Innovation Puts Medtronic in the Lead

Medtronic’s MDT acquisition of Covidien has produced a combined company that’s a force to be reckoned with in medical technology. 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 Medtronic’s position as a key partner for its hospital customers.

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 postreform 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. We estimate Medtronic generated roughly $1.5 billion in Chinese sales in fiscal 2018. Medtronic’s broad portfolio of products fits well with the company’s earlier purchase of Kanghui Holdings, which provides the company with an established network of native distributors that can reach thousands of hospitals in China.

Many Factors in Medtronic's Wide Moat 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.

In the cardiac area, Medtronic competes with roughly three companies 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, including renal denervation and transcatheter mitral valves, 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.

Diverse Portfolio Mitigates Risk Based on the average volatility of cash flows from a diverse product portfolio in relatively less discretionary therapeutic markets, we rate Medtronic's 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 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.

Medtronic’s financial health deteriorated somewhat after financing a significant portion of the Covidien merger with new debt issuance. Covidien shareholders owned about 30% of the combined entity at the time of the merger, which allowed the combined entity to invert to Covidien’s Irish domicile, lowering its tax rate and enhancing its ability to access overseas cash. At the end of January 2016, Medtronic owed $36 billion in debt, or around 4 times adjusted EBITDA, which is up from around 2 times historically. Since then, the company has paid off roughly $10 billion of the debt. 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.

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) companies 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. However, we think many of Medtronic’s other acquisitions should add value over time, including CoreValve, CryoCath, and Covidien.