Medtronic's Dominance Results in Wide Moat

Two aspects of the recently reported fiscal third quarter were particularly noteworthy, from our perspective. First, management’s comments regarding the Guardian Connect continuous glucose monitor lead us to believe that Medtronic is ready to put some muscle behind marketing it as a stand-alone product. While the monitor has been available on a stand-alone basis, most of Medtronic’s focus has been on the insulin pumps. Medtronic’s continuous glucose monitor offers individualized predictive alerts and taps into the Big Data analytics of IBM Watson. Though its sensors have trailed those of Dexcom DXCM on accuracy, Medtronic has begun competing on other meaningful features and benefits. We see this latest effort as another way Medtronic can leverage its major competitive advantage in diabetes: its data collection and analysis that leads to better predictive algorithms.

Second, Medtronic has pioneered ways to benefit from the shift to value-based reimbursement through risk-based contracting. For example, roughly 25% of U.S. cardiac rhythm management devices are under these types of contracts and have contributed to significant sales of Medtronic’s Tyrx anti-infective envelope. While Tyrx has not established separate reimbursement, hospitals are willing to pay extra for it, with the knowledge that Medtronic will pay for the treatment of any patients who come down with device-related infections.

We think this kind of risk-based contracting will gain steam with hospitals seeking to reduce their financial risk associated with patient complications, and Medtronic is well positioned to partner with customers in these types of situations. The company has already begun to launch other types of risk-based programs, including for repeat target lesion procedures for patients who used Medtronic’s drug-coated balloon and rehospitalization of patients using Medtronic’s cardiac resynchronization technology. Medtronic has been aggressively piloting this approach and then applying it to other technologies in its portfolio.

Key Partner for Hospitals Medtronic's acquisition of Covidien has produced a combined company that's a force to be reckoned with in the med-tech landscape. Pairing Medtronic's diversified product portfolio aimed at a wide range of chronic diseases with Covidien's breadth of products for acute care in hospitals has bolstered the company's position as a key partner for its hospital customers.

Medtronic historically has focused on designing and manufacturing devices to address cardiac care, neurological and spinal conditions, and diabetes. All along, the company has remained focused on its fundamental strategy of innovation. It is often first to market with new products and has invested heavily in internal research and development efforts, as well as acquiring emerging technologies. However, in the post-reform healthcare world with higher hurdles for securing reimbursement for next-generation technology, Medtronic has slightly shifted its strategy to focus on partnering more closely with its hospital clients by offering a greater breadth of products and services to help hospitals operate more efficiently. The addition of Covidien further entrenches Medtronic’s presence in hospitals and brings it closer to direct competition with Johnson & Johnson’s JNJ surgical device business.

We have always appreciated Medtronic’s diverse portfolio, where certain waning product lines would be offset by growth in other categories. The addition of devices and consumables used in the surgical suite should further stabilize potential speed bumps in individual product lines. Medtronic continues to focus on penetrating emerging markets, especially China. Its broad portfolio of products fits well with the earlier purchase of Kanghui, which provides Medtronic with an established network of native distributors that can reach thousands of hospitals in China.

Wide Moat Fed From Several Sources Medtronic's wide economic moat is rooted in its dominant presence in highly engineered medical devices to treat chronic diseases, including those beyond its historical stronghold in heart disease. Medtronic's moat comes from several sources.

Medtronic has roughly three competitors across its heart-related portfolio. The markets for pacemakers, implantable cardioverter defibrillators, coronary stents, heart valves, and neuromodulation generally operate as rational oligopolies.

In the spine area, Medtronic’s moat is strengthened by high switching costs for surgeons. 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. 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.

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. According to independent intellectual property evaluation publications Device Link and The Patent Board, Medtronic holds the strongest intellectual property position based on number and technological strength of its patents.

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. Investments in neuromodulation, diabetes, and spinal products from the middle to late 1990s paid off in spades through 2010. Although the spine and ICD businesses have been hit with slower market growth since then, the company has seen double-digit growth in its diabetes, surgical technologies, drug-coated balloons, and atrial fibrillation segments. While some of Medtronic’s product lines have waned as new clinical data has altered treatment guidelines, the company continues to invest in emerging technologies that should drive future growth.

The addition of Covidien deepens Medtronic’s competitive advantages, as Covidien’s medical device segment enjoys brand recognition, technological innovation, and substantial scale. Covidien’s innovation record, enhanced by incremental research investment during the past few years, has resulted in a steady stream of product upgrades and new technologies. Most of Covidien’s device subsegments operate in an oligopolistic fashion; the absence of irrational price competition and the evolutionary rather than revolutionary nature of innovation tends to lead to only marginal share shifts in the industry and strong excess returns.

We have seen no new entrants making significant inroads. New competitors sometimes pop up on the margins, ranging from less sophisticated (discounted prices) to high end (technological advancements), but they rarely result in monumental market shifts. The existing players’ positioning is very defensible, with most practitioners rarely switching to competitors’ products because of inertia as well as up-front training costs. While arguably the surgeons’ influence on procurement decisions is waning, the established players also have administrators’ ears. Medtronic and J&J dominate a number of surgical specialties with the breadth of their portfolios, rendering competitors’ efforts to displace them on cost on an individual product basis less meaningful.

Medtronic’s moat remains stable, partly thanks to the stable oligopolies the company competes in, primarily with Boston Scientific BSX and Abbott ABT for cardiac devices and with Johnson & Johnson for hospital-oriented surgical devices and tools. 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 structural heart, neuromodulation, and insulin pumps. The company continues to innovate internally and purchase new or complementary technologies to remain on the forefront of medical devices.

In the wake of healthcare reform, more doctors are signing up as employees at healthcare providers. We think this shift is realigning doctors’ financial interests with those of the hospital or practice group. However, Medtronic is already maneuvering to better position itself to partner with hospitals and healthcare 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 and has been introducing more services that can be wrapped around the devices themselves. With its hospital solutions service, Medtronic has taken a big step into a new role as manager of catheterization labs. If Medtronic can deliver operational efficiencies, we think more hospitals could seek out the company for these services.

Risks Include Reimbursement and Regulation With baby boomers hitting Medicare age, there could be future cuts to Medicare reimbursement for device-related procedures. Innovation is the name of the game in medical devices, but the bar has been raised in the wake of healthcare reform. Successfully securing price premiums for new technology is no longer a given and now depends on favorable clinical data. Increasing regulatory attention and interest in conducting more extensive clinical trials and aftermarket studies could increase development costs for Medtronic. Product recall and liability and inventory write-downs are occasional sore spots for the industry. Although the U.S. Department of Justice wrapped up its investigation into off-label use of the Infuse product without issuing any charges, the controversy around the investigation added uncertainty and contributed to a decline in Infuse sales. Potential investigations into other products and their marketing remain a risk in the medical device business.

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, the company 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. 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 Covidien.