No Surprises in Medtronic's Fiscal Third Quarter
The firm is on track to meet our full-year estimates, and our $60 per share fair value estimate and wide moat rating are intact.
The firm is on track to meet our full-year estimates, and our $60 per share fair value estimate and wide moat rating are intact.
Medtronic's (MDT) wide moat is rooted in its dominant presence in highly engineered medical devices that treat chronic diseases, including those outside its historical stronghold in heart disease. Medtronic's moat comes from several sources. First, in the cardiac area, Medtronic benefits from efficient scale, with roughly three competitors in total across its heart-related portfolio. The markets for pacemakers, ICDs, coronary stents, and neuromodulation generally operate as rational oligopolies.
Second, in the spine area, Medtronic's moat is strengthened by high switching costs for surgeons. This dynamic tends to keep spinal surgeons loyal to Medtronic's products, as long as the company does not fall too far behind its competitors when it comes to introducing new technology.
Finally, Medtronic's wide moat is bolstered by several intangibles, including intellectual property and carefully nurtured relationships with physicians. Thanks to its persistent ability to innovate, Medtronic is often first to market with new products in various therapeutic areas. We expect Medtronic to continue its record of innovation, based on its extensive patent portfolio.
Fiscal Third-Quarter Results Confirm Our View of Medtronic
Medtronic released fiscal third-quarter results that met our expectations on the top and bottom lines. The firm remains on track to meet our full-year estimates, and we're standing behind our $60 per share fair value estimate and wide moat rating.
Total quarterly revenue increased 4% in constant currency compared with the prior-year period, fueled by strength in diabetes, surgical technologies, and neuromodulation. We were pleased to see eager U.S. adoption of the MiniMed 530G insulin pump, as well as new technology for surgical navigation and nerve-monitoring equipment. Management contends that the spine market has further stabilized, with INFUSE quarterly revenue nearly flat year over year. INFUSE is well on its way to reaching our projection for $449 million in fiscal 2014, though we assume the product will see further decline in ensuing years. If INFUSE sales were to stabilize after this year and grow at 1% going forward, this would add roughly $1 to our fair value estimate. Medtronic's cardiac rhythm management sales remain anemic. Although the implantable cardioverter defibrillator market has stabilized and Medtronic had displayed some strength in that area over the last few quarters, competition from St. Jude Medical and Boston Scientific (BSX) has damped Medtronic's performance in this market.
All eyes are on Medtronic's U.S. launch of its CoreValve transcatheter aortic valve. Even though Medtronic and Edwards Lifesciences continue to battle each other over intellectual property, Medtronic is encroaching on the monopoly Edwards has enjoyed in the U.S. over the past two years. Efficient scale has been a significant moat source for the cardiac device companies, and most product categories can accommodate three competitors, who then compete rationally. We think the transcatheter aortic valve market will fall into the same pattern.
Finally, coming off the disappointing results of Medtronic's most recent renal denervation trial, we think there is a 50/50 chance that the firm will pursue development of its Symplicity technology. We think the American College of Cardiology conference next month may be the first opportunity to learn more details about what happened in the trial, and about Medtronic's inclination to continue development. At this point, Covidien has bowed out of the market, but St. Jude Medical remains committed to commercializing its EnligHTN renal denervation system.
Medtronic Enjoys Reputation of Being First to Market
While several of Medtronic's key markets have experienced slowing growth (including implantable cardioverter defibrillators and spinal procedures), the firm has remained focused on its fundamental strategy of innovation. It is often first to market with new products. For instance, Medtronic reached the U.S. market first with its Revo MRI-compatible pacemaker in 2011, and followed up with its next-generation pacemaker this year. Thus far, competitors have not yet launched comparable products in the U.S. Because an estimated one third to one half of pacemaker patients will eventually need an MRI, Medtronic's technology addresses a key limitation of early generations of pacemakers. We expect Medtronic to apply the same engineering knowledge to introduce MRI-compatible ICDs in the coming years. Additionally, Medtronic enjoys a dominant position in the emerging neuromodulation market. While Medtronic's electrical devices have been primarily used for subsegments of incontinence and chronic pain patients, the general therapeutic approach is being applied to a number of additional conditions including epilepsy, Parkinson's, treatment-resistant depression, and essential tremor.
Medtronic has pinned its hopes for growth on atrial fibrillation, transcatheter heart valves, and drug-resistant hypertension. The firm recently bulked up its technology in these three areas with a series of acquisitions. There is a growing body of clinical evidence to support the efficacy of these therapeutic approaches, especially for calcified aortic stenosis and uncontrolled hypertension. We note that these remain health conditions for which there are few good treatment options. As favorable data come out of the clinical trials, Medtronic is appropriately armed to expand these therapies into sizable new markets.
We're watching closely to see how Medtronic's efforts to partner directly with health-care providers turn out. This may be where the postreform health-care world is heading.
Diversified Medical Technology Portfolio Keeps Medtronic's Wide Moat Safe
This wide-moat company's vision is to establish a significant presence in chronic diseases, in addition to its historical stronghold in heart disease. Investments in neuromodulation, diabetes, and spinal products from the middle to late 1990s paid off in spades through 2010, offering new revenue streams and taking some pressure off heart products. While some of Medtronic's product lines have waned as new clinical data has altered treatment guidelines, the firm continues to invest in emerging technologies that should drive future growth.
We think Medtronic's diversified medical technology portfolio allows it to better weather occasional glitches in the development or approval process for any particular new device. For example, even though the spine and ICD businesses have been hit with slower market growth, the firm has seen double-digit growth in its diabetes, surgical technologies, drug-coated stents, and atrial fibrillation segments. Another element of Medtronic's wide moat is its highly trained salesforce and relationships with medical practitioners. Doctors often rely on medical-device sales reps for their deep device knowledge as well as their experience with device usage in a wide range of patients. As a result, Medtronic's reps play the role of highly specialized experts who advise practitioners on implantation, programming, and maintenance of Medtronic devices and create sticky relationships with medical practitioners.
Medtronic's moat remains stable, partly thanks to the stable oligopoly it competes in, primarily with Boston Scientific and St. Jude Medical. The competitors may trade a few market share points over several years, but the relatively short product cycles allow peers to regain that share fairly quickly. Medtronic has consistently controlled about 50% of the cardiac rhythm management market, and it is also the dominant competitor in spinal devices and insulin pumps. The firm continues to innovate internally, as well as purchase new or complementary technologies, to remain on the forefront of medical devices. In the wake of health-care reform, more doctors are signing up as employees at health-care providers. We think this shift could realign doctors' financial interests with those of the hospital or practice group. However, we note that Medtronic is already maneuvering to better position itself to partner with hospitals and health-care systems, as doctors see their influence wane. With its wide-ranging product portfolio, Medtronic is particularly suited to play this role in a way few competitors can. With its new Hospitals Solutions service, Medtronic has taken a big step into a new role as manager of catheterization labs in Europe. If Medtronic can deliver operational efficiencies, we predict more hospitals could seek out the firm for these services.
CEO Ishrak Brings Global Perspective to Medtronic
In 2011, Omar Ishrak left GE Healthcare (GE) to lead Medtronic as CEO and chairman. While Ishrak had little direct experience with the cardiac market or the device industry, he was considered a rising star at GE. Ishrak was the pioneer behind GE Healthcare's successful entrance into the China market--he led efforts to expand the product portfolio in order to compete head-to-head with local Chinese imaging companies such as Mindray , which gave GE a substantial leg up in the midmarkets in China. Considering that Medtronic has been making a number of investments in China and has identified emerging markets as a strategic source of growth, we think Ishrak can bring valuable perspective to the party. We think he has pushed Medtronic away from its U.S.-centric past and focused the organization more closely on the potential in emerging markets.
Management's capital-allocation decisions have been primarily solid, with an occasional misstep when it comes to acquisitions. Like the other major medical device companies, Medtronic makes regular acquisitions of smaller (often privately held) firms that offer emerging technology. These purchases are typically dilutive in the short term because the technology still requires much development to reach commercialization. Though it is difficult to assess the value of what was purchased, we tend to view these investments akin to the internal investments that Medtronic must make in R&D. Our main concern is that even though Medtronic has not seen a pattern of goodwill impairment, it has not hesitated to pony up generous offers for certain acquisition targets that did not seem to add value over the longer term. For example, Medtronic spent $4.2 billion to purchase Kyphon in 2008--an acquisition that turned out to be a disappointment as there were fewer-than-expected synergies in terms of sales, marketing, and physician relationships. In the past four years, Medtronic has not been able to goose Kyphon's products back into robust growth. However, we think many of Medtronic's other acquisitions should add value over time, including CoreValve, Cryocath, and Ardian.
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