sales $15,933
Spinal
$3,414
21%
Neuromodulation
$1,592
10%
Diabetes
$1,347
8%
Surgical
Technology
$1,036
7%
Restorative
Therapies
Group
$7,389
46%
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Medtronic, Inc.
May 31, 2011
Business Strategy and Competitive Advantage
Market-Leading Performance
Medtronic is the largest player in the Medical Device Manufacturing industry with an approximate 17.2%
market share.i Medtronic is the market leader in most of the segments in which it operates. It is the
dominant player in the CRDM, Spinal, Diabetes and Neuromodulation markets, and is one of the leading
players in the Cardiac Surgery market.ii Medtronic has maintained low volatility in both revenue and
profitability over the years, largely due to its product and geographic diversity. Additionally, its large
product offering provides various cross-sell opportunities to customers, as well as a competitive
advantage over smaller competitors.
Innovation and New Product Development
Medtronic’s research and development spend historically has remained relatively constant at
approximately 9.5%. According to a quote from a 2001 interview with former Chief Executive Officer,
Bill George, “research and development is one budget that is never cut”.iii Medtronic plans to launch
more than 60 new products over the next two years and has one of the strongest new product pipelines
(see Appendix I) that it has seen in a number of years. iv Medtronic recently announced U.S. Food and
Drug Administration (FDA) approval of several high-profile products in the Cardio and Vascular Group,
including the Revo MRI SureScan pacemaker, Consulta and Syncra CRT-P pacemakers with OptiVol
fluid monitoring capability, AMPLIFY bone morphongenetic protein therapy for posterolateral spinal
application, and the Protecta implantable defibrillator with SmartShock technology. v Additionally, the
RESOLUTE stent is to be released in the U.S. in the second half of fiscal 2012, which bodes well for
Medtronic’s stent market share.vi These new products will help to offset declining sales resulting from
pricing pressures in these key product categories, as well as allow the Company to maintain its leading
market share in the industry.
Global Growth and Geographic Diversity
Medtronic currently has over 16,000 people working outside
Fiscal 2011 Sales Mix by Geography
of the U.S. and operates in approximately 120 countries.
($ in Millions)
During fiscal year 2011, approximately 43% of Medtronic’s
revenues were derived from international sales as shown in
the chart to the right. Given that approximately 95% of the
world’s population resides outside of the U.S., this
Outside
represents a tremendous opportunity for the Company. vii
U.S.
$6,813
United
Medtronic recently modified its business strategy to
43%
States
capitalize on such global growth opportunities. Instead of
$9,120
defining its business according to U.S. and international
57%
markets, the Company has reorganized its resources around
developed markets and emerging markets. In developed
markets, Medtronic is focusing on innovation. In emerging
Consolidated 2011 Net Sales $15,933
markets, including China, India, Brazil, Russia, the Middle
East and Africa, the Company is focusing on building health
care infrastructure, including distribution, training and education, to ensure greater access to its products
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Medtronic, Inc.
May 31, 2011
and therapies. The Company recently opened new state-of-the-art facilities in Singapore, Russia, Ireland,
Canada, Brazil and Mexico. viii
Recent Developments
New Chief Executive Officer Named
As of June 13, 2011, Omar Ishrak will become Medtronic’s new Chairman and Chief Executive Officer.
Mr. Ishrak has been an executive with General Electric (GE) for over 16 years. He most recently served
as President and Chief Executive Officer of GE Health Care Systems, a $12 billion division of GE Health
Care. From 1998 to 2010, Mr. Ishrak successful grew GE Health Care’s Ultrasound business from $400
million to $1.8 billion. He also nearly doubled sales in the Clinical Systems division to $5 billion from
2004 to 2009.ix
“One Medtronic” Initiative
The Company’s “One Medtronic” strategy is focused on streamlining operations by consolidating
manufacturing and eliminating non-core product lines, aligning resources around the Company’s higher
growth opportunities, and centralizing certain functional activities that are not unique to the individual
business segments.x This cost savings initiative, which began in 2008, is aimed at cutting $1 billion over
five years. As of fiscal year 2011, the Company was over half way through its plan, having cut $600
million in expenses and having identified the remaining $400 million.xi Medtronic has been able to
maintain its margins despite the economic downturn and pricing pressure in its key markets largely as a
result of this project.
Acquisitions
Acquisitions that took place during fiscal year 2011 are detailed below:
On February 25, 2011, Medtronic acquired privately-held Jolife for approximately $53 million. Jolife
develops, manufactures, and markets the LUCAS Chest Compression System (LUCAS) together with
complementary technologies. LUCAS assists first responders, paramedics, nurses, and physicians by
delivering quality chest compression.
On January 13, 2011, Medtronic acquired privately-held Ardian, Inc. (Ardian) for $1 billion. The
Company had previously invested in Ardian and held an 11.3% ownership position. Ardian develops
catheter-based therapies to treat uncontrolled hypertension and related conditions.
On November 16, 2010, the Company acquired Osteotech, Inc. (Osteotech) for $123 million. Osteotech
develops innovative biologic products for regenerative medicine.
On September 14, 2010, the Company acquired a developer of vascular suturing products used in
connection with cardiovascular and vascular procedures that require a puncture or incision to the artery
for $21 million.
On August 12, 2010, the Company acquired ATS Medical, Inc. (ATS Medical) for $394 million. ATS
Medical is a leading developer, manufacturer, and marketer of products and services focused on cardiac
surgery, including heart valves and surgical cryoablation technology.
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Medtronic, Inc.
May 31, 2011
In June 2010, the Company acquired Axon Surgical (Axon) for $62 million. Medtronic distributed a
large portion of Axon’s product prior to the acquisition. The agreement will allow the Company to bring
to market the next generation of surgeon-directed and professionally supported spinal neuromonitoring
technology and expand the availability of this technology.
INVESTMENT THESIS
Fundamental Drivers
In additional to Medtronic exhibiting strong fundamental qualities, including being the market leader in
its industry and in numerous product segments, establishing a strong track record for revenue growth and
maintaining profitability despite difficult economic times, the following drivers further portray the
Company as attractive investment opportunity.
New Chief Executive Officer a Potential Catalyst for Growth
Mr. Ishrak, Medtronic’s newly named Chairman and Chief Executive Officer, could provide new
direction for the Company and potentially unlock a significant amount of value. Mr. Ishrak has an
impressive record for driving growth in emerging markets, which has and will continue to be an important
expansion opportunity for Medtronic going forward. Additionally, Mr. Ishrak primarily was focused on
organic growth during his time at GE. In recent years, Medtronic has become overly reliant on
acquisitions to drive increases in sales. xii Additionally, Mr. Ishrak’s leadership should come as a
welcome change. The Company has missed guidance on numerous occasions in recent years, which has
negatively impacted the credibility of current management.xiii
Solid New Product Pipeline
Medtronic’s new product pipeline is encouraging and is believed to be its strongest in quite some time.
Over the next couple of years, these new products will help to offset some of the recent pricing pressure
felt by the Company, to stabilize or improve market share, and to potentially increase investor confidence.
New product approvals and introductions began contributing to sales growth during the fourth quarter and
will continue to drive growth in fiscal 2012.
Attractive Total Return Investment
Medtronic offers an attractive total return on investment. Medtronic’s Annual Report states that
management is “committed to returning a minimum of 40% to 50% of free cash flow to shareholders,
while investing to drive sustainable, profitable long-term growth.”xiv In addition to significant upside
potential on the value of its shares, the Company currently offers a 2.2% dividend yield. Additionally, the
Board of Directors authorized the repurchase of up to 60 million shares in June 2009 with 20.7 million
shares remaining as of January 28, 2011.xv
Underperformance Despite Consistent Sales Growth
As demonstrated on the following page, Medtronic shares have underperformed over the past decade.
Interestingly though, the Company has reported strong sales growth during the majority of this period.
These results are even more impressive given the adverse market-related and macro factors of recent
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Medtronic, Inc.
May 31, 2011
years. Additionally, the Company has successfully maintained its margins despite increased pricing
pressure in the CRDM, Stent and Spinal markets. This underperformance may be attributable to a lack of
management credibility as Medtronic has missed guidance more than a few times, and the Company’s
long-term objectives also remain unclear. Additionally, the weakening growth fundamentals of
Medtronic’s two key markets, CRDM and Spinal, may be negatively impacting the valuation of
Medtronic’s other, stronger divisions.xvi
Medtronic 10-Year Comparison
Price to Earnings
Revenue ($ in Millions)
50x
$18,000
45x
$16,000
40x
$14,000
35x
$12,000
30x
25x
20x
15x
10x
$10,000
$8,000
$6,000
$4,000
5x
$2,000
0x
$0
Macro Environment
Medtronic has an approximate 17.2% market share of the $55.4 billion U.S. Medical Device
Manufacturing industry.xvii The industry has grown at an average annual rate of 18.9% since 2005. By
2015, revenue is projected to reach $76.4 billion with sales expected to grow at an average annual rate of
6.6% through 2015.xviii The decline in sales growth from the previous five-year period is largely
attributable to the changing regulatory environment. Potential reform to the approval process for new
devices is anticipated to hinder innovation and cause more companies to shift operations overseas.
Demographic Trends
The increasing longevity of the human population will benefit Medtronic over the projected period.
Medical advancements, better nutrition and improved safety are allowing Americans to live longer than
ever before. Additionally, changing demographics in the U.S. will also serve to increase demand for
Medtronic products going forward. The number of people ages 65 and over in the U.S. is forecasted to
increase by an average rate of 3% annually as the Baby Boomer generation continues to grow older. By
2015, senior adults will make up approximately 14.5% of the population compared to 13% in 2010.xix
People generally need more medical care as they get older, which provides a tremendous opportunity for
Medtronic as many of its products, including CRDM, cardiovascular and neurological devices, are
targeted toward an older demographic.
Increasing Prevalence of Chronic Diseases
Chronic diseases such as heart disease, stroke, cancer, diabetes and arthritis are the most common, costly
and preventable of all health problems in the U.S.xx In 2005, 133 million Americans, or almost 1 out of
every 2 adults, had at least one chronic illness and this number was projected to reach approximately 157
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Medtronic, Inc.
May 31, 2011
million by 2010.xxi The increasing prevalence of chronic conditions will positively impact demand for
Medtronic products and the Company continues to expand its product offering into chronic disease
management given this trend.
Number of Physician Visits
Per Capita Disposable Income
Demand for the Company’s products is affected by an
individual’s ability and willingness to pay for health care and
associated medical devices. People who cannot afford to pay
for needed services often defer treatment. As a result, the
improving economy is expected to cause an increase in the
number of physician visits over the next few years and
particularly in 2014, which is when the health care reform
initiatives will take effect.xxii
Health Care Reform
Source: IBISWorld
U.S. health care reform seeks to expand coverage to more people by loosening eligibility criteria for
enrollment in Medicaid. Individuals with incomes of less than 133% of the federal poverty level will be
eligible to enroll for Medicaid. Additionally, mandatory insurance requirements and broader availability
of insurance through health benefit exchanges will further reduce the number of uninsured people.xxiii By
providing more Americans with health care coverage, the amount of out-of-pocket expenses needed for
care will be reduced and, therefore, the number of physician visits and demand for Medtronic products
will increase.
On the negative side, health care reform is providing a great deal of uncertainty for medical device
companies. The reform has tightened the pricing environment for many of these companies, and the
proposed tax on medical device companies is expected to further hurt profitability. President Obama
signed the Patient Protection and Affordable Care Act into law in early 2010, which imposes significant
new taxes on medical device makers. Industry operators will be required to pay 2.3% of the sales price of
devices to the government. This fee applies to all manufacturers regardless of size, but will have a lesser
overall effect on large industry players like Medtronic due to economies of scale and scope. This tax
could cost to the Medical Device industry approximately $20 billion over ten years.xxiv
Pricing Pressure
Large purchasing groups act as distributors to many of the country’s hospitals. Since these customers
provide a considerable amount of revenue, industry operators tend to concede in pricing negotiations.
Additionally, rising health care costs have caused insurers and government programs to limit payments
for certain treatments that require medical devices. As a result, doctors and hospitals are pushing back
more on price increases. Industry profit is expected to decline to 9.0% of revenue in 2010 from 9.8% in
2006, largely due to these pricing pressures. xxv Medtronic sells to these purchasing groups and is
experiencing such pricing pressure in its CRDM, Spinal and Stent businesses.
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Medtronic, Inc.
May 31, 2011
Compliance Requirements
Participants in the Medical Device industry must devote considerable resources to meet legislative
compliance requirements. This amount is expected to increase going forward as regulation in the industry
increases. Reports of device-related injuries, deaths and malfunctions have increased significantly since
2005.xxvi Resulting concerns over product safety have caused the FDA to change its policy on device
approval and the process has become more difficult and costly. Medtronic’s profitability may be reduced
as regulatory costs increase. Additionally, it may detract from research and development or other
expenditures by the Company that are meant to boost demand.
Limited Growth Opportunities in Key Segment
The Cardiovascular market is highly competitive and has reached saturation. Many companies are
producing similar products and there is limited room for innovation. Acquisitions are prevalent as larger
companies are acquiring smaller companies to expand their product offerings. This market segment did,
however, remain relatively stable during the economic downturn. xxvii Medtronic’s Cardio and Vascular
Group accounted for over half of revenue during fiscal 2011.
Financial Analysis
Historical
The chart below provides historical financial results for Medtronic:
Medtronic Historical Financial Summary
2007
($ in Millions)
2008
2009
2010
2011
Cardiac Rhythm Disease Management
Cardio/Vascular
Physio-Control
Spinal
Neuromodulation
Diabetes
Surgical Technologies
Total Revenue
% Growth
$
Gross Profit
% of Sales
$
Research & Development Expense
% of Sales
$
1,239 $
10.1%
1,460
9.2%
$
1,508
9.5%
Selling, General & Administrative Expense
% of Sales
$
4,153 $ 4,707 $ 5,152 $ 5,415
33.8%
34.8%
35.3%
34.2%
$
5,533
34.7%
Operating Profit
% of Sales
$
3,361 $ 2,776 $ 2,623 $ 4,215
27.3%
20.5%
18.0%
26.6%
$
4,001
25.1%
EPS Basic
EPS Diluted
4,876 $ 4,963 $ 5,014 $ 5,268
$ 5,010
1,909
2,131
2,437
2,864
3,109
385
329
343
425
425
2,417
2,982
3,400
3,500
3,414
1,183
1,311
1,434
1,560
1,592
863
1,019
1,114
1,237
1,347
666
780
857
963
1,036
$ 12,299 $ 13,515 $ 14,599 $ 15,817 $ 15,933
8.9%
9.9%
8.0%
8.3%
0.7%
9,131 $ 10,069 $ 11,081 $ 12,005 $ 12,021
74.2%
74.5%
75.9%
75.9%
75.4%
2.44
2.41
1,275 $
9.4%
1.89
1.87
1,355 $
9.3%
1.85
1.84
2.80
2.79
2.87
2.79
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Medtronic, Inc.
May 31, 2011
Medtronic historically has generated strong revenue growth of around 8% to 9%. Net sales growth in
2011, however, slowed to 0.7% due to declining sales in the CRDM and Spinal businesses. Growth in
these segments has lessened due to market saturation of products, such as pacemakers and stents. Much
of the Company’s growth in recent years has come from international sales, which increased 5.6% during
fiscal year 2011 to $6.8 billion.
The Company has successfully maintained strong gross margins, which have historically averaged around
75%, despite the weakening economy and challenging dynamics in the CRDM, Stent and Spinal markets.
This is largely attributable to the Company’s “One Medtronic” initiative that is focused on streamlining
operations by consolidating manufacturing processes. Research and development spending also has
remained relatively constant at around 9.5% of sales. Selling, general and administrative expense has
declined slightly as a percentage of sales in recent years. The Company derived some savings in general
and administrative expense by centralizing various functional activities that were not unique to the
individual business segments.xxviii
Projections
The chart below provides projected financial results for Medtronic:
Medtronic Projected Financial Summary
2011
($ in Millions)
2012E
2013E
2014E
Revenue
% Growth
$ 15,933
0.7%
$ 16,452 $ 17,129 $ 17,815
3.3%
4.1%
4.0%
Gross Profit
% of Sales
$ 12,021
75.4%
$ 12,421 $ 12,933 $ 13,443
75.5%
75.5%
75.5%
Research & Development Expense
% of Sales
$
1,508
9.5%
$
Selling, General & Administrative Expense
% of Sales
$
5,533
34.7%
$
5,594 $ 5,824 $ 6,067
34.0%
34.0%
34.1%
Operating Profit
% of Sales
$
4,001
25.1%
$
4,260 $ 4,521 $ 4,709
25.9%
26.4%
26.4%
EPS Basic
EPS Diluted
2.87
2.79
1,563 $
9.5%
3.01
2.92
1,627 $
9.5%
3.23
3.13
1,695
9.5%
3.36
3.26
Revenue growth is expected improve over the projected period. The rebound will be driven by new
product introductions, the impact of recent acquisitions and international sales. Medtronic has a strong
pipeline of new products that are expected to gain approval and launch over the next couple of years.
Operating margins are projected to improve as the Company continues to implement its cost-savings
initiatives through 2013.
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Medtronic, Inc.
May 31, 2011
Peer Comparison
The chart below provides a comparison of Medtronic to its industry peers:
Peer Comparison
Medtronic
Market Capitialization:
Revenue (ttm):
Qtrly Rev Growth (yoy):
Gross Margin (ttm):
EBITDA (ttm):
Operating Margin (ttm):
Net Income (ttm):
EPS (ttm):
P/E (ttm):
PEG (5 yr expected):
P/S (ttm):
$43.0 billion
$15.9 billion
2.4%
75.4%
$4.8 billion
25.1%
$3.1 billion
3.0
13.4
1.4
2.7
Boston
Scientific
$10.6 billion
$7.8 billion
-1.8%
65.2%
$1.9 billion
14.3%
$570.0 million
0.4
18.3
2.5
1.4
Johnson &
Johnson
$181.7 billion
$62.1 billion
3.5%
69.4%
$19.3 billion
26.3%
$12.3 billion
4.4
15.0
2.1
2.9
St. Jude
Medical
$16.3 billion
$5.3 billion
9.0%
73.4%
$1.6 billion
25.7%
$902.3 million
2.7
18.1
1.2
3.1
Industry(1)
$72.2 million
$41.8 million
17.4%
56.5%
$1.7 million
3.9%
N/A
N/A
26.7
1.4
2.7
Source: Yahoo! Finance. May 25, 2011.
(1) M edical Appliances & Equipment Industry.
The recession has had a mixed impact on operators in the Medical Device Manufacturing industry.
According to a survey conducted by the Massachusetts Medical Device Industry Council, approximately
45% of industry operators, including Medtronic, experienced significant or slight growth during 2008 and
2009, 14% had a flat growth rate and 42% reported a slight or significant decline. xxix
Operating profit in the industry tends to vary according to company size and product type. Industry
operating profit for fiscal 2010 averaged approximately 9% of revenue. Larger industry players, such as
Medtronic, tend to generate margins over 20%.xxx
Valuation Analysis
Discounted Cash Flow Analysis
A detailed discounted cash flow model for Medtronic can be found in Appendix II. This analysis
provides an estimated value for the Company of approximately $46.34 per share. Key assumptions used
in the model are as follows:
•
•
A revenue growth rate of 4%. It is assumed that Medtronic will grow in line with the market as
softer sales growth in its Cardio and Vascular Group will be offset by new product development
and increasing international sales.
The 10% discount rate of the market was assumed for Medtronic. Although defensive sector
stocks typically warrant a lower discount rate than the market, the Company is facing certain
uncertainties in regards to health care reform, a new Chief Executive Officer who has not yet
communicated his vision for the Company, and limited growth opportunities in its key market
segments.
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Medtronic, Inc.
•
•
May 31, 2011
Operating margin was held in line with past results at 26%. The Company has been able to hold
margins constant despite the difficult economic environment through extensive cost-cutting
initiatives that are slated to run through 2013.
A tax rate of approximately 21.6%. This is approximately 2.3% higher than Medtronic’s
historical average tax rate of 19.3% given the 2.3% sales tax that is to be imposed on medical
device makers under the Patient Protection and Affordable Care Act.
The chart below sensitizes Medtronic’s estimated fair value per share to changes in the discount rate and
terminal growth rate. At the various growth rates shown, Medtronic’s value per share ranges from
approximately $41.03 to $53.68. This analysis further demonstrates the considerable upside potential for
Medtronic’s shares. As of May 25, 2011, Medtronic’s shares were trading at approximately $40.23.
Sensitivity Analysis
Growth Rate
Discount Rate
3.50%
3.75%
4.00%
4.25%
4.50%
9.50%
$47.89
$49.15
$50.52
$52.03
$53.68
9.75%
$45.97
$47.10
$48.34
$49.68
$51.16
10.00%
$44.20
$45.22
$46.34
$47.54
$48.86
10.25%
$42.56
$43.49
$44.49
$45.58
$46.76
10.50%
$41.03
$41.88
$42.79
$43.78
$44.84
Sector Valuation
The table below provides valuation multiples for the Health Care sector on both an absolute basis and
relative to the S&P 500 based on ten years of financial history:
Health Care Sector Valuation
Absolute Basis
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
High
30.1
27.2
8.7
3.9
22.9
Low
9.9
10.0
2.2
1.0
7.6
Median
18.5
17.5
4.0
1.8
13.7
Current
12.8
12.2
3.0
1.3
11.8
High
1.4
1.2
2.5
2.4
1.9
Low
0.7
0.7
1.2
0.9
0.9
Median
1.1
1.1
1.4
1.3
1.3
Current
0.9
0.9
1.3
1.0
1.2
Relative to S&P 500
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
Source: Thomson Reuters Baseline. May 26, 2011.
The Health Care sector appears to be undervalued using all of the metrics shown above. Current
multiples are significantly below the ten-year medians and only slightly higher than the ten-year lows.
Specifically during the last two years, the Health Care sector has significantly underperformed both the
12
Medtronic, Inc.
May 31, 2011
S&P 500 and historical sector performance. This can be attributed to continued uncertainty facing health
care reform, a pending patent cliff, weak utilization, as well as Health Care being a defensive sector and
investors favoring the more cyclical sectors given the improving economy.xxxi
Industry Valuation
The table below provides valuation multiples for the Health Care Appliances & Equipment industry on
both an absolute basis and relative to the S&P 500 based on ten years of financial history:
Health Care Appliances & Equipment Industry Valuation
Absolute Basis
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
High
36.0
31.4
9.0
5.5
25.6
Low
12.1
11.7
2.3
2.0
8.7
Median
23.3
21.4
4.6
3.8
16.4
Current
15.7
14.8
3.0
2.7
12.1
High
1.7
1.5
2.6
3.6
2.0
Low
0.8
0.8
1.1
1.9
1.0
Median
1.4
1.3
1.7
2.6
1.6
Current
1.1
1.1
1.3
2.1
1.2
Relative to S&P 500
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
Source: Thomson Reuters Baseline. May 26, 2011.
Similar to the broader Health Care sector, the Health Care Appliances & Equipment industry is relatively
inexpensive on an absolute basis and relative to the S&P 500. The current multiples are much less than
the ten-year medians and only slightly above the ten-year lows for the industry. The reasons stated above
for the underperformance of the Health Care sector also apply to the Health Care Appliance & Equipment
industry.
Company Valuation
As shown in the table on the following page, Medtronic is currently trading near its ten-year low relative
to both the industry and the S&P 500. The stock continues to underperform given the challenges facing
the Health Care sector. Additionally, uncertainty surrounds Medtronic as it recently named a new Chief
Executive Officer and long-term objectives for the Company are unclear at this time. Also, weakening
growth fundamentals in its key markets may be negatively impacting the perception of the Company’s
overall performance.
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Medtronic, Inc.
May 31, 2011
Medtronic Company Valuation
Relative to Industry
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
High
1.4
1.3
1.6
2.2
2.2
Low
0.8
0.7
0.8
1.0
1.0
Median
1.0
1.0
1.2
1.4
1.4
Current
0.8
0.8
0.8
1.0
1.0
High
1.9
1.8
3.3
7.3
3.3
Low
0.7
0.7
1.0
1.9
0.9
Median
1.4
1.4
2.1
3.8
1.9
Current
0.8
0.8
1.1
2.1
1.0
Relative to S&P 500
Price / Trailing Earnings
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
Source: Thomson Reuters Baseline. May 26, 2011.
In the chart below, the target price is based on target multiples at approximately 90% of the median. This
is because growth for the Medical Device industry is projected to be weaker going forward due to the
effects of health care reform, increasing regulation and companies having to maintain quality while
reducing costs. xxxii
Medtronic Company Valuation
Absolute Valuation
Price / Forward Earnings
Price / Book
Price / Sales
Price / Cash Flow
Price / EBITDA
High
Low
Median
Current
Target
Multiple
39.7
11.2
11.1
38.6
33.1
9.0
2.3
2.2
7.9
7.0
21.5
6.2
5.5
20.0
16.6
11.3
2.6
2.7
9.5
7.7
19.4
5.6
5.0
18.0
14.9
Target
Value
/ Share
Target
Price
2.8
14.4
14.4
2.5
4.3
$54.18
$80.35
$71.28
$45.00
$64.05
Source: Thomson Reuters Baseline. May 26, 2011.
14
Medtronic, Inc.
May 31, 2011
Price Target
As shown in the chart below, the target price for Medtronic is $55.00 based on the various metrics and at
the weights provided. The discounted cash flow analysis is believed to be the most accurate predictor of
future price and, therefore, is the most heavily weighted. With a current price $40.23 as of May 25, 2011,
Medtronic has a potential upside of approximately 36.71% and is recommended as a BUY.
Medtronic Price Target
Metric
Discounted Cash Flow
Price / Forward Earnings
Price / Sales
Price / Book
Price / EBITDA
Price / Cash Flow
Projected Target Price
Current Price (as of May 25, 2011)
Potential Upside
Target
Price
Weight
$46.34
$54.18
$80.35
$71.28
$45.00
$64.05
50%
10%
10%
10%
10%
10%
$55.00
$40.23
36.71%
RISKS AND CONSIDERATIONS
Pricing Risk
The Medical Equipment and Device industry is highly competitive. In recent years, Medtronic’s key
business segments have experienced significant pricing pressure due to increased competition in the
CRDM, Stent and Spinal markets. Although Medtronic has been able to maintain its margins through
aggressive cost cutting efforts, the competitive pricing environment is not expected to improve going
forward.
Pipeline Risk
The success of Medtronic’s business depends on new product flow through innovation and acquisitions to
drive revenue growth. The Company has consistently spent around 9.5% of sales on research and
development expense.
Health Care Policy Risk
In an attempt to control the rising costs of the Health Care sector, there have been various proposals by
the government to reform the U.S. health care system. For example, the Patient Protection and
Affordable Care Act imposes significant new taxes on medical device makers such as Medtronic. Health
care reform is providing a great deal of uncertainty for medical device manufacturers.
15
Medtronic, Inc.
May 31, 2011
Regulatory Risk
Medtronic is subject to rigorous regulation by the FDA and other federal, state and foreign government
entities. Regulation by governmental authorities may increase compliance cost and exposure to litigation.
Litigation Risk
Medtronic operates in an industry characterized by extensive patent litigation and is susceptible to
significant product liability claims. The Company has elected to self-insure with respect to product
liability risks; however, product liability claims or product recalls could have a material adverse effect on
its business and reputation.
CONCLUSION
With a target price of $55.00, Medtronic is currently recommended as a BUY. The target price represents
an approximate 36.71% upside from the $40.23 closing price as of May 25, 2011. The BUY rating
reflects the strong market share, revenue growth and profitability fundamentals underlying the Company.
Medtronic also recently named a new Chief Executive Officer with a proven track record in the industry
and who may act as a potential catalyst for improvement. Additionally, an established pipeline of new
products will contribute to sales growth in years ahead. Finally, Medtronic offers an attractive total return
investment and valuation metrics demonstrate that its shares currently are relatively inexpensive
compared the market and based on historical performance.
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Medtronic, Inc.
May 31, 2011
APPENDIX 1: MEDTRONIC NEW PRODUCT PIPELINExxxiii
Medtronic New Product Launches
Business
Product
Approval/Launch Expectations
Cardiac Rhythm Management
ICDs
Protecta defibrillators (ICD/CRT-D)
Pacemakers
REVO MRI compatible pacemaker system
Atrial Fib
Arctic Front CryoAblation catheter system
Atrial Fib
Ablation Frontier ablation catheter system
*** US Approved March 2011, Japan FY12
*** US Approved February 2011 ***
*** Approved December 2010***
US FY12 (FDA panel likely, taking longer)
Spine
Core Spine
Core Spine
Core Spine
Core Spine
Biologics
SOLERA next-gen posterior fixation system
PRESTIGE LP (Cervical), Low Profile
Balloon kyphoplasty device
Xpander II balloon, EXPRESS Currette, Xpede Cement
AMPLIFY
US full launch underway
US 1H-FY12
Japan Shonin received. Initiating launch.
Launched
Not approvable letter received F3Q; status unclear
Cardiovascular
BMS
DES
DES
Heart Valves
Heart Valves
Endovascular
Endovascular
Endovascular
Cardio
Integrity bare metal stent (BMS)
ENDEAVOR Resolute drug-eluting stent (DES)
RESOLUTE Integrity drug-eluting stent
CoreValve ReValving transcatheter valve
Ventor Engager
Talent AAA grafts
Endurant Thoracic Stent grafts
Valient Thoracic Stent graft
Ardian SYMPLICITY System
US FY12
EU launched, US FY14
US CY14
EU FY13, US CY15
Japan 2H-FY11/1H FY-12
Japan 2H-FY11/1H FY-12
US 1H-FY12, Japan FY13
US FY15 estimated
US FY15 estimated
Diabetes
CGM
Pump
Pump
Pump
iPro continuous glucose monitoring system
Next-generation durable pump
ENLITE Sensor
Insulin patch delivery system
US FY12
US FY12
US FY12, EU launched April 2011
US FY13 (taking longer)
Neuromodulation
DBS
Active SC deep brain stimulation system
Gastro
InterStim therapy for bowel control
SCS
RestoreSensor spinal cord stimulation (SCS) system
Launched
US Approved March 2011
US 2HFY12
Surgical Tech
Nav
Launched
O-Arm 3.1
Source: Deutsche Bank, Company Reports
17
Medtronic, Inc.
May 31, 2011
APPENDIX II: DISCOUNTED CASH FLOW ANALYSIS
Medtronic Discounted Cash Flow Valuation
Terminal Discount Rate =
Terminal FCF Growth =
10.0%
4.0%
Year
Revenue
2011
2012E
% Growth
Operating Income
3.3%
25.1%
$
Interest % of Sales
Taxes
278 $
$
2017E
2018E
2019E
2020E
2021E
4.0%
4.0%
4.0%
4.0%
4.0%
4.0%
4.0%
165 $
627 $
26.0%
171 $
1.0%
885 $
26.0%
178 $
1.0%
940 $
26.0%
185 $
1.0%
26.0%
193 $
1.0%
26.0%
200 $
1.0%
26.0%
208 $
1.0%
26.0%
217 $
1.0%
26.0%
225 $
1.0%
234
1.0%
962 $ 1,000 $ 1,040 $ 1,082 $ 1,125 $ 1,170 $ 1,217 $ 1,266
21.6%
21.6%
21.6%
21.6%
21.6%
21.6%
21.6%
21.6%
21.6%
21.6%
$ 3,096
$ 3,211
$ 3,410
$ 3,492
$ 3,631
$ 3,777
$ 3,928
$ 4,085
$ 4,248
$ 4,418
$ 4,595
3.7%
6.2%
2.4%
4.0%
4.0%
4.0%
4.0%
4.0%
4.0%
4.0%
$
804 $
5.0%
$
% of Sales
Subtract Capex
2016E
16.8%
% of Sales
Plus/(Minus) Changes WC
2015E
4.0%
26.4%
1.0%
% Growth
Add Depreciation/Amort
4.1%
25.9%
1.7%
T ax Rate
Net Income
2014E
$ 4,001 $ 4,260 $ 4,521 $ 4,632 $ 4,817 $ 5,010 $ 5,210 $ 5,419 $ 5,635 $ 5,861 $ 6,095
Operating Margin
Interest and Other
2013E
$ 15,933 $ 16,452 $ 17,129 $ 17,815 $ 18,527 $ 19,268 $ 20,039 $ 20,840 $ 21,674 $ 22,541 $ 23,443
(610) $
(3.8%)
$
773 $
4.7%
(163) $
(1.0%)
501 $
788 $
4.6%
(213) $
(1.2%)
625 $
802 $
4.5%
(178) $
(1.0%)
668 $
815 $
4.4%
(185) $
(1.0%)
713 $
829 $
4.3%
(193) $
(1.0%)
760 $
852 $
4.3%
(200) $
(1.0%)
809 $
886 $
4.3%
(208) $
(1.0%)
852 $
921 $
4.3%
(217) $
(1.0%)
886 $
958 $
4.3%
(225) $
(1.0%)
921 $
996
4.3%
(234)
(1.0%)
958 $
996
Capex % of Sales
3.1%
3.8%
3.9%
4.0%
4.1%
4.2%
4.3%
4.3%
4.3%
4.3%
4.3%
Free Cash Flow
$ 2,789
$ 3,196
$ 3,317
$ 3,403
$ 3,502
$ 3,603
$ 3,727
$ 3,876
$ 4,031
$ 4,193
$ 4,360
14.6%
3.8%
2.6%
2.9%
2.9%
3.4%
4.0%
4.0%
4.0%
4.0%
% Growth
NPV of Cash Flows
NPV of Terminal Value
Projected Equity Value
Free Cash Flow Yield
$ 22,265
$ 29,139
$ 51,404
6.2%
43.3%
56.7%
100.0%
Current P/E
Projected P/E
Current EV/EBITDA
Projected EV/EBITDA
14.4x
16.6x
11.0x
12.5x
13.9x
16.0x
10.5x
11.9x
Shares Outstanding
1,109
Current Price
Implied equity value/share
Upside/(Downside) to DCF
$ 40.23
$ 46.34
15.2%
Debt
Cash
Cash/Share
$ 9,835
$ 1,382
1.2x
Terminal Value $ 75,579
13.1x
15.1x
10.0x
11.3x
Free Cash Yield
5.8%
Terminal P/E
16.4x
Terminal EV/EBITDA
11.8x
18
Medtronic, Inc.
May 31, 2011
APPENDIX III: ANALYST INFORMATION
Analyst Certification
I, Tracy Shoemaker, hereby certify that the views expressed in this research report accurately reflect my
personal views about the subject companies and their underlying securities.
Analyst Biography
Tracy Shoemaker will soon be joining KeyBanc Capital Markets as an Investment Banking Associate in
the Loan Syndications group. In June 2011, she will obtain a Master of Business Administration from the
Max M. Fisher College of Business at The Ohio State University. Prior to returning to business school,
Ms. Shoemaker worked for six years in various roles at National City Corporation, now a part of PNC.
Most recently, Ms. Shoemaker was employed as a Capital Markets Analyst in National City’s Loan
Syndications group. In this role, she worked within a cross-functional team to structure and market
syndicated loans ranging from $30 million to $500 million on behalf of middle market companies and
private equity firms. Prior to this, Ms. Shoemaker served as a Project Analyst within National City’s Best
in Class initiative. She also worked as a Commercial Credit Analyst as part of National City’s Corporate
Banking Development Program. Ms. Shoemaker earned a Bachelor of Business Administration from
Kent State University and graduating Summa Cum Laude in 2003.
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Medtronic, Inc.
May 31, 2011
APPENDIX IV: SOURCES
i
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
iii
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
iv
Hawkins, W. (April 30, 2010). Medtronic 2010 Annual Report. Medtronic, Inc.
v
Hawkins, W. (April 30, 2010). Medtronic 2010 Annual Report. Medtronic, Inc.
vi
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
vii
Hawkins, W. (April 30, 2010). Medtronic 2010 Annual Report. Medtronic, Inc.
viii
Hawkins, W. (April 30, 2010). Medtronic 2010 Annual Report. Medtronic, Inc.
ix
Roman, D. (May 11, 2011). Medtronic: Omar Ishrak Appointment Looks Positive. Goldman Sachs.
x
Hawkins, W. (January 28, 2011). Medtronic, Inc. Form 10-Q. Medtronic, Inc. www.sec.gov
xi
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xii
Roman, D. (May 11, 2011). Medtronic: Omar Ishrak Appointment Looks Positive. Goldman Sachs.
xiii
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
xiv
Hawkins, W. (April 30, 2010). Medtronic 2010 Annual Report. Medtronic, Inc.
xv
Hawkins, W. (January 28, 2011). Medtronic, Inc. Form 10-Q. Medtronic, Inc. www.sec.gov
xvi
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
xvii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xviii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xix
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xx
Chronic Disease Prevention and Health Promotion. Center for Disease Control and Prevention.
http://www.cdc.gov/chronicdisease/.
xxi
Unknown. (September 2004). Chronic Conditions: Making the Case for Ongoing Care. Johns Hopkins University.
xxii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xxiii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xxiv
Hawkins, W. (April 30, 2010). Medtronic, Inc. Form 10-K. Medtronic, Inc. www.sec.gov
xxv
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xxvi
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xxvii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xxviii
Simpson, G. (April 8, 2011). Medtronic, Inc.: Initiating Coverage With a Buy. Wunderlich Securities.
xxix
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xxx
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S. IBISWorld.
xxxi
Rubin, J. and Haider, A. (May 1, 2011). Americas: Healthcare: Recent Outperformance of Healthcare: More than
just Defensive? Goldman Sachs
xxxii
Snyder, S. (November 2010). IBISWorld Industry Report: Medical Device Manufacturing in the U.S.
IBISWorld.
xxxiii
Steward, K. (May 25, 2011). Medtronic: Good Riddance FY11; Bar Set Nicely For FY12; Maintain Buy.
Deutsche Bank.
ii
20