Medtronic Inc. Smart Cody Porter Matt Watts Denton Serre Sophie

Transcription

1 Medtronic Inc. Smart Cody Porter Matt Watts Denton Serre Sophie 1

2 Contents Executive Summary...5 Business & Industry Analysis...11 Company Overview...11 Industry Overview...12 The Five Forces Model...14 Rivalry Among Existing Firms...14 Conclusion...18 Threat of new entrants...19 Threat of new/substitute products...23 Power of Buyers and Suppliers...25 Value Chain Analysis...31 Medtronic Corporate Strategy Analysis...34 Accounting Analysis...48 Key Accounting Policies...49 Accounting Flexibility...52 Actual Accounting Strategy...54 Qualitative Quality of Disclosure...56 Quantitative Quality of Disclosure...57 Potential Red Flags...72 Adjusting accounting distortions...74 Financial Analysis, Forecasting Financials and Cost of Capital Estimation...86 Financial Analysis

3 Liquidity Ratio Analysis...87 Profitability Ratio Analysis...98 Capital Structure Analysis Internal Growth Rate and Sustainable Growth Rate Analysis Financial Statement Forecasting Cost of Capital Estimation Analysis of Valuation Method of Comparables Intrinsic Valuations Analysts Recommendation Appendix Sales Manipulation Diagnostic Ratios Core Expense Manipulation Diagnostic Ratios Effect of R&D on Net income Table Income Statements Actual and Forecast Balance Sheets Actual and Forecast Statement of Cash Flows Actual and Forecast Common size Statements Balance Sheet after Adjustments Income Statement after Adjustments Regression Summaries Beta Summary Table Weighted Average Cost of Debt Table Weighted Cost of Capital Table Medtronic Ratios

4 Liquidity Analysis Tables Profitability Analysis Tables Capital Structure Analysis Tables IGR & SGR Table Credit Risk Free Cash Flow Models Residual Income Models Long Run ROE Residual Income Models Abnormal Earnings Growth Models Discounted Dividend Model Method of Comparables References

5 Executive Summary Investment Recommendation: Overvalued, Sell 4/1/08 Medtronic Inc. (NYSE: MDT) $48.46 Altman's Z - Score 52 Week Range $ $ Revenue B Market Capitalization 55.31B Shares Outstanding 1.12B Valuation Estimates Percent Institutional Ownership 78.20% Actual Price (04/04/08) $48.46 Book Value Per Shares ROE 20.32% Financial Based Valuations ROA 11.74% Initial Revised Trailing P/E $ $ Cost of Capital Estimate : R^2 Beta Ke Forward P/E $ $ years % P.E.G. $ $ years % P/B $ $ years % P/EBITDA $ $ years % Enterprise Value/EBITDA $ $ years % Assumed Ke 12.12% Intrinsic Valuations Discount Dividend $ Published Beta 0.22 Free Cash Flows $ Kd (Before Tax) 4.56% Residual Income $ Kd (After Tax) 0.48% Long Run Return on Equity $ WACCBT 11.01% Abnormal Earnings Growth $

6 Industry Analysis Medtronic was founded in 1949 by Earl Bakken and Palmer Hermundslie. It was incorporated in 1957 in Minneapolis Minnesota. They provide medical devices and instruments to more than 120 countries worldwide. Medtronic is in the medical device industry, with Cardiac Rhythm Disease Management (CRDM) make up approximately 40% of their net sales. With CRDM, they also have an additional 7 areas they specialize in: Spinal & Navigation, Vascular, Neurological, Diabetes, Cardiac Surgery, Ear, Nose, and Throat, and Physio-Control. Medtronic s primary competitors in this highly competitive industry are Boston Scientific Corp, Johnson & Johnson, St. Jude Medical Inc, and Zimmer Holdings Inc. The medical device industry is highly competitive with regards to technological development. This industry is currently growing at 8-10% annually with approximately 6000 manufacturers who employ around 300,000 people (10-K). The industry is heavily regulated by the government and firms are constantly using their time and money to approve new products and then test those trial products. This industry has a high degree of rivalry among existing firms, a low threat of new entrants, and a high threat of substitute products. The industry has moderate power over suppliers. The suppliers need the industry just as much as the industry needs its suppliers. It also has relatively low bargaining power over buyers. Buyers do have the choice, in some instances, to not use the industry s products. Some of the key success factors of the industry is accounting of research and development, diversification of the products segmentation, and superior product quality. If companies in the industry can compete well on these three factors, then they will significantly improve their profitability in the industry. 6

7 Accounting Analysis The main purpose of financial reports is to credibly communicate economic consequences of business activities. Since a lot of this data is reliant upon people made numbers then there will most likely be discrepancies in the financial reports. Corporations provide these financial statements to the public so investors will have some evidence by which to make the best decision on whether or not to invest in a company, and to what extent. However, many companies will only disclose what is required by the SEC, which may not be enough to help investors make the best decision. When valuing a company, it is important to be aware of these manipulations and shortcomings in amount of discloser. Medtronic is strong in some areas of disclosure, but weak in others. They seem to have abnormal ways of recording both goodwill and IPR&D (in progress research & development). There is no real pattern in the way it is recorded. It is up to the managers to decide, year by year, on how it is to be recorded. However, Medtronic is strong in disclosing warranty information. This is important industry wide because of high expectations in detailed explanations of warranty information. Also, Medtronic has a high quality of disclosure when discussing the affect of foreign currency to the company. Medtronic does business all around the world, which means currency has a large impact on business, for better or worse. Medtronic compensates for any lack of information given by an extensive management discussion. A few concerns about Medtronic s financials that raise red flags are the classification of operating leases and other long term contracted obligations that do not seem appropriate. 7

8 Financial Analysis, Forecasts, and Cost of Capital Estimations An analysis of Medtronic s financial statements is needed to determine how they stack up to their competitors and the industry. We look at several ratios to determine liquidity, profitability, and the capital structure of Medtronic, and these ratios are then used to forecast the financial statements. Medtronic does quite well in the liquidity analysis compared with the industry, which implies they can easily meet their short-term obligations. They also perform quite well in the profitability analysis, exceeding the industry in operating income and net profit margins. Medtronic seems to be pretty solid in the capital structure analysis. They only have.44 cents of debt per dollar which, compared to the industry, is significantly lower. However, their debt service margin is low indicating they may have a problem in providing cash from cash flow from operations to pay its current installment of long term debt. The 10 year forecast for Medtronic shows that they will outperform the industry with a 12.16% growth rate compared to the assumed industry average of 11.33%. The industry average was weighted because larger companies like Johnson & Johnson had a smaller growth rate compared to smaller firms like St. Jude with a larger growth rate. Other notable assumptions in our forecast include profit margin declining by approximately 7% by 2015, and return on equity declining by about 8%. The beta of Medtronic we calculated to be.3022 which had the most explanatory power with our regression models. Our cost of equity is 12.12% which was calculated using the 2 year risk free rate, an assumed interest rate which was 80% of debt, and our previous calculation of beta. Using the weighted average approach, we concluded that the cost of debt was 4.59%. Our WACC before tax was roughly 11% and our after tax WACC was 8.8%. 8

9 Valuations The last step after an industry analysis, accounting analysis, and financial analysis is valuing the company. We want to evaluate the company by using different valuation methods. First, we value the company by a method of comparables before and after adjustments. We take eight different ratios and by comparing them with the industry, are able to value the company. These ratios include the forward and trailing P/E ratio, P/B, P.E.G, EV/E.B.I.T.D.A, P/FCF, P/E.B.I.T.D.A, and D/P. Several ratios, such as the P/B and D/P gave us overestimated value for Medtronic which leads us to think that investors will likely shy away from investing in an overvalued company. Ratios, however, rely strictly on industry averages and thus may or may not be a relevant method for valuing every company. Next, we estimated Medtronic s market value of equity using different models based on theory. The first model that we used was the dividend discount model. We discounted back the dividends forecasted from 2008 to 2017 and added in a perpetuity discounted from 2017 to infinity and arrived at an estimated share price today. The price we derived from the model using a 10% growth rate and a 12.12% cost of equity gave us an estimated share price of $ The dividend discount model though has relatively low explanatory power and thus should not be the primary valuation method. The FCF model incorporates the difference between CFFO and CFFI. Using the WACC, we discount this model back to arrive at a new valuation. The residual income model helped us to determine how much Medtronic s future residual income influences its current share price. The RI model overvalues Medtronic by about $17 a share which is consistent with other valuations. 9

10 The long run residual income perpetuity model is another method of valuing the company. At the current estimated cost of equity of 12.12% and an average Return on Equity of 25% it clearly shows that Medtronic is overvalued. There are instances that Medtronic is undervalued on the sensitivity analysis but only at extreme, unlikely instances. With a projected growth rate of 6%, we estimate Medtronic s share value to be $33.79, which compared with the current price of $48.46 is highly overvalued. The final valuation method, the AEG model, compared what we earned to what we should ve earned. According to this model which is the second most reliable behind the RI model, Medtronic is overvalued by approximately $26 dollars. 10

11 Business & Industry Analysis Company Overview Medtronic was founded in 1949 by Earl Bakken and Palmer Hermundslie. It was incorporated in 1957 in Minneapolis Minnesota. Their main objective is providing medical technology and instruments to physicians and patients around the world. They have been able to expand their business from a small repair company, which serviced medical equipment in hospitals, to being able to serve physicians and patients in more than 120 countries worldwide. They were the first to create a wearable cardiac pacemaker in From then on they have focused on cardiac rhythm technology and other areas of Cardiac Rhythm Disease Management. Along with CRDM, they also have an additional 7 areas they specialize in: Spinal & Navigation, Vascular, Neurological, Diabetes, Cardiac Surgery, Ear, Nose, and Throat, and Physio-Control. Their mission statement, written more than 40 years ago, explains their broad organizational goal, To contribute to human welfare by application of biomedical engineering in the research, design, manufacture and sale of products that alleviate pain, restore health, and extend life (Medtronic 10-k). Medtronic currently has a market cap of billion dollars. Over the last five years they have been able to nearly double their net sales from $6.4 billion in 2002 to $12.3 billion in Their most emphasized sector, CRDM, contributes to 40% of their net sales. Medtronic s primary competitors are Boston Scientific Corp, Johnson & Johnson, St. Jude Medical Inc, and Zimmer Holdings Inc. This will transition our focus to the medical technology and equipment industry as a whole. 11

12 Industry Overview Medtronic is a part of the Medical Appliances & Equipment industry. With increasing technological advances, the medical device industry is highly competitive with regards to technological development. High tech industries are very competitive in nature. A stagnant organization will quickly lose market share if its products become obsolete. The medical device industry is currently growing at 8-10% annually with approximately 6000 manufacturers who employ around 300,000 people (10-K). The industry is heavily regulated by the government and firms are constantly using their time and money to approve new products and then test those trial products. According to the International Trade Administration (ITA) Issues related to reimbursement rates for medical devices are a primary concerns for U.S. medical device companies, as an adequate reimbursement rate usually determines whether a product will be viable in a given market. Demand for products must be quite high. Unlike other industries where the price of a product must cover simple production costs and overhead, high tech sectors must earn revenue margins high enough to cover the cost of research and development. This is not simply the R & D used to develop the product being sold. Expenses related to continuing development and testing of potential products must be covered. The fact that technological feasibility does not always translate into commercial viability increases the volatility of the market. This translates into high market risk for equity investors which must be mitigated by high risk premiums. A demographic factor affecting this industry is the rising population of senior citizens. The census bureau, who periodically publishes statistics showing the U.S. population by their respective age bracket, estimates that the percentage of people 65 and older will increase from 12.4% in 2000 to 20.7% by There were approximately 35 million Americans in 2000 that were over the age of 65. They estimate that by 2020 that number will rise to 54 million people and to 86 million by 12

13 2050. ( Also, people are living longer today than they did 30 or 40 years ago. This will cause changes in the medical device industry. Companies will have to stay ahead of the game, technologically speaking, or they will be left behind by other more innovative companies. Not only does this industry have to contend with government regulations and technological advances, the success of their products rely on their relationship with physicians. Physicians will continue to use what works. Corporate image is a key to developing trust with buyers. The problem is if one company has made a technological breakthrough, but has a negative image with consumers, they will have trouble selling that product simply because physicians don t trust them and are hesitant to switch. 13

14 The Five Forces Model The five forces model is used by analysts as a tool to classify and assess the industry based on five main components. After which financial analysts are able to value a particular company. First, we assess the rivalry among existing firms and the degree of industry competition. Economies of scale and scope can influence potential equity valuations. Second, we consider the threat of new entrants. Can a company easily get into the industry and compete? Do firms have the ability to sustain first mover advantage? Third, we focus on the threat of substitute products. Understanding the effect of switching costs and product differentiation is vital. Finally, we assess the bargaining power of customers and suppliers. Balancing the demands of each group is an ability that can result in sustained competitive advantage. This is a summary of our findings. Industry Industry Threat of Threat of Power over Power Over Competition Concentration New New Buyers Suppliers Entrants Products High Moderate (mix) Low High Low Moderate Rivalry Among Existing Firms Rivalry among existing firms takes into account the intensity of competition among firms in an industry. With intense competition, firms have to compete based mainly on price to gain profitability. There are several ways to measure this intensity. Industry growth rate, concentration and balance of competitors, degree of 14

15 differentiation and switching costs, economies of scale, and the excess capacity and exit barriers all play a major factor in determining the level of competition. Industry Growth Rate Industry growth rate is one determinant of rivalry in an industry. If an industry is expanding rapidly, then firms do not need to compete with one another on price, in most cases. However, if there is hardly any growth, then firms will have to compete solely on price. From some perspectives, the industry is growing. This is due to the continued advancement of technology in the field. With that in mind, if firms cannot continue to use this technology to their advantage, creating products that bring in sufficient revenue streams, then they will fail to compete. The Wall Street Journal has touched on that subject. Boston Scientific recently announced that they foresee revenue at 8.2 billion for 2008, which would put them at around a 3-5% growth rate. WSJ said Company officials, speaking on a conference call following the release of fourth quarter results late Monday, also set sales targets for the company s top heart devices in the first quarter. The outlook includes an expectation that Boston Scientific won t give up much ground in the U.S. drug coated stent market this quarter to new arrival Medtronic Inc The arrival of Medtronic s endeavor device injects fresh competition into what had been a two-company market with Boston Scientific and Johnson & Johnson. The industry is growing, but firms are still required to compete on price to gain market share. The effect of market concentration will be assessed here after. 15

16 Concentration and Balance of Competitors Typically the more firms you have in an industry the higher the degree of competition. There are over 6000 manufactures of medical devices. However, the medical device industry s market share is completely unbalanced. Medtronic competes with a huge number of individual companies, but there are only a few which compete directly against its major product lines. Nevertheless, since the medical device industry is growing so fast technologically, firms must continue to offer new and improved products or they will not last. In the current environment of managed care, consolidation among healthcare providers, increased competition, and declining reimbursement rates, we have been increasingly required to compete on the basis of price. In order to compete effectively, we must continue to create, invest in, or acquire advanced technology, incorporate this technology into our proprietary products (Medtronic s 10-K) The medical device industry must also contend with alternative medical therapies. Medtronic s 10-K addresses this directly, We face competition from providers of alternative medical therapies such as pharmaceutical companies. (Medtronic s 10-K) I would describe the concentration as mixed. Only a few major companies compete directly against Medtronic s major product lines, emphasizing technological growth. While competition from a large number of alternative products has increased the need to keep prices low. This all adds up to a moderate level of concentration. Degree of Differentiation and Switching Costs Differentiation would allow companies in an industry to set their product higher than others in that industry, with respect to price. If this were possible, then relative switching costs would be high from a customer s perspective. Switching costs for a firm 16

17 deal with the feasibility of alternative asset use. This is a complicated question for the medical supply and technology industry. Firms in the industry are heavily invested in patents and R & D. For most of these companies, intangible assets make up a considerable portion of their balance sheet. In some industries, the major factor influencing switching costs is whether or not the firm can still utilize its capital expenditures (manufacturing equipment, production lines, and factories). If it can, then switching costs are low. In the medical equipment industry, the critical factor is whether their patents and research can be used for alternative purposes. For this reason, we feel that switching costs for a firm wanting to completely change its production lines would be very high since patents and research tend to be relatively specific. This raises the degree of competition industry wide. 17

18 Excess Capacity Excess capacity is when supply exceeds demand in an industry and firms must cut their prices to fill this capacity. In the medical device industry, there is an ever increasing demand for medical devices because of the increasing population of senior citizens. So, excess capacity is not a problem in the medical device industry. Exit Barriers Exit barriers are the cost to a particular firm when they feel they must leave an industry. Since the medical device industry is so heavily regulated by the government, to leave this industry would be costly. The reasons are similar to those causing high switching costs. Since the industry relies so much on advancing technology and investing in R & D, the exit barriers are high for the medical device industry. Conclusion The rivalry among existing firms in the medical device industry is intense. Established firms must continue to develop technology and keep costs low. Firms must also compete with alternative pharmaceutical companies that are not necessarily in the industry. Another factor is that exit barriers are high which increases the level of competition. So as the industry continues to expand, we can see that the level of competition will as well. This is a highly competitive industry. 18

19 Threat of new entrants The threat of new entrants in the medical appliance & equipment industry is dependent upon a few main factors: legal barriers, economies of scale, first mover advantage, and, to some extent, a form of brand image. Legal barriers In the medical industry there is high degree of government regulation. The medical appliance & equipment sector is no different. There has been increasing control over the years, which in some ways limits the threat of new entrants. To commercially distribute a new medical device in the U.S. is to do so through only one of two ways: 1) 510(K) process says that the new product is substantially equivalent to an already existing device. In this way it might be helpful to new entrants, citing the copy-cat approach. 2) PMA requires a firm to independently show that a new device is both safe and effective. In this process, it is much harder for a new firm to emerge due to differentiation, as it requires much more time, money, and research. In this industry, there is also intense patent litigation and product liability claims. These combined make it difficult for an emerging firm to compete. Either the idea has already been taken, in which case you must pay royalties, or one major lawsuit can wipe out a small companies hopes. 19

20 Economies of scale Hospitals, Doctors, and to some extent patients like to stay with what works. This self-evident fact is a major disadvantage to new entries into the industry. When a firm is large enough that it covers so many different areas in the industry (such as Johnston & Johnston, Medtronic, and St. Jude) it is difficult for a firm to get a foot in the door. With large firms investing so much into research and development, the possibility of a new entrant keeping up with future developments as well as day-to-day operations is remote. Along with government regulations, even the large firms are forced more and more to compete based on price. Smaller, less experienced, and less known entrants will have a very difficult time competing in this fashion. A small firm could theoretically enter the market with a cheaply made product and at once have a lawsuit, or not even get pass FDA clinical trials. This also poses a hurdle for new entrants. The chart below shows the five major medical device firms in this industry and their assets for the last 5 years represented in millions of dollars. A lot of times the size of a firm will determine how much power they have in particular industry. However, even though there are several large manufacturers in the medical device industry, there are also several small manufacturers who offer a limited selection of products. We do feel that the potential for economies of scale does exist because large firms, heavily invested in R & D, can spread their costs out by selling more products. (Chart on next page.) 20

21 First mover advantage Many times, when a new idea is formed within the industry it spurs other innovative ideas that go hand in hand with the new product or idea. The problem for new and upcoming firms is that the more patents you have, and the faster you claim them, the more of the market you will have. It is nearly impossible to compete in with the patents of larger firms. As a new market is developing, the larger firms can put much more money into research and development which leads to a greater number of patents. They also have the ability to spend much more money on legal staff, helping them uphold their patents in court. Brand Image Johnson & Johnson and St. Jude probably have the best brand image in the industry because of a perceived focus on children and the family. Medtronic does not focus on this idea as much right now but plans are in the works to compete in this arena. This type of positive brand image is developed through public recognition of philanthropy. People and doctors, especially recently, have been more environmentally conscience and are responding to public concerns over human rights. One example is that consumers want to support the company that they think is helping the 21

22 underprivileged children or the undervalued individuals of society. In some way, this makes consumers and investors feel like they are helping vicariously. In cases where there is not much difference in the products, positive brand image does have an effect. New Firms entering an industry do not have the funds to perform massive altruistic acts. To begin developing a positive brand image they must increase public philanthropy. The problem is that at first they must gain equity financing to do this (it might be difficult to take out a loan with the intent to give it all to charity). As stated before, investors want to invest with companies that have a history of philanthropy. So the company can t get equity financing without contributing to the public good, and they can t contribute to the public good without equity financing. This is a large barrier to entry in some situations. Conclusion It would be difficult for a company to enter the market in the short run. However, given time to create innovative patents, follow government standards, and manage effectively, there is some risk of new entrants into the market. Still we feel this risk is low. 22

23 Threat of new/substitute products The medical appliance & equipment industry could have one of the greatest threats of new products out of all industries. This threat of new products is because of the extensive technicality of the equipment (to allow many different forms of new science to enter the market) and the sheer possibilities of new products taking over a function previously had by another product (substitution). Technicality of Equipment Few realize the extreme complexity of medical equipment. To compete in this industry a company must not only make equipment that will pass FDA codes and provide efficient treatment, but also do it cost effectively. One example of this is reported in Wall Street Journal. The FDA on February 1, 2008 approved Medtronic to sell its Endeavor drug coated stent. Coronary stents are tiny metal devices used to prop open heart arteries, and coated stents such as Endeavor use medication to combat re-narrowing, which can be an issue with older bare-metal devices. About one million Americans get stents in angioplasty procedures each year. 1 So, even though stents are not a new device, the coated stents are an emerging product in the market (pending inspections with positive results for 5 years)

24 The high technicality of products is not a true threat to the industry. In a way, it is the backbone of the industry. The goal of every firm is to keep bringing out new products. Individual firms develop technology so fast that they routinely make their own products obsolete. New products become a threat when the industry slows down on technological development. Still, in general, the threat of new products is high. Range of Possibilities There are several ways to treat most diseases or ailments. Few make it and even fewer can sustain their place in the market. Still this means new products every year by both large and small companies. Take for instance the disease of depression. About 4 million people in the United States suffer from severe depression. Some have tried many different cures that have failed. However, St. Jude, a direct competitor or Medtronic, has started and been approved, as of February 7, 2008, to begin testing a stimulus pacemaker type product for this very broad potential market. This new device will of course be patented and secured for St. Jude s continued research and development. One side-note is that in the broad studies leading up to this discovery, Medtronic s deep brain stimulation technology was used. 2 However, there will be no shortage of competition from the other major medical appliance companies to find an alternative, which in turns leads to new products

25 Conclusion The threat of new products is very real in this industry. It is actually one of the few things the industry can be sure of. Firms will continue creating new products, and the industry must react appropriately. Power of Buyers and Suppliers The strategic relationship between suppliers and buyers in the medical equipment and appliance industry has become increasingly complex. As the industry has boomed to a 163 billion dollar sector of healthcare market cap, the competition in areas such as price, technological progress, and consumer safety has followed suit. Power of Suppliers Supplier power over an industry is relative to the degree that firms can bargain with suppliers. Price sensitivity is also important. In the medical equipment and supply sector, suppliers have very differentiated products. This creates a rather strange equilibrium. Suppliers must sell their products to the medical supply industry, since they have little or no use for other industries. The medical supply industry has a limited number of suppliers that make the products it needs so they must remain price sensitive to the demands of suppliers. Basically, the supplier relation in the medical equipment industry is a product of a mutualistic dependency. The suppliers need the industry and the industry has no alternative to its suppliers. Medtronic is a company with only a few major suppliers, Abbott Labs being the 25

26 largest. This puts the company in a unique situation where maintaining market share, keeping good supplier relations, and a good cash flow are pivotal. All of these factors contribute to the industry s, and thus Medtronic s, power over suppliers. We will first look at the power of suppliers from a broad industry wide perspective. Analysis of the Supplier Relationship (Industry perspective) 1. Power over suppliers is derived from a suppliers need to do business with the industry. Industries with large markets give suppliers the most business. This kind of industry dominance allows firms to negotiate prices in order to keep costs down. In a price sensitive industry, lower costs allow a firm to stay competitive without sacrificing profit margin. 2. Good supply chain relations are also a critical factor. A supplier must trust the industry to pay promptly and continue to give the supplier business. If conflict arises between the supplier and the industry, the supplier could choose to focus its production on other orders or, if arguments persisted, abandon the relationship with the industry entirely. If the latter option is viable, the cost of changing production must be lower than the perceived benefit suppliers will receive from abandoning the industry. 3. Maintaining a strong financial outlook is one of the most important factors affecting the firm/supplier relationship. If an industry loses the ability to generate revenue it must generate funds, either through debt or equity financing, to continue to pay suppliers. If the sales stagnation continues, individual firms might lose the ability to pay its increasing liabilities which will affect its credit rating and its ability to purchase supplies on account. When this happens the power of the supplier has increased dramatically and the industry loses its ability to negotiate over price. Keeping a strong A/R turnover, manageable current 26

27 liabilities, and a low write off percentage in doubtful accounts is very important. Conclusion The industry has moderate power over suppliers. The suppliers need the industry just as much as the industry needs its suppliers. An equilibrium is in place that does not allow one side to make unrealistic demands of the other. But, both sides have some bargaining power. Power of Buyers The medical supply industry provides medical equipment to a diverse group of consumers. For Medtronic, not 1 customer accounts for more than 10% of its total revenue. The industries primary customers are hospitals, clinics, third party healthcare providers/insurance, and governmental healthcare programs including Medicare. As healthcare has become a more consumer conscious industry, due to the increase in pharmaceutical advertising and the general effects of the shaky health care sector, the industry must understand how to maintain a strategic hold on buyers. This includes understanding the disconnect between the desires of the customers that purchase their products (physicians), concentrating on aspects like price and distribution, and the customers that use their products (patients), whose primary concern is safety and effectiveness. Even though the check might come from the insurance company, the industry must understand that continued demand comes from the people who use and work with their products. Power over buyers is derived from 27

28 the buyer s need for an industry s products. If a client needs and wants the product of a firm, the ability to set prices increases. As before, an analysis of the industry wide buyer relation will be discussed. Analysis of the Buyer Relationship (Industry perspective) To keep demand high and maintain power over buyers, the industry sector must spread out into new fields. Emerging healthcare industries have low barriers to entry and are a cost effective way to recruit new buyers in new sectors. This also helps diversify their holdings by allocating a portion of its assets into less risky, and therefore less legally liable, sectors. Malpractice suits are increasing, and focusing on high risk patients in need of cardiac and vascular treatment, as it currently does, could endanger the industries long term solvency. Diversity in product lines helps maintain power over buyers. Increasing focus on already developed products is important for success in both the buyer and supplier markets. Large product lines such as CRDM, vascular technology, and spinal navigation account for the bulk of the medical equipment and supply industry s revenue. They already have a strong hold in this area and customers have come to rely on their products. Many of these products, such as internal cardiac defibrillators, have no pharmaceutical substitute. This is a major strength for the industry. The industry must continue to be a dominant in these areas to have power over customers. In general, there are still alternatives to most products. The success of some product lines has, as of yet, not offset the power buyers have to use alternatives. The industry must also recruit new buyers in global markets. Nearly every industry is feeling the effects of globalization. The healthcare equipment sector is no different. Gaining access to companies and patients in emerging economies as well as untapped industrialized nations is critical. It would be a huge mistake not to take 28

29 advantage of these new markets. Expanding geographic scope could give firms a first mover advantage, allowing them to make loyal customers, set industry standards, and control lines of distribution. This results in immense power over buyers. Continuing research and development is also a key success factor. Buyers want the latest technology, especially in the competitive healthcare industry. The medical equipment industry cannot afford to lose customers because of a lack of innovation. Other areas of the healthcare market like pharmaceuticals and homeopathic remedies can pull away consumers. Technological progress must be coupled with a strong legal presence. The ability to manage intellectual property and uphold patents, both internally created and externally acquired, is just as critical as the ability to invent new products. New technologies are often very expensive. Patients still have the option of using more cost effective traditional solutions. The industry has not capitalized on their potential power, as of yet. The industry should also focus on its ability to effectively deal with purchase orders. Buyers want an industry that is efficient. They must be able to process orders quickly and accurately. Aspects such as shipping and distribution are also a factor. Customers will take their business elsewhere if they do not trust the industry wide infrastructure and its ability to get them the products they want when they want them. Communication between management and order takers must be effective or firms run the risk of losing valuable members of its clientele. This is definitely a hindrance to the medical equipment and supply industry. Products are often customized and surgery is necessary. This takes time. If patients want treatment immediately they have the option of trying pharmaceuticals before opting for a medical appliance. Possibly the most important aspect of developing customer power is safety. When people rely on your products in a life threatening situation, nearly perfect product quality is essential. This relates to nearly every area of the medical equipment and 29

30 supply industry. Without safe products, because of lacking quality control or poor quality standards, consumers retaliate. Industry image is tarnished, customers leave, and you open yourself up to legal consequences. When an industry is forced to defend its image in the media spotlight it loses nearly all power over the consumer. The recent fallout in the toy industry, from unsafe manufacturing processes involving lead, is a great example of how an entire industry can be damaged by consumer safety concerns. When this happens, the industry is left begging customers to continue using its products. Some safety concerns have been raised (as explained later). This is a particular area in which bargaining power has been reduced. Conclusion Because of the nature of the industry, firms have relatively low bargaining power over buyers. Buyers have options and can choose, in some instances, not to use the industry s products. Of course there are some patients that have no other options (there is not a pill that can replicate a valve replacement), but for the vast majority, substitution is possible. This increases competition over price sensitive consumers that still have options. The power over buyers is relatively low. 30

31 Value Chain Analysis Competitive Strategy Analysis The medical appliances and equipment industry has a high degree of rivalry among existing firms, a low threat of new entrants, and a high threat of substitute products. Because of the high threat of substitutes, there is low bargaining power over customers. The mutualistic dependency between the industry and its suppliers results in moderate bargaining power for both sides. The industry is characterized by a moderate mix of industry concentration (with direct competitors being highly concentrated while indirect competitors, focusing on substitute products, have low concentration). The medical appliances and equipment industry is a competitive market that relies on innovation, specialization (in some forms), diversification (in other forms), and high quality standards. In order to remain profitable, the firm takes into great consideration all investments in research & development, the diversification of product segments, quality standards, and the complexity of the firm and its corporate social responsibility. Research & Development The medical device industry funnels a tremendous amount of money into research and development to fund innovation, which will have a significant impact on medical equipment and supply markets. The medical appliances and equipment industry is subject to rapid technological advancements. So by investing in R&D, companies can become more competitive in the market. Constant improvement of products and introduction of new products is necessary to maintain market leadership. It gives a 31

32 comparative advantage. Research and Development can also help to meet new or unsatisfied patient needs and can reduce long term care costs and the length of hospital stays by improving existing technologies. Diversification in Product Segments Diversification decreases the degree of dependence on one specific segment and increases the number of patients reached. In other words, a company with diversified segments will rely less on one of them, leading to greater flexibility. Flexibility within the firm is all the more necessary in the medical market because of increasing technological advances and new regulations. Flexibility allows the company to jump on new opportunities of a different nature. The more segments a company develops, the more opportunities it creates, and the company can easily switch its orientation to specialize in a more promising field of research. This has the effect of mitigation the high industry switching costs, since the company already has its foot in the door. Increasing product varieties also enhances the brand position and allows a broad market presence to be forged and growth to be allocated among a more diversified mix of products. Consequently, brand name is more present and better known by professionals, and the level of patient trust increases. Quality Standards and Brand Image High quality standards provide another comparative advantage against competitors. A high quality product helps consumers recognize the product's brand and to prefer it over alternatives. The brand image becomes a choice criterion. Professionals and patients demand higher quality for products using brand new technologies. 32

33 Consumers are becoming increasingly aware that FDA approval does not necessarily implicate safety. From a company s perspective, it is impractical to launch an imperfect product (even if it meets regulations and is already authorized). Brand image can be affected by quality standards and health concerns (like reports of life threatening chemical substances). Any of which can lead to a sales decrease. Comparative advantages, like brand image, are seriously at stake in the medical industry because life relies on their products. A few disappointments can kill a brand name, resulting in public perception as an inferior good. Social Complexity and Corporate Social Responsibility Another strategy giving a comparative advantage is the development of a socially responsible firm. Corporate Social Responsibility is the continuing commitment by a business to behave ethically and contribute to economic development while accounting for the total impact of their operations on the social and natural environment. It is difficult to reproduce and therefore it represents a unique advantage, even though it has substitutes like another strong complex social system in a different firm. In the medical industry, the care for the environment is as important as the respect for human beings. A social network is all the more significant because patients want to know their doctors and doctors want to know the products and technologies they use. Knowledge and reliability, respect and trust, bring out close relationships between people in the world of medicine. A socially responsible firm may find it easier to obtain equity financing from philanthropic investors. 33

34 Medtronic Corporate Strategy Analysis To understand how a firm operates, certain key policies and strategies must be recognized and evaluated. Medtronic s policies and performance in areas such as research and development, diversification, financial structure (growth, market cap, expenses, etc.), product quality, customer/supplier satisfaction, and social responsibility will all be addressed. Research & Development/ Intellectual Property In the medical appliance and equipment industry, research and development funds are vital for continued growth. Medtronic, Zimmer Holdings Inc., Saint Jude Medical, Edwards Lifesciences Corp., Boston Scientific Corp and their other more or less direct competitors know that. All of them invest a substantial percentage of their total revenue in the research and development. Compared to its direct competitors, Medtronic barely invests 10% of its total revenue for For being the biggest company in this segment, that can be confusing. However when we look at the amount invested in R&D ($1,239,000), we realize that they can afford ten times more than its competitors. It provides Medtronic with a great advantage, but we should not forget that Boston Scientific Corp is developing a similar advantage. Nevertheless, the venture budget (20% of the R&D budget) allows Medtronic to cooperate with the world's leading physicians and scientists, which most of its competitors cannot afford. Medtronic also allocates a portion of the R&D budget to an 34

35 international knowledge exchange forum, the Bakken Society. It encourages creativity, dialog and innovation by promoting the exchange of research data and technical information across the industry. The process is not used to this extent by its competitors in the medical device industry. This gives Medtronic a comparative advantage. Industry R & D expenditures* Companies Period 2007 ($) invested in R&D % Total revenue ($) invested in R&D % Total revenue ($) invested in R&D % Total revenue 2005 Medtronic 1,239, % 1,112, % 951, % Zimmer Holdings Inc. 188, % 175, % 166, % ST Jude Medical 431, % 369, % 281, % Edwards Lifesciences Corp. 114, % 99, % 87, % Boston Scientific Corp. 1,008, % 680, % 569, % Medtronic s ability to aquire external R & D is also important. In September 2006, Medtronic settled a 75 million dollar deal with Dr. Eckhard Alt for patent rights to proprietary information used in the firms CRDM division. According to Medtronic s K, patents have a useful life of 11 years and the firm capitalized 74 million dollars in technology based intangible assets. The acquisition of proprietary technology gives Medtronic a leg up over buyers that need the firm s products when there are no industry substitutes. *Source: derived from respective income statement s

36 Acquiring patents is only beneficial if a firm can uphold these patents in court. In October 1997, Cordis, a subsidiary of Johnson & Johnson, filed a suit against Medtronic alleging that the company infringed on certain intellectual property rights by producing certain vascular modular stents. The two companies have been fighting it out as Medtronic has continued to appeal lower court s decisions. It now seems that the legal battle may be coming to a halt. In Court Affirms Patent Ruling Favoring Johnson & Johnson The Wall Street Journal states, A U.S. appeals court affirmed earlier judgments from a long running case that said Medtronic Inc. and Boston Scientific Corp. infringed patents for heart stents held by Johnson & Johnson s Cordis unit The verdict against Medtronic was for 271 million. (January 8, 2008). Medtronic is still trying to appeal and has not listed the contingency on its books. If Medtronic cannot defend the technology it uses in court, the firm will not be able to capitalize on its intangibles. Falling behind technologically in a rapidly developing industry will cause Medtronic to lose price sensitive customers to competitors with more cost effective products. Diversification in Products and Markets Before mentioning diversification, it is relevant to discuss Medtronic s success in its primary product lines and markets. Continued growth in already dominant product lines is important. Medtronic s CRDM division is by far its largest and most profitable branch. The firm has done a good job increasing sales in CRDM and its other product lines as of late. From 2002 to 2007, Medtronic has seen its net sales nearly double from billion to billion. Sales in its vascular division have grown by 28% last year, but growth in other product lines has lagged. 36

37 Medtronic has seen a small drop in revenue from implanted cardiac defibrillators and medicated stents. Some analysts suggest this could be because of changing market conditions. Wall Street Journal blogger Shirley Wang writes, Concerns in recent years about drug-coated stents causing blood clots in rare cases have led to a drastic decline in use of the devices and contributed to layoffs at Boston Scientific and Johnson & Johnson Use of drug-eluting stents hit a trough of 62% in September 2007 and stayed around there for the rest of 2007, perhaps signaling that there won t be a further decline. Drug-coated stents were used in 88% of procedures as recently as mid (February 4, 2008). If doctors and patients are becoming resistant to the use of medicated stents, contributing to a loss in demand and power over buyers, Medtronic could end up in the same situation as its competitors. Luckily the FDA has just approved a new Medtronic stent, the first since 2004, which could signal a coming rise in product usage in the healthcare industry. Medtronic needs to remain dominant in these developed product lines to keep the upper hand in price negotiations with customers. Medtronic operates through eight business divisions: cardiac rhythm disease management (CRDM), spinal and navigation, neurological, vascular, diabetes, cardiac surgery, Ear Nose & Throat (ENT), and Physio-control. As a result of having such a broad product portfolio, Medtronic has a diversified stream of revenues and is not excessively dependent on one particular segment. This strategy differs from all of its competitors, which specialized in fewer segments. For instance, Boston Scientific Corp. works in three segments 37

38 (Cardiovascular, Endosurgery and Neuromodulation), and Zimmer Holdings Inc offers devices in five divisions (orthopaedic implants, dental implants, spinal implants, trauma products, and related orthopaedic surgical products) If we want to find a competitor as diversified as Medtronic in the medical device industry, we have to look at Johnson & Johnson. Medical devices represent one of the three segments where it specializes, whereas it is the whole activity of Medtronic. Like Johnson & Johnson, Medtronic with its broad product portfolio not only enhances its reach and its market share, but also generates a diverse revenue stream. This limits Medtronic s exposure to the risks associated with a particular segment. For the fiscal year 2007, the cardiac rhythm disease management contributed 39.6%, spinal and navigation (20.7%), vascular (9.8%), neurological (9.6%), diabetes (7%), cardiac surgery (5.7%), ENT (4.4%) and physiocontrol (3.1%) of total revenues to the company. (See above chart) Even though Medtronic is relatively diversified, with respect to product lines, it continues to attempt to reach customers with different needs. Medtronic has a history of expanding the scope of its product lines. Some new technologies have been pursued with the help of suppliers; reinforcing the notion that power over suppliers turns into power over buyers. In 2005, Medtronic collaborated with Zimmer Holdings, a large supplier, to expand its product line. A 05 Zimmer press release elaborates; The first electromagnetic Computer-Assisted Solutions knee replacement procedure was successfully performed on February 14, 2005, at The Methodist Hospital in Houston, Texas Zimmer and Medtronic Navigation, who have an exclusive partnership for MIS surgical navigation solutions, developed the proprietary system, which involves computer-assisted equipment, software and Zimmer instruments. (Warsaw, IN). Medtronic has also branched out more recently, but it has been followed by industry competition. Within a few years, Americans may have a new tool to fight back against obesity; electricity. Not from the power grid, but from implanted pacemaker-like 38

39 devices that influence a key nerve linked to food-related functions, including feelings of hunger and fullness Some medical-technology companies have been chasing the implanted electrical-device angle to help fill the void. The companies include Medtronic Inc., St. Jude Medical Inc., and health-care giant Johnson & Johnson. (Jon Kamp: January 30, 2008, WSJ) This could prove to be a step in the right direction for Medtronic, but the firm will have to act fast to capitalize before the competition. Doing so would open up a new market in the U.S. where currently around one third of Americans over 30 are considered obese; increasing its customer base and power over buyers. Expanding product lines is just one aspect of diversification. Expanding geographic scope is also important. Medtronic has already made a push into global markets. From 2006 to 2007 Medtronic has seen sales outside the U.S. jump from 32% to 36%, a move from billion to billion in revenue generated. This is a good sign that the company recognizes the need to expand into untapped markets. Medtronic has made a recent deal to open up the market for health care equipment in China by partnering with the Shandong Weigao Group Polymer Corporation. In Medtronic Moves to Widen China Footprint Laura Santini writes, While Medtronic is attempting to widen its reach in China, Weigao s chairman, Chen Xue Li, said his company hopes to improve its product quality by collaborating with Medtronic as well as increase the array of products it offers in its home market. (WSJ December 18, 2007). Medtronic is hoping this move will give it a strategic first mover advantage. 39

40 In the same article, Medtronic CEO William Hawkins states, Strategically for us, China is where we wanted to expand our footprint. China has huge potential for developing a large customer base. This could cause increased bargaining power over domestic clients as U.S. companies are forced to negotiate for access to Medtronic products. Financial Outlook Medtronic is the leader in market capitalization in the medical equipment and supplies industry. Although it has 8 divisions, it dominates the market for Cardiac Rhythm Disease Management. CRDM accounts for 40% of Medtronic s total revenue. In this 9 billion dollar a year sector, Medtronic s CRDM division accounts for billion. That is a 54% market share. Overall, Medtronic, within the scope of market share, is doing a good job at maintaining leverage over suppliers that must continue their business with the industry leader. As stated before, Medtronic has the leading market capitalization in its category. This reveals its strong financial performance recorded over the last few years. Revenues doubled from 2002 to 2007 from $6,410.8 million to $12,299 million. Further, Medtronic s five-year average rate of return on investment was 17.6% as compared to the industry average of 12.7%. The five-year average rate of return on assets of the company was recorded at 13.7%, whereas the industry recorded a return of 9.1%. Moreover, the company s five-year return on equity was recorded at 23.5% which was very impressive against the industry average of 18.1%. The five-year average operating profit margin and net profit margin of Medtronic during the period was reported at 28.5% and 21.3% respectively. These ratios are significantly high when compared to the industry average of 16.5% and 10.9% respectively for the same time 40

41 period. Strong financial performance of the company would positively affect investor confidence. source yahoo.finance Source: yahoo.finance.com This financial solidity enables Medtronic to invest in joint ventures and to acquire new patents, rights, tangible or intangible materials, entire young and innovative companies, or other privately held companies. These strategic alliances strengthen the reach of the company across various markets. This, in turn, increases the profits and market shares of the company significantly, and helps Medtronic to outdistance its competitors who cannot afford to follow the same large-scale strategy. Some areas of concern should be addressed. An in depth analysis will be covered later in this report but there are a few major factors that need to be considered. Being able to collect from customers is a huge aspect of maintaining sufficient operating cash 41

42 flow, and in turn financial solidarity. Without efficient collections, Medtronic might not be able to meet its payments to suppliers without taking on unneeded debt. In 05 and 06, Medtronic was writing off 13.71% and 13.79% of its allowance for doubtful accounts, respectively. In 07, this percentage ballooned to 32.06%. These numbers are all less recoveries. These numbers could be a warning sign since the 59 million wrote off in 07 was 15 million more than the combined write offs of 05 and 06. Write offs Balance at Charges to Other Balance Beginning Earnings Changes at End of of (Debit) Fiscal Year Fiscal Year Credit Allowance for doubtful accounts: Year ended 4/27/07 $ 184 $31 $(59)a $4 $160 Year ended 4/28/06 $ 175 $39 $(24)a $(6) $184 Year ended 4/29/05 $145 $43 $(20)a $175 (a) Uncollectible accounts written off, less recoveries. A broader analysis of financial and accounting data is needed to assess the true implications. On first glance it does appear that this could possibly be attributed to the health care crisis and the shaky health insurance industry. Medtronic receives a large amount of revenue from insurance companies or other third party payment firms, including government programs like Medicare. The inability to collect has a huge effect on Medtronic. Further research, that will be covered in another section, is needed to decide if this risk is idiosyncratic or industry wide. 42

43 Product Quality and Safety Medtronic's emphasis on product quality is manifested with ongoing efforts in world-class manufacturing processes, meticulous product testing, and statistical quality controls. In 1990, Medtronic began its Customer-Focused Quality (CFQ) process, in which they incorporated all Medtronic quality strategies, programs, and procedures, and expanded them throughout all levels of the organization worldwide. CFQ underscores a total commitment on the part of all Medtronic employees to focus on customers needs and wants by providing them with unsurpassed quality in Medtronic s products, services, and relationships. Examples of Medtronic's ongoing quality efforts include having sales representatives available 24 hours a day to ensure that customers have the appropriate products and support when needed, testing Medtronic mechanical heart valves over a span of more than one billion cycles--67% more than required by the United States Food and Drug Administration s guidelines, publishing a detailed product performance report--unique in the medical industry--that provides performance data on Medtronic's pacemakers and leads, and conducting customer satisfaction surveys for the collection and assessment of perceptions and imperatives. Even though the policies are in place to ensure high quality products, it has not always translated into an enhanced public perception. The most important aspect of developing power over buyers is quality. Medtronic must make safe products or they lose the ability to negotiate over relatively trivial matters such as price. This might be viewed as a shortcoming. Medtronic is in the process of defending itself against a huge class action suit. Certain implanted cardiac defibrillators have been recalled after reports of malfunctions 43

44 resulting in serious injury, and even death. There are currently over 1100 individual cases making up the U.S. class action suit (this is along with 5 smaller Canadian class action suits). The trial date is set for July 1, The ordeal has become very public and patients are becoming increasingly aware of the situation. Implanted cardiac defibrillators are an important product in Medtronic s CRDM division. A huge loss in demand for this strategic product could put Medtronic in serious financial trouble. Medtronic is currently funding clinical tests attempting to demonstrate the superior safety of their ICD s compared to those of Johnson & Johnson. With the massive publicity the case has received it is doubtful that the results of the research will have much effect. With the general instability in the current healthcare industry, this is not a good time to lose buyers in a key product line. If Medtronic cannot find a way to revive its tarnished image, serious financial consequences could follow. The impact will be much larger than the settlements awarded to the plaintiffs. This could result in a total loss of power to negotiate over price with buyers that are scared, literally for their lives, to use Medtronic ICD s. Customer Relations Medtronic makes most of its sales through direct customer representatives. Buyers want their orders to be taken and delivered efficiently. The company has been consulted by Oracle in hopes of improving sales team effectiveness. The Oracle website summarizes its role; Challenges: Maintain a competitive advantagephysician/customer loyalty- as the company grows, Optimize sales force performance and customer service by providing the sales team with accurate customer data, Provide reporting functionality not present in the company s current business objects system. Solutions: Worked with BI Consulting group to implement Oracle Business Intelligence Enterprise Edition creating a business analytics system which measures and monitors key sales metrics, Improved insight into key data such as devices sold per region- 44

45 physician loyalty- pending purchase orders- etc., Realized over 45,000 productivity hours saved annually among the company s user group. Keeping customers happy with the service they receive is critical. Medtronic has acknowledged this and has made steps to improve its sales force/ customer relations. This all translates into increased buyer return rates and bargaining power. Customer service can be seen as a competitive advantage. Research and technology can be duplicated some times, but the relationship between sales team members and customers is hard to replicate. This can translate into a sustained advantage. Supplier Relations Medtronic s record on supply chain relations has not been as sterling. Information on arguments with suppliers is limited. This makes it hard to make an accurate generalization from what could be an isolated incident. Major conflicts that have reached the point of litigation should be mentioned. On December 24, 1997 a subsidiary of Abbott Labs, a major supplier to Medtronic, filed a suit regarding intellectual property infringement (10-K). The company, ACS, claimed that Medtronic used patented information in the creation of vascular stints. The courts ruled in favor of ACS. This decision has been upheld through appellate courts but, as of 2008, Medtronic has continued to appeal and has not listed any contingencies on its books. Medtronic continues doing business with Abbott labs but this could be a sign that the market giant might be seen as a necessary evil to some. If suppliers are not happy with their treatment by Medtronic they could remove certain privileges such as credit lines and discounts. This increasing the cost of doing business, resulting in lower margins. 45

46 Social Complexity and Corporate Social Responsibility Since Medtronic was named to FORTUNE magazine's annual list of "America's Most Admired Companies" during seven consecutive years from 1998 to 2004, it means that the company managed to produce an effect on the public and to transmit a vision of its way of doing business. It has a Code of Conduct exposing humanist and environmental friendly goals. For example, Medtronic implements programs reducing greenhouse gas emission and consumption of water; Medtronic used approximately 29,000 gallons of water per million dollars of revenue in fiscal year Comparing fiscal year 2006 to fiscal year 2005, Medtronic s rate of water consumption decreased over 10 percent, resulting in an actual decrease of 1.5 million gallons of water use. Moreover, Medtronic takes care of their customer education. They don t just create high quality products, they want their employees, doctors, and patients to understand Medtronic's new technologies. To do so, an essential element of its service is the customer education program, which includes product training sessions, the sponsorship of major medical and scientific seminars and symposia throughout the world, and professionally accredited workshops. "On April 27, 2007, we employed approximately 38,000 employees. Our employees are vital to our success. We believe we have been successful in attracting and retaining qualified personnel in a highly competitive labor market due to our competitive compensation and benefits, and our rewarding work environment. We believe our employee relations are excellent." That's what is said in Medtronic's 10-K 2007, and it appears to be accurate. Reports show that they care a lot about their employees' condition and develop services to recognize the personal worth of employees by providing an employment framework that allows for personal satisfaction in work accomplished as well as financial security, advancement opportunities, and means to share in the company's success. 46

47 Conclusion Medtronic seems to be doing an adequate, not stellar, job in fulfilling its objectives. Continued improvement in maintaining sustainable competitive advantage is necessary. Accounting and financial analysis will be performed to evaluate Medtronic s holistic performance, with the eventual goal of reaching an accurate equity valuation. 47

48 Accounting Analysis Accounting analysis is a tool used by analysts to evaluate the financial statements of a firm. Corporations provide these financial statements to the public so investors will have something to go by when deciding whether to invest in that company or not. Moreover the main purpose of financial reports is to credibly communicate economic consequences of business activities. Since a lot of this data is reliant upon people made numbers then there will most likely be discrepancies in the financial reports. Indeed choices may contain material errors and biases, we will need to undo as we will use these numbers for the firm s valuation. So we need to understand where these numbers come from to decide how reliable they are and how much value we can put on them. With that in mind, the accounting analysis consists of 6 steps that are used to correct those discrepancies and show the true nature of the financial statements. The first step is to identify principal accounting policies, and what policies a firm uses to measure its key success factors. The second step focuses on assessing the accounting flexibility of a firm. Is the firm able to hide their true performance? If so, that brings us to the third step: evaluating the accounting strategy of a firm. If they have accounting flexibility, do they use it to communicate their firm s economic situation or to hide true performance? (Palepu & Healy) Step 4 is evaluating the quality of disclosure and how well managers disclose information. The next step is identifying potential red flags and whether there are unusual transactions that account for a boost in profits. The final step is undoing accounting distortions. If the firm s numbers are misleading, then the analyst will use this step to correct those to the best of their ability. 48

49 Key Accounting Policies Identifying the key accounting policies is the first step of the accounting analysis. These are closely linked to the key success factors as discussed in the Firm Competitive Advantage Analysis. By understanding a firms key success factors, we will be better able to understand the policies the firm uses to measure these key success factors. A firm has the ability to disclose or not disclose vital information relating to the firm in order to gain a competitive advantage in the industry. That is why it is important to understand what policies are currently in use and whether they should be altered in any way to show the true performance of a firm. According to the competitive advantage analysis discussion, the key success factors of the business activities are research and development, diversification in the products segmentation, and superior product quality. The key accounting policies of Medtronic that would affect these key success factors is the accounting of research and development, accounting of goodwill, and the accounting of warranty expenses. Research and Development Generally Accepted Accounting Principles state that all research and development must be expensed when incurred. This is exactly what Medtronic is doing. In Medtronic s 10-K it specifically says that R&D is expensed when incurred. However, there is something called IPR&D which stands for In Process Research & Development charges. When Medtronic acquires a company, the policy uses to account for this is IPR&D. Based on their 10-K, all value were determined by estimating the revenues and 49

50 expenses associated with a project s sales cycle and the amount of after-tax cash flows attributable to these projects. The future cash flows were discounted to present value utilizing an appropriated risk-adjusted rate of return. It goes on the mention that the rate includes a factor that takes into account uncertainty surrounding the IPR&D. Since Medtronic is in the ever-expanding medical device business, having to record R&D as an expense, rather than being able to capitalize on it, is a definite disadvantage. Goodwill Goodwill is the difference between what a company pays for another company and the fair value of the acquired assets of that company. When Medtronic acquires a company, the price of that company is allocated between IPR&D, tangible and intangible assets, and goodwill. These are based on projected future cash flows. Goodwill is tested for impairment annually, which requires Medtronic to make several estimates regarding its value. Over the past three years, it has been determined that no goodwill should be impaired. The amount of Goodwill as of April 2007 was 4.3 billion which represented 22% of all assets % 35.00% 33.96% 30.00% 25.00% 20.00% 30.03% 25.76% 22.10% 22.18% 15.00% 10.00% 5.00% 0.00%

51 past 5 years. The chart above shows the percentage of Goodwill as it relates to assets for the Warranty Liability Warranty is the guarantee that an object purchased will be free of defects and will work as it is supposed to for a reasonable amount of time. Since all products of Medtronic cannot be perfect, there will be instances in which Medtronic will have to pay to replace an item. Medtronic uses accrual accounting and sets the money aside for when such replacements must be made Warranty Claims Provision Settlements Made The chart above shows the amount allocated to warranty liability and the actual settlements made for the past 4 years. There are a lot of estimates in accounting for the costs that may be incurred under its warranties. They base their estimates on the number of units sold, historical rates of warranty claims, and the costs of those claims. 51

52 Accounting Flexibility Accounting flexibility is the amount of freedom managers have in reporting numbers that portray the value of a firm. GAAP is the law managers have to go by in reporting numbers. Sometimes GAAP is very restrictive as in the case with R&D. R&D must be expensed when incurred and they allow for no flexibility in this matter. On the other hand, GAAP allows for flexibility in other areas such as estimating warranty liabilities. When managers have this flexibility, it gives them the control of managing the firms reported numbers. This step looks carefully at the firm and analyzes whether Medtronic has this flexibility. R&D Flexibility GAAP sets a high degree of constraint in reporting R&D. They mandate that research and development should be expensed when incurred. Since R&D is a main key success factor with Medtronic, this is quite unfortunate that it cannot be capitalized as an asset. The medical device industry is constantly expanding technologically and the lack of recording R&D as an asset hinders companies like Medtronic in growing faster. 52

53 Goodwill Flexibility Whereas R&D has little flexibility, it s almost the exact opposite for goodwill. Goodwill allows managers great flexibility in reporting those numbers. The Statement of Financial Accounting Standards (SFAS) No. 142 states that Goodwill is not to be amortized. Rather, Goodwill is tested for impairment annually. When the carrying amount of the reporting unit s net assets exceeds the estimated fair value of the reporting unit, then an impairment loss is recognized. (Medtronic s 10-k) Per Medtronic s 10-k, they have reevaluated their Goodwill and have determined that none should be impaired. This has been the case for the past 3 years. As was mentioned before, Goodwill has accounted for over 20% of their assets for the past 5 years. This proves that the point that managers have the ability to recognize impairment only when they see fit. Thus, managers have extreme flexibility and control in recognizing goodwill. Warranty Flexibility Warranty costs are estimated at the time a product is sold and then records a liability for those estimated costs. Medtronic periodically assesses the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. (Medtronic 10-k) Obviously, this allows for great flexibility in allowing Medtronic to manage the numbers reported for warranty liabilities. Underestimating these costs would allow Medtronic to overstate net Income and overstate assets. 53

54 Actual Accounting Strategy There are different strategies when reporting the financials. A firm can be either a high or low disclosure company, or somewhere in-between. Many times, if a company is doing very well and above expectations in reality, they theoretically would have no problem being a very high disclosure company. As well, a firm not performing to expectations might be more inclined to hide their actual standing as a company by having lower disclosure. However, this is not always the case. Companies, even when doing well, may disclose less than ample because of legal reasons. GAAP standards allow for this luxury, despite the rising of standards. However, lower levels of disclosure (barely covering what is required by GAAP) can be very misleading for any readers of financial statements. Medtronic Inc. has a high level of disclosure in its financial reports. On everything discussed, there are detailed explanations as well line-by-line charts and notes. One thing Medtronic does not report is its contingent litigation liabilities. In other words, it seems that Medtronic will not recognize its lawsuits until they are forced by law to pay them, even when they are estimable. Usually, this would seem to lower the disclosure, but in Medtronic s case they provide all of the information in detail in the management discussions and notes. This tactic allows Medtronic to keep the books stable during the appeals process while at the same time disclosing very much to the readers of the documents and not keeping investors in the dark. By providing all the information needed, the adjustments will be made in the Undoing Accounting Distortions section. Medtronic managers use a very aggressive strategy when reporting its financials. For example, on section 6 titled Goodwill and Other Intangible Assets it is said that the company had no impairment whatsoever on its goodwill for the fiscal years of This seems unusually aggressive, if not misleading. In contrast, Boston Scientific amortizes certain intangibles different ways, such as patents and license 54

55 anywhere between 2-25 years and customer relationships 5-25 years. However they have a set time table, not purely up to the discretion of the managers. Amortization aside, the amount of aggressiveness in this industry in reporting goodwill is atrocious. This chart helps us understand. Goodwill as a % of assets Medtronic 22.1% 22.18% Zimmer Holdings 42.1% 39.51% Boston Scientific Corp % 48% St Jude medical 34.44% 31% Johnson & Johnson 18.9% 17.45% Even though the goodwill value reported by Medtronic in the balance sheet is very high, we notice that all of its competitor s balance sheets show goodwill as a large percentage of their assets, it is the norm of the industry. In 2007, goodwill represents 48% of Boston Scientifics assets, 39.5% of Zimmer holdings, 31% of St Jude Medical and 17.45% of Johnson & Johnson. So it looks to be a common trend in the industry. This is for sure related to the necessity of merger and acquisition in the medical appliances industry to keep growing, innovating and sharing knowledge and technologies. Medtronic is second lowest to Johnson & Johnson (a much larger company) in percentage which is a good position to hold, yet it is a high number by any standards. Still, one must know what amortization should be, and how it would affect the reports. This will be discussed in the section of Goodwill and Other Intangible Assets. 55

56 Qualitative Quality of Disclosure When looking at a company s financial data, there is a lot to consider in the area of quality with the information that you are receiving. If an investor is confident that a company has integrity in the quality of disclosure, it helps that investor have confidence in the numbers. However, if there are major areas that are somewhat shady or misleading, an investor cannot help but question all the numbers. For this reason, it behooves any company to have a well rounded, high quality of disclosure. Some companies in this industry, such as Boston Scientific, have much more goodwill than Medtronic. However, this is due to large mergers within Boston Scientific, which were considerably more than Medtronic. One thing that keeps Medtronic s goodwill and other intangibles is that they see no need to amortize them. This seems to be a problem, making one question the quality of the information given. When one looks at research and development, as another example, it is somewhat unclear how and when the IPR&D (in progress research and development) is recorded. It seems that it is up to the discretion of the managers if it is recorded as finished R&D or if it recorded as goodwill. It seems to be up to different circumstances, like what the research is and if it is successful or not. These two, goodwill and IPR&D are questionable, but they are consistent with the industry. There are many more items, however, that have a very high quality of disclosure. Part of this reason is medical companies, such as those in this industry, are held to a higher standard of preciseness because of the horrendous consequences of bad decisions. Warranties, for example, must be spelled out clearly because of the seriousness of the product functions. Also, with the extreme legal oversight of this industry, there are more incentives to be accurate and not misleading. Another thing Medtronic does at least par with, if not better than the industry, is figuring how much positive or negative impact foreign currency has on the final earnings. Since Medtronic does quite a bit of business outside the U.S., foreign currency has a major impact, for 56

57 better or worse, on all the financial reports. Overall, Medtronic should be said to have a somewhat high level of quality disclosure, with some areas of needed improvement, ones of which are industry wide problems. Quantitative Quality of Disclosure A quantitative analysis of disclosure measures the same idea as qualitative disclosure discussed above, but in a different way. In quantitative, we actually look at the numbers. The GAAP standards are flexible enough to allow some discrepancies on how to report such items. This in itself is not a bad thing. It allows companies managers to make the best decisions for shareholder wealth, while at the same time being truthful. However, some numbers may be skewed. Knowing this, we must identify which numbers are biased and possibly misleading from the ones that are reliable. By analyzing these diagnostics we can determine, with more confidence, the state of the firm. Once we understand where the red flags are for the company, then it is only a matter of undoing these distortions to see the firm more for what it is worth, above and beyond the scope of GAAP standards. First, we will perform a revenues manipulation diagnostic and then an expenses manipulation diagnostic in relation to the medical appliances and equipment industry. Ratios we will compute should reveal inconsistencies in the accounting policies, if any. Then we will deduct motives for such distortion that might lead investors to a misleading valuation of the firm. In the quantitative analysis, we will also compare the financial elements of Medtronic and its main competitors: Boston Scientific Corp., Johnson & Johnson, St Jude Medical Inc. and Zimmer Holdings Next, we will look at the core expense manipulation diagnostics. These, in contrast to sales (revenue) diagnostics which might distort income of a company, the expense diagnostics will determine if a company is trying to unjustifiably distort their 57

58 periods expenses. These expenses are important to understand correctly, as any distortions will have large affects on the final determination of the valuation of a company. It is vital to take note on these diagnostics and the red flags (if any), and do not allow a final valuation of a firm be skewed in any way. In a good note for Medtronic, the qualitative disclosure makes up for the quantitative disclosure. Whenever there seems to be an error or discrepancy, it is discussed by the managers in the 10-K, and the information is adequate to compensate for the distortion. Core Sales Manipulation diagnostics To determine if there is any distortion due to revenue manipulations, we use several ratios related to Medtronic's sales over the past five years and we compare them to the sales of its four biggest competitors. These ratios are comprised of the sales of the year and divided by either cash from sales, accounts receivables, or inventory. Furthermore, these ratios will help us forecast financial statements, foresee sales and account receivable, inventory as well as unearned revenues and warranty. The Net Sales/Cash from Sales ratio helps determine how much of the sales are collected into cash. Intuitively we understand that this ration should be as close as possible to 1:1, as the firm prefers to quickly collect its revenues into cash rather than waiting for credit transactions. From the graph below it is possible to say that most of the companies in the medical appliances and equipment industry draw their revenues from cash collection. Medtronic is in the average and shows a straight-line trend for its ratio of cash collection compared to Boston Scientific Corp. which collection differs a lot from one year to another. This can be due to its fast growth in the industry, or to the nature of their customers. While Johnson & Johnson and Medtronic have very reliable customers such as the government and private institutes, Boston Scientific Corp and St Jude Medical Inc. mainly sell their products to direct sales force, and a network of 58

59 distributors and dealers. Overall we can see that with the net sales over cash from sales ratio being so close to 1:1, that Medtronic cash from sales is accurately supported by their actual sales and therefore shows no signs of accounting or financial distortions. Simply said, the cash collections cycle accurately supports the sales cycle legitimating and reinforcing the quality of their accounting practices. The Accounts Receivable Turnover shows how much sales were credit transactions. Medtronic has a low ratio compared to its main competitors, which is all the more favorable because it shows a constant ratio between Net Sales and the proportion of receivables. Outstanding receivables from customers outside the U.S. totaled in % of total outstanding accounts receivable, and in % of total outstanding accounts receivable. The increase in the percentage of accounts receivable from customers outside the U.S. is primarily driven by increased sales volume outside the U.S. and the strong impact of foreign currency exchange rates. All the competitors follow the same upward and then downward motion, which can reveal a common trend in the industry over the past five years. The Medtronic s steady ratio for the account receivable turnover does not reveal any manipulation and that Medtronic did not try to alter the perceived value of the firm through altering net sales or net accounts 59

60 receivable. To conclude, we can say that it can be trustfully used later for our forecast of sales and account receivable. The net sales to inventory ratio shows how much inventory levels support revenues. Medtronic and St Jude Medical Inc. have both the highest ratios on the graph; it reveals that these companies may have a low inventory cost and/or high sales. Johnson & Johnson and Boston Scientific Corp. follow the same trend with very similar low ratios. It can reflect companies with high inventory costs and/or low sales. As Johnson & Johnson have the biggest sales recorded in the industry, we think that what is drawing down the Days Sales Outstanding ratio could actually be a very high inventory cost. As a high and consistent ratio is preferred, we can deduct that both Medtronic and St Jude have found a profitable equilibrium they should maintain in the future. Both of them may have either a low inventory cost or high sales. In Medtronic's case, we think that inventory costs are well balanced and that they boost this ratio with their high sales. Medtronic's inventory is consistently low because they have a strong inventory management policy, as it is an important business concern due to the potential for obsolescence, long lead times from sole source providers, and foreign 60

61 currency exposure. All this leads us to think that there were no manipulation affecting the net sales/inventory ratio and also the financial statements of the firm. Concerning the net sales / unearned revenues ratio, none of the firms do report unearned revenues and therefore we couldn t compute the ratios neither for the industry, nor for Medtronic. This is almost the same situation concerning the net sales / warranty liabilities ratio. We couldn t compute ratios for all the firms due to the lack of disclosure. Only Medtronic and St Jude Medical Inc. seem to be continuing to disclose this information, which makes them the only two within the industry to do so. Boston Scientific Corp started to disclose its warranty liabilities in a warranties obligation balance in 2005 and keeps on doing so for the moment. From the graph above, we can easily notice that there is no steady trend for all the three firms. This may reveal a red flag in Medtronic s case, as warranty liabilities should be in the same proportion as the sales recorded in the business course. Factors that affect the Company s warranty liability include the number of units sold, historical and anticipated rates of warranty claims, and cost per claim. as said in the Medtronic s 10-K of the fiscal year So if we believe that there is no sales manipulation (as we previously didn t find any), it could show a 61

62 warranty liabilities manipulation or a sudden change in their warranty policy. However we actually found out some modifications in the Medtronic s warranty reserve, which could lead to a different estimation of the warranty liabilities. A warranty policy is a business strategy. A warranty reserve is a signal of product quality as well as a contingent liability to be honored in the future. Since warranty accruals require estimation of future claims, any discretion in this context can also be used as a tool of earnings management. Consistent with this expectation, this evidence indicates that managers might have used warranty accruals to manage earnings opportunistically to meet their earnings targets. Why could Medtronic have done that? The fiscal years 2004, 2005 and 2006 present consistent and steady ratios. As we don t have so much information about the industry warranty policy, we cannot compare with all the main competitors, but Medtronic s ratios are quite close to the St Jude Medical Inc. ratios here. So if this three-year trend be based on the exact ratio of net sales over warranty liabilities, it could reveal a manipulation in 2003 and in We now think that warranty liabilities could have been overestimated, then as it is a future expense, expenses could be overestimated, net earnings underestimated and as a result equity could be underestimated as well. Assets remain unaffected. 62

63 warranty reserves N/A N/A 9.4 million 20.4 million 13 million Assets = Equity + Liabilities Revenues - Expenses Net Earnings N U O N O U N= Non affected U= Understated O = Overstated Conclusion So far we can conclude that there is no obvious anomaly to investigate in the first three graphs: Net sales/ cash from sales, Net sales/ Account receivable and net sales/ inventory. Drops and gains look to be in the normal course of business. In the first graph, net sales divided by cash from sales showed strong drops and gains in the overall industry, but nothing affecting the constant line of Medtronic's ratios. Nevertheless we have found out that warranty liabilities could have been overestimated, here we set a red flag. It does not appear that Medtronic could have manipulated its sales. The overall revenues manipulation diagnostic gives a quite favorable image of Medtronic, which was found to be either averaging or even out performing compared to the medical appliances and equipment industry averages. 63

64 Tables used for the Revenues Manipulation Diagnostics Medtronic net sales/cash from sales net sales / account receivable days sales outstanding net sales/ inventory net sales / unearned revenues N/A N/A N/A N/A N/A net sales /warranty liabilities Boston scientific corp net sales/cash from sales net sales / account receivable days sales outstanding net sales/ inventory net sales / unearned revenues N/A N/A N/A N/A N/A net sales /warranty liabilities N/A N/A Johnson&Johnson net sales/cash from sales net sales / account receivable days sales outstanding net sales/ inventory net sales / unearned revenues N/A N/A N/A N/A N/A net sales /warranty liabilities N/A N/A N/A N/A N/A St Jude medical inc net sales/cash from sales net sales / account receivable days sales outstanding net sales/ inventory net sales / unearned revenues N/A N/A N/A N/A N/A net sales /warranty liabilities Zimmer holding net sales/cash from sales net sales / account receivable days sales outstanding net sales / inventory net sales / unearned revenues N/A N/A N/A N/A N/A net sales /warranty liabilities N/A N/A N/A N/A N/A 64

65 Expenses Manipulation diagnostics To determine if there is any distortion due to expenses manipulations, we use several ratios related to Medtronic's assets and cash flows over the past five years and we compare them to the same data provided by its four main competitors in their respective 10Ks. The asset turnover ratio is calculated by dividing net sales by total assets. Medtronic has kept a good even average with a short slowing trend over the past five years due to a slowing sales growth (from 20% in 2003 to 9% in 2007). However in 2007 Medtronic returned to its regular level of asset turnover. This ratio really brings into question whether or not Medtronic is appropriately writing off or depreciating its assets. We know from the 10-k that Medtronic has goodwill that almost equates one quarter of its total assets. We are certain that if Medtronic writes off all its goodwill reported in the balance sheet, the asset turnover ratio will suddenly rise, as the assets are overestimated to date. Nevertheless, Medtronic shows a fairly stable flatter line. It indicates that there is neither accounting distortion, nor other manipulation in the accounting policies implementation. Moreover, Medtronic is actually the only firm in the industry with a very stable asset turnover and a good average ratio when we want to compare it with the big drop of Boston Scientific Corp or the rise shown by the curve of Zimmer Holdings for example. This ratio reports that Medtronic produces with each dollar of asset a revenue productivity of $0.63. However, we know that the asset productivity is affected and underestimated by its goodwill weight. 65

66 The Change in Cash Flow from Operations divided by the change in Operating Income shows how far the operating income results from the net cash provided by operating activities. As this is a percentage, it should be as closest as possible to 100% because the company's main activities in the medical appliances and equipment industry aren't financing or investing activities. We can deduce from the graph above that Medtronic is on average with the industry during the first three years. Thereafter, Medtronic is no longer showing consistency: the ratio decreases in 2006 and then hugely increases in As we look to see if accrued or deferred expenses have been 66

67 manipulated in order to affect net operating income, it seems interesting to question Medtronic's accounting. We think that there is a red flag here. Let's have a closer look at the financial statements in the K. There are several variable fields affecting the ratio. The change in Cash Flow from Operations rises from to It indicates a deep modification in the weight of the cash flows. By looking at the statement of cash flows, we find out that CFO 67

68 decreased by 21% between 2005 and 2006 while net earnings increased by 41%, sales rose by 12% and operating income increases by 24% the same year. The big drop in CFO in 2006 are mainly caused by the negative change in Accounts Payable and Accrued Liabilities (-340% from 2005 to 2006). A decrease in the change in Accounts Payable and Accrued Liabilities means that cost of goods sold and/or expenses on a cash basis are higher than they are on an accrual basis. Medtronic may have sought to correct this inaccuracy. Furthermore we can notice that Medtronic tried to balance this drop by deferring income tax, in order to avoid a too big negative cash flow. In other words, income had been realized but tax on that income had not in Medtronic Change in CFFO -0,01-0,22 0,35 Change in OI -0,09 0,24 0,11 Change in CFFO/change in OI 0,1-0,89 3,12 It appears clearly that the 2007 Change in CFFO/Change in OI ratio had been affected by the 2006 expense manipulations; in 2006 we would have signaled a red flag as a result of our expense manipulation diagnostic. However, since 2007 statements don't indicate any expense manipulation, we expect Medtronic's ratio to return to a more regular level if 2008 is not affected by any additional manipulation during the normal course of business. 68

69 Change in CFFO/Change in NOA Medtronic Boston Sc. Corp. Johnson&Johnson St. Jude Medical Inc Zimmer Holding Change in Net Operating Assets is computed by dividing Change in Sales by Normalized Asset Turnover. So it refers to the cash investment and the new operating accruals. The ratio of change in cash flows from operations to change in net operating assets shows how much income is derived from the net operating assets. The higher the ratio, the higher the return on net operating assets. By looking at the graph above, we can easily deduce that Medtronic actually best manages this aspect of the market in However, it appears likewise that in 2006 Medtronic managed its net operating assets much worse. We suddenly feel more suspicious. What happened? Should we point out any red flag? Medtronic Change in CFFO 0,31 0,37-0,01-0,22 0,35 Change in NOA 0,32 0,29 0,17 0,21 0,14 Change in Sales 0,2 0,19 0,11 0,12 0,09 Asset Turnover 0,62 0,64 0,61 0,57 0,63 Change in CFFO/Change in NOA 0,97 1,28-0,05-1,03 2,5 The expense manipulation affecting the Change in CFFO has had a necessary impact on the Change in CFFO/ Change in NOA ratio. The second factor, which is the change in NOA ratio, is lowered by the sales growth slowing down to 9%. The Asset 69

70 Turnover remaining quite constant over the past five years has had very few impacts on the latter. As a result, we don't have any doubt about the irregular trend of the Change in CFFO/change in NOA ratio since we can explain it by the impact of the 2006 CFFO manipulation and by the decrease in the sales growth rate. Therefore we don't see any additional expenses manipulation. Conclusion So far we can conclude that there is no obvious anomaly to investigate in these graphs. Here ups and downs look to be in the normal course of business. It does not appear that Medtronic could have manipulated its expenses. The overall expenses manipulation diagnostic gives a very favorable image of Medtronic. 70

71 Tables used for the Expenses Manipulation Diagnostics Total Assets Turnover Medtronic 0,62 0,64 0,61 0,57 0,63 Boston Sc. Corp. 0,61 0,69 0,77 0,25 0,27 Johnson&Johnson 0,87 0,89 0,87 0,76 0,75 St. Jude Medical Inc 0,76 0,71 0,6 0,69 0,71 Zimmer Holding 0,37 0,52 0,57 0,59 0,59 Change in CFFO/change in OI Medtronic 0,57 1,9 0,1-0,89 3,12 Boston Sc. Corp. 0,49 1,03 1,3-0,26 0,5 Johnson&Johnson 1,74 0,57 0,78 5,89 0,26 St. Jude Medical Inc 0,59 1,56 1,29-0,44 4,92 Zimmer Holding 10,04 1,07 0,05 1,77-1,3 Change in CFFO/Change in NOA Medtronic 0,97 1,28-0,05-1,03 2,5 Boston Sc. Corp. 0,22 1,45-3,33 1,06-1,98 Johnson&Johnson 1,68 0,34 0,84 2,85 0,37 St. Jude Medical Inc 0,49 1,05 0,41-0,5 1,67 Zimmer Holding 1,2 0,68 0,07 1,68 0,22 71

72 Potential Red Flags Here we consider any manipulation of information that could create accounting distortion. Indeed, questionable accounting should be emphasized when there are red flags. We have already carried out the revenues and expense manipulation diagnostics. We did not find any revenues manipulation, but we have identified a distortion in the 2006 Statements of Cash Flows. The impacts of this distortion are still misleading investors and analysts in their backward-looking opinion about Medtronic. However, the 2007 statement of Cash Flows does not show any distortion. So now let's examine more closely other parts of the 10-K that have not been already discussed and that could provide misleading information about Medtronic's financial statements. Foreign exchange derivative contracts Due to the strong exposure to foreign currency fluctuations in the global market Medtronic deals with, the company tries to minimize earnings and cash flow volatility by buying foreign exchange derivative contracts. They own $5.372 million of foreign currency contracts outstanding to date; the fair value of these contracts at April 27, 2007 was 125 million less than the original contract value. But none of them is actually reported in any statement, it is only reflected as a contractual obligations related to offbalance sheet arrangement. The reason provided to explain this inaccuracy relies upon the fact that these obligations would be offset by losses/gains on the related assets, liabilities and transactions being hedged. Nevertheless, to be more accurate, we need to make the adjustments into the balance sheet as long term liabilities now. 72

73 Operating Leases Furthermore, Medtronic has some capital leases which equate to approximately $89 million at present value, according to information disclosed in their K. But they do not recognize operating leases of $193 million on their balance sheet as they should do. As operating leases reflect future contractual obligations, their payment cannot be avoided or canceled, so it must be a part of the liabilities, as well as a part of their asset. Some of their operating leases require future payments such as real estate taxes, insurance, maintenance and other operating expenses associated with the leased premised that are not included in the $193 million. This is not an important red flag as the value is not is not significant compared to the overall value of the firm, but it must be mentioned. Other contractual obligations Moreover, Medtronic reports inventory purchase commitments of $621 million in an off-balance sheet arrangement. They need to be adjusted as a part of the long term liabilities for the balance sheet to be more accurate and also to reflect the Medtronic's true financial position. In addition, the company doesn't reflect on the balance sheet other obligations like commitments to replace their existing legacy enterprise resource systems and to construct their new Cardiac Rhythm Disease Management (CRDM) campus. Putting it all together, it equals $383 million. 73

74 Warranty liabilities As we don t have so much information about warranty liabilities and warranty reserves, it is hard to explain why Medtronic decreased its warranty liabilities when sales are steadily growing. But we think that a red flag should be set here. Warranty liabilities could have been overestimated, and then as it is a future expense, expenses could be overestimated, net earnings underestimated and as a result equity could be underestimated as well, this is without any impact on assets. Adjusting accounting distortions Accounting distortions can appear in many different forms. Distortions are most likely to arise in areas that have a significant impact on liquidity, profitability, or capital structure. Medtronic s industry has specific characteristics that help the analyst focus in on areas of importance. The healthcare equipment industry has a unique competitive structure similar to the computer technology industry. In both industries, heavy investment in research and development is essential. But, unlike defense and aeronautics, R & D is not pursued in hopes of creating drastic product differentiation. Instead companies must develop new technology to meet industry standards. Competition for price sensitive consumers is the focus, but continuing advances in technology are necessary. This highlights the importance of intangible assets. Medtronic s combined intangibles account for nearly 30% of total assets, 29.52% to be exact. Medtronic follows GAAP standards by expensing all internal R & D expenditures. The capitalization of such expenditures could have a drastic effect on net income and, in turn, the accurate valuation of the firm. 74

75 R&D Capitalization There are a few important steps to accurately assessing the effect of R & D capitalization. First a rate of intangible depreciation should be derived to predict depreciation expense. We will estimate this rate by averaging the rate of depreciation used on amortizable intangibles over the last few years. The next step is finding a rate that accurately predicts changes in R & D expenditures for prior and future periods. We will do this by averaging changes in internal R & D expense over the last 5 years. We will make sure this rate is consistent with actual expenditures incurred in historical periods by measuring the difference in reported numbers and numbers predicted by our expenditure growth model. We will then use both of these rates to correct accounting distortions, specifically noting their effects on net income and cost growth. Medtronic depreciates all of its intangibles on a straight line basis over the duration of their useful life. The firm estimates useful life, according to their 10-k, anywhere between 3 and 20 years. Since there is no logical way to assign a useful life to the future gains of R & D expenditures, we feel that using the average rate of depreciation on intangibles over the last few years, using that rate to determine initial depreciation for prior expenses and subtracting that value on a straight line basis, will give a more accurate figure. The carrying value of total amortizable intangibles at the beginning of 06 and 07 is 1767 and 1615, respectively. This gives an average intangible balance of 1691, prior to amortization. Amortization expense for 06 was 175 and expense for 07 was 182, giving and average expense of Computing amortization expense as a percentage of intangible carrying value gives an average rate of 10.55%. We can use this rate to estimate depreciation expense on capitalized R & D. This rate implies that R & D should amortize in full between the 9 th and 10 th year after capitalization. The theoretical basis for an amortization rate (accountants use the rate to match the expense with the periods in which additional revenue is earned from the asset) should be able to explain the 75

76 derived rate. This can be examined by looking at the expected useful life of purchased patents and technology. In 2007, Medtronic estimated average original useful life of externally acquired technology at 14.5 years. This useful life can be viewed as comprising of 2 separate parts; the amount of time it takes to turn technological feasibility into a commercial product launch and the amount of time it takes for the resulting patent to expire. Most U.S. patents have a 10 year life so the remaining 4.5 years can be viewed as an estimate of the amount of time it takes to turn technology into product value. Since Medtronic competes in an industry where all firms invest heavily in R & D, the risk of substitute technologies will eventually offset the first mover advantage of a new product. Simplifying this by assuming that both counteractive effects develop at an equal rate implies that the actual post production life of technology is closer to 5 years than 10. Adding this figure to the developmental lead time gives an estimated useful life of 9.5 years. This qualitative derivation meshes nicely with the quantitative one introduced earlier. 76

77 Medtronic s R & D expense for 07, 06, 05, 04, and 03 are, respectively, $1239, $1113, $951, $851.5, and $749.3 (all numbers in millions and taken directly from 10-k statements). Calculating the yearly % change, and averaging, yields a derived expenditure growth rate of % (standard deviation of 2.26 percentage points). This growth rate gives a predicted value for 1999 R & D expense of $ The actual reported expense for 99 was $ We feel this difference shows that our derived expenditure model predicts historical data with accuracy sufficient for its purpose. The significance of this rate will be explained at the end of this section. Using the depreciation rate we calculated, 10.55% annually, we can make the assumption that the average useful life of capitalized R & D is 9 years (the remainder of the depreciable base will expire in the 10 th year after the expense was capitalized but this figure will be quite small and difficult to predict, we feel the effect will be marginal and irrelevant for the purpose of this model). This means that amortization expense from capitalized R & D up to 9 years prior to 2007 will have an effect on total amortization expense in 2007, and thus affect income tax paid and net income. Under this assumption we will calculate the partial depreciation expense for every year from 1999 to

78 Calculating amortization expense for years 99-07, multiplying R & D expense by 10.55%, gives values of $46.6, $51.5, $60.9, $68.2, $79.1, $89.8, $100.3, $117.4, and $130.7 (respectively, using historical numbers with results rounded to the nearest tenth). The sum of these values gives the estimated amount of total amortization expense incurred in This value is $ In 2007, R & D expense was listed at $1239. If this amount was in fact capitalized as an amortizable intangible, then expenses were overstated by $494.5 million ($1239-$744.5=$494.5). Subtracting the overstatement from total cost yields a restated total cost of $ (Total reported cost, $8784, minus overstated cost, $494.5, equals restated cost, $8289.5). After deriving Total Cost and EBIT, we calculated the applicable tax rates for each year. This resulted in an after tax adjustment to NI of $ The calculations were performed for the years 2002 to 2007 (see appendix). Our results showed that as the tax rate stabilized, the effect of capitalizing R&D was an approximate 14% increase in NI. This is where the importance of calculating the average growth rate of R & D expenditures becomes apparent. As calculated previously, Medtronic s R & D expense grew at a rate of about 14 %( 13.92% to be exact). This 14% change is the driver behind the proportionate increase in net income compared to reported net income via 10-k. Based on this information, we can conclude that as long as net sales increase at a stable rate consistent with historical growth and expenses not associated with R & D increase at a proportional rate (a rate consistent with historical cost growth), assuming the tax rate remains around 20%, the net effect of capitalizing R & D expense will be an approximate 14% increase in net income(as compared to net income when R & D is expensed). This principle has wider applications. The effect of capitalizing and amortizing an expense, all else equal (or more specifically, all else proportional) does not depend on the rate of depreciation or useful life of the asset, assuming a straight line amortization model, but on the constant growth rate of the capitalized expense. 78

79 This fact will make forecasting future financial statements much more efficient if we want to see the effect a specific change in accounting policy would produce. To create an adjusted income statement, we replaced R&D expense with R&D amortization. We then calculated the appropriate changes to total expenditures, income tax, etc. To create an adjusted balance sheet, we added a line item for net capitalized R&D. We then created a deferred tax liability by multiplying accumulated capitalized R&D by the tax rate. The remainder of the balance needed to equate Assets with Liabilities + Equity was added to stockholders equity. The ratios of earnings per were adjusted accordingly. Legal Contingencies Another common distortion in accounting involves the assessment of legal contingencies. Currently, Medtronic is in the midst of a FDA recall of Internal Cardiac Defibrillators equipped with Fidelis brand lead wires. These wires have been linked to painful and potentially life threatening shocks. According to Gordon Gibb, a writer for Lawyersandsettlements.com, these faulty leads have led to 5 reported deaths. The impact of this lawsuit was known in 2006 when class action suits were filed against Medtronic. These suits resulted in the recall but Medtronic, in compliance with GAAP standards that don t require listing a contingency until the loss can be accurately estimated, did not list any contingency on its books. To properly asses the value of the firm, a portion of the expense should be realized in To do this the analyst should attempt to estimate the amount of liability and determine how much of this liability should be expensed in According to FDA press release, the faulty leads could affect as many as 235,000 patients. According to Medtronic, the firm has estimated that 5000 of these leads will fail within 30 months. Medtronic has agreed to replace the unit, at an average cost of 20,000, and pay for 800 in related medical expense. In 2005 a similar product recall affecting up to 87,000 patients resulted in certain litigation expense of $654 million. 79

80 Even though these numbers could be the used as the basis of a liability estimate, we don t think that either would give an accurate result because of the uncertainty and volatility of the new case (new claimants are emerging and the effect is unclear). Luckily, as analysts, we are able to have some hindsight into the estimate. Medtronic reported a 40 million dollar legal contingency expense in 2007 but none of the figure dealt with liabilities associated with the recall (the expense was the result of a law suit regarding fraudulent practices in the sales and marketing departments). Looking into quarterly reports for 2008 showed that Medtronic did not list any new legal contingencies until its most recent 3 rd quarter filling. This delayed reporting could signal problems in itself but even more troubling is that the firm valued the contingency at $366 million. With our ability to give an accurate estimate to the expense, we can retroactively use this value to better allocate the expense to the period it was incurred. To mitigate the loss associated with such a large expense we will allocate half of the value to 2007 and the rest will be taken in has been a rough year for the healthcare sector and the redistribution of the loss could be seen as a way to compensate for the Big Bath style write down that might appear on Medtronic s pending k. Companies involved in continuing legal proceedings often use this technique, writing off portions of expected debt before the expense is incurred, when faced with a substantial loss. Microsoft settled a long running legal battle with the European Union in September for a record breaking $613 million, but since Microsoft had been expensing portions of the liability for years the effect on their 2008 financials will not be substantial. Adding an additional $183 million in litigation expense to 2007 (366 divided by 2) brings total certain litigation charges to $223 million ($183+ $40 million in reported expense). This results in a 2.5% increase in total expenses bringing EBIT to $3292. Using the tax rate calculated in the previous R & D capitalization, 20.28% brings net income to $ (3292* ). This 6.3% decline in net income is significant and will help even out fluctuations in total cost reported in To show that this correction reports a more accurate net income, the effect of the 2005 litigation expense reported above should be examined. In 2005, when $654 80

81 million in litigation expense was incurred, net income was $1804. In 2006, when no contingent legal charges where listed, net income was $2547. This is an astounding 41.2% increase in net income. Simply looking at these numbers would give an investor the impression that Medtronic had a stellar year. But, noting that net sales increased by only 12.3% from 05 to 06 might tip off analysts to the true nature of the perceived increase in net income. In fact, from 06 to 07 net sales increased by 9% while net income increased by only 10%. This illustrates how the misappropriation of cost can result in an inaccurate assessment of performance and growth in proceeding periods. Amortization of Intangibles The amortization of acquired intangibles is another area that can result in accounting distortions. Since GAAP standards do not allow for internally created R & D to be capitalized, it is common for firms involved in heavy investment to capitalize large portions of intangibles when they can legally do so. This has many implications for firms involved in acquisitions (one of the instances in which R & D can be capitalized). Companies should make sure that the value of externally acquired intangibles (including R & D, good will, etc.) is measured accurately. When there is doubt regarding the true value, a conservative estimate should be used that links the value of the intangible to future expected gains in revenue. This expected future gain can be ambiguous and hard to pin point. Medtronic states, in its unaudited manager s discussion for 2007, that capitalized externally acquired R & D is expected to reach technological feasibility but this does not insure commercial viability. It might be arbitrary for an analyst to make judgments regarding the future value of intangibles. Still, looking into what percentage of the acquisition price is allocated to intangibles could provide insight into the true value of a firms acquired assets. 81

82 Medtronic made several purchases of external companies from 05 to 07. Of these, the 4 most significant acquisitions were of Image-Guided Neurologics, privately held TNI inc., Angiolink, and Coalescent Surgical group. These acquisitions resulted in the gain of $503 million in total assets (444 net). Of the total acquired assets, 94% were some form of intangibles. There is no basis for accurately revaluing these intangibles, but the sheer proportion of physical to nonphysical assets (15.8 to 1) underlines their importance. Especially since total intangibles only represented 29.5% of Medtronic s total assets in The large gap between the percentage of intangibles within the firm and the amount of estimated intangible value of externally acquired firms might signal an analyst to look into discrepancies between Medtronic s actual and perceived asset value. One aspect of intangible accounting that can be logically adjusted is a firm s stated rate of depreciation on amortizable intangibles. Noting the high ratio of nonphysical assets in a firm s portfolio makes this amortization rate critical for accurately assessing cost structure and performance. Most trademarks and patents have a life of 10 years at the U.S. patent office (there are exceptions but Medtronic lists the weighted average life of internally created trademarks and patents at 10.1 years so the traditional useful life is a good estimate). It might seem logical to use the same 82

83 depreciation rate for externally acquired intangibles as I did for internally created R & D, but this would be a mistake. External patents and technology have a useful life that is a combination of the life of the patent and the life of the research needed to develop the patent (the two will most likely have some overlap). The life of capitalized R & D should be shorter than that of acquired intangibles. Instead, we will use the average life of purchased patents and technology for the industry (specifically Medtronic s major competitors; Johnson and Johnson, St. Jude Medical, and Boston Scientific). To Medtronic s credit, the only of the 3 major industry competitors to list weighted average original life on its 10-k was Johnson and Johnson. The reported original life of purchased technology and patents was 16 years. Deriving the value for the other 2 firms took some calculation. Since both companies amortized on a straight line basis we needed to calculate the amount of amortization associated with newly acquired patents and technology; we did this by dividing the difference between gross amortizable intangibles (less acquired goodwill) for 06 and 07 by the difference in accumulated amortization associated with acquired patents and technology. For Boston Scientific this resulted in a 15.8 year average life; gross balance 07 ($9809) - gross balance 06 (2110) =7699, accumulated amortization 07 (1157) accumulated amortization 06 (669) =488, 7699/488=15.8 years. This process was repeated for St. Jude Medical yielding an average life of 14.9 years. All three of these figures resulted in an industry average weighted average life of purchased patents and technology of 15.6 years. This rate is very close to Medtronic s reported useful life of 14.5 in The number could even be seen as slightly conservative based on industry standards. In conclusion, although Medtronic does seem to capitalize a large percentage of acquired intangibles (in comparison to total assets acquired), their actions are consistent with industry standards and there is no evidence that they have manipulated the weighted average life of purchase patents and technology to maximize net income or minimize total cost. 83

84 Goodwill The other significant portion of acquired intangible assets is goodwill. Goodwill is the equal to the purchase price of acquisition plus new liabilities less new assets. An impairment to goodwill is assessed when the carrying amount of the reported unit s net assets exceed the estimated fair value of the unit. This fair value is calculated using discounted future cash flow analysis. This approach follows GAAP standards but it can be misleading. If goodwill is amortized like other intangibles (there are theoretical reasons for believing that the value of goodwill depreciates over time), the effect on total assets and expenses can be significant. A logical way to determine the useful life of goodwill would be to amortize it over the amount of time that first mover advantage is sustained. We estimated this earlier at 5 years and will use this as the term life of goodwill. Under this assumption, all goodwill acquired before 2003 will be fully amortized before After looking through old 10-k s we noticed a huge change in accounting policy in Medtronic stopped amortizing goodwill and switched to an impairment system. This resulted in a monumental increase in goodwill of over 3 billion dollars in 02. Luckily we chose a 5 year life instead of a 6 year or our calculations would have been quite distorted. 84

85 To get amortization expense we will find the increase in goodwill as a result of acquisition for years 03 to 07. Each of these will contribute 20% of their value to total amortization expense. This results in $58.6 million in goodwill amortization for Subtracting this from the carrying value of goodwill equals and ending goodwill balance of $91.7 for 07. The reported balance, via 10-k, of goodwill was $4327, which results in a net change after adjustment of $ This change is huge but a more realistic value might be calculated by subtracting the $ million in goodwill acquired in This number is the result of accounting changes and not physical acquisitions. This adjustment shifts the net change to a more reasonable $1199. Goodwill has not been impaired since 02 so the additional $58.6 in expenditures results in a total cost of $8842. This change in total cost gives an EBIT of $ and a net income of $ This represents a 1.7% decrease in net income. Although the change is not very significant for net income, the effect on the balance sheet is profound. 85

86 Financial Analysis, Forecasting Financials and Cost of Capital Estimation Financial Analysis In order to estimate and forecast the future financial value of Medtronic, we need to compute and analyze several ratios. These ratios are classified into 3 different categories and meet various needs. Liquidity ratios help determine the firm's ability to pay off its short term obligations. It is commonly understood that a company with high liquidity ratios has a wide margin of safety to cover its short-term obligations. Profitability ratios are helpful to determine how profitable the firm's activities are. We seek to know if the firm is efficiently using its assets and equity and we also use these ratios analysis to compare the firm's productivity with the industry overall performance. The other section, which deals with capital structure ratios, allows us to find out how the firm is financing its activities. It can also reveal difficulties related to debt pressure, interest load or cash needs. We have computed seventeen ratios for these three sections, plus two ratios related to the growth capacities, the internal growth rate and the sustainable growth rate. We have also used the Z-Score to gauge bankruptcy risk. All these ratios will help us forecasting the future of Medtronic and its possible position among the medical appliances industry. The more accurate the ratios are, the more helpful they will be for our forecasting. 86

87 Liquidity Ratio Analysis To better understand how able a company is to meet their short term obligations, we need to look at liquidity ratios. To measure operating efficiency, we look at ratios such as accounts receivable turnover, inventory turnover, and working capital turnover. Also, we need to look at the two most basic ratios, the quick and current ratios. These two ratios will tell us if the company is either not liquid enough to meet its short term obligations, if the ratio is too low; or if they are being inefficient by not using their short term assets correctly, if the ratio is too high. These ratios are all important for lenders to look at to decide if and how much money to lend to a firm. In the liquidity ratios, the higher the better, but of course, like everything, in moderation. If they are too high for the industry, the firm might not be acting in an efficient manner. Current Ratio CURRENT RATIO AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

88 3.50 Current ratio MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The current ratio is found by dividing current assets by current liabilities of every firm. Thereby we can see to what extent the liquidated current assets can cover the current liabilities. A high ratio signals an ability of the firm to pay off its obligations and reveals that it does not have any urgent cash need to make the payments in the allotted time. It can cover them with the cash provided with its regular activities. From the graph above, we can conclude that Medtronic has never experienced a cash crisis, even during its worst year in We know this because it has always had the required minimum to cover its short-term obligations (at least a current asset of 1). Since 2004, Medtronic has improved its ratio, and in 2007 the firm even reached a leading position in the industry. As St Jude and Johnson & Johnson were very inconsistent over the years, Boston Scientific started to decline and Zimmer holding kept a steady increase. Medtronic, after a slump in 2004, has risen to the top in the industry as far as the firms current ratios. 88

89 Quick Asset Ratio Quick asset ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Quick Asset Ratio MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The quick asset ratio refers to the sum of all the highly liquid assets like cash, cash equivalents, securities and accounts receivable divided by current liabilities. Therefore, quick ratio is similar to current ratio, only quick eliminates the current assets that are not current enough. Here, as in current ratio, we prefer a number greater than one because it indicates that the firm has a strong ability to meet its short-term obligations only using assets able to be liquidated in 10 days. Medtronic has an increasing ratio, which is good for its financial position among the industry and outperformed its main competitors for three consecutive years. It also has the highest average over the past five years in the industry, which shows Medtronic's care to efficiently support current liabilities with liquid items. 89

90 Following the trend seen in the current ratio graph, we see that 2004 for Medtronic was a year where they were shorter on cash than any other year. Indeed, the Medtronic's K explains that in 2002 approximately $4.1 billion in cash have been paid for acquisitions. Approximately $2.0 billion of the cash paid was funded by issuing contingent convertible debentures that were classified as short-term borrowings as of April 26, The debentures were classified as short-term borrowings as holders had the option to require the Company to repurchase the debentures (referred to as a put feature) in September As the next put feature [was] due in September 2004, the debentures [had] been classified as short-term borrowings as of April 30, 2004, reducing the working capital and current ratio in comparison to fiscal year 2003 when the debentures were classified as long-term debt. However, despite this classification issue, there defiantly is a trend in the industry to be somewhat sporadic, even more so than this one year that Medtronic experienced. It seems clear that Medtronic is the most consistently efficient in using its quick assets. Accounts Receivable Turnover A/R Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

91 8.00 Accounts receivable Turnover MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Accounts receivable turnover is computed by dividing sales by accounts receivable. This ratio refers to the firm's effectiveness in collecting credit from sales. Here again, we prefer a higher number so that in the course of one year a higher number of turnover can be attained by a faster collection of accounts receivable. Since we are dealing with the medical appliance industry, it is to be expected to have somewhat lower account receivable turnover ratios, because there are not a lot of cash transactions, but more on a receivables basis.looking at the graph above, we notice that Medtronic does not perform very well compared to the industry. Its average ratio is around 4.5 turnovers, while the average for the industry is around We have already pointed out this Medtronic's weakness, but since we do not have very much information about Medtronic s credit policy, it is difficult for us to add more explanation. We only can assume that it may be linked to a problem with the ability to collect receivables, or to a credit policy differing greatly from the competitors. 91

92 Days Sales Outstanding A/R Days AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Days Sales Outstanding MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Days sales outstanding is a ratio showing how many days are necessary to collect receivables. In this case, the lower the better, since that would mean that a company is able to collect its accounts faster, which is then able to be reinvested.this graph is consistent with the accounts receivables turnover, as to be expected. The Medtronic's days sales outstanding is steady with an average of 81 days, this number is not really increasing nor decreasing, but is high compared to the industry. Medtronic and St. Jude Medical have a static problem, which means they are relatively inefficient at collecting their receivables. Around 80 or higher in this ratio is considered static, and if both firms do not improve this soon it might have a bad impact on the current and quick asset ratios in the future. Zimmer was static in 2003, however they took care of the problem and brought their days sales outstanding considerably down. 92

93 Inventory Turnover Inventory Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Inventory Turnover MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The inventory turnover is commonly computed by dividing the costs of goods sold by the average inventory. This is a ratio showing how many times a firm's inventory is sold and replaced. A low turnover can be a consequence of poor sales and often excess in inventory, which is unhealthy because of the costs and the rate of return of zero for such an investment. A high ratio is preferable and indicates a better efficiency in the inventory management. Medtronic's inventory turnover obviously is slightly above the industry's average. This means that Medtronic is doing relatively well compared to other firms in the industry. However, looking at the graph, we see that both Johnson & Johnson and Boston Scientific are doing significantly better than Medtronic. This means that if Medtronic wants to compete in the long run with these companies, it must improve its inventory management. 93

94 Day Supply of inventory Days supply of inventory AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Days supply of inventory MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The day supply of inventory is a measure of the time (in days) it actually takes to turn the money invested in inventory into sold products revenues. Looking at the graph, we see that the averages of the firms vary somewhat greatly. This could mean that it points out the difference in how basic operations are run (as with Zimmer) or the scope of the business operations (as with Boston Scientific). We can easily see that Medtronic hovered in the industry's average with 152 days, so within the industry there is room to improve. However, like in the inventory turnover, improvement would come from better inventory management. 94

95 Working Capital Turnover Working Capital Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Working Capital Turnover MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Working capital turnover gauges the sales created by working capital. The Working capital ratio is found by subtracting current assets by current liabilities, and then we divide sales by this number. With working capital turnover, generally the higher it is, the better. It reveals how efficiently sales are produced from its investments in working capital. The 2004 Medtronic's working capital suddenly increased and does not follow any previous trend. This can come from either an increase in current assets or a decrease in current liabilities. We know that Medtronic had reclassified a lot of its debentures in 2004, and reclassified again other debentures into long-term investments from shortterm investments in fiscal year 2007 to generate higher interest income offset by normal operating changes in other account balances. Medtronic's K says. As a result current liabilities increased and have decreased the working capital ratio of this 95

96 fiscal year, giving a non-consistent high ratio. The decrease in our working capital relates to our movement of cash. The following years show a turnover relatively constant for Medtronic. Also, Medtronic's ratio follows a quite steady trend, which is more or less similar to the Zimmer's trend and to Boston Scientifics trend over the last two years. This allows us to think that we can determine a kind of industry's common trend for companies having similar market capitalizations. Indeed Johnson & Johnson and St Jude Medical Inc. respectively have bigger and smaller market capitalizations and activities compared to the overall industry. We can also see a relationship between the graphs: current ratio, quick asset ratio and working capital turnover. While current ratio and quick asset ratio indicated a drop in 2004 and then displayed a raising trend for the following years, working capital turnover reflects exactly the opposite. Over the past two years, Medtronic's current assets has went down by 23% because of a drop in cash, securities and other shortterm investments, which reflects the reclassification into long-term investments explained above. Its current liabilities have dropped by 80% as a result of a drop in short-term borrowings. We can attribute most of this drop to the reclassification of New Debentures and some of the Old Debentures from short-term borrowings to long-term debt as a result of the September 2006 put option expiring. Medtronic is relatively underperforming the industry mainly because of these reclassifications was profitable for Medtronic to show a high ratio, but the 2007 reclassification has had a bad impact and does not help Medtronic look interesting to amateur investors. 96

97 Conclusion Medtronic s current ratio was 2.29 for a five year average, which is above the industry average, and so was its quick asset ratio. Medtronic s account receivable turnover did not meet up to the industry average, but to be fair a lot of this could be chalked up to the vagueness of the information given by Medtronic, as well as other firms in the industry. This same aspect will affect the day s sales outstanding; however it is clear that there needs to be improvement on Medtronic s part since they are currently static. Inventory turnover for Medtronic is slightly higher than the industry, which gives us confidence in its liquidity, however taking Johnson & Johnson and Boston Scientific as examples, there is room for improvement on this also. However, knowing its weaknesses, Medtronic still does better overall than the industry in a liquidity analysis, which builds investors confidence that it can meet its short term obligations within the medical appliance industry. 97

98 Profitability Ratio Analysis The profitability ratio analysis provides us with a way to estimate how efficiently assets and equity are used by the firm to generate profit. Information drawn from the analysis will allow us to forecast a trend for the company s future and to position it more accurately in the industry. This helps determine its real value in the eyes of investors. Gross Profit Margin Gross Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Gross Profit Margin MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The gross profit, which simply refers to sales minus costs of sales, is divided by sales in order to find the gross profit margin. This is a percentage, but in the table and graph below, numbers are given as decimal. It helps assess firm s core activities profitability by excluding all the fixed costs. As a result the higher the ratio, the more 98

99 profitable is the firm and the bigger is the margin of profit able to cover costs generated by sales. Obviously Medtronic has a slightly higher margin than its competitors. Nevertheless we notice that the trend is slightly descending. Besides Johnson & Johnson is following the exact same flow, while Boston Scientific sees a big 6% drop and Zimmer and St Jude Medical have respectively consolidated their gross profit margin at 78% and 72%. This bad trend affecting Medtronic s margin actually is due to an increase by 1.5% of its cost of goods sold over the past two years. 1.5% is not a huge number in itself, but it is enough to make the profit margin slightly fluctuate between 76% and 74%. This change in cost of goods sold mainly is attributed to unfavorable foreign currency translation and to geographic and product mix shifts: a result of decreasing sales of higher margin like ICDs in the U.S. and increasing sales of INFUSE Bone Graft and certain other particular products in the Spinal business which have margins that are below Medtronic s average gross margins. Operating Expense Ratio 1.20 Operating Expense Ratio MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

100 Operating Expense Ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The operating expense ratio indicates in what proportion selling, general and administrative expenses are accrued compared to the generated sales. We can also define which companies are spending more or less in expenses that generally are not related to one specific product but to the overall selling and administrative activities. Here the trend must be downward for the company to be perceived as efficient. Medtronic has a satisfyingly steady ratio, except for one outlier in Boston Scientific. However it has the higher ratio in the industry, which is a not a good profitability and efficiency sign. Actually 2007 selling, general and administrative expense has increased by 1.4% (still as a percentage of net sales) from 2006 to 33.8%. From Medtronic s 10-K we learn that most of this rise is attributed to the recognition of incremental stockbased compensation expense of $104 million. Another factor is related to an increase in the expenses associated with investments for the marketing campaign for Cardiac Rhythm Disease Management, the expansion of their sales forces across all businesses, especially in the Vascular business as Medtronic is about to prepare for the U.S. launch of Endeavor DES, and finally other costs associated with their global information technology system implementation. Operating Profit Ratio Operating Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

101 Operating Profit Margin MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The operating profit ratio is another way to measure profit margin as a percentage, here the numbers are expressed in decimal. The higher the operating profit margin, the more efficient the company is being in terms of creating profits after all operating expenses has been subtracted. So, in terms of creating profit after all operating expenses have been paid, we can see exactly how firms are doing over the last five years. For this ratio, Medtronic is safely within the industry average. All the competitors ratios are really close to one another, which reflect a common trend. Notice as well that Boston Scientific has been left off over the two past years due to important losses. We felt it not important to include such a outstanding outlier. Net Profit Margin Net Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

102 0.30 Net Profit Margin MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Net profit margin, which shows net income as a percentage of sales (here in decimal), is the most used ratio. It helps determine how much of each sales dollar will have to be split between dividends, retained earnings and property of the business. We can easily understand why this ratio can be considered as one of the most important ratios in the eyes of investors. Here too the higher the ratio, the more profitable the activities. Medtronic is in the industry s upper average and keeps a steady ratio, which is good and allows relevant forecasts. Once again, Boston Scientific is an outlier for reasons discussed earlier. It is interesting to note how close together all the firms are (excluding Boston Scientific). 102

103 Asset Turnover Asset Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Asset Turnover MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The asset turnover ratio measures how efficiently the assets of year 0 generate sales in year 1, which basically means it measures asset productivity. It is also a common used ratio, because of its relevant purpose. Indeed computing it, we estimate to which extent each asset dollar comes out of sales. This measure is important to determine how assets are used and how much value they are able to produce in one fiscal year. So we can detect if investments in assets are profitable or not. 103

104 Obviously Medtronic s ratio is not good enough compared to the industry: 69 cents are produced for each dollar invested in asset. For the past five years Medtronic has kept a steady underperforming ratio. Its assets book value slightly keeps going up, while its increasing sales are not enough to make Medtronic competitive on that point. Nevertheless, we should keep in mind the huge part of non-impaired goodwill loading Medtronic s assets and distorting the real efficiency and profitability index of the firm. Return on assets Return on Assets AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Return on Assets in % MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The rate of return on assets is a percentage reflecting a combination of the net income and the total assets. So it basically measures asset profitability. It is found by dividing the current year s net income by the previous year s assets. This follows the same logic as the asset turnover computation, since the firm will produce value with assets it holds in the course of the year and not the assets it purchased during this 104

105 same year. These assets will also be taken into account but in the ROA s computation for the following fiscal year. From the graph above, we can notice that Medtronic is not performing that bad, it follows the overall rate of return on assets of the industry and keeps an acceptable trend. This will help us have accurate and relevant forecasts. Return on Equity Return on Equity AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Return on equity in % MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The return on equity ratio is a measure of the effectiveness in running equity to create net income. As for the ROA computation, we take the current period s net income divided by the previous period s owner s equity. High returns on equity reflect companies who finance their operations with more debt than equity or who receive more return from their use of equity. The companies with lower returns on equity use less debt in financing operations. 105

106 We see that Medtronic has improved its ratio over the past two years in order to lead the industry in As the ratio has not been so good over the three previous years, we still cannot decide if Medtronic is beginning a new leading trend in the industry or if it only is a consequent of the course of business for the year The 2007 Medtronic s financial statements indicate growing sales and steady owner s equity. If sales keep going like that and if owner s equity don t increase that much, keeping the same trend there too, it is feasible to obtain an even better ratio in the future. Conclusion Medtronic seems to be doing alright overall for profit margins. They exceeded the industry average in net profit margins, and is on the high end of the average for operating income. There were steady with the industry for operating profit, and return on assets, and on par with the industry for return on equity but increasing. The only troubling aspect is in the management of assets in the asset turnover ratio. However, overall Medtronic seems to be strong in profitability and, if it can improve its stated weakness, will be able to be profitable in the future. 106

107 Capital Structure Analysis The capital structure of a company is designed to obtain equity with which to acquire new assets, needed to produce value through net incomes. Companies can either borrow money from banks or selling shares as stocks to finance their business, the first way refers to issuing debts, the second one to equity. As a result, the capital structure analysis allows us to see how efficient and productive each of these different strategies is within the business. Debt to Equity Ratio Debt to equity ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Debt to Equity ratio MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

108 The debt to equity ratio allows figuring out in which proportion the firm actually is financing its activities. The debt to equity ratio reflects how much of the company is financed by debt compared to its overall equity. For a healthy company, we would prefer a small ratio, as it portrays the balance between debt and owner s equity. Medtronic s ratio for the 2007 fiscal year is 0.44; it means that for each equity dollar, the firm has 44cent of debt. A ratio less than one is preferable as a financing by equity is healthier than financing by debt, as interest can turn out to be a load for the company. Compared to the industry, Medtronic strikes one of the better balances between both strategies. It outperforms the industry s average since This would lead us to believe that Medtronic is satisfied with its current capital structure and debt to equity ratio and keeps trying to stabilize it, while competitors such as Johnson & Johnson s or St Jude Medical s debt to equity ratios are not performing very well compared to the industry because of big drops and rises showing inconsistency in their financing strategy. We think that Medtronic s consistency in this ratio gives it value in the investors eyes as it means less risks of bankruptcy and a lower interest load. Times interest earned Times interest earned MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

109 Times interest earned AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Times interest earned is a company s ability to meet its debt obligations (investopedia.com). It tells us exactly how many times the operating income of the firm can cover the interest expense of debt. Times interest earned is calculated by dividing income from operations over interest expense, a change in the interest expense will directly affect the ratio and an interest load born upon the firm s will easily be noticed, if any. The first thing we see when looking at the graph above is the huge drop of Medtronic s ratio in Indeed interest expense keeps getting bigger and bigger, in three years they have been multiplied by 242% from $45m in 2005 to $154m in 2007; interest rate cannot only explain that variation even if Medtronic declares to be very sensitive to them. But since that year, Medtronic tries to better run its times interest earned, what we can notice looking at the graph. After 2004, there is no longer such a big drop, and the fluctuations in the graph are likely to be due to interest rate changes. Debt Service Margin Debt service margin AVERAGE MEDTRONIC J&J St Jude Medical no short term debt no short term debt 0.74 no short term debt Boston Scientific no short term debt Zimmer no short term debt no short term debt

110 Debt Service Margin MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The debt service margin tells us how a company can finance its debt with its cash flows from operations. To compute it, we take the current cash flows from operations of the current year and we divide it by the previous year s current portion of long-term debts. By doing so, we are actually taking the current installment due on long term debt that will be paid in the current year. This ratio shows a lot of volatility, like the previous one. We notice that Medtronic has a ratio with a less volatile trend compared to its competitors. That doesn t mean that Medtronic is doing well. The higher ratio is the better one concerning the debt service margin; because it indicates that the firm is having enough cash flow from operation to support its current portion of long debt. Obviously Medtronic is not at all outperforming the industry; it is even under the industry s average with a 3.05 average over the past five years, compared to an industry average level above 110. We know that with such volatility it is hard to talk about a really relevant average. We also know that some of the competitors didn t have current portion of long-term debt during some previous fiscal years and that the comparison is biased on all these points. Nevertheless when we look at the Medtronic s average, we cannot overlook the fact that it may clearly have problem to provide cash from cash flow from operation to pay its current installment due on long term debt due to a very underperforming ratio. 110

111 Credit Risk Z-Score AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Z-Score MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The Altman Z-Score is a way for lenders to evaluate the risk of lending a firm capitol. It is a model that measures bankruptcy risk. It gives a window between 1.81 and Below this window is high probability of bankruptcy; while above this window is very low risk for bankruptcy. However, anything in between this window is undetermined and able to go either way. This score is found by adding the following calculations: 1.2 (Working capital/total Assets) + 1.4(retained earnings/total assets) +3.3 (EBIT/Total Assets) 111

112 + 0.6(Market capitalization/book value of liabilities) +1(Sales/ Total assets) The average Medtronic Z-score is equal to 7.99, which is two points above the overall industry average. With a score so high, Medtronic shows it s competency and ability to avoid insolvency risk. It has the second best z-score among the industry, which shows a strong Z-Score throughout the industry. However, they are having a downward slope, but they are trying to stabilize the trend in the industry is that all the Z-scores are going down (less the outlier Zimmer) but even with this decline, the Z- scores for the industry, and Medtronic, are very strong. 112

113 Internal Growth Rate and Sustainable Growth Rate Analysis Internal Growth Rate IGR AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer IGR MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer The internal growth rate or IGR refers to the highest level of growth that a company can attain using only internal financing methods. It enables us to understand that if there is no external financing added to help the company grown, if the company reinvest its net income straight into its assets, it can attain a certain growth rate. The IGR is computed by taking the return on assets and multiplying it by one minus the dividend payout ratio. The dividend payout ratio is the dividends paid divided by the net income. This shows how much of the net income will be depleted prior to the company converting left over funds from the net income into retained earnings. 113

114 Medtronic is in the industry average with a percentage hovering between 10% and 13% over the past five years and over the past two years it has slightly outperform the 10% IGR industry s average. As a result we assume that Medtronic cannot grow as fast as the industry average because it doesn t re-invest enough resources of its own back into the business. It also may not earn enough from its sales in net income to afford to do re-invest more in its own resources and therefore cannot grow at a higher rate due to a lack of internal financing. We also have to consider the fact that St Jude Medical, Boston Scientific and Zimmer holdings don t pay any dividend to their shareholders and therefore their IGR may be equal to their Return on assets. Sustainable Growth Rate Sustainable Growth rate AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer SGR MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

115 The sustainable growth rate, or SGR, offers another way to determine a growth rate, it is said to be more relevant as it takes into account the capital structure ratio, which is overlooked by the previous method. The sustainable growth rate is found by taking the IGR and by multiplying it by one plus the Debt to Equity ratio. This allows us to find a more accurate and more plausible growth rate to forecast the company s future by holding the same debt leverage. It points out the fact the company is not only using internal funding but also adding new borrowing or issuing new shares. Medtronic shows a quite steady SGR compared to the overall industry and it is even outperforming a bit with its average sustainable growth rate of 17%. This means that Medtronic, which can support a 12% growth rate by itself keeping the same debt to equity balance, can support an additional 17% growth by borrowing from outside sources. This is in line with the industry average (or just a little below), less the outlier Boston Scientific. 115

116 Financial Statement Forecasting Forecasting financial statements is a critical step in assessing the value of a firm. Certain assumptions about industry standards, idiosyncratic risk, and macroeconomic conditions must form the basis of our forecast. As uncertainty about the future of medical care in America builds, it is becoming apparent that the coming presidential election will bring at least moderate change to the medical industry. Whether the change is drastic, such as a move to regulated single payer healthcare, or less extreme, mandated insurance requirements and political price setting, the effect of such policies will change the forecast outlook for Medtronic. We feel that the coming regulation will not have a drastic effect on sales growth since even if prices are regulated Medtronic will not face a decrease in demand (people will still need their products). We do feel that increased oversight might cause some loss of concentration within the industry. Spreading out demand between more firms has the potential to cause a small drop in sales. This may be along the line of a 1% slowdown on sales growth. The main consequence will be a reduction in profit margin and return, especially return on equity. We will not assume that a true price setting regulation will come into effect. The increased costs will most likely come in the form of increased inspections and safety procedures which will not be compensated for by the government. In other words, the costs will affect margins after gross profit. This assumed reduction in net profit margin would be seen industry wide. This will be a critical factor in our forecast. 116

117 Forecast Drivers Certain ratios act as principle drivers of income and these ratios will be the basis of our forecast. Since forecasting should start with the income statement and move to the balance sheet and cash flow statement, measures of sales growth and profit margin can be seen as the backbone of forecasting. Sales growth, along with rates of return (ROE, ROA, Net Profit margin), are mean reverting. That means that firms experiencing above industry average returns will eventually see declining growth until they reach industry equilibrium. Here we have to make assumptions regarding industry growth rates and returns. We believe that the average rate of sales growth for Medtronic s main competitors should be the basis for assessing industry standard growth. A simple way of computing this would be to calculate a basic average of each firm s sales growth over the last 5 years and average these rates to derive an industry norm. This method would likely result in an over estimate of equilibrium growth. Since small firms often experience growth in sales at a disproportionate rate compared to larger firms, weighting each firm equally will potentially skew results. To remedy this potential problem, we will instead use a weighted average to compute sales growth. We have isolated 5 firms, including Medtronic, as key components of the health care supply sector. These firms were selected through various criteria including direct competition with Medtronic, individual market cap within the sector, and overall similarity with Medtronic (correlations between growth, capital structure, and product lines). Through this industry analysis we concluded that Johnson & Johnson, St. Jude Medical, Boston Scientific, and Zimmer Inc. are the major components of the industry. Averaging these firms growth rates over the last 5 years gave us individual average growth rates ranging from 9.14% to 21%. This finding validates our use of a weighted average. Large firms like Johnson & Johnson (net sales of 61 billion) had a growth rate 9.14% while smaller firms like St Jude (less than 4 billion in net sales) had a growth rate of 17.7%. Medtronic falls in the middle with 12.16% average sales growth and 117

118 7.665 billion in net sales. We used net sales as the basis of our average weight (firm s net sales over total sector net sales acts as the weight factor for each firm). After calculation, the industry standard, or equilibrium, sales growth rate was found to be 11.33%. If we did not weight the individual averages the equilibrium rate was much higher. Since Medtronic grew their sales on average of 12.16%, the correct weighted average shows that our firm actually has higher growth than industry equilibrium. If we had used the other simple average method it would appear that Medtronic was actually underperforming industry standards and our forecast assumption would be for sales growth to increase as it reverted towards the mean. This raw forecast error would drastically alter our eventual valuation of the firm. Based on our findings, we will assume that Medtronic will be able to maintain competitive advantage in the short run (till 2010) and sales should continue to grow at 12.16%. After that time Sales growth will slowly decline towards the industry equilibrium of 11.33, reaching that rate by After that, we will assume that rate will be maintained at equilibrium for the duration of the forecast (including terminal assessment). Theoretical Predictions A good model should be grounded in theory. If a theoretical benchmark can be estimated, harsh deviation from the results of the manual forecast can signify flaws in either forecast assumption or method. We have attempted to estimate such a benchmark by analyzing some of the other forecast drivers. The other forecast drivers are rates of return. Like sales growth, rates of return are expected to be mean reverting. Return on sales, or net profit margin, is one of the most important rates. Sustainable growth rate is driven by net profit margin, asset turnover, earnings retention rate, and financial leverage. Assuming that capital structure and dividend policy will not change dramatically, profit margin is pivotal for accurate forecasting 118

119 assumptions. But, there is a problem with directly calculating industry norms by averaging profit margins. The main measure of total asset productivity is ROA. Firms drive ROA by trading off between margin and turnover. A firm with high asset turnover will likely have low profit margins (walmart). Firms with high margins will have low turnover (zales). Averaging profit margins will have the effect of setting an industry standard that does not reflect individual firm s strategies for developing ROA. Our solution to this problem is to standardize profit margins relative to the capital structure of Medtronic. We will then use the average ROE of the industry to estimate Medtronic s equilibrium profit margin. ROE should converge towards the industry average since firms with higher ROE s will expand their investment base until their returns stabilize. Since ROE=ROA*Leverage, we will be using the industry average ROE and Medtronic s 06 Leverage ratio to standardize returns (The lag in leverage is needed to calculate return). This gives ROEm/Levaragej=Profit margin*asset turnover. Plugging in each firm into the asset turnover variable gives, (ROEm/Leveragej)/ATx=Profit margin. In theory, the net effect of standardizing profit margins is to view each firms asset turnover in equilibrium (industry equilibrium ROE), if they maintained the same capital structure as Medtronic (Leverage= 1+D/E). Averaging this for all firms should give and equilibrium profit margin for Medtronic. This is not an industry wide equilibrium rate (implying that all firms will eventually reach this profit margin), it is a specific firm s, in this case Medtronic s, equilibrium rate. Industry average ROE times Medtronic s O6 Leverage gives a value of After going through the proper calculations for each firm and averaging, we reached a long term equilibrium return on sales of %. 119

120 Income statement It is useful to calculate a benchmark long run return, but basing a forecast on a net profit margin can lead to error. Approaching a forecast in this manner is equivalent to working backwards. It will inevitably lead to flaws when we attempt to derive a balance sheet from our calculations because of the inherent circularity of working from the bottom up. But, if we can work our way to a sound theoretical conclusion that conforms to our prior predictions, we can further justify the soundness of our forecast. Based on the sales forecast explained above and our assumptions about the future of Medtronic and the health care industry, we have chosen to use the gross profit margin of 07 for the duration of the forecast. We do not expect this margin to change considerably from the 07 level of 74.24%. This coincides with historical data showing that the most distant margin from 07 within the last 5 years was the 05 rate of 75.67%. A consistent gross profit margin of 74.24% is used with our sales forecast to determine COGS. Beside COGS, one of the most important expenses for Medtronic in particular is R&D expense. As detailed in our accounting analysis, R&D expenditures have grown at an average rate of 14% per year. We don t see this slowing. If Medtronic began to back off on R&D it would fall behind the industry in just a few years. We feel that the management of Medtronic is fully aware of the highly competitive industry it is in and would avoid a reduction in R&D expense even if it meant cutting into its net margin. We will assume a 14% growth rate for the duration of the forecast. Total expenditures, which include R&D and COGS, are what separate revenue from EBIT. Forecasting individual constituent expenses would be tedious and provide little insight. Under the assumption that COGS and R&D expense are moving at fixed rates, the only variable assumption that needs to be accounted for is effect that our revenue growth model has on gross profit. Total expenditures could be viewed as a function of revenue growth and some constant. One thing we do know is that when sales growth becomes constant at 11.33% in 2015, total expenditure growth should 120

121 also move at 11.33% (since all variables are locked). This is where we have to make some assumptions. The average growth of total expenditures from 04 to 07 was 13.5% annually. This is very close to our 14% R&D expense growth rate. After calculating net income for a few rates between that range (multiplying EBIT by 1- the prevailing tax rate), we found that an initial total expense growth rate of 13.9% (within our range) that slowly declined at a constant rate of 11.33% in 2015 (equilibrium sales growth) yielded a forecasted series of net incomes that moved exactly as predicted by our theoretical standardized profit margin model. Our predictions for equilibrium profit margin where surprisingly accurate (given we have the liberty to move within the half percentile range of 14 to 13.5%). As predicted, as sales growth reached its 11.33% equilibrium in 2015, net profit margin rested at %. The transition between real and forecasted numbers was smooth in every line item on the income statement. Balance Sheet After deriving net income, we used a constant 18 % dividend as a percentage of net income ratio to calculate dividends paid. This rate is consistent with reported data from the last few years. We then calculated total equity as TEt-1+(Nit-DIVt)=TEt. Because of changes in accumulated comprehensive loss/income, there was a 52 thousand dollar difference between reported TE and RE in This difference makes up less than 2/5 of a percentile of TE. To simplify our forecast and maintain internal consistency during valuation, we placed RE=TE for the duration of the forecast. An important consideration when forecasting the balance sheet is to make sure that asset growth is supported by sales. Ratios like asset turnover are relatively stable and provide a way of determining the amount of assets needed to obtain the desired amount of sales in the following year. Medtronic s asset turnover is stable at around.7. All forecasted numbers requiring a lag, like asset turnover, should be consistent as they transition from reported to forecasted numbers. Asset turnover in 08 (using forecasted 121

122 revenue and 10-k reported total assets) was.706. We used the.7 S/TA ratio to forecast total assets. Total liabilities are simply the difference between TA and TE. To predict our level of receivables for a given year, we used the average A/R turnover rate of 4.5. This is the best way to measure receivables since it matches our sales growth changes with their equivalent quantity of receivables. To calculate PP&E we used the average percentage of total assets from 02 to 07, 11.6%. We don t believe that a foreseeable change in capital structure will affect this rate. It was used for the duration of the forecast. Cash Flow Cash flow from operations was derived from the CFFO/Revenue rate, previously determined to be 24%. The adjustment to forecast free cash flows (cash used in investing activities) was calculated as the annual change in PP&E. Common size financials The balance sheet was standardized as a percentage of total assets. The income statement and statement of cash flows were standardized as a percentage of revenue and net earnings, respectively. Restatements after adjustment In previous sections we outlined several accounting adjustments used to compensate for possible distortions. Impairment of goodwill, amortization of intangibles, assessment of legal contingencies, and capitalization of R&D expense were all areas covered in that section. Out of these, the adjustment with the largest effect on earnings that could be continually projected and had the least amount of subjectivity 122

123 was capitalization of R&D. Instead of going through the tedious process of assessing the effect of such an adjustment on a comprehensive basis, we feel that showing the net effect on earnings is the most applicable and relevant for our purposes here. We have added a line item after net income that shows the effect of R&D on earnings. As detailed in the previous accounting analysis section, the net effect of our adjustment will be a 14% increase in net income (since we assume a constant growth rate for R&D expenditures). Conclusion An in depth analysis of this forecast will have to wait until we have implemented the various valuation models. Some things of importance should be noted. Two important ratios that we did not directly forecast were ROA and ROE. We don t feel it is wise to base a forecast primarily on those measures for the same reason it is not good to forecast from return on sales. But, once the forecast is done we can look at what these rates imply. ROA from 03 to 07 was at 14.5% on average. Our forecast implies a drop in ROA to 11% by This is a 3.5% drop from the average and a 1.8% drop from the reported low in 05 of 12.8%. ROE ranged from 20% to 30% over the course of 03 to 07. Our forecast shows Medtronic s ROE decreasing quickly at first, and then slowing down and stabilizing at around 14.32%. This is interesting since our upper bound cost of equity was found to be 14.42% (though we have reason to believe the more accurate measure is 12.11%). This could be coincidence or it could be equilibrium. We hope to be able to answer that question soon. 123

124 Cost of Capital Estimation Cost of Equity & Regression Analysis The cost of equity of a company is possibly the most important analysts number for the firm. It measures the risk, and therefore the potential reward for investors. To find cost of equity, we assume CAPM. Doing so makes a lot of assumptions; however it is a well tested way of comparing firms, if done correctly. In this formula, we use the beta (the risk of the individual firm), the market risk premium, and the risk free rate. In this analysis, we assumed the 2 year risk free rate, and also assumed an interest rate on 80% of short term debt. If this is incorrect, the difference would be somewhat significant; however, we feel it is an educated guess, educated enough to confidently estimate the following analysis on. We performed a different regression for the treasury yield along different time periods of 24, 36, 48, 60, and 72 months in order to test beta variance with 72 observations. As expected, the longer term regression yielded the highest beta with the highest Adjusted R2, or level of explanatory power of the beta. When choosing which beta to use, the only logical one was to use the only yield that had a positive explanatory power at all. This gives us a beta of This is at least close to the published beta of Medtronic, which is.22. This can give us some level of confidence. What is extremely troubling however is that this beta, even given with the best explanatory power is not very good. Adjusted R squared is at its highest at 3.62 %. This takes away all the confidence we gain by being close to the published beta. What it really means is that there is no good way to find beta, at least though CAPM for Medtronic. 124

125 BETA ADJ R2 T STAT P-VALUE significance Regression Statistics Multiple R R Square Adjusted R Square Standard Error cost of debt 2007 Maturity by fiscal year Payable* Average Interest rate weight in % weighted rate Current Liabilities bank borrowings % commercial paper % current portion of capital lease obligations % Accounts payable % Accrued compensation % Accrued income taxes % Other accrued expenses % TOTAL CL Long-Term Liabilities Contingent convertible debentures % senior convertible notes % senior notes % senior convertible notes % senior notes % Other % Long-term accrued compensation % Other long-term liabilities % TOTAL LTL TOTAL LIABILITIES 8535 *Numbers are in millions ** Data Gathered from Medtronic s 10-K Total Kd= 4.56% 125

126 The cost of debt for a company is the price they pay for money, or in other words, the interest rate they pay to borrow money as it pertains to their risk. Medtronic had a wide variety of interest rate difference as well as a few time period differences, ranging from.83% to 5.38% and from , respectively. The total debt owed by Medtronic was just over 8.5 billion. After the weighted average approach, we concluded the cost of debt for Medtronic to be 4.559%. Weighted Average Cost of Capital The weighted average cost of capital formula measures both the cost of equity and the cost of debt, and while putting them into perspective relative to the overall financial assets. The two different types of WACC is before tax and after tax calculations. We found before tax to be roughly 11% and after tax to be roughly 8.8%. In many ways companies are encouraged to finance through debt. It is debatable which one gives a more accurate statement of the firm and its position in the market. However, even though taxes do not reflect business dealings, it is important to note that companies pay close attention to what tax breaks they are going to be getting, which does affect the company decisions. WACC Before Tax (MVE/MVA)*ke+(MVL/MVA)*Kd 11.01% WACC After Tax (MVE/MVA)*ke+(MVL/MVA)*Kd(1-tax rate) 10.89% 126

127 Analysis of Valuation Method of Comparables Method of comparables is a way of calculating a share price estimation from the industry average of the same ratio. The industry average was calculated from Medtronic s competitors. Using these averages, there were eight ratios calculated, both before revisions and after revisions. Also, there are corresponding estimated share prices for each ratio, before and after revision. By looking at these ratios, investors can determine if the firm is over or under valued. Fairly valued is understood to be +/- 20%. Forward P/E P/E Industry Average Estimated Share Price Medtronic (BR) $49.50 Medtronic (AR) $56.10 Johnson&Johnson St. Jude Zimmer Boston Sc To calculate the forward P/E, we took all numbers (minus the revised Medtronic s numbers) from yahoofinance.com. When we did this, the industry average came out to 17. We then multiplied 17 and the expected earnings found on our forecasts. This gave us a before revision share price of $49.50, and an after revision estimated price of $56.10, both of which are in the fairly valued range. 127

128 P/E (Trailing) Price earnings P/E Industry Average P/EPS MDT Share Price Medtronic (BR) $44.71 Medtronic (AR) $48.12 Johnson&Johnson St Jude Zimmer Boston Sc The trailing P/E is calculated by dividing price by earnings of all the relevant competitors, dividing by the number of competitors to get a industry average of Then we multiply the industry average by the earnings of Medtronic to get an estimated share price. We found that before revision share price is estimated at $44.71, and an after revision basis share price of $ So this means that both the before revision and after revision share prices are fairly valued. P/B Ratio P/B Industry Average Estimated Share Price Medtronic (BR) $34.58 Medtronic (AR) $45.38 Johnson&Johnson 4.31 St Jude 5.30 Zimmer 3.35 Boston Sc

129 Price to book ratio before revising and for the competitors are taken from Using these numbers, we find an industry average of By setting this equal to Medtronic s P/B ratio, we find that an estimated share price before revising is $34.58, and after revising a share price of $ This means that while the revised share price is slightly within the fair value range, the share price before revision tells us the firm is overvalued. D/P Ratio D/P Industry Average Estimated price Medtronic.26%.63% $19.92 Johnson & Johnson.63% The dividend payout ratio isn t as effective in this industry because only two companies pay dividends; Johnson & Johnson and Medtronic. This means that the industry average to compare to Medtronic s is only on firm. However, since this is as accurate as possible, we found that with the industry average of 63%, and share price of $ As stated, this is very inaccurate, but it would say that Medtronic is overvalued. PEG Ratio published PEG computed PEG Industry Average Estimated Price Medtronic (BR) $42.50 Medtronic (AR) $69.70 Johnson&Johnson 1.99 St Jude 1.31 Zimmer 1.47 Boston Sc

130 The price earnings growth model, also known as the P.E.G. ratio, calculates the firms stock price by using the (P/E) ratio and dividing it by the expected earnings growth rate. The industry average of 1.78 is multiplied by the estimated growth rate for Medtronic of percent, and then multiplied by before and after revision earnings of 2.65 and 2.85 respectively. This gives us a estimated price of $42.50 before revision and $69.60 after revision. This tells us that while before revising, this ratio gives us a fairly valued estimation; once we revise we find that Medtronic is undervalued. P/EBITDA P/EBITDA Industry Average Estimated Share Price Medtronic (BR) $55.79 Medtronic (AR) $57.74 Johnson&Johnson 3.65 St Jude Zimmer Boston Sc 6.67 EBITDA means earnings before interest, taxes, depreciation, and amortization. By dividing current price per share by EBITDA for all competitors listed on Yahoo Finance, and industry average was found of Setting the industry average equal to Medtronic s P/EBITDA, we come to the conclusion on a share price of $55.79 before revisions and $57.74 after revision. Both before and after are fairly valued. 130

131 EV/EBITDA EV/EBIDTA Industry Average Estimated Share Price Medtronic (BR) $41.62 Medtronic (AR) $48.27 Johnson St Jude Zimmer Boston Sc Enterprise Value is market value of equity value of liabilities minus cash and investments. So basically, it is core underlying productive assets. So to find this ratio, we get the average of the industry for EV/EBITDA, and we multiply it by Medtronic s EBITDA. From there, we subtract liabilities and add back cash and investments, which will give us MVE. Doing this, we found that before revising, share price is estimated at $ After revising the estimated share price is of $ This means that both revised and unrevised are fairly valued. Conclusion After revisions, Medtronic seems to be fairly valued after revisions in all methods of comparables except for the P.E.G ratio. For the P.E.G. ratio, Medtronic is undervalued. The revisions, to the best of our ability, are accurate, so the revised numbers are the ones to be trusted rather than the published numbers. 131

132 Intrinsic Valuations Intrinsic valuations, which are based on theory, are more accurate and reliable valuation when compared to the method of comparables. The five models that we used to value Medtronic is the Dividend Discount Model, the Free Cash Flow Model, The Residual Income Model, the Long Run Residual Income Perpetuity Model, and the Abnormal Earnings Growth Model. After evaluating the results of each model, we hope to accurately value the equity of Medtronic. Dividend Discount Model Our first valuation model is the Dividend Discount Model. It values a firm by discounting back future forecasted dividends to our current time. This model is better than the method of comparables since we use expected dividends that are discounted back. However, that is a problem in itself. This model assumes companies will last forever, which we all know is false, because at any time a company can go bankrupt or be taken over by another firm. The present value of dividends were determined by the following formula: PV Factor = 1/(1+Ke)^( Number of years from P0) Once this formula was calculated, we totaled all of the PV factors for 10 years to give us the total present value of projected dividends which was $3.54. Next, we had to calculate the continuing terminal value perpetuity by using the following formula: Continuous Terminal Value Perpetuity = Yr 10 Projected Dividend/ (Ke g).93/( ) 132

133 We then multiplied that perpetuity by the PV factor for yr 10 to get the present value of the perpetuity of $14. Summing the PV of the perpetuity and the PV of all projected dividends, we arrive at an estimated share price of $ We conclude from this model that Medtronic is overvalued. We performed a sensitivity analysis and the results are displayed below: ke / g 0% 2% 4% 6% 8% 6% % % % % % % Actual Share Price(4/1/08) = Residual Income Model The Residual Income Model is the best valuation method, because of its low sensitivity compared to that of the Dividend Discount Method and Free Cash Flow model. It relies less on estimated cost of equity and growth rates, so the valuation will not be significantly affected if there are errors in the forecast. The model estimates firm s share price by using this information: book value of equity, forecasted earnings, forecasted dividends, cost of equity, and the growth rate of residual income. The Residual Income Model takes the present value of forecasted residual income and discounts it back to the current time period to arrive at an estimated price. The forecasted residual income is computed by using the benchmark for book value of equity, which is previous year s book value of equity multiplied by cost of equity, and then subtracts that number from that same year s earnings. The resulting number is our forecasted Residual Income. We then calculated the terminal value perpetuity. It is derived by taking the Residual Income of year 1 and dividing it by the cost of equity 133

134 minus the growth rate. Taking this number multiplied by the PV factor of year 10 and we end up with the present value of the perpetuity. Our calculations are as follows: Continuous Terminal Value Perpetuity = RI 10/ (Ke growth rate) $7, = $890.07/ ( ) PV of the terminal perpetuity = Cont. TV perpetuity * PV Factor 9 $2, = $7, *.3571 The present value of the terminal perpetuity and the present value of residual income were then added to the current book value of equity(4/1/08) to achieve an estimated Market value of equity which, when divided by the number of shares, gave us a share price of $ This estimated share price indicates, by this model, that we are highly overvalued. A sensitivity analysis was performed and the results are indicated below. ke/g 0% -10% -20% -30% -40% -50% 8% % % % % % % % % Actual Share Price(4/1/08) = As you can see from the above analysis, the share price really doesn t fluctuate that much with a change in cost of equity or growth rates. This is the reason that the Residual Income model is so highly favored and the most accurate of any model. 134

135 Long Run Residual Income Model The long run residual income model is a quick an easy way to evaluate a firm and get a general valuation idea without spending too much time. This model uses four different variables in calculating estimated market value of firm: average return on equity for the past 5 years, long run equity growth rates, book value of equity, and a firm s cost of equity. This model is computed by using the following formula: Market Value of Equity = Book Value of Equity *(1+(ROE-Ke)/(Ke-g)) 22, = $10,977 *(1+( )/( )) Estimated market value of equity is roughly 22.6 billion dollars. Taking this number and dividing by the approximately 1.1 billion shares we estimate Medtronic s share price to be $ As you can see this is considerably lower than the current observed share price of $48.46 indicating Medtronic is overvalued. Sensitivity analysis comparing the effects of different values of ROE, growth rate, and Ke are covered below. 135

136 ke/g 0% 2% 4% 6% 8% 10% 8% % % % ROE= % % % % % Actual Share Price(4/1/08) = ke/roe g=0% Actual Share Price(4/1/08) = g/roe Ke= Actual Share Price(4/1/08) = Overvalued < Fairly Value +/ Undervalued >

137 The Abnormal Earnings Growth Model (AEG) The AEG model s goal is to make an intrinsic assessment of the market value of equity by comparing the total wealth effect to shareholders with a benchmark return. The total wealth effect is not simply the earnings in the year being referenced, the model assume that a portion of the previous year s dividends will be reinvested in the company. Earnings on reinvested dividends (DRIP) is equal to the previous year s dividends times the cost of equity. Drip plus NI gives us cumulative dividend earnings. The benchmark earnings is equal to NIt-1 times 1 plus cost of equity. One of the benefits of AEG is the lack of sensitivity to growth assumptions. Generally speaking, it has one of the highest R squared values, second only to the Residual Income model. These two features make it a relatively successful model. In reality, stocks often go up and down because of differences between expectations and actual returns. A company expected to grow at 15% that returns growth of 10% will see a decrease in market value, while a company expecting a 5% increase and returning at 10% will see a rise in stock prices. This relationship between benchmark and real return underlines the theoretical and practical soundness of the AEG model. As was expected, AEG was one of our best performing models (very close to estimates of the residual income models). Using our assumptions, a 12.12% cost of equity and a -7% perpetuity growth rate, we came out with an intrinsic time consistent share price of $ While this was less than half of the reported price of $48.46, its estimate was consistent with our other findings (in other higher performing models). Through sensitivity analysis we discovered that the perpetuity growth rate had little effect on our model. At our estimated cost of equity, changing the growth rate from 0% to -40% only changed our share price by $17.5. Changes in cost of equity had a more significant role. Taking growth out of the equation, if Medtronic could decrease their cost of equity to 9% they would be able to raise their intrinsic share price to nearly $45. This decrease in cost of equity increases the spread between cumulative dividend 137

138 earnings and benchmark, resulting in an increase in AEG and, consequently, market value. Still, AEG analysis conclusively reports that Medtronic is overvalued. ke/g 0% -10% -20% -30% -40% 9% % % % % % % Actual Share Price(4/1/08) = Free Cashflows The free cash flow model is based on the assumption that the present value of future free cash flows (CFFO-CFFI) is roughly equivalent to the market value of assets. The idea is that by subtracting the book value of liabilities (equivalent to the market value due to mark to market accounting standards) from the present value of free cash flows, you can estimate the intrinsic market value of equity. Free cash flows are discounted using WACC. The WACC is used instead of the cost of equity, Ke, because both debt and equity holders contribute to the value of assets. This model is often criticized because of its intense sensitivity to assumptions. A small change in growth rate yields a massive change in the present value of the terminal perpetuity. Because of this sensitivity, assumptions must be very accurate or the model will be skewed. For Medtronic, we found the free cash flow model predicted an intrinsic share price of $ This is so far from the actual market price that we doubt that 138

139 interpreting the model has any real significance. Our WACCbt was (Before tax WACC is used to avoid double taxation) and we assumed a growth rate of 10%. This growth rate is so critical that changing the assumption has unpredictable exponential effects. The magnitude of the growth rates effect increases as it moves towards the WACC. Sensitivity analysis shows that at our current WACC a growth rate of 9% gives a share price of about $6.8. Increasing growth to 10% gives our reported share price of $12.85, while an additional 1% increase, to 11%, gives a price of over $875. Even though this model does predict that Medtronic is overvalued, we feel that this model should only contribute a small fraction to our final assessment. WACC/g 8.50% 9.00% 9.50% 10.00% 10.50% 10.70% % % % % % % Actual Share Price(4/1/08) =

140 Analysts Recommendation After comparing results from a wide range of sources including multiple based valuations and intrinsic model valuations, the initial conclusion was somewhat mixed. Multiple based valuation, overall, rated Medtronic as a fairly valued company. The results from intrinsic valuation models were quite different. Even our best performing models (the RI models and AEG) found Medtronic as overvalued. One consequence of multiples based valuation is the risk of evaluating your firm against and over/undervalued industry. Because of this fact, we feel that the intrinsic models better represent the value of the firm. We still will give some weight to the results of our multiples based models in our final valuation. We believe that Medtronic is Slightly Overvalued. 140

141 Appendix Sales Manipulation Diagnostic Ratios medtronic net sales cash from sales change in AR AR inventories unearned revenues NA NA NA NA NA warranty liabilities boston sc. corp. net sales cash from sales change in AR AR inventories unearned revenues NA NA NA NA NA warranty liabilities N/A N/A J&J net sales cash from sales change in AR AR inventories unearned revenues NA NA NA NA NA warranty liabilities NA NA NA NA NA St Jude medical inc. net sales cash from sales change in AR AR inventories unearned revenues NA NA NA NA NA warranty liabilities Zimmer holding net sales cash from sales change in AR AR inventories unearned revenues NA NA NA NA NA warranty liabilities NA NA NA NA NA 141

142 Core Expense Manipulation Diagnostic Ratios Medtronic Asset Turnover Change in CFFO/change in OI Change in CFFO/Change in NOA Boston Scientific. Corp Asset Turnover Change in CFFO/change in OI Change in CFFO/Change in NOA Johnson&Johnson Asset Turnover Change in CFFO/change in OI Change in CFFO/Change in NOA St Jude medical inc Asset Turnover Change in CFFO/change in OI Change in CFFO/Change in NOA Zimmer holding Asset Turnover Change in CFFO/change in OI Change in CFFO/Change in NOA Effect of R&D on Net income Table 142

143 R & D expense Span of amortization Calculated as 10.55% of R&D expense After Tax effect Calculated with tax rate used by 10-K

144 Total Expenses Effect on EBIT (+) Tax rate per year After Tax Effect (NI) Reported Earnings Restated Earnings % change in earnings % % % % % % Cumulative Asset balance

145 Income Statements Actual and Forecast 145

146 Balance Sheets Actual and Forecast 146

147 Statement of Cash Flows Actual and Forecast 147

148 Common size Statements 148

149 149

150 150

151 Balance Sheet after Adjustments 151

152 Income Statement after Adjustments 152

153 Regression Summaries SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 72 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0% Intercept X Variable

154 SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 60 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0% Intercept X Variable

155 SUMMARY OUTPUT Regression Statistics Multiple R R Square E-06 Adjusted R Square Standard Error Observations 48 ANOVA df SS MS F Significance F Regression E E Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0% Intercept X Variable

156 SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0% Intercept X Variable

157 SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 24 ANOVA df SS MS F Significance F Regression Residual Total Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95,0% Upper 95,0% Intercept X Variable Beta Summary Table observations BETA ADJ R2 T STAT P-VALUE significance

158 Weighted Average Cost of Debt Table 158

159 Weighted Cost of Capital Table 2007 Market Value of Equity Market Value of Asset Market Value of Liabilities 8535 Cost of Equity Cost of Debt Tax Rate decimal WACC before tax (MVE/MVA)*ke+(MVL/MVA)*Kd % WACC after tax (MVE/MVA)*ke+(MVL/MVA)*Kd(1-t) % 159

160 Medtronic Ratios MEDTRONIC AVERAGE RATIOS LIQUIDITY Current Ratio Quick Asset Ratio A/R Turnover A/R Days Inventory Turnover Inventory Days Working Capital Turnover PROFITABILITY Gross Profit Margin Operating Expense Ratio Operating Profit Margin Net Profit Margin Asset Turnover Return on Assets Return on Equity CAPITAL STRUCTURE Debt to equity ratio Times interest earned interest expense/io Debt service margin retention ratio IGR Sustainable Growth rate D/E Structure Z-Score *(WC/TA) *(RE/TA) *(EBIT/TA) *(Market Cap/BVL) *(Sales/TA)

161 Liquidity Analysis Tables CURRENT RATIO AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Quick asset ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer A/R Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

162 A/R Days AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Inventory Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Days supply of inventory AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Working Capital Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

163 Profitability Analysis Tables Gross Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Operating Expense Ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Operating Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

164 Net Profit Margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Asset Turnover AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Return on Assets AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Return on Equity AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

165 Capital Structure Analysis Tables Debt to equity ratio AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Debt service margin AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific no short term debt no short term debt 0.74 no short term debt no short term debt Zimmer no short term debt no short term debt Times interest earned AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

166 IGR & SGR Table IGR AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Sustainable Growth rate AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer Credit Risk Z-Score AVERAGE MEDTRONIC J&J St Jude Medical Boston Scientific Zimmer

167 Free Cash Flow Models 167

168 Residual Income Models 168

169 Long Run ROE Residual Income Models 169

170 Abnormal Earnings Growth Models 170