Medtronic, Inc.‘s (NYSE: MDT) recently reported third quarter fiscal 2014 results reflected operational revenue growth of over 4% year over year to about $4.2 billion, driven by steady growth across all its divisions. Its largest divisions, Cardiac Rhythm Disease Management (CRDM) and Cardiovascular, continued to grow in low single digits, generating sales of $1.18 billion and 935 million, respectively. Other business divisions such as Neuromodulation, Surgical Technologies and Diabetes also registered robust revenue growth. International sales accounted for 46% of total revenues for the medical device maker, driven by 12% year-over-year growth in emerging markets. 
Gross Margins improved by 80 basis points sequentially to 74.8% as cost saving efforts under its five-year $1.2 billion cost reduction plan bore fruit. However, adjusted earnings, excluding certain acquisition and impairment charges, declined 3% year over year to $916 million, owing to higher medical excise taxes and non-renewal of R&D tax credit in the U.S. Going forward, the company expects operational sales growth to be in the range of 3%-4% year over year for the fourth quarter, as well as for fiscal year 2014.
Our price estimate for Medtronic’s stock is currently around $57, which is about in line with the market price.
Steady Growth In Major Businesses
Cardiac Rhythm Disease Management (CRDM), primarily consisting of defibrillators and pacemakers, is Medtronic’s largest division, accounting for about 30% of total sales. During Q3 FY 2014, the division’s sales increased by a modest 2% year over year to $1.18 billion driven by over 20% growth in the Atrial Fibrillation (AF) business and 1% operational growth in implantable cardioverter defibrillator (ICD) sales. However, CRDM division revenues declined almost 7% sequentially due to a decline in pacemaker sales and moderation in inventory replenishment at hospitals. ((Medtronic’s CEO Discusses F2Q 2014 Results – Earnings Call Transcript, November 19, 2013))
Growing acceptance of new products such as the Evera ICD, Viva XT CRT-D (ICD with pacing capabilities) and Arctic Front CryoAblation System drove CRDM sales, especially in Western Europe and Japan. International sales accounted for almost 50% of total sales in the division.
Cardiovascular, consisting of the Coronary, Structural Heart and Endovascular businesses, offers products such as stents, heart valves and renal denervation systems for treating hypertension. The Cardiovascular division, contributing over 20% to Medtronic’s sales, grew 2% year over year, registering sales of 935 million in the fiscal third quarter. Sales of drug eluting stents (DES) increased 5% on an operational basis driven by strong global sales of the company’s Resolute Integrity DES. Although Endovascular sales increased by 4% year over year, they were negatively impacted by discontinuation of below-the-knee (BTK) drug-eluting balloon program and divestment of the re-entry catheter products.
CoreValve Transcatheter Aortic Valve (TAVR) system, part of the Structural Heart business, continued its strong growth momentum in international markets. The company received an earlier-than-expected FDA approval to sell its CoreValve system in the U.S. in the later half of the third quarter. Although its impact on Q3 sales was marginal, CoreValve could generate $50-$70 million from sales in the U.S. by the end of CY 2014 (read our note Medtronic’s CoreValve Gets Early FDA Approval; U.S. Sales Likely To Get A Boost for further details).
Other Divisions Continue Improvement In Sales
Medtronic’s Neuromodulation segment sales increased 7% year over year to $478 million, backed by strong global sales of its Activa Deep Brain Stimulation (DBS) system as well as growing U.S. sales of its PAINSTIM SureScan MRI spinal cord stimulator system. Diabetes segment revenues grew 16% driven by robust sales of new products such as the MiniMed 530 G with Enlite CGM sensor. This product, first of its kind in the U.S., is a precursor to the company’s plans of developing an automated artificial pancreas. Medtonic’s CEO reiterated in the earnings call on February 18 that therapy innovation will remain a key strategy for the medical device maker to consolidate and build upon its global market leading position.
Spinal sales improved in the third quarter, after declining for the past several quarters, due to growing efficacy concerns about a key product—bone graft paste Infuse (read Medtronic: Independent Review Raises Doubts On Benefits Of Infuse Bone Graft). Although concerns still remain regarding its Infuse product, overall flat sales were reported on the back of strong demand for Bone Morphogenetic Proteins (BMP) products. Spinal sales are expected to get a further boost in the coming quarters as the Minneapolis, Minnesota based company is planning a summer launch of its Prestige LP next-generation cervical disc in the U.S. market this year.
Cost Reduction Measures Bearing Fruit
Gross margins improved 80 basis points sequentially in the third quarter to 74.8% as the company successfully dealt with the accumulated obsolete inventory and higher write-offs, which had impacted margins in Q2. However, gross margins were negatively impacted by costs incurred in resolving quality issues in the Neuromodulation and Diabetes segments. Going forward, the company expects gross margins to remain stable at around 75%, excluding the impact of foreign exchange.
Medtronic’s research and development (R&D) costs have typically ranged between 9% and 9.5% of it revenues over the past several years. Its R&D costs as a percentage of revenue were 8.6% in the third quarter fiscal 2014 owing to improvements in organisational productivity. Shifting and setting up its R&D centers to new regions across the globe such as China and India has helped the company reduce its R&D costs further. It expects R&D costs as a percentage of sales to come down to 8% by the next quarter. If Medtronic stabilizes its R&D costs to around this level in the medium to long term, there could be a potential upside of nearly 4% to our price estimate for the company.
New Products To Watch Out For
Medtronic is banking on its new product launches across all business divisions to drive sales in the coming quarters and effectively compete with its peers: Boston Scientific (NYSE:BSX), St. Jude Medical (NYSE:STJ) and Edwards Lifesciences (NYSE:EW). In the CRDM division, products to watch out for include the Evera ICD, Viva XT CRT-D (ICD with pacing capabilities), Arctic Front CryoAblation System and the Reveal Linq minimally invasive insertion device. In the Cardiovascular business, new products which are expected to drive growth are the CoreValve TAVR device and the Impact Admiral drug eluting balloon for superficial femoral artery (SFA). CoreValve received FDA approval for use in ‘extreme risk’ patients last month and FDA approval for its use in ‘high-risk’ patients is expected by mid-FY15.
Other new products to watch out for in the coming quarters include the Prestige LP next-generation cervical disc, SureScan MRI spinal cord stimulator system, Activa Deep Brain Stimulation (DBS) system, MiniMed 530 G system with the Enlite sensor and the MiniMed 640 G insulin pump system.Notes:
- Medtronic’s CEO Discusses F3Q 2014 Results – Earnings Call Transcript, Seeking Alpha, Feb 18, 2014 [↩]