Medtronic Plc. (NYSE: MDT)

Krause Fund Research Fall 2016 Healthcare Medtronic Plc. (NYSE: MDT) Recommendation: BUY November 12, 2016 Analysts Navya Mannengi srisainavya-mannengi@uiowa.edu Hannah Hendricks hannah-hendricks@uiowa.edu Company Overview Medtronic, headquartered in Dublin, Ireland, is among the world s largest medical technology, services, and solutions companies within the medical device industry. Medtronic strives to contribute to human welfare by the application of biomedical engineering in the research, design, manufacture, and sale of products to alleviate pain, restore health, and extend life. Medtronic has four operating segments: cardiac and vascular, minimally invasive therapies, restorative therapies, and diabetes. For the fiscal year ended 4/29/2016, total revenues rose 42% to 28,833 million; however, the high increase was due to Medtronic s completed acquisition of Covidien. i Stock Performance Highlights 52 week High $89.27 52 week Low $71.03 Beta Value 0.93 Average Daily Volume 4.9 M Share Highlights Market Capitalization 114.37B Shares Outstanding 1.41B Book Value per share $36.78 EPS 2.51 P/E Ratio 44.60 Dividend Yield 2% Dividend Payout Ratio 60% Price per share (as of 11/12/2016) $82.07 Current Price $82.07 Target Price $74.00 - $84.00 Opportunity found within aging demographic Increasing senior population will drive future health care spending; increased health care coverage correlates to higher insurance rates, and thus, more utilization of the Medtronic s products Due to the aging demographic, the future influx of chronic illness provides Medtronic the opportunity to take leading positions in medical device markets by producing new technology that the population needs and demands. On April 6, 2016, the FDA approved Medtronic s Micro, the smallest pacemaker available. With the latest generation of pacemakers available in the market, Medtronic will obtain market share in the cardiovascular devices market. On September 28 th, the FDA approved Medtronic s new automated insulin pump that is for patients with type-1 diabetes. With around 25% of the senior population suffering from type-1 diabetes, a new insulin pump will address their demands and bring Medtronic profits. Medtronic s leading presence in markets should drive growth and profit for the future. One Year Stock Performance Company Performance Highlights ROA 3.55% ROE 6.80% Sales 28.83 B Financial Ratios Current Ratio 2.89 Debt to Equity 0.60 Source: Yahoo Finance 1

Executive Summary Due to a beneficial macroeconomic outlook, an increase in demand of medical devices by the aging demographic, and Medtronic s ability to take strategic actions in the market, we are issuing a buy rating for Medtronic for the Krause Fund portfolio. We believe the aging demographic to be the key driver in Medtronic s performance; it creates a domino effect that provides major opportunities for Medtronic to obtain market leadership. Economic Outlook Our team identified the following four economic variables as most significant in affecting the health care sector: demographics, government changes, GDP growth and unemployment rate. Demographics As they age, the baby boomers will transform health care. In the year 2011, the baby boomer generation, the demographic born between the years 1946 and 1964, started to turn age 65. Between 2016 and 2050, the United States is expected to experience rapid growth in its older population due to the baby boomer generation reaching senior age of 65. By 2030, all of the members in the baby boomer generation will have moved into the senior population age group and by 2050, the population aged 65+ is estimated to reach 83.7 million, which is nearly double the population of 43.1 million in 2012 ii. As seen in the table below, approximately 21% of the United States population will be considered seniors, meaning that almost 1/5 of the population will have increasing health care demands ii. As a result, the aging population has larger social and economic implications that are of notable interest to policy makers and programs (Social Security and Medicare), the private sector, and the health care industry. The aging of the baby boomer generation presents the economy with both challenges and opportunity. The older an individual, the higher the heath care expenditures; this relationship is due to three factors: increase in chronic illness, medical costs associated with chronic illnesses, and long-term care necessitated by older age. Although the economy and government will be burdened with the increasing medical expenditures and government programs, such as Medicaid and Medicare, the aging population presents the health care sector a great opportunity. With an aging population, there needs to be additional healthcare resources and product innovation to manage the longterm care necessitated iii. As Medtronic is a medical devices company, the changing demographic provides the firm the opportunity to apply their biomedical skills in producing new, cutting-edge equipment that can help alleviate the pain and increase the quality of life of the increasing percentage of chronic illnesses that the older population will be facing in the future years. Government Changes The U.S.A Federal Government develops and enforces regulations that are legal for companies to adhere to; the government has the power to create and change regulations associated with health care that has severe complications if not followed. Depending on the regulation, it could drastically affect the operations of a business, resulting in either profit or loss. A recent regulation that changed health care was the ACA that was enforced during President Obama s term. As the following figure shows, the 2016 uninsured rate is at an all-time low of 11.9% for Americans 18 64, which is a significant decrease from 14.6% in 2008 iv. Source: Gallup-Healthways Well-Being Index Source: U.S. Census Bureau 2012 Due to the enactment of ACA, the current enrollment numbers are roughly 20 million total between the marketplace, Medicaid expansion, young adults staying 2

on their parent s plan, and other coverage provisions iv. The increased enrollment positively influences the health care sector and Medtronic since the more individuals insured, the more individuals that can utilize Medtronic s products. Additionally, the ACA issued Medicaid Expansion, which allows families to qualify for free or low-cost care Medicaid if a family of 4 is making $33,465. This expansion was issued in order to fill in the gaps in Medicaid eligibility for adults v. However, a Supreme Court ruling on ACA stated that states could opt out of Medicaid expansion. Currently, 31 states expanded their Medicaid eligibility, which added 15.7 million people to the program vi. The following figure showcases the current status of state Medicaid expansion decisions. republicans won t be able to repeal the law due to strenuous road congress has to take to change legislation, while others are saying that Trump is proposing ideas that similar to ACA viii. There is a high level of uncertainty and the future outlook of health care coverage is dependent on Trump s presidency. Although there is uncertainty surrounding the future of ACA, it is inevitable that the aging population has critical implications for future Medicare and Medicaid spending. GDP Gross Domestic Product (GDP) represents the total dollar value of all the goods and services produced. It is a primary indicator of the health of a country s economy. A healthy economy corresponds with a low unemployment rate, and a higher standard of living. In a healthy economy, the ideal rate is between 2% - 3%. The current GDP growth rate is 2.9%, which falls between the margins of the ideal rate. As seen in the figure below, it is forecasted that the GDP will decrease slightly, but will still remain between in the margins of the ideal GDP rate. Source: KKF.org Additionally, in January 2020, there will be a Cadillac Tax of 40% on insurance plans that exceed the cost of $10,200 for individuals and $27,500 for families in order to help finance the ACA. Ideally, the Cadillac tax will encourage employer s to reduce spending on high-cost plans. However, there could be unintended consequences: employers could pass costs to employees (e.g. higher employee premiums). There could be more cost sharing, and as a result, an underinsured workforce vii. However, the future of health care coverage looks uncertain due to the recent president election. On November 8 th, Donald Trump, a republican candidate, was elected president of the United States. With his presidency, there is risk that Americans on Medicaid could lose health coverage if Trump repeals the ACA, including the 15.7 million from Medicaid expansion. Trump proposes changing Medicaid form an entitlement program into a block grant program, which gives States more flexibility to run their Medicaid programs, or into per capita cap where states would be given a set amount of money per enrollee vi. However, both of the ideas have been met with severe resistance. There have been many speculations; some critics have stated that Source: trading economics Total Health Expenditure: The four components used for calculating the GDP are personal consumption expenditures, investment, new exports, and government expenditure. The government sponsors Medicare, a program that provides health care coverage to older people age 65 or older, and Medicaid, a program that provides health care coverage to poor people. It s more critical for the health care industry to be tracking the health care expenditure, as that is what correlates to higher insurance rates, and thus, more utilization of the health care sector s products. As showcased in the following graph, there has been an upward trend in health care expenditure as a percentage of GDP. Currently, the percentage of health care expenditure in GDP is 17.41% ix. Source: WorldBank 3

The total health expenditure is influenced by the increase in funding for government health care programs: Medicaid and Medicare. The aging US population signals an increase in the number of Americans who qualify for Medicare. Even with the uncertainty related to Trump and his actions against ACA, it is inevitable that Medicare expenditures will increase as Medicare is tied to age levels. Medicare will be more influenced by the change in demographics. Net Medicare spending is projected to increase from $527 billion in 2015 to $866 billion in 2024 v. According to the figure below, Medicare s share of the federal budget is projected to increase from 14.3% in 2015 to 15.2% in 2024, and Medicare spending as a share of GDP is projected to increase from 3.0% in 2015 to 3.3% in 2024 v. Source: KFF Medicaid spending is tied to income levels and the recent enactment of the Patient Protection and Affordable Care Act (ACA) in 2010. The following figure captures the story of the ACA. The increase in enrollment from the ACA in 2010 is showcased by the sharp uptake in total Medicaid spending in the following couple years. With Medicaid expansion in 2014, there was another sharp increase in enrollment and spending in 2015. Currently, the enrollment has slowed down to 3.3% and spending at 4.5%, although it is possible that more states will choose to opt into Medicaid Expansion in 2017 x. Source: KFF Due to the combination of ACA s coverage expansions, and aging population, health care spending is expected to grow 1.3% faster than GDP; as a result, total health expenditure as a part of GDP is projected to rise from the current rate of 17.41% to 20.1% by 2025 xi. An increase in Medicaid and Medicare spending will have a positive impact on Medtronic since Medtronic s product utilization is directly impacted by medical coverage. However, the federal government is faced with the enormous challenge of assuring that there is enough resources available in 30 years in 2050, when the elderly population is twice as big as it is today xii. It is unknown how well the federal government can support the 83.7 million seniors xiii. Unemployment The unemployment rate is of significant interest to patients, health care institutions, and policymakers as it is tied to health insurance and the demand of health care supplies. The correlation between unemployment rate and rate of preventative health utilization is significant: a 1% increase in state-level unemployment is associated with a 1.58% decrease in the quantity in the state-level preventive care services utilized xii. This relationship signals the health care industry, including Medtronic, to look out for periods of low unemployment rates in America. If unemployment is correlated to a decrease in preventative health utilization, then Medtronic will loss profits during periods of unemployment. Since Medtronic is a medical device company that manufactures technology to help in diagnostics, Medtronic depends on patients, hospitals and other health institutions to purchase medical equipment and supplies from them. Thus, although health care is generally considered a defensive sector, evidence indicates it sill suffers from decreased demand during recessionary periods. Additionally, there is a negative relationship between the unemployment rate and the probability of having health insurance. For adult males, a 1% increase in the unemployment rate results in 1.67% decrease in the probability of having health insurance xiv. Without health insurance, individuals will not be able to afford the new devices, and technology that Medtronic produces. The relationship between unemployment rate and health insurance affects one of the key drivers of Medtronic s performance: physician visits. Hospitals are one of the major purchasers and users of medical devices. There is a strong relationship between the total number of physician visits in a year and the need to purchase or replace medical equipment. As more individuals visit the physician, more medical supplies and devices that are needed to help treat the patients. It s important to note that higher the unemployment rate, the lower the insured individuals that will visit the hospital, and utilize 4

Medtronic s products. Therefore, it s important for the industry to keep a watch on the unemployment rates. The current unemployment rate is at 4.9%, and the following table forecasts the unemployment rate for fiscal years 2016 2020. Source: trading economics The slight increase in unemployment rate corresponds to the slight decrease in GDP, and increase in Medicaid spending since Medicaid spending is tied to income levels, as described in the previous sections. The Federal Reserve estimates that the natural rate of unemployment in a health economy is between 4.7% and 5.8%. Therefore, in the near future, unemployment should not interfere with the demand for medical device supplies or insurance since the unemployment rate is staying near the natural rate. Although it is important for Medtronic to be vigilant in observing the economic cycle and its recessionary periods, it s important to note that the unemployment rate only includes individuals that do not have a job, have actively look for work, and are currently available for work. Individuals who are out of the work force and are retired are not included. The aging population, who will all retire and be out of the work force within the next decade, provides the biggest opportunity for Medtronic. Thus, it s critical to track the trends following the aging population, such as GDP, and U.S. government health programs. Capital Markets Outlook Since the current and forecasted future unemployment rate will remain near the natural rate of unemployment, we believe it won t be a contributing factor to the performance of Medtronic. However, with Trump s plans for the ACA unknown, future enrollment could either increase or decrease. The uncertainty with government changes in Medicaid and Medicare is risky. However, as of today and in the near future, health care expenditure is projected to increase. We are optimistic that Trump will not be able to drastically decrease funding for government programs due to the long road in regulation changes in congress as well the consequence of political fallout. With the expectation of increasing healthcare, there is risk of pricing pressure. Medicare has a fee-for-service payment system where health care institutions are paid for every service they perform. As a result, there is increased spending in those institutions to drive profit. Currently, the national trend among hospitals is to form group purchasing organizations to enhance purchasing power against the medical equipment and supplies industry. However, Medtronic takes a strong precaution against pricing pressure by not depending on any single customer for more than 10% of total net sales 1. Therefore, we believe that pricing pressure is not a risk, and Medtronic can only benefit from the increase in health care spending. Future performance: With an aging population, increasing health care spending, and technological advances, it is estimated that the revenue for the medical equipment and supplies industry is expected to grow 2.9% annually xviii. Industry Analysis Industry Definition Medtronic is a part of the medical equipment and supplies industry, which is a constituent of the healthcare sector. The medical equipment and supplies industry primarily researches, develops, and produces non-electronic medical, surgical, dental, and veterinary instruments and apparatuses. The FDA defines a medical device as "an instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent or other similar article that is intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease" xv. Medical devices are divided into two categories: conventional devices and high technologically advanced products. Conventional products are easy to produce, and are utilized for a variety of medical purposes. Conventional products consist of kits, trays, gloves, gowns, syringes, anesthesia items, surgical apparel, and other disposables and intravenous products. Due to mass manufacturing, conventional products yield narrow margins. Consequently, companies who produce conventional products have to depend on high sales volume to make a profit; typically, conventional supplies are sold in large volumes to health care providers. To be successful in the sale of conventional products, companies have to maintain long-term contracts with large-scale institutional health care products. The benefit of selling conventional products is the steady cash flow; usually, the profits help companies invest in research and development for high-tech products xv. Compared to conventional products, high-technology products provide the company a competitive advantage. These products depend on cutting edge research and 5

development to address specific health care applications. The highly specific application is what can give the company an advantage in the market. If the products showcase utility and face limited competition, the hightech products can charge a premium; companies profit from the high margins on high-tech products until competitors produce a more high-tech product to replace it xv. Examples of high-technology products include implantable cardiovascular devices such as pacemakers, advanced wound care management, IVD tests, and surgical instruments xv. Industry Trends The figure below illustrates the health care equipment and supplies stock performance. For the past five years, the health care equipment and supplies industry underperformed compared to the health care sector, however, the industry beat the S&P 1500. More specifically, the industry had a return of 77.8%, compared to the 60% S&P 1500 and 15.7% for the health care equipment and supplies xv. lease one chronic disease (heart, cancer, stroke, and diabetes). Source: CDC, National Center for Health Statistics In U.S. population aged 65 years and older, around 40% were found obese in 2009-2012 and more than 25% have type-1 diabetes xvii. The following figure showcases the limitation of activity caused by chronic health condition. Source: U.S Census Bureau Source: S&P Global Market Intelligence In this industry, innovation is what gives companies a competitive advantage. Typically, the highest returns come from small and mid-cap companies, as they are the driving force behind innovation. Usually, when small and mid-cap companies develop cutting-edge products, larger companies, such as Medtronic, acquire them. Recent Developments and Market Trends: Chronic Illness in the Aging Demographic Chronic illness, disease, and disorder increase with age, which consequently increases demand for medical equipment and treatment. As seen in the figure below, heart disease and cancer are the leading causes of death among U.S adults aged 65 or older in 2007-2009. Other chronic illnesses such as stroke, respiratory diseases, Alzheimer s disease, and diabetes also contribute to death among adults xvi. According to the National Council on Aging, approximately 92% of the elderly have at The CDC notes that people living with disease experience a long period of decline and disability as a result. Therefore, the need for caregiving within their home will increase tremendously as the population increases in age. The aging of the baby boomer generation shifts healthcare needs. Growing markets With roughly 20% of the population being 65 years or older by 2030, there will be an influx of disease, providing the medical equipment and supplies industry an opportunity to meet the health challenges of the aging population. The industry s segments include cardiovascular, dental, disposable equipment and supplies, general equipment and supplies, in vitro diagnostics, life science tools and services, neurovascular, ophthalmic goods, orthopedic implants and prosthetics, and patient monitoring equipment and therapies xviii. However, to stay competitive, current technology has to advance to match the current the demand for devices; 6

with the aging demographic, there is growth opportunity found in cardiovascular devices, irradiation devices, neuromodulation and spinal devices, diabetes treatment, and in-home healthcare. The following figure showcases the product and services segmentation in addition to the percentage share of the available market, respectively. Source: NetAdvantage Source: IBISWorld Markets and Competition Competitive Landscape and Major Players Currently, the medical equipment and supplies has a market capitalization of $640.08B. Medtronic competes in the therapeutic and diagnostic markets in approximately 160 countries around the world. The industry is characterized by rapid change from technological advances and scientific discovers that happen in the medical field xviii. Listed below are Medtronic s primary competitors based on their business segment i. 1. Cardiac and Vascular Group: St. Jude Medical, Boston Scientific Corporation, Sorin Group, Edwards Lifesciences Corporation, C.R. Bard Inc, and Abbott Laboratories. 2. Minimally Invasive Therapies Group: Johnson & Johnson, Boston Scientific, Baxter International Inc., and Bard. 3. Restorative Therapies Group: Johnson & Johnson, Boston Scientific, St. Jude, Stryker Corporation, NuVasive, and Zimmer Holdings. 4. Diabetes Group: Johnson & Johnson, DexCom, Tandem Diabetes Care, Insulet Corporation, and F. Hoffmann-La Roche Ltd. The current P/E ratio in the medical equipment and supplies industry is 27.3 xix. The peer group evaluation showcases that Medtronic s P/E ratio is higher than the industry, but falls behind two of its competitors, Bard and St. Jude. This suggests that Medtronic is expecting higher earnings in the future since it is valued more than the industry s P/E ratio, but may face competitive pressures from its peers. Porter s Five Forces Analysis Threat of Competition: HIGH As patients demand the best treatment, and hospitals only purchase the latest technology, it is of paramount importance that companies produce medical devices that are superior to others. Thus, the industry is characterized by rapid change as companies constantly strive to improve existing products and introduce new products through technological advances and scientific discoveries. With the increasingly aging demographic and chronic illnesses, companies are under pressure to innovate, or obtain market leadership of devices that can treat age-related conditions. As a result, the drive to produce the first and the best solutions to current health issues creates a highly competitive climate. Threat of New Entrants: LOW The industry had to strictly adhere to the many regulations formed by the FDA. On top of that, the APA has a 2.3% excise fee on the sale of medical devices; large-cap companies produce enough profit for the fee to not deter them; however, the sales tax is significant for incoming entrants and small-cap players. Additionally, since the market rewards companies with new products, many companies have patents to protect their technology. Heavy regulation, high investment costs, and a high level of competition result in new entrants having to invest a significant amount in R&D in order to enter the market. Thus, just the sheer cost of regulation and product development will deter new entrants. Threat of Substitutes: MODERATE Conventional devices are general and can be easily replaced by companies cutting costs. In contrast, hightechnology products are highly specific and are protected by patents. However, large-cap companies who have the resources can purchase a small-cap company with innovative ideas or invest in R&D to produce a more effective and advanced product that can substitute an older version of the product. Additionally, at some point, the market will become so statured with products that it is it hard to maintain a competitive advantage. Bargaining Power of Suppliers: LOW Conventional products are mass-produced. With mass production, there is economies of scale which allows 7

companies to spread their fixed costs among several products; as a result, companies can maintain negotiating power, which lowers the power of suppliers. Bargaining Power of Buyers: MODERATE To benefit from conventional devices, companies have to have long-term contracts with their buyers. The buyers have more leverage in this situation as there are more companies fighting to build relationships than buyers. Therefore, the buyers have some say in the pricing of the products. However, due to government healthcare cost containment efforts, there might be more stringent requirements for device reimbursement, which will drive hospitals to demand lower pricing i. Catalysts for Growth and Change Research and Development Constant improvement to existing products and introduction of new products is necessary for companies to remain competitive in the market that it operates. However, Ernst & Young cautioned high R&D expenses could just indicate a need to spend more money to keep up to pace on the current levels of growth, and not high innovation levels xv. Consolidation and Globalization The high demand for product innovation and up to date technology has led to the increasing merger and acquisition activity in the medical equipment and supply industry. The increasingly higher costs for developing new technology in a short amount of time has encouraged large-cap companies, including Medtronic, to acquire immerging small-cap companies that are producing new technologies. With the increase in competition, taxes, and regulations, outsourcing is attractive for major players in the industry. Over the past five years, the industry has become more globalized, particularly in emerging markets such as China, India, Latin America, and the Middle East where the GDP is rising xv. Key Investment Positives and Negatives Positives Aging demographics o The elderly make up a large share of patients who need medical equipment and supplies; the aging demographic corresponds with the increase in demand for medical devices. With the increasing incidences of chronic illness in age, there is demand for specialized equipment to match the current needs of the population. o The aging population also increased Medicare spending, which provides more coverage to patients Opportunity found in growing markets o With Medtronic having business segments in cardio, spinal, neuro, and diabetes, there is a big opportunity to gain market share if they produce the most advanced technology in those markets. Effects of legislation o The recent US healthcare reform, Affordable Care Act, expanded Medicaid coverage to more patients; as a result, more people will have access to healthcare, driving demand for medical services and devices Globalization o Access to global markets gives access to unpenetrated markets, unlike the USA. Negatives Effects of legislation o The US government dictates strict health regulations in health care. As Medtronic is a medical devices company, their products are subject to numerous regulations by the U.S FDA and similar agencies outside the U.S. The FDA requires Medtronic to comply with regulations that govern the development, manufacturing, labeling, marketing, and distribution of their products. Additionally, since Medtronic deals with patients, the company is also subject to patient privacy laws, cost containment initiatives, and environment health and safety laws and regulations. It s critical for Medtronic to follow regulations; otherwise, Medtronic is subject to severe criminal and civil penalties. o The FDA changed its 510(k) product approval process to be more stringent, which restrain innovation for high-tech products. Company Analysis Company Overview Medtronic, Inc. (MDT) is among the world s largest medical technology, services, and solutions companies within the medical device industry. It is currently headquartered in Dublin, Ireland. Medtronic was founded in 1947 and has grown to serve hospitals, physicians, clinicians, patients, distributors, and other institutions (such as governmental health care programs and group purchasing organizations) in approximately 160 countries worldwide i. Over the years, Medtronic has pioneered advances in technology for various medical concerns, making it a market leader. They are committed to innovating, developing, and acquiring new products and solutions through two primary strategies: therapy innovation, globalization, and economy value. 8

Products and Markets Medtronic has four operating segments that primarily manufacture and sell device-based medical therapies: cardiac and vascular group, minimally invasive therapies group, restorative therapies group, and diabetes group. Currently, technology has to match the current demand for devices. Because of the leading causes of chronic death and illness in the aging population, importance is placed on the cardiovascular devices, irradiation devices, neuromodulation and spinal devices, diabetes treatment, and in-home healthcare. Medical devices have to be cutting-edge technology and have to closely match patient s needs to take a lead xv. Currently, about 30% of patients with heart failure could benefit from CRT-defibrillators xv. Medtronic has the latest generation of CRT-Ds and even has the first Implantable Cardioverter Defibrillators (ICD) system with a CE Mark, which is used for MRI scans. Additionally, Medtronic has the first detachable tip micro-catheter in the restorative therapies group. By being the first to introduce new products in a growing market, Medtronic addressed unmet patient needs with updated high-tech technology. Recent News As stated before, the markets that Medtronic belongs to has rapid technological advances. Companies are always at the risk for being replaced by more superior products in the market. Thus, it s critical to constantly watch the market and analyze the current news. Recently, Medtronic has produced superior products: On April 6, 2016, the FDA approved Medtronic s Micro, the smallest pacemaker available. With the latest generation of pacemakers available in the market 1, Medtronic will obtain market share in the cardiovascular devices market. On September 28 th, the FDA approved Medtronic s new automated insulin pump that is for patients with type-1 diabetes i. With around 25% of the senior population suffering from type-1 diabetes, a new insulin pump will address their demands and bring Medtronic profits. Medtronic s leading presence in markets should drive growth and profit for the future. Corporate Strategy Medtronic s strategy is to provide a broad range of therapies using a wide variety of technologies. To obtain strong market leadership, Medtronic has to keep up with the rapid pace of technological development and the all the discoveries that lead to specialized equipment. With the highly competitive nature of the medical equipment and supply industry, it is near impossible for Medtronic to develop a broad range of therapies by itself. Therefore, Medtronic relies and will expect to rely on acquisitions to obtain ownership of new technologies that are superior in the market. Recent Acquisition: On January 26, 2015, Medtronic acquired Covidien, an Irish global leader in the development, manufacture and sale of healthcare products for use in clinical and home settings for $50.0 billion. The majority of Covidien s operations were included in the Minimally Invasive Therapies. As stated in the previous section, the need for caregiving within their home will increase tremendously as the population increases to age xvi. Covidien s products were created for in home setting, which means that Medtronic is keeping in pace with the current demand of the aging population. Additionally, the Minimally Invasive Therapy segment contributes approximately 33% of Medtronic s total sales. Also, with the acquisition of Covidien, Medtronic s headquarters transferred to Ireland. The change in headquarters to Ireland presents cost benefits in tax savings due to the lower tax rates in Ireland. Those three factors contribute to the expected success of the acquisition, allowing Medtronic to obtain marketing leadership and remain competitive in the market. Production and Distribution Medtronic sells most of it s medical devices through direct sales representatives in the U.S. Medtronic s marketing and sales plan is focused on organizing marketing and sales team around physical specialties. As a result, Medtronic can develop knowledge and trends for the future, which will help it stay competitive. Outside the U.S, Medtronic s largest markets are Western Europe and Japan because they are emerging markets that are unpenetrated, unlike the markets in the USA. Weighing the risk factors Aging demographic: key benefit Due to the baby boomer s reaching retirement age, approximately 21% of the whole United States population will be considered seniors by 2030. As chronic illnesses increase in the senior population, so does the demand for medical devices; the future influx of chronic illness provides Medtronic the opportunity to take leading positions in growing medical device markets by producing new technology that the population needs and demands. Thus, the aging demographic drives government healthcare program spending which increases medical coverage; as a result, more people can afford to go to health care institutions, which increases the utilization for Medtronic s products. 9

Merger and Acquisitions: benefit Medtronic relies on Merger and acquisition to acquire new technologies advances in the market. M&A activity does not produce as much organic growth as R&D, which Medtronic spends less on compared to its peers. Mergers and acquisitions of medical technology companies are risky since there is no assurance that it will be successful in the future; however, Medtronic makes a strategic choice to acquire companies that can stimulate new technologies and market growth, such as Covidien. The change in headquarters to Ireland also presents Medtronic tax benefits. We are confident in Medtronic s ability to make strategic choices, as they have been successful in the past. Patents and Licenses: risk Medtronic is substantially dependency on patents to protect their technology; the dependency gives them enormous risk as their industry is characterized by extensive patent litigation. Litigation results in significant damage, and can hurt their margins. Their management notes states that they intend to defend any threats, but cannot be sure that they will be successful. Therefore, we are not confident that Medtronic can protect their intellectual property. Environmental laws: risk Medtronic is subject to many environment laws and regulations and as result, subject to many expensive fines. Although there are many risks present, we believe that the benefits surpass the risks. We are confident in Medtronic s ability to fight competition and take profitable actions, as seen in Medtronic s leading presence in the cardiovascular device market, strategic acquisition of Covidien, and production of latest generation medical devices. With the aging demographic providing future opportunities to take market leadership, we are confident in giving a buy recommendation to Medtronic. Valuation Analysis Our group has issued a buy recommendation for Medtronic. We believe that the outlook for Medtronic is largely positive in the face of the increasing prevalence of chronic conditions within the aging population. Medtronic has also continued to increase its business offerings in auxiliary specialties such as orthopedics, which helps boost growth as they enter new markets. The firm s R&D expenditures are approximately 8% of net sales, which is moderate compared to it peers. Additionally, Medtronic s heavy dependence on mergers and acquisitions does add value; however, this value is not as sustainable as organic growth via R&D expenditures. Revenue Growth When projecting the overall for growth for Medtronic s operations, we first examined the long-term industry growth rate. The healthcare supply and equipment industry is expected to maintain a 2.9% growth rate until 2022. An ageing population, the increasing proportion of GDP spent on healthcare, and the need for technologically innovative products all contribute to this sustained high level of growth. Cardiac medical devices are expected to grow at a CAGR of 2% while cardiac rhythm management products have a projected 4.8% growth rate. With Medtronic s continued innovation in the Cardiac and Vascular space, its respective division should experience high growth around 3.40% on the outset of the projection period. Thereafter, growth should level off at 2.60%, just below the industry growth rate. Medtronic s Minimally Invasive Therapies Group was largely developed from the 2015 Covidien acquisition. This line of therapy is expected to outpace the industry growth rate as the increasingly older population has a higher demand for in-home healthcare. Restorative Therapies has a lower level of projected growth at 2.50%, with a lower level of expected demand. Finally, the Diabetes division is expected to consistently outpace the industry with growth starting at 3.00%. Medtronic has been at the forefront in diabetes equipment with the release of the MiniMed 670G, one of the most technologically sophisticated insulin pumps currently in the market xx. With 25% of the U.S. population projected to be diagnosed with diabetes by 2030, Medtronic can expect to enjoy a high level of demand in the years to come. Profit Margins Medtronic has historically enjoyed high margins around 60%. Our forecasted Cost of Goods Sold expense is based on historic percentages of revenue; this value is a constant percentage of 61.71% throughout the projection period. Our projections for gross margins are relatively optimistic based on the strong growth that was projected for key divisions such as Diabetes and Minimally Invasive Therapies. Research and Development (R&D) Medtronic moderately depends on its R&D to fuel its growth and maintain its market dominance. Projected R&D expenditures were based on historic R&D spending as a percentage of sales. This value then grew proportional to sales. Due to the consistency in historic R&D expenses relative to sales growth, we are confident in the projected expenditures. 10

Capital Expenditures Medtronic s capital expenditures were forecasted using a constant rate of 3.00% to reflect historical purchases of gross plant, property, and equipment. Medtronic s capital expenditures mostly likely jumped in 2015 due the large-scale acquisition performed in the same year. From this point, PP&E purchases can be expected to exhibit a lower and more consistent rate of growth. Other Key Assumptions Long-term debt Our projected long-term debt amount was projected as the percentage of long-term debt over non-cash assets. Given the material amount of debt that was taken on during the Covidien acquisition, we are confident that this projection is appropriate for the required payment schedule. Common Stock Repurchases Information regarding share repurchasing was obtained from the annual Form 10-K filing. Interest Rate Expense The product of the after-tax cost of debt and the firm s combined long-term and short-term debt levels determined the interest expenses throughout the projection period. Dividend Payment We projected dividend payments by examining the historically increasing dividend payment and continuing that trend forward. Weighted Average Cost of Capital (WACC) We arrived at an overall WACC of 6.51% using Medtronic s capital structure of 78% equity and 22% debt. The following steps were taken to find the cost of equity and cost of debt, respectively: Cost of Equity Medtronic s cost of equity was obtained through the use of the Capital Asset Pricing Model (CAPM). A risk-free rate from the yield on a 30-year treasury bond was used because of its accurate reflection of market expectations as well as its overall favorableness towards the CAPM model. Additionally, we utilized Bloomberg to identify the average beta of.93. The Equity Risk Premium was found via Bloomberg. Cost of Debt The cost of debt was found by assessing Medtronic s debt ratings in the Form 10-K. Moody s has assigned an A3 rating for long-term debt and a P-2 rating for shortterm debt. The respective default rates of 1.15% and 1.50% were then added to the risk free rate of 2.61% to arrive at the pre-tax cost of debt of 5.26%. Valuation Models Discounted Cash Flow and Economic Profit Through the use of the DCF and EP valuation models, we arrived at identical intrinsic values (on a per share basis) of $74.40. We utilized our projected value drivers to arrive at this price and also our continuing value estimates for growth and return on invested capital. The intrinsic price was then adjusted to the current date. We believe that the DCF is the most reasonable method for valuation due to Medtronic s predictable yearly free cash flows. Dividend Discount Model (DDM) The dividend discount model yielded a target price of $83.67 after adjustment for the current date. The dividend discount model utilized future dividend cash flows and a terminal value derived from the P/E ratio and EPS estimate for the continuing value year. Relative Valuation The third valuation methodology we utilized was relative valuation. We selected five of Medtronic s peers and evaluated them based on their levels of market capitalization and estimated earnings. From there, we found the average of the peer companies relative P/E multiples and multiplied them by Medtronic s 2016 and 2017 EPS estimates to arrive at target prices for those two periods. Sensitivity Analysis Our sensitivity analysis examined how incremental changes in leading variables affected the intrinsic share price that was found under the DCF method. In these tests, the WACC was compared against the growth rate for the CV year, the percentage of COGS relative to net sales was compared against the percentage of SG&A relative to net sales, and the beta was compared against the Equity Risk Premium. The comparison of the WACC and the growth of NOPLAT in the CV year was the most variable, with share prices as low as $36.99 and as high as $289.90. We felt that the WACC was a key variable to analyze due to its use in both the DCF and EP valuation methods along with it serving as a key indicator of a firm s capital structure and underlying risk. The comparison of the Equity Risk Premium and the beta value yielded a price range from $42.38 to $152.67, with prices increasing as the beta and Risk Premium decreased and decreasing as the beta and Risk Premium increased. Lastly, the comparison of COGS and SG&A as a percentage of net sales produced the smallest price range of $49.45 to $93.48. This comparison allowed us to evaluate how changes in Medtronic s cost structure influence the intrinsic share 11

price on a much smaller scale than value drivers such as the growth rate and the WACC. Ultimately, our target price range was $74 - $84 with Medtronic currently trading at $82.07. 12

Important Disclaimer This report was created by students enrolled in the Security Analysis (6F:112) class at the University of Iowa. The report was originally created to offer an internal investment recommendation for the University of Iowa Krause Fund and its advisory board. The report also provides potential employers and other interested parties an example of the students skills, knowledge and abilities. Members of the Krause Fund are not registered investment advisors, brokers or officially licensed financial professionals. The investment advice contained in this report does not represent an offer or solicitation to buy or sell any of the securities mentioned. Unless otherwise noted, facts and figures included in this report are from publicly available sources. This report is not a complete compilation of data, and its accuracy is not guaranteed. From time to time, the University of Iowa, its faculty, staff, students, or the Krause Fund may hold a financial interest in the companies mentioned in this report. 13

BIBLIOGRAPHY: i Medtronic: Sec Form 10-K. (2016, April 29). Retrieved November 13, 2016, from http://www.medtronic.com/us-en/about/corporatereports.html. ii Ortman, Jennifer. An Aging Nation: The Older Population in the United States. 2014 May. Retrieved November 13, 2016 from https://www.census.gov/prod/2014pubs/p25-1140.pdf iii Top Health Industry Issues of 2015. 2014 December. Retrived November 13, 2016 from http://www.pwc.com/us/en/health-industries/top-health- industry-issues/assets/pwc-hri-top-healthcare-issues- 2015.pdf iv ObamaCare Enrollment Numbers. Retrieved from http://obamacarefacts.com/sign-ups/obamacareenrollment-numbers/ v Garfield, Rachel. The Coverage Gap: Uninsured Poor Adults States that Do Not Expand Medicaid. Retrieved from http://kff.org/uninsured/issue-brief/the-coveragegap-uninsured-poor-adults-in-states-that-do-not-expandmedicaid/ vi Galewitz, Phil. Millions could Lose Medicaid Coverage Under Trump Plan. 9 November, 2016. Retrieved from http://khn.org/news/millions-could-losemedicaid-coverage-under-trump-plan/ vii Roy, Avik. Obamacare's 'Cadillac Tax' Could Help Reduce The Cost Of Health Care. Retrieved from http://www.forbes.com/sites/theapothecary/2014/02/26/o bamacares-cadillac-tax-could-help-reduce-the-cost-ofhealth-care/#5fa097b864f2 viii Sneed, Tierney. What Happens to Obamacare now? 9 November, 2016. Retrieved from http://talkingpointsmemo.com/dc/trump-win-obamacarerepeal ix The World Bank. Health Expenditure, total % of GDP. Retrieved from http://data.worldbank.org/indicator/sh.xpd.totl.zs? end=2014&locations=us&start=1995&view=chart xi Retrieved from https://www.cms.gov/researchstatistics-data-and-systems/statistics-trends-andreports/nationalhealthexpenddata/nhe-fact-sheet.html xii NHE Fact Sheet. Retrieved from https://www.ncbi.nlm.nih.gov/pmc/articles/pmc146401 8/ xiii Barr, Paul. Baby Boomers Will Transform Health Care as They Age. 1 January, 2014. Retrieved from http://www.hhnmag.com/articles/5298-boomers-will- Transform-Health-Care-as-They-Age xiv Cawley, John. The Impact of the Macroeconomy on Health Insurance Coverage: Evidence from the Great Recession. 2001 November. Retrived from http://ftp.iza.org/dp6124.pdf xv Retrieved from http://www.netadvantage.standardandpoors.com.proxy.li b.uiowa.edu/nasapp/netadvantage/sr/showstockrepo rt.do xvi Centers for Disease Control and Prevention. The State of Aging and Health in America 2013. Atlanta, GA: Centers for Disease Control and Prevention, US Dept of Health and Human Services; 2013. xvii American Diabetes Associated. Older Adults. American Diabetes Association. Diabetes Care Jan; 39(Supplement 1): S81-S85. xviii Curran, Jack. Medical Device Manufacturing in the US. 2016 September. Retrived from http://clients1.ibisworld.com.proxy.lib.uiowa.edu/reports /us/industry/default.aspx?entid=764 xix CSIMarket. Medical Equipment and Supplies Industry Ratio Retrived from http://csimarket.com/industry/industry_valuati on_ttm.php?pe&ind=804 xx Whalen, Jeanne. FDA Approves Medtroni s New Automated Insulin Pump Retrieved from http://www.wsj.com/articles/bt-co-20160928-711910 x Medicaid Enrollment Spending Growth in 2016 2017. Retrived from http://kff.org/report- section/medicaid-enrollment-spending-growth-fy-2016-2017-issue-brief-8931/). 14

Medtronic Revenue Decomposition Fiscal Years Ending April 29th 2014 2015 2016 2017E 2018E 2019E 2020E 2021E Cardiac and Vascular Group 8,847 9,361 10,196 10,543 10,838 11,120 11,409 11,705 Minimally Invasive Therapies Group - 2,387 9,563 9,802 10,077 10,379 10,690 11,011 Restorative Therapies Group 6,501 6,751 7,210 7,390 7,575 7,749 7,927 8,110 Diabetes Group 1,657 1,762 1,864 1,920 1,978 2,037 2,104 2,173 Total Net Sales 17,005 20,261 28,833 29,655 30,467 31,285 32,130 33,000 Percentage of Total Net Sales Cardiac and Vascular Group 52.03% 46.20% 35.36% 35.55% 35.57% 35.54% 35.51% 35.47% Minimally Invasive Therapies Group 0.00% 11.78% 33.17% 33.05% 33.07% 33.18% 33.27% 33.37% Restorative Therapies Group 38.23% 33.32% 25.01% 24.92% 24.86% 24.77% 24.67% 24.58% Diabetes Group 9.74% 8.70% 6.46% 6.47% 6.49% 6.51% 6.55% 6.59% Total 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Segment Growth Cardiac and Vascular Group 1.70% 5.81% 8.92% 3.40% 2.80% 2.60% 2.60% 2.60% Minimally Invasive Therapies Group 0.00% 0.00% 300.63% 2.50% 2.80% 3.00% 3.00% 3.00% Restorative Therapies Group -17.70% 3.85% 6.80% 2.50% 2.50% 2.30% 2.30% 2.30% Diabetes Group 0.00% 6.34% 5.79% 3.00% 3.00% 3.00% 3.30% 3.30%