Medtronic plc (MDT) Earnings Call Transcript & Summary

Good morning and thank you for joining us for the fourth day of the 2021 Morgan Stanley Healthcare Conference. I'm Cecilia Furlong, medical device analyst and a member of the health care research team here at Morgan Stanley. It's my pleasure to have Medtronic Chairman and CEO, Geoff Martha, with us today. And before we begin, I'll run through our disclaimer. For important disclosures, please see the Morgan Stanley research disclosure website at www.morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. And with that, Geoff, thank you for joining us today.

Yes, thanks, Cecilia. Thanks for having me.

And I wanted to just briefly turn it over to you for some quick remarks, and then we can dive into Q&A.

Yes, sure. I'll be quick here. So thanks for the opportunity. And so I know we have a broad audience on this call. So for those that are less familiar with Medtronic, we're the world's largest medical technology company. We've got really strong scientific underpinnings and a broad-based and a deep portfolio of innovative therapies focused in areas of cardiovascular, medical-surgical, neuroscience and diabetes. We are founded in a Minneapolis garage over 70 years ago. I'm in Minneapolis. Here is where our operational headquarters are. A strong mission-driven company, to alleviate pain, restore health and extend life, which is it's really guided us for decades. And I could tell you as the new CEO, it really helped over the pandemic period here. Our top priority here is sustainable, accelerated revenue growth at or above our end markets, and we can dive into that. To do that, we've got a very robust pipeline of inventive and, in some cases, disruptive technologies launching now and over the coming years that address unmet patient needs in very attractive markets. We have some large catalysts coming in our pipeline in the near term too. As we're anticipating that, we'll see data from our renal denervation system in early November, which I'm sure we'll get a lot of questions about. And we're just starting to roll out our Hugo robotic-assisted system, just to name 2 of the many opportunities in the pipeline. We also have a robust footprint in emerging markets with providing significant runway. It's almost like an independent growth vector for us over the pre-COVID for the last 40 quarters. We've been growing at double digits in emerging markets. And it's a huge piece, like 17%, of our overall revenue. Over the past year or so, we've made some, what I would call, transformational, structural and cultural changes to really to unlock value at the company. We've put in place a new operating model with 20 focused businesses versus those 3 big portfolios of businesses or groups of businesses we talked about. We're also leveraging some of the strengths of our enterprise. We've instilled new cultural traits, including acting boldly, competing to win, moving with speed and decisiveness in everything we do and getting results but getting them the right way. And then we've spent a lot of time deploying capital and thinking about how to do that through investments in organic R&D as well as disciplined M&A, leveraging our balance sheet. We have a strong balance sheet. We've announced that we're increasing R&D by more than 10% this fiscal year, which is the largest dollar increase in our company's history. And we continue to look for and to execute on tuck-in acquisitions that we can grow over time. And we don't buy growth. We grow what we buy. And finally, we're committed to delivering a double-digit shareholder return with our long-range plan. This starts with a 5%-plus organic revenue growth, and I'll emphasize the plus, combined with the leverage and margin expansion to get to 8%-plus EPS growth. And we're committing -- we're committed to converting over 80% of our earnings to free cash flow and balancing the deployment of this capital to investments in the business and delivering strong returns to our shareholders, including our strong and our growing dividend. You can't forget about that. So real quick here just to wrap up. In the short term, we have -- we indicated on our earnings call a few weeks ago, we are seeing some impact from the Delta variant. I'm sure we'll get more questions on that. We're seeing some on our business. And we've seen what happens -- and we'll see what happens over the second half of our quarter here. But regardless of the timing and trajectory of the recovery, we expect headwinds from this latest wave to be transient. And we fully expect to recover and have a strong second half of our fiscal year. Getting back to the long term, based on our balance sheet, our technology, our product pipeline, the new operating model, we're well positioned, and our future is bright. And we look forward to creating a lot of value for shareholders. And with that, I'll turn it back over to you, Cecilia, and happy to take the questions.

Yes. Thanks, Geoff. And I wanted to start with cultural and organizational changes at Medtronic that you touched on at the beginning of your statements that you've cut costs, moved to a more nimble operating unit structure and got out of stocking. As you stand today, which of these cultural and org changes is paying the greatest dividends? And looking forward too, where do you see the greatest opportunities to continue to evolve Medtronic's culture and drive organizational changes?

Well, thanks for that question. I mean some of the things that you mentioned, those changes are immediate; and some, well, the impact will take a little longer. So for the immediate, I would start with stocking, this -- eliminating the stocking orders has been massive for us. And the benefits, it gives us visibility into utilization that we didn't have before. We do a large stocking order at the end of the quarter, and it takes a couple of weeks for the health systems to burn through that. And now we don't have to deal with that dynamic. We have visibility in utilization. We see average daily sales trends, which help us to pivot quickly when we see an issue. It also improves the accountability of our businesses, and we can hold them accountable -- our sales teams rather. It's difficult to hold them accountable when you're doing these -- you have this variability in your sales through stocking. So that's been helping. What's still playing out of the changes is the op model. I do believe it's quite a big change. And then the disruptive phase of this is behind us. And we're starting to see the benefits or are already starting to accrue, and I think they're going to expand over time. So culturally, the cultural changes will take time. So the cultural changes, what we're calling the Medtronic mindset is what I talked about at the beginning, this is competing harder, taking bigger bets, this type of approach. We're seeing it play out in a number of our businesses. Like I was just down with our Structural Heart team 2 weeks ago in a business review, and I can see the changes that they're making to how they compete and how they market. We've got great products, but I would argue, in the United States, our share is not commensurate with our -- the technology we have. I think our share should be higher. And so I see them, they stopped, we were losing share for a couple of years ago. That's turned around. We're gaining share now in the United States and around the world. But in the United States, we have the biggest share gap. So I see it like in that business. Overall -- I mean I could go business by business, but overall, the employee engagement at Medtronic is at the highest levels we've ever had them. And I think it's part they're excited about this new approach and the aggressiveness. But also, they're excited about our pipeline. So I can talk about that later. But there's other changes that are playing out. Compensation changes, people -- there are some people changes, right? When you hold people accountable to a certain level of results, it's not for everybody. So there are some -- the opportunity that I see is more consistent performance across the company like we're seeing, I talked about, in structural heart, and greater resolve. I mean with this new operating model, we have these 20 operating units and clear line of sight to the end market, the end market opportunity, the competition. And with that comes, I'd say, a greater resolve to make the trade-offs to fund the large opportunities in front of us. By trade-offs, I mean cutting expenses in one place so that you can invest more in R&D or pulling R&D funds from one business and doubling down on another. These are trade-offs. Things -- this is helping us go after things like structural heart, mitral and tricuspid, moving to enabling technology in spine from screws and rods. These are all big investments. And one way we're funding that is making the trade-offs. But another way is creating room in our margins. And we've brought in a new supply chain leader in Greg Smith from Walmart. And this is a big piece for us. I mean half of our employees are in supply chain and operations. So getting some productivity there and improving our product availability, all of this is part of this new operating model because the operations side is kind of one of the play big. If the businesses are focused on playing small, the certain things like certain technology platforms, operations is part of the big side of the model and a lot of opportunity there. So we went through quite a bit there, but I would argue that we're seeing changes right away with the stocking. And then the operating model, the rest of the operating model is playing out over time and heading in the right direction.

I wanted to ask and push further on the reinvestment theme. And at your Investor Day last fall, you laid out an expectation to fully realize annual savings of $450 million to $475 million by the end of your fiscal '22 stemming from your simplification program. Does this all get reinvested back into the business? And reinvesting in R&D, it's a clear focus. You highlighted it. And do these cost savings help support and drive similar levels of R&D investment beyond your targeted fiscal '22 levels? And where else are you focused on reinvesting the savings?

Sure. I mean what it does is, well, first of all, the program we talked about, the simplification program was really -- secondary benefit was cost savings. The primary benefit was simplifying the company, so we can be more agile and get rid of some bureaucracy. We took out 3 layers of management. Like I talked about earlier, we decentralized these 3 big groups, Cardiology, Neuroscience and MedSurg, into a portfolio of 20 operating units that can move faster and, like we'd like to say, be focused and play small, like a start-up. That was the reason for it. Cost savings was a secondary benefit, but it does allow us to make these investments in several large opportunities and accelerate our revenue growth. And without getting into -- I wouldn't -- a specific order, some of the biggest opportunities that we're prioritizing is renal -- RDN, which is we expect to be a $3 billion opportunity by 2030. And we have a big lead with a novel approach of treating the world's #1 preventable cause of death and disability. Another one after that would be Hugo, our soft tissue robot, where we're excited about the potential to penetrate the surgical robotics market around the world. We just -- we have maybe 50 surgeries under our belt, so we're early. And we hope -- we anticipate being on the market in Europe here in the fall, so a very exciting time there. And we have to invest not just in the technology in both RDN and Hugo, but we have to invest in the commercial resource, sales and marketing ahead of these product launches. And that's a big investment for us. Then there's cardiac rhythm management, where we're disrupting the pacemaker market with Micra and creating a $2 billion leadless pacing market out of nothing. Leadless pacing will be about $2 billion or so by 2030. And then we're launching in the ICD market with our EV ICD, which is a $1 billion opportunity by 2030. And then after I hit those, I mean there's PFA for cardiac ablations, PillCam Genius in our GI business, our continued innovation in TAVR and in structural heart, and I mentioned mitral and tricuspid. And then you have in the neuroscience space the spinal cord stimulation and deep brain stimulation and neuromod and then, of course, diabetes. So these are like the -- where we're putting the money. And yes, we're reinvesting savings from the simplification program to drive these programs and others, but there's a lot more in the pipeline. But make no mistake, at the same time, we're focusing on driving margins. Driving leverage and operating margin expansion are both key elements in translating our long-term growth objective of 5%-plus on the top line into 8%-plus on the bottom line. I want investors to have a high degree of confidence in us delivering that 8%-plus on the bottom line. So as we drive margin expansion, we expect to get back to pre-COVID levels and then continue to drive further improvement in our margins. And we can do this simultaneously with investing in innovation because, like I said, we've gotten better at managing our SG&A and driving our leverage there. Like I said, SG&A is going to grow slower than revenue. We're going to allow our R&D to grow at revenue rates. And then we're getting gross margin improvement through our operations changes through bringing in a new operations leader who has experience running Walmart's -- he ran Walmart's supply chain and before that was in the food and ag business and as well as the automotive business and bringing a whole level of rigor and sophistication to our supply chain that we didn't have before, which will create further margin opportunity for us. That's how we think we can do this both at the same time.

I wanted to ask too, like Medtronic now is -- there's a huge focus on market share arguably more so than your competitors. As you've shifted the focus to share, how are you seeing attitudes, execution and ownership shift across your operating units? And really just how do you balance this focus on share and driving competitive wins in established markets versus driving toward new market creation and market growth?

So look, Medtronic, what makes Medtronic -- one of the things, I think, makes Medtronic special is our ability to create new markets and do market development, and that's hard to do. And I didn't even fully appreciate that when I first got here 10 years ago, but I do now. And so that's always going to be a focus. But the problem is we invest -- like take renal denervation. We're going to create this new market. But all too often in the past, we create -- we do all the hard work and investment, blood, sweat, tears, time to create these new markets, and then we let competition come in too quickly and take share. And that has to stop because we need to fully benefit from these investments. And market share is a good marker of that, right? It's a good metric for us. And we have set share goals for our businesses and expect them to hit it. We want our businesses to be growing at or above the market. And that's like kind of a bare minimum. And that execution pays for more of this market creation, so they work together. What you can't do is one without the other. At some point, you can't keep gaining share unless you're truly innovating. And the fastest path to growth is creating new markets altogether. But you can't keep creating new markets if you don't get fully benefit the -- get the return on those investments. And so I would argue that we've under -- we've always been focused on market creation but not enough focused on market share. So that's why you see the huge focus on this. And it's -- I think it's paying off. Our overall performance relative to our competition over the last couple of quarters has been markedly better than historical performance. And I still think we've got -- I know we've got opportunity to improve from there.

And there are several key franchises investors focus on when they think about share, TAVR, SCS, SNM, diabetes, CRM. But as you think across your broader portfolio, what are some of your franchises that really receive less external focus where you're either driving share gains or see opportunities to reverse prior share loss?

Well, you've highlighted a couple of like really high-growth segments, TAVR, SCS, sacral nerve modulation, diabetes. These are -- you mentioned CRM as well, I think. But those other 4 are like smaller for us but much higher growth. Our biggest businesses are cardiac rhythm management, spine and surgical innovations. They all -- those are what we call the big 3. They might be the fastest -- may not be the fastest growers, but they all are growing mid-single digit. And we have to make sure that those businesses are growing at or above the market on a consistent basis. And cardiac rhythm management, I already talked about, it's been growing above the market here for quite some time. And our spine business is now gaining share. And our SI business goes back and forth with Ethicon, and they're driving market growth and market share. So that's important for us. And sometimes -- we can't take that for granted. Those big 3 have to do well. The businesses that don't get as much attention, that I know that we're positioned very well for multiyear share gains, one would be deep brain stimulation for things like essential tremor and Parkinson's. And we're looking at other disease states. But we've launched a new system that actually senses signals in the brain, and we launched a new lead system which accentuates those sensing and also is steerable and allows us to close the loop. So over time, meaning that we apply energy, we see how we can listen to the signals in the brain, how energy is -- or the body is reacting to that, and we can adjust. And so we can close the loop and personalize the therapy over time. Same with our SCS business with ECAPs that will be coming to the market here soon. Similar, it can actually quantify pain and adjust the signals to increase or decrease the energy. And then -- so those are 2 big ones that don't get as much attention, particularly DBS. And opportunities to reverse share loss, we talked about diabetes, we've got a big investment in our pipeline there. But cardiac diagnostics is another one as we ramp the production of our LINQ II. The 2 businesses that are losing share quarter-over-quarter, diabetes and our cardiac diagnostics, cardiac diagnostics is more of a manufacturing problem, which we're -- with the production issue that we're fixing. But we've got a great product there. Diabetes is a longer -- a little bit longer-term play.

Okay. And I wanted to ask about M&A, your strategy in M&A. You've spent $2.3 billion across 7 announced deals since the beginning of your fiscal 2021, including the most recent announcement, Intersect. But as you think about Intersect, is Intersect a good illustration or representation of the type and size of strategic deals Medtronic will continue to pursue? And growth assets where you see the potential to really further accelerate growth under Medtronic's umbrella, is that the strategy? Or how would you frame kind of how you think about future M&A?

Yes. I mean look, we continue to focus on tuck-in acquisitions that can drop into our existing businesses and enhance our weighted average market growth rate and generate strong returns. So size can vary from tens of millions to low billions. And Intersect is right in between there. Intersect has an attractive high growth. It's got complementary products that fit perfectly into our existing ENT product portfolio. The transaction is accretive to our WAMGR. It's a high-growth segment in the ENT space, the highest-growth segment. It's neutral and then accretive to earnings, and the returns are expected to be well ahead of our cost of capital and very strong returns. That's exactly the type of tuck-in deals that you should expect from us. That's the focus for us.

What are other key strategic areas you'd potentially look to M&A ahead of R&D to fill current portfolio gaps?

Well, first, I'd say, like we just talked about, we're focused on the tuck-ins, first and foremost. And I don't see a need for us to go chasing white space that don't have the strategic synergies or cost synergies or any synergies to Medtronic today. I mean we have enough in the segments that we're playing in and some adjacencies there. We're taking early-stage positions in companies and doing some structured deals, and you'll see us continue doing those type of deals. And the issue that we're fighting against is some of these assets in med tech are, even though they're early and have not been derisked, the public markets are giving them a high valuation. And so what we find ourselves doing is getting in earlier and doing these stage acquisitions. We're doing more venture investing to get earlier looks and put in place structured deals, where we -- and ultimately take on a little more risk. But that's been working out for us. It's better than sitting around and waiting, and then these assets get priced too high and it's -- we can't get -- we can't make the numbers work. So yes, so that's kind of how we're thinking about: go earlier, do structured deals; don't chase -- no need to chase white spaces right now. We've got enough to work on.

On the flip side, you've signaled before an interest to divest businesses. How should we think about either growth or margin thresholds for potential candidates for divestiture?

Well, look, we're really focused on doing -- look, we're doing a lot more portfolio management. And what we do is we put all of our 20 businesses into this framework that we have. And on one end, you got strategic bets that we're doubling down in; and on the other end, you've got businesses that are, for whatever reason, the markets aren't great or we have some problem in the business and it needs fixed. And it could be just organically fixing it, it could be some acquisition we do or could be something we have to divest. And all of this is in an effort to get the weighted average market growth rate of the company higher. I mean that's a big indicator of success or growth is what's your weighted average market growth rate. And then you set your expectations to grow at or above that. And so in some cases, it's going to result in some divestitures because they're -- we're just -- whether it's a market issue or a Medtronic execution issue or some technology issue, we've got to get out of that. So we've created this capital allocation group within the leadership team. We're meeting multiple times a month looking at this. And this includes myself; Karen Parkhill, our CFO; and the portfolio leaders across the company and even one of our regional leaders. And we debate the portfolio of the company, do we have the right businesses to drive the accelerated and sustained growth and are there opportunities to increase our weighted average market growth rate. These are the things that we're focused on. And the businesses that we don't see a turn in the far-right column, that need fixed, that optimized column, we either take decisive action or get out of those businesses. So that's how we're doing it. And I would see over time there's opportunities for divestitures over time.

Okay. And going back to R&D, you talked about increasing it over 10% year-over-year. Can you highlight just the biggest buckets, how they're broken down in terms of investment priorities? You talked about Hugo, RDN, but if you could kind of speak to other areas that you're focused on today. And then I'm just curious kind of your thoughts on MCIT, the news there, just how that impacts medical device technology companies as they think about innovation going forward.

Sure. So let me answer the first part, and then I'll get to MCIT. So we're -- I'd say the best way to look at it is to look at it across maybe a couple of themes here. One is entering new markets, so -- or creating new markets. Like renal denervation, we're creating one. Or surgical robotics, we're entering one. So that's one place we're putting R&D as well as acquisitions. And then there's other like investing in high-growth markets: and so PFA in AFib; mitral and tricuspid investments in structural heart; numerous products in neuromodulation like ECAPs, I mentioned earlier, for our pain business; and a long list of investments in diabetes, which is a super high-growth area of several segments. So that's investing in high-growth areas. So new markets, entering new markets and disproportionately investing in high-growth markets, like the ones I mentioned. And then the third, I'd say, is adding capabilities. We purchased a few companies over the last couple of years that have more capabilities like digital surgery to bring data and AI capabilities into our surgical innovations business and our robotics business. So every once in a while, we do these kind of capabilities deals. They're less frequent but very impactful. So that's how I would break down the M&A, in terms of the R&D and where that 10% is going into those 3 buckets. The MCIT, look, I mean it would be nice. I hope that this is not the end. I know there's still a 30-day comment period but like assume that the Biden administration decides not to kind of go forward with MCIT the way it was proposed. For these breakthrough products, it pushes things out. And for us, the big one was -- is RDN. And again, it's -- when I say big, it's relative. I mean most of the RDN patients that we anticipate are going to not be of Medicare age, and so you still have to do the work that we're doing around working with commercial payers and governments in other countries. But having MCIT would have accelerated that Medicare population, that sliver of patients, that cohort of patients. And so now without -- if that -- without it, it's going to push it out several months. But we needed to do the reimbursement and health economics work with the commercial payers anyway. And the conversations are going well with them. They're very intrigued. They like the safety profile. They like the -- they want to see the unmet data. But the data we've showed them so far, they're very excited about it, and they like the way it translates to less strokes, less heart attacks, that point they get. So the health economics, I think, are going to -- are -- we're finding those conversations going well with payers that can be skeptical. And -- but MCIT would have helped us with Medicare for sure. It would have been something to point to for payers. But again, all of our estimates did not assume MCIT. They didn't assume it would happen. So the 20 -- the $1 billion market by 2026, the $3 billion market by 2030, these are things that didn't need MCIT to happen.

Okay. You talked about AFib also. And I'm curious, AFib, it's one of the fastest-growing markets in med tech today. You have cryo. You're rolling out RF. You have a pipeline opportunity in PFA. Do you see a need over time to add a mapping system? Or are there other target areas you'd look to augment your portfolio and support share capture?

The answer is yes. I mean I agree AF is a fantastic opportunity. I was just with some customers the other day at a large health system, some electrophysiologists, and they walked me through all the things we're doing with our technology and how the market is growing. It's really exciting. And we're getting -- they gave me some great feedback on DiamondTemp, and we're getting great feedback in Europe. These are trial sites in the United States that I'm talking about. So great -- very excited to get DiamondTemp on the market in the United States. And PFA has the potential to disrupt the market completely. So PFA will make this -- the procedure a lot faster. And so they're very excited about the opportunities. And we also have the exclusive first-line indication in cryo. So this is another opportunity, right, behind the technology innovation, is to move towards the front of the line for cryo patients or for those -- for the cryotherapy ahead of pharma. This is a huge opportunity, and this is something that will grow the market. And then getting back to mapping and navigation technologies, we have things like CardioInsight noninvasive mapping system, and they're important to our cardiac ablation solution system. But we continue to make -- to be looking -- making progress and looking for opportunities in map nav. We continue to make progress with our exclusive strategic relationship with Philips with their cardiac imaging and mapping system. And we're leveraging occlusion confirmation technology to support the cryoballoon procedure. So when you look at all segments of AF, I think it's a fast-growing opportunity. We've got great catheter technology, great therapeutic technology. And definitely working on strengthening our map nav is a priority.

I know we're about out of time. But Geoff, I wanted to thank you for the time this morning and then just turn the floor back over to you for any last closing remarks.

No. Look, I thank everybody for their interest in Medtronic. And we laid out a plan at the Investor Day. It was relatively early in my tenure as CEO, and I think we're executing to that plan. And I hope you see that, and you're seeing the proof points. And we're very excited. Same messaging. The pipeline is full. We're hyperfocused on refilling that pipeline and keep those investments going but, at the same time, driving that operating leverage based on what we talked about today. So thanks for the interest and the questions. And I appreciate, Cecilia, for you having me here today.

Thank you.