Medtronic's Portfolio Is Unmatched

Medtronic has historically 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 where there are 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 greater breadth of products and services to help hospitals operate more efficiently. By partnering more closely and integrating itself into more hospital operations, we think Medtronic is well positioned to take advantage of more business opportunities in the value-based reimbursement environment.

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, where we estimate the company generated roughly $1.5 billion in sales in fiscal 2016. Medtronic’s broad portfolio of products fits well with the earlier purchase of China Kanghui Holdings, which provides the company with an established network of native distributors that can reach thousands of hospitals in China.

Moat Is Wide and Stable Medtronic's wide 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. This moat comes from several sources.

In the cardiac area, Medtronic competes with roughly three rivals in total 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 representatives 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.

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. 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, neurovascular, 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 tend to lead to only marginal share shifts in the industry and strong excess returns. Covidien currently ranks at or near the top in all product categories where it competes in devices and vies mainly with Johnson & Johnson JNJ; the rest of the field is typically highly fragmented, with most companies occupying product niches rather than competing broadly against the big two.

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 surgeons’ influence over procurement decisions is arguably waning, the established players also have administrators’ ears. Covidien 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 oligopoly it competes in, primarily with Boston Scientific BSX, Abbott ABT (with its purchase of St. Jude Medical), and Edwards Lifesciences EW 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 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, as well as purchase new or complementary technologies, to remain at 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. 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 new hospitals solutions service, Medtronic has taken a big step into a new role as manager of catheterization and electrophysiology labs. If Medtronic can deliver operational efficiencies, we think more hospitals could seek out the company for these services. In turn, the closer integration of Medtronic services with hospital operations could also raise switching costs for its hospital customers.

Risks Include Reimbursement, Regulation On the basis of the average volatility of cash flows from a diverse product portfolio in relatively less discretionary therapeutic markets, we rate Medtronic's fair value uncertainty as medium.

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 Medtronic’s 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.

We think Medtronic can easily shoulder its current debt load. Beyond its debt obligations, the company aims to return a minimum of 50% of its annual free cash flow to shareholders. Medtronic shoots for a 40% dividend payout ratio and consistently engages in share repurchases.