MEDTRONIC. That s a lot of Solid Heart Beats. INVESTMENT THESIS FINANCIAL STATISTICS COMPANY PROFILE. Financial History EQUITY RESEARCH
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1 SMUSM COX SCHOOL OF BUSINESS EQUITY RESEARCH UNITED STATES OF AMERICA MEDTRONIC COMPANY UPDATE: Prospects for 2004 HEALTHCARE - Medical Equipment & Supplies PAGE 1 BUY Benjamin Q. Luong luong_benji@hotmail.com Kanaiya Kapadia kkapadia@mail.smu.edu Miranda Peters mpeters@mail.smu.edu Ryan Wannemacher rwannema@mail.smu.edu FINANCIAL STATISTICS Price: $48.90 (as of April 8, 2004) Symbol Exchange: MDT NYSE 52-Week Range: $42.90-$52-92 Market Capitalization: $ billion Shares Outstanding: 1,210 billion Relative Price-to-Earnings (P/E): 1.10 Trailing P/E: (Stock) vs (Industry) Forward P/E: (Stock) vs (Industry) Current PEG Ratio: 1.8 (Stock) vs (Industry) Forward PEG Ratio: 1.6 (Stock) vs (Industry) Return on Assets (ROA): 18.1% Return on Equity (ROE): 19.3% Annual Dividend: 0.30 Dividend Yield: 0.59% Price Target: $59.39 COMPANY PROFILE Medtronic is one of the largest medical technology company that manufacturers implantable biomedical devices, with sales to over 120 countries. The Company treats chronic diseases by primarily offering products, which include bradycardia pacing, tachyarrhythmia management, heart failure, atrial fibrillation, coronary vascular disease, endovascular disease, peripheral vascular disease, heart valve replacement, extra-corporeal cardiac support, minimally invasive cardiac surgery, malignant and non-malignant pain, diabetes, urological disorders, gastroenterological ailments, movement disorders, spinal surgery, neurosurgery, neurodegenerative disorders and ear, nose and throat (ENT) surgery. Medtronic operates in five business segments: Cardiac Rhythm Management (CRM); Neurological and Diabetes; Spinal, Ear, Nose and Throat, and Surgical Navigation Technologies (SNT); Vascular, and Cardiac Surgery. Cardiac Rhythm Management products (bradycardia & tachycardia) accounted for 47.4% of 2002 sales; Neurological, Spinal, and Diabetes, 35.3%; Vascular products (stents), 10.1%; and Cardiac Surgery (heart values, perfusion systems), 7.2%. SOURCE: Valueline and Reuters.com That s a lot of Solid Heart Beats. April 8, 2004 INVESTMENT THESIS Healthy, diverse revenue base with a strong balance sheet. Although Medtronic is trading at a premium, their diverse business combinations and rich cash flow offers management an opportunity to augment internal growth with further acquisitions and stock repurchases. Favorable demographics and trends will drive growth in the market. Irrespective of company size and product, Medtronic s overall customer base seems to be expanding domestically and overseas as changing demographics and rising standards of living will demand a steady stream of new and improved medical products. Market consensus expects growth expectations for 2004 and 2005 to be around 15%. After with net income falling in 2001 and 2002 due to increased acquisitions and competition from drug-eluting stents (DES), Medtronic s businesses have strengthen and stabilized with diversified product lines. The Company s bare metal stents seems to be performing well in Europe and is again penetrating the DES (medical devices that improve coronary artery disease) market. Meanwhile, the important CRM business will perservere positively, given both a recent sharp increase in reimbursement for Medicare and a strong product pipeline. Research & Development (R&D) expenditures have continued to pay off. Medtronic recently launched two FDA-approved heart devices designed to treat irregular heart beats and abnormalities. The Food and Drug Administration (FDA) also approved their CD Horizon Legacy 5.5 spinal system. Further, the FDA approved the Guardian continuous glucose monitoring system. Also, Medtronic s Physio-Control division announced a partnership with Walgreens to sell automated external defibrillators online. Medtronic further received Japanese approval for their Sprinter Semi-Compliant Rapid Exchange Balloon Dilatation Catheter. Additionally, Medtronic is continuing SCD-HeFT research, the largest implantable cardioverter defibrillators (ICD) trial to date, for benefits of ICDs in a broad group of patients at risk of sudden cardiac arrest. Results of this Medtronic-National Institute of Health cosponsored trial will emerge near the end of fiscal year Recently, Medtronic received FDA-approval to begin its Endeavor III clinical study a randomized trial study evaluating the safety and efficacy of Medtronic s Endeavor DES. DES represents an opportunity for further growth for Medtronic in Drugcoated stents constitute the next, biggest development in stent technology and promise to double the size of $2.5 billion sector. Data from Endeavor I and II DES showed positive results, and their DES program remains on track to obtain European approval in late 2004, US approval in late 2005, and Japanese approval in late If expectations fall through, Medtronic will be the third market entrant in the US DES market after Boston s Scientific s recent Taxus DES FDA-approval. According to Merrill Lynch Research, Medtronic could potentially capture US DES revenues of $360-plus million and 10% of the market share. Financial History SOURCE: Company Reports
2 MDT PAGE 2 BUSINESS MODEL SOURCE: Standard & Poor s The Medical Equipment and Supplies Industry develops, manufactures and markets products used to improve patient health. These include commodity-type items such as kits, trays, gloves, gowns, syringes, and other disposable medical supplies. Medical device products provide a steady cash flow for companies and usually some of their revenues are budgeted for Research & Development (R&D). Important value-added products include infusion and related intravenous supplies and equipment, diagnostic and laboratory products, wound-management supplies, orthopedic, reconstructive implants, spinal devices, surgical devices, cardiac products, and diagnostic equipment. The Industry s most profitable groups are those involved with innovative high-technology products, such as implantable and external cardiac defibrillators, orthopedic devices, and sophisticated diagnostic imaging systems. New products will be the engine of growth in the market because they have a very high growth potential. Currently, the Standard & Poor s (S&P) Health Care Equipment Index gained 8.4% compared to a 1.1% gain from the consolidated S&P Health Care Index. Business Segments Generally, markets for certain products, such as cardiac and orthopedic devices are dominated by a small number of players, including Medtronic, Guidant Corporation, and Boston Scientific. Currently, the industry is intensifying into new market prospects, such as orthobiologics, deep brain stimulation, drug-coated coronary stents, congestive heart failure treatment, and robotic surgery. The United States (US) will particularly benefit cardiovascular products, such as pacemaker, defibrillators, and angioplasty catheters, which are used mostly on elderly patients. Also, this Industry represents several, developed business segments that Medical Device manufacturers can derive their revenues from: Cardiology, Diagnostic Imaging, Orthopedics, In-vitro Diagnostics, Peripheral Vascular Disease, and other (see Chart A). Cardiology: In 2002, worldwide medical device sales accounted for approximately 6.9%. Cardiac Rhythm Management (CRM) represented 44% of the cardiology market. Other products such as coronary stents took 17%; angioplasty, angiographic catheters and other interventional devices accounted for 13%; products used in bypass procedures, heart values and other surgical items took 15%; vascular grafts and other vascular products contributed 5%, and the rest, 6%. According to the American Heart Association s Heart and Stroke Statistical Update 2002, since 1999, 62 million Americans had some form of cardiovascular disease (CVD) and accounted for 40.1% of all deaths that year. Since 1900, CVD has been the Number One killer in the US every year, except Global CVD market is expected to expand by 13% to 14% annually through 2007 (see Chart C). of to date, diagnostic imaging product sales still come from conventional x-ray equipment, ultrasound imaging, magnetic resonance imaging, radiation therapy, nuclear medicine, and computed tomography. Orthopedics: These products are used to repair or replace parts of the human skeletal system. Generally, they have been achieving a compound annual growth rate of 7 to 9%, generating global orthopedic industry generated sales of about $13 billion. US, Europe, Asia, and other markets have contributed sales of 63%, 19%, 13%, and 5%, respectively. An area growing faster than 20% annually, is the $2.4 billion spine market. Over 10,000 spinal cord injuries occur each year in the US and nearly 50% of which are related to motor vehicle accidents. Additionally, in the US, there are 1.1 million spinal procedures each year. In-vitro Diagnostics: This segment represents a worldwide market worth of about $23 billion, accounting for an estimated 12% of total industry sales. In-vitro diagnostics involve tests performed on blood, urine, and other body fluids and tissues to detect pathological conditions. For overseas markets, especially in development nations, a stronger growth in this segment is expected. Peripheral Vascular Disease (PVD): This newly-interested segment focus on non-coronary diseases of the vascular system, including the brain. For instance, the most prevalent diagnosis is a stroke. PVD affects about one in 20 persons over the age of 50 or about eight million people in the US. PVD is attractive to medical device manufacturers because they can extend their patient treatment capacity to both arterial and venous diseases and aneurysms (localized swellings in arteries). Guidant, Medtronic, and Boston Scientific have become leading innovators in this segment market. Specifically, Medtronic s diverse core businesses focus in Cardiology, Orthopedics, Peripheral Vascular Disease, and Neurology areas (see Chart E). CHART A : Projected US Sales for 2005 Diagnostic Imaging: This particular segment has been steady, measuring in the range between $4.5 billion to $5.0 billion. As
3 OVERALL MARKET PERSPECTIVE SOURCE: Standard & Poor s Market Size The worldwide medical device business represented a global market of about $190 billion in 2002 an increase of about 10% from $172 billion in According to Standard & Poor s, US medical device manufacturers continue to generate about 40% of their unit sales in foreign markets, regardless of the pricing benefits accruing from a weakened US dollar relative to both the Euro and the Yen. During 2002, about $85 billion, or 45%, of industry sales were generated overseas. Industry Outlook Industry outlook remains favorable and positive. According to Standard & Poor s, worldwide market growth for medical supplies and devices is expected to be around 12% as of mid While rising healthcare cost seems to be the focus around the world, the aging population, the availability of new and better medical treatments, and the global demand for healthcare products and services continues to be strong worldwide, particularly in developing markets. U.S. companies are benefiting from sales of new technology devices by forcing a premium on unit pricing in comparison to older products. Aided by price and volume increases and favorable foreign exchange fluctuations, Standard & Poor s expect industrywide sales growth will approximate 15% growth in Interventional cardiology and cardiac rhythm management, spinal surgery and orthopedic joint replacements will be among the products that will contribute to that growth. Earnings will be expected to grow approximately 18% to 20% in Expansion in gross margins due to a higher proportion of sales from new products, stable R&D outlays, reduced interest costs, and positive tax rate implications will drive this performance measure. Recently, the Centers for Medicare & Medicaid Services proposed new rates for implantable cardioverter defibrillators (ICDs) which will increase Medicare reimbursements by 3.9%. This guideline as well as few other legislations, such as Medicare RX ($400 billion budget allocated for the elderly) is expected to increase the number of people receiving ICDs by about 65,000 per year. An increase in Medicare reimbursements is seen as a positive factor. Drug-coated (or -eluting) coronary stents have become the center of the attention. The first product line approval by the FDA was given to Johnson & Johnson (J&J) for their Cypher stent. This drug device is intended to help reduce restenosis (reblockage) of a treated coronary artery. Coronary stents are flexible metal tubes that are inserted into diseased coronary arteries after an angioplasty procedure a catheter with a small balloon at the end is inserted into a blocked artery. Once the inflating balloon clears the blockage, the balloon catheter is removed and the stent, which acts as a platform to keep the artery open, is inserted. While the procedure can effectively restore blood flow to the MDT PAGE 3 heart and often eliminates the need for invasive coronary artery bypass graft (CABG) surgery, vessel reclosure or restenosis at the site of the stent may occur. This negative after-effect can be treated by coating the stent with drugs. Recently, medical device companies have demonstrated that drug-coated coronary stents can significantly reduce restenosis. The drugs used to coat coronary stents are anticancer compounds that inhibit cell proliferation and dynamically allows for release of the drug over a period of time. So far, J&J has been unable to meet all of the demand coming from physicians and their patients for their Cypher product, which leaves ample room for competitors to penetrate the market. Coronary stents presently account for industrywide sales of $2.5 billion or about 19% of the interventional cardiology market. As other companies gain FDA approval for their drug coated stent, the global stent market will reach $4.5 billion by the end of 2004 (see Chart B). CHART B : Drug-Eluting Stent (DES) Market Increases in Mergers & Acquisitions. A number of smaller acquisitions are taking place run by some of the largest players, who seek to fill their product lines with niche acquisitions. These deals will provide great opportunity for them to capitalize on the recent increases in stock prices and historically low levels of interest rates. Continued aging population = more patient population. Medicare constituents at the age of 65 and older may more than double in the coming decades, from 37 million today to 70 million in 2030 and 82 million in Although the elderly represents slightly less than 13% of the total US population, they contribute an estimated 40% of total healthcare expenditures. Also, an aging bundle of baby boomers will provide further stimulus for industry wide demand. Baby boomers currently represent 23% of the US population. According to the World Health Organization, the global over-65 age population is projected to rise from 390 million in 1997 to 800 million people by However, an expected 24 million deaths per year will increase in the years ahead mostly because many people have unhealthy lifestyles, such as smoking, obesity, poor diet, or lack of exercise.
4 MDT PAGE 4 Outpatient procedures heightens equipment sales. Inpatient procedures are shifting towards the less expensive outpatient settings. Nearly 75% of all surgical procedures will be performed on an outpatient basis because new medical device technology has helped fuel this trend. With the aid of new medical products, surgeons now perform a one-day surgical procedure for conditions that once required expensive inpatient surgery, lengthy and expensive hospital stays, and weeks of recuperation. CHART D : Medtronic Product Pipeline Managed care enterprises = Biggest customer. Managed Care enterprises have developed influential, bargaining power within medical markets. Managers of health maintenance organizations (HMOs), preferred provider organizations (PPOs), large hospital consortiums, government agencies, and other large managed care buyers have made more purchasing decisions. For instance, 60% of all medical device purchases in the United States are made by managed care buyers, and this percentage is projected to rise to over 80% by 2005, according to the Advanced Medical Technology Association. Increased Internet-based sales usage. In order to combat competitive pricing pressures on gross margins, many medical device manufacturers have resorted to the Internet to close this offset by boosting shipment volumes. CHART C : Cardiovasuclar Industry SOURCE: Standard & Poor s PRODUCTS AND SERVICES (see Chart D and G) SOURCE: Company Reports & Website Medtronic operates in five key business units developing products in Cardiac Rhythm Management (CRM), Cardiac Surgery, Vascular, Neurological and Diabetes, and Spinal, ENT and SNT. Medtronic CRM develops products that restore and regulate a patient s heart rhythm, as well as improve the heart s pumping function. The business markets implantable pacemakers, defibrillators, cardiac ablation catheters, monitoring and diagnostic
5 devices and cardiac resynchronization devices, including the first implantable device for the treatment of heart failure. In addition, the business markets automated external defibrillators (AEDs) - which are increasingly being placed in public places, such as businesses, airports, shopping centers and even homes - and the industry s first Internet-based network to enable physicians to remotely monitor their patients who have cardiac devices. Medtronic Cardiac Surgery develops products that are used in both arrested and beating heart bypass surgery. The business also markets the industry s broadest line of heart valve products for both replacement and repair, plus autotransfusion equipment and disposable devices for handling and monitoring blood during major surgery. COMPETITION MDT PAGE 5 Three main competitors fight for this market: Guidant Corporation, St. Jude Medical, and Boston Scientific Corporation (see Chart D, E, F and Exhibit 1). Medtronic ranks 1 st among others due to their diverse product segments and sales, capturing much of CRM. CHART E : Competitve factors - Product Line Sales SOURCE: Standard & Poor s Medtronic Vascular develops products and therapies that treat a wide range of vascular diseases and conditions. These products include coronary, peripheral and neurovascular stents, stent graft systems for diseases and conditions throughout the aorta, and distal protection systems. The business is also moving forward with the development of a drug-eluting stent to prevent restenosis. Medtronic Vascular also markets a full line of balloon angioplasty catheters, guide catheters, guidewires, diagnostic catheters and accessories. Medtronic Neurological and Diabetes offers therapies for movement disorders, chronic pain and diabetes. It also offers diagnostics and therapeutics for urological and gastrointestinal conditions, including incontinence, benign prostatic hyperplasia (BPH)/enlarged prostate and gastroesophageal reflux disease (GERD). Products include infusion and neurostimulation systems, as well as shunts and powered surgical tools for cranial surgery. Medtronic Spinal, ENT and SNT develops and manufactures products that treat a variety of disorders of the cranium and spine, including traumatically induced conditions, deformities and tumors. It also develops image-guided surgical navigation systems (SNT) and a wide range of products for use in ENT (ear, nose and throat) procedures. CHART D : Competitve factors - Geographic Sales Guidant Corporation (GDT) The Company develops, manufactures and markets implantable defibrillator systems, implantable pacemaker systems, coronary stent systems, angioplasty systems and cardiac surgery systems. Guidant s lifesaving medical technologies are designed to improve life-threatening cardiac and vascular disease. Its primary medical devices treat the heart, managing its rhythms, clearing its arteries and permitting less-invasive surgeries. Guidant has principal operations in the United States, Europe and Asia. Guidant recently won FDA approval for their new cardiac devices and ICD. SOURCE: Yahoo!.com
6 St. Jude Medical, Inc. (STJ) Together with its subsidiaries, STJ develops, manufactures and distributes cardiovascular medical devices for the global cardiac rhythm management (CRM), cardiac surgery (CS) and cardiology and vascular access (C/VA) therapy areas. The Company s principal CRM products are bradycardia pacemaker systems (pacemakers), tachycardia implantable cardioverter defibrillator systems and electrophysiology catheters. Its principal CS products are mechanical and tissue heart valves, and valve repair products. C/VA products offered include vascular closure devices, angiography catheters, guidewires and hemostasis introducers. The principal geographic markets for St. Jude Medical s products are the United States, Europe and Japan. The Company also sells its products in Canada, Latin America, Australia, New Zealand and the Asia-Pacific region. SOURCE: Yahoo!.com Boston Scientific Corporation (BSX) A worldwide developer, manufacturer and marketer of medical devices whose products are used in a range of interventional medical specialties, including interventional cardiology, peripheral interventions, neurovascular intervention, electrophysiology, vascular surgery, endoscopy, oncology, urology and gynecology. The Company s products are offered for sale by two dedicated business groups, Cardiovascular and Endosurgery. The Cardiovascular organization focuses on products and technologies for use in interventional cardiology, peripheral interventions, vascular surgery, electrophysiology and neurovascular procedures. The Endosurgery organization focuses on products and technologies for use in oncology, endoscopy, urology and gynecology procedures. During 2003, approximately 72% of the Company s net sales were derived from the Cardiovascular business and approximately 28% from the Endosurgery business. Boston Scientific recently won FDA approval for their Taxus DES and launched their Sentinol self-expanding Nitinol Biliary Stent System. Boston recently acquired Precision Vascular for new projects in interventional cardiology, oncology, and endoscopy. SOURCE: Yahoo!.com CHART F : Competitive Factors Matrix* *Ratings based on three factors on a scale from 1 to 5: CRM Sales, COGS-to- Sales, and Patents. Medtronic (blue), Guidant (purple), St. Jude (yellow), Boston Scientific (baby blue). RISK ANALYSIS MDT PAGE 6 According to S&P, widening government budget deficits both in the US and abroad may result in industrywide pricing pressure. Thus, longer-term growth in healthcare spending may slide steeply. Foreign markets are stressed out. Europe: France and Germany account for nearly 50% of the continent s medical device sales. Due to increased budget deficits, these two countries have focused on lowering healthcare expenditure levels. Japan: At about $24 billion annually, Japan is the largest global market for medical technologies. US manufacturers exports about $2 billion to Japan each year. According to the S&P, Japan represents about 10% of industry sales by US manufacturers in However, trends indicated this has fallen in recent years. China: In order to combat these political policies, US medical device manufactures have resorted to the Chinese market an area of potential growth. According to the US Department of Commerce, US medical device exports to China doubled to $227 million from 1997 to Regardless, Medtronic s foreign operations could be negatively impacted by changes in foreign policy changes on a political, social and economic level. Additionally, foreign governments frequently impose reimbursement limits. In effect, government spending will be controlled and their citizens will be able to obtain medical products and services at a low cost. Executive decisions regarding limiting or eliminating reimbursement for Medtronic products may have a materially adverse affect on their net earnings. Increased Market Risk. Due to the global nature of their operations, Medtronic is also susceptible to foreign currency exchange rate fluctuations. However, the primary currencies are hedged towards the Euro and the Japanese Yen so that earnings and cash flow volatility will be minimized. In 2002, foreign translations were favorable in sales and product growth. Increased regulatory requirements from Food and Drug Administration (FDA) and other comparable foreign agencies. There has been an increase in the amount of testing, such as sideeffects testing, and documentation required for FDA clearance of new drugs and devices, which consequently increases new product introductions expenses. Future FDA approval or non-approval of medical devices could adversely impact Medtronic s financial condition and market position. Increased Legal Implications. While companies must navigate FDA requirements prior to commercializing their products, intellectual property lawsuits, such as patent infringements, are an important risk element, along with potential product recalls. Many suits, involving Guidant, J&J, Boston Scientific, Arterial Vascular Engineering, and Medtronic still have ongoing battles with each other with final rulings still pending. Medtronic also operates in an industry vulnerable to product liability claims brought by individuals or class groups seeking monetary relief.
7 CUSTOMERS Medtronic s revenue base includes a diverse mixture of customers from around the world. The Company supply medical device products for health care facilities, such as managed care enterprises and hospitals; physicians and profit and non-profit organizations in the field of cardiology, cardiovascular surgery, electrophysiology, endrocrinology, ENT surgery, gastroenterology, guided surgery (SNT), neurology, neurosurgery, oncology, pain management, spinal surgery, urology/urogynecology, vascular and many other medical fields; and patients with diseases, such as Abdominal Aortic Aneurysm (AAA), Bladder Control Problems, Benign Prostatic Hyperplasia (enlarged prostate), Cancer, Diabetes, Digestive Problems, Heartburn (GERD), Heart Conditions, Hydrocephalus, Ménière s Disease, Pain, Parkinson s Disease, Seizures and Fainting, Severe Spasticity, Shaking/Tremor, Sinusitis, Spinal Disorders, Unexplained Fainting and many other chronic diseases. DUE DILIGENCE Medisend is a non-profit organization based in Dallas and recycles the medical surplus (surgical, diagnostic, and therapeutic medical supplies and equipment) of wealthy countries. According to Medisend, more than $6 billion worth of medical surplus is generated in the US. Medisend gathers these medical surplus and distributes them to more than 71 countries. In their biomedical equipment storage area, Medisend carries numerous working equipment that have been replaced by newer technology. Medisend receives requests from these 71 developing countries for their older generation biomedical equipment because there is a shortage and a lack of government funds to purchase new equipment. However, with only a small amount of equipment left in stock, Medisend can supply those countries with limited capability. Thus, Medisend suggested that overall demand for new or old equipment and supplies will accelerate in the future. PAST ACQUISITIONS Medtronic slid downwards during 2001 and 2002 due to increased acquisitions, but has now stabilized and strengthen their diversified product lines for future growth. For instance, the Company acquired Spinal Dynamic Corporation for development of an artificial disc designed to maintain mobility of the cervical spine. The artificial disc is currently marketed in Europe and will hit the US markets by During the second quarter of 2002, the Company completed acquisitions in Minimed (world leader in developing medical systems for treating diabetes) and Medical Research Group (developer of implantable pumps and sensors for treating diabetes) for a total purchase price of $3.807 billion. In the third quarter of fiscal year 2002, Medtronic acquired Endonetics (developer of technologies for the diagnosis and treatment of gastroesophageal reflux disease or GERD) for $67.2 million. In the fourth quarter of fiscal year 2002, the Company also acquired VidaMed, Inc. (developer of non-surgical treatment products for benign prostatic hyperplasia or BPH) for $328.6 million. MDT PAGE 7 MANAGEMENT & OWNERSHIP Source: Dun & Bradstreet and Yahoo!.com CEO & CHAIRMAN: ARTHUR D COLLINS JR (1948) Graduated Miami University of Ohio. Graduated Wharton School, MS in business administration Abbott Laboratories, various management positions, lastly Corporate Vice President. Jun 1992-present: Medtronic, Inc. CHIEF FINANCIAL OFFICER: ROBERT L RYAN (1943) Prior to 1982 several management positions at Citibank and McKinsey & Company Union Texas Petroleum Corp, treasurer, 1983 Controller, 1984 Vice President Finance and Chief Financial Officer. Apr present Medtronic, Inc, Senior Vice President and Chief Financial Officer GENERAL COUNSEL DAVID J SCOTT He came to Medtronic from United Distillers & Vintners (UDV) in London, England, where he has served as general counsel since Prior to that, he served as Senior Vice President and General Counsel for London-based International Distillers & Vintners (IDV). He graduated from Cornell Law School in 1978 and started his professional career as a trial lawyer in upstate New York. SENIOR EXECUTIVE STEPHEN MAHLE He has been Senior Vice President and President, Cardiac Rhythm Management, since January Prior to that, he was president, Brady Pacing, from May 1995 to December 1997 and vice president and general manager, Brady Pacing, from January 1990 to May Mr. Mahle has been with the company for 28 years and served in various general management positions prior to SENIOR EXECUTIVE ROBERT M GUEZURAGA He has been Senior Vice President and President, Cardiac Surgery, since August 1999, and served as Vice President and General Manager of Medtronic Physio-Control International, Inc., from September 1998 to August Mr. Guezuraga joined the company after its acquisition of Physio-Control International, Inc. in September 1998, where he had served as president and chief operating officer since August Prior to that, Mr. Guezuraga served as president and CEO of Positron Corporation from 1987 to 1994 and held various management positions within General Electric Corporation, including GE s Medical Systems division. Breakdown of Major Holders % of Shares held by All Insider and 5% Owners: 1% % of Shares held by Institutional & Mutual Fund Owners: 70% % of Float held by Institutional & Mutual Fund Owners: 70% Number of Institutions Holding Shares: 10
8 FUNDAMENTAL ANALYSIS (see Exhibit 1) Sales and Net Income (see Chart G) Medtronic ranks 1 st in sales and net income among our choice of comparable companies. Net income was driven by growth in Medtronic s Cardiac Rhythm Management (CRM) and Spinal, Ear, Nose, and Throat (ENT), and Surgical Navigation Technology (SNT) operating segments. CRM net sales increased 23% because of new product introductions, continued strong growth in existing products, growth in the emerging heart failure market, and the acceleration in growth of the tachyarrhythmia market. Therefore, Medtronic achieved a 47% increase in net sales of implantable defibrillators and a 10% increase in net sales of pacing systems. Spinal, ENT, and SNT net sales increased 32% because of continued strong growth in existing products, growth in the spinal market, continued acceptance of their INFUSE Bone Graft product for spinal fusion and their rapidly growing family of MAST (Minimally Access Spine Technologies) products. Earnings per Share (EPS) Medtronic seems to be the underperformer in EPS each year, but still exhibits EPS growth appreciation each year. We believe Medtronic s different fiscal year-end date among others accounts for this discrepancy or offset as there may be cyclical factors not incorporated into EPS estimates. Balance Sheet Medtronic has a large cash amount of $1,190.3 billion, which allows them to potential pursue opportunities to capitalize on new investments. Total debt, common equity, assets, receivables, and inventory are high across the board. Stock Data Medtronic s current stock price is relatively low among the comparable companies. Medtronic also possess higher than aggregate common shares, market capitalizations and enterprise value. Financial Ratios Medtronic exhibited a high Last Fiscal Year (LFY) EBIT- DA margins of 30.6% against other comparable companies. Yet, Medtronic and Guidant also hold LFY gross margins of approximately 75%. Medtronic maintains relatively well-above averaged and better Return on Equity (ROE) of 19.3%, shy under St. Jude Medical s ROE of 20.9%. Return on Assets (ROA) in terms of measuring profitability for Medtronic is also well-above average at 18.1%. Current ratio is also very low at 1.11, indicating that Medtronic is less liquid than others. Growth Historical 3-year revenue growth rate for Medtronic looks attractive at 15.18% while St. Jude has a history of 17.91% growth. Medtronic s year-over-year (YOY) EPS growth and projected growth in EPS with the next five years is relatively moderate at around 16%. However, Morningstar.com determined the MDT PAGE 8 latest quarter YOY EPS growth rate to be 56.0%. Also, Medtronic offers a Dividend Yield of 0.59%. Risk Debt does not seem to be a critical risk factor for Medtronic. Standard and Poor s Rating Group and Moody s Investors Service issued Medtronic a strong long-term debt ratings of AA- and A1, respectively, and strong short-term debt ratings of A-1+ and P-1, respectively. Current ratings have remained unchanged and rank Medtronic in the top 10% of all U.S. companies. Relative Valuation Medtronic s Current Fiscal Year (CFY) Price-to-Earnings (P/E) is fairly high at 30.0 while Next Fiscal Year (NFY) P/E also remains high at Because the P/E ratios are somewhat high, the market seems to be more willing to pay for each dollar of annual earnings. However, Medtronic s TTM P/E ratio of is lower than its main competitors whereas Boston Scientific, Guidant and St. Jude Medical have P/E ratios of 78.52, 51.9, and 40.49, respectively. Also, Relative P/E is high at 1.10, but below St. Jude Medical s Additionally, Medtronic s current P/E-to- Growth (PEG) ratio is high at 1.8 when compared to the Industry s 1.51 PEG ratio. NFY PEG also remains high at 1.6 for Medtronic. TTM PEG ratio of 1.68 from Medtronic lies between Boston Scientific s and St. Jude Medical s PEG numbers. In sum, Medtronic demonstrates an overall easing combination of comparative, valuation measures. DFCF MODEL ASSUMPTIONS (see Exhibit 2) We made several assumptions that will serve as inputs into our DFCF model for simplicity purposes. Capital Expenditures-to-Depreciation ratio Using Medtronic s 2003 financial figures, we arrived at a ratio of 0.93 and gradually grew to 1.50 for purposes of growing capital expenditures and expectations that the Company will pursue investments throughout forecasted years. The decrease in capital expenditures from 2003 to 2004 results from a sharp decrease in Long-term Net Assets from 2003 to 2004 as working capital dramatically increased in Revenue growth % Historically, Medtronic has achieved around 15% revenue growth each year. We have conservatively determined that Medtronic will implicitly grow at an average of 12.8% throughout forecasted years, although market consensus predict 15%. For years 2004 and 2005, we project revenue to grow at 11%. In the years 2006 to 2009, we expect Medtronic to recognize at least 12% revenue growth based on new product releases. Gradually, revenue growth will drop 100 basis points and will eventually reach 12% towards the terminal year. We also expect Medtronic to receive large synergies from their entrance in the DES market during years 2005 to By 2010 and beyond, Medtronic may pursue expansion plans and in effect, may reduce revenue growth.
9 Our revenue assumptions are based on the following reasons: our investment thesis outlined at the beginning, increased competition that could detract revenues from Medtronic, increased price pressure from foreign markets and competition, strong product demand, and solid business segments. We also believe Medtronic will be able to sustain 12% revenue growth terminally for these following reasons in addition to continuing, favorable demographics. Cost of Goods Sold (COGS) and Selling, General, and Administrative (SGA) Efficiencies We assumed COGS growth efficiencies to range from 11.6% to 11.7% growth each year in-line with about 24% of revenues produced each year (see Exhibit 2 - Key Percentages). We also assume SGA growth efficiencies to slowly decline from 11.5% to 11.3% (in-line with about 31% of revenues produced each year) towards terminal year as Medtronic attempts to establish significant quality measures. However, we projected 11.5% SGA growth in the terminal year for perpetuity. Depreciation-to-Assets Using Medtronics 2003 financial figures, we arrived at 4.3% (also see Exhibit 2 - Key Percentages) and assumed this percentage remained constant for purposes of growing depreciation throughout forecasted years. Debt Interest Rate % Using interest expense by long-term and short-term debt, we determined the debt interest rate to be 8.3% and assumed this percentage remained constant for purposes of growing interest expense throughout forecasted years. Tax rate Medtronic has benefited from their tax strategies that allowed them to use a tax rate below the standard. Therefore, we used a fair tax rate of 31.7% for 2003 and kept this figure constant throughout forecasted years. Working Capital Growth Working capital dramatically increased from 2002 to According to Company reports, the increase in working capital primarily relates to the reclassification of $1,973.8 million of contingent convertible debentures from current liabilities to long-term liabilities in the second quarter of fiscal year In April 26, 2002, Medtronic s working capital, current ratio, and net cash position were negatively impacted by the $4,057.6 million of cash paid in fiscal year 2002 for acquisitions. From 2004 and beyond, we normalized working capital and long-term net assets by growing working capital at flexible growth rates. We assumed working capital to slowly grow at 8% by 2007 after assuming Medtronic achieves 12% revenue growth from their DES and other product releases in MDT PAGE 9 Debt Growth We assumed a 10% growth in debt for the next three years as Medtronic utilizes new capital for R&D expenses for furthering completion of product trials and then moderately grew their debt to 15% by Key Percentages for 2003 Percentages for each line item indicate as percentage of revenue except for Depreciation, which is a ratio between current year s Depreciation and previous year s Long-term net assets. These percentages were used to forecast most line items in forecasted years (see Exhibit 2). Beta We regressed the beta equity of the firm using Medtronic and S&P returns of the last ten years to arrive at (see Exhibit 3). Weighted Average Cost of Capital (WACC) With our inputs and class consensus of a risk-free rate of 2.7% and a Market Premium of 6%, we calculated the WACC to be 8.48% for the levered firm (see Exhibit 3). Terminal Growth % We used 4% as a terminal growth input to determine the intrinsic value of the company (see Exhibit 4). FINAL VALUATION & CONCLUSION Based on our assumptions, we have determined that Medtronic is undervalued on a Discounted Free Cash Flow (DFCF) basis. We feel that Medtronic has the capability and the capacity to pursue and achieve much growth in the industry. We also feel Medtronic s diverse business segments will attract a large portion of the overall customer base, capturing significant revenues, and thus, justifies the premium price. If Medtronic performs better than expected 15% revenue growth over our forecasted 13% in the coming years, Medtronic will undoubtedly be an attractive stock in comparison to other competitors and be in a strong position. Further, we believe favorably that Medtronic will be able to obtain FDA-and-abroad approval as well as penetrate the DES market as a top-line competitor. In conclusion, we view these factors, including favorable investment highlights, positive qualitative and quantitative analysis, modest fundamentals, and strong management structure constitute Medtronic an attractive buy.
10 MDT PAGE 10 EXHIBIT 1 : Comparable Company Analysis Rex Thompson P/E Aggregate Ratio (Thompson PEAR) The Thompson PEAR method is determined using the ratio of the sum of the all comparables market capitalization by the sum of the each comparables common shares times their EPS.
11 MDT PAGE 11 EXHIBIT 2 : Projected Financials
12 MDT PAGE 12 EXHIBIT 2 : Projected Financials (continued)
13 MDT PAGE 13 EXHIBIT 3 : Risk and Required Return CHART G : Net Sales by operating segments SOURCE: Company Reports
14 MDT PAGE 14 EXHIBIT 4 : Sensitivity Analysis
15 MDT PAGE 15 GLOSSARY SOURCE: Company Reports
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