Medtronic plc (MDT) Earnings Call Transcript & Summary

We're glad to have the Medtronic CFO, Thierry Pieton, here with us. So welcome. Thank you for joining us.

Thanks for having me.

Good. So you've been on the job kind of about 6 months now. So maybe if you think about the first 6 months and coming into Medtronic, curious how you're thinking about the business today and how you want investors to kind of think about your plan for kind of shareholder value creation from here and sort of the initial earnings here in the first 6 months?

Yes. So look, one of the reasons or some of the reasons I decided to join Medtronic is, first, I had the perception that the company was about to level inflection in terms of growth rate. And as I went through the selection process, we talked about some of the growth opportunities with the business leadership, cardiac ablation, Ardian, Hugo, et cetera. And so I knew these would be present coming in. The second part is we talked about how with an automotive background, I could help bring some incremental value and the way the business is performing. And I would say after 6 months in the position now, it sort of comforts those two areas as the places where I can focus. So I would say, first of all, we're about to have an inflection and the growth is about to accelerate in the second half, and we can get into the specifics of some of those areas. The goal for us is to capitalize on those growth areas and turn around and create a flywheel where we use a portion of the benefit that we're going to get from those to reinvest in innovation, both organically and from an M&A perspective to fuel the next generation of growth. So for me, that's going to be the key focus. The second part is part of capitalizing on those opportunities is delivering leveraged earnings. So coming from a tough industry from a sort of margin rate perspective, I think I can -- even though a lot of progress has been made by the company, I think I can still help in making sure that we improve the margins and ultimately, we deliver a more leveraged P&L altogether.

And one of the things like you're already talking about high single-digit EPS growth for next year. And so it's been a focus for investors to kind of get Medtronic back to growing earnings. And so curious on kind of -- one, the commitment, but also like the visibility to go ahead and say this early on that you're committed to high single-digit EPS growth this early in the year?

Yes. So first, it's a commitment, right? So it's not we don't make or I certainly don't make commitments without having the right level of comfort and data behind it. So part of my onboarding and where the business has been to look at the performance, to look at the roll up and to look at the construction that is going to be required to get there and to get comfortable that we had a clear path to achieve this. So number one, I think the math is there. More importantly, I think the question is around the algorithm and what we need to put in place to get that done. And if you take a step back, first, it's about accelerated growth. And I mentioned that already. And so that's going to help with the leverage. We'll have higher growth, so better absorption of some of the overhead. The second part is delivering incremental gross margin. So if you look at the gross margin rate today, the gross margin rate today versus what it was prior to COVID were about 4 points lower. And we're -- we have a solid path to going back and create things, sort of having the actions to get us back to the margin rates that we had prior to COVID. And I can get into the detail of that. Then below that, we still have significant opportunity to deliver leverage at the SG&A level, and it's really mostly with G&A, we'll protect the selling side to make sure that we capture the growth opportunities that we have ahead of us. So if you look at this accelerated growth, better gross margin and leverage from an SG&A perspective, we can then use a portion of that to reinvest in innovation, both organic R&D and M&A and sort of create this flywheel that I was talking about to fuel the future growth for the future. So that's kind of the algorithm, and we can go into the detail of any one of those different items.

Yes. Maybe starting with gross margin because revenue growth will get to in a bit, but the gross margin is probably a key aspect of the P&L leverage.

Yes. So look, as I said, we're about 380 basis points lower than we were prior to COVID. And so for us, the target should be to get back to where we were. And here's how I look at it. There are really two today, and if you look at our performance from a gross margin perspective, there are two, sort of opposing trends. One is, operationally, our performance is really improving. So if you look at pricing, we used to be a business that lost price on a consistent basis. Now we gain price on a year-over-year standpoint, thanks to better contracting, better pricing controls, et cetera, but also thanks to innovation because our customers are ready to pay for highly differentiated innovation that have a material impact on the patient or on the hospital's economics, right? So pricing is getting better. And if you look at our Q1 performance, price was up between 1 and 1.5 points, which delivered about 40 basis points of gross margin improvement. Second part is cost management. And in a similar way, the business is now in a position to deliver a sustainable net cost out to the tune of 1% to 1.5% on a yearly basis. And again, that translates into 30 to 40 basis points of gross margin improvement year-over-year. And that's thanks to all the work that's been done by Greg Smith, in terms of our global operations and supply chain, improving manufacturing operations, improving relationships with suppliers. We used to have four manufacturing teams. Now we have one. We used to have nine purchasing teams. Now we have one. So the team is really able to generate much better savings on the cost side. So you take those two things, pricing and cost out performance, and they add up to about 80 basis points of gross margin improvement today. Today, that's being offset by business mix, and that's really driven by two things. One is diabetes that grows faster than the rest of Medtronic, but with lower margins. And as you probably all know, we're in the process of divesting that business. So that pressure point will go away sometime in the second half of '27, right? So that will give us about 50 basis points of gross margin right away. And remove that sort of headwind that we've had in a consistent basis. The second part is cardiac ablation. And first of all, it's a good problem to have because it's a business that is dilutive at gross margin but very, very attractive from an operating margin perspective. But more importantly, today, it's dilutive because the mix between capital sales and catheters is skewed towards capital sales because we're growing fast and building the installed base. And in the second half of '27, that mix is going to start to shift and it will become a tailwind instead of being a headwind. So this mix pressure is going to disappear and the operational improvements that we're making in pricing and costs are going to start showing up at the gross margin level. And so we should be in a position to start delivering meaningful, sustainable gross margin improvement starting in the second half of '27.

Very helpful. And then how are you thinking about G&A leverage versus increasing R&D and increasing the investments on the OpEx line?

Yes. So again, if you look at what we spend in R&D today, we're at about 8% to 8.5% of revenue. And we think the right level based on the roll-up that we've got internally and the projects that we'd like to fund in the midterm is closer to about 10% of revenue, right? So we've got about 2 points to 1.5 points of increased R&D to deliver from -- as a percentage of revenue. A lot of that will be offset by -- more than offset by the gross margin improvement that I just went through. And we still have an opportunity to deliver significant leverage in SG&A. If you look at the first quarter as an illustration, right? We grew R&D about 100 basis points faster than sales, but we delivered about 170 basis points of leverage on the SG&A line, right? So we're more than offsetting the R&D growth with SG&A sort of cost control. And we're going to continue to do that. And you kind of have to split the S part from the G&A part. The S part today is hiring the mappers to capture the opportunity in cardiac ablation. It's about building the direct marketing for Ardian, so we need to protect those budgets and continue to fund that. On the flip side, G&A is back office. And there, we still have an opportunity to generate savings through simplification, digitization, et cetera. So that's kind of the algorithm that we're putting in place.

And then currency has been a thing that Medtronic had to kind of deal with and hedging and stuff like that. Curious how you're managing FX differently at Medtronic. So we're not kind of surprised on some of the FX movements.

Yes. So there are a couple of things. So first of all, the best way before you go into hedging is to avoid the FX pressure to start with. So we're looking at how we can move the cost base to have more matching between where our costs lie from a currency perspective and where the revenue lies. More short term, we made a change last year, which is to measure countries that have high foreign exchange volatility on a USD basis. So essentially, if you're the General Manager in Turkey or in Argentina in a place where there is typically FX pressure, we're asking you to offset the devaluation with pricing, right? And we started that last year. We've made it more systematic this year, and it's paying off and it's contributing also to the fact that pricing is getting better. So that eliminates a lot of the exposure in a way. And then with the exposure that's left, you need to have a good hedging program. And I think it's been the case, but it's been a little bit sort of -- on average, it was on a 3-year horizon, which makes it difficult to explain externally. So we did some analysis and figured that we could get about the same efficiency from a hedging perspective, reducing the horizon to 2 years instead of 3. So we're in the process of shifting in that direction. We'll get the same kind of coverage, but it will be a lot easier to explain externally for you and for the market.

Okay. That's helpful. One thing that kind of been consistent with Medtronic, it's like some of the historically execution and kind of visibility of the businesses and stuff like that. And curious what kind of discipline you're going to bring to Medtronic in terms of forecasting how much visibility do you have in the business kind of day-to-day so you can kind of set guidance with confidence. And so we're kind of getting back to the consistent execution that we want to see.

So look, first, I think a lot has been done already. So I mentioned some of the things that Jeff and the team have put in place over the last 3 to 4 years, it's been a change of the incentive systems to make sure it's a true performance-based incentives as opposed to a profit share. It's been a change in the operating system, where basically some of the critical to execution functions such as quality, procurement, manufacturing have been centralized, right? So as I said, we've got one manufacturing team under Greg Smith. We've got one procurement team under John Klein, who is under Greg. And so that's brought much better discipline. So for example, in manufacturing, every site I go has the same KPIs, the same operating mechanisms, the same review processes. Greg's implemented what we call MPS, which is Medtronic Performance Systems, which is a translation of the Danaher system to Medtronic in a way. So that's already driven much better execution. And it's also taken the weight of some of those problematic off the shoulders of the operating units. So they can now focus on innovation and performance from a commercial standpoint, which is ultimately what's going to make them successful, right? So I think a lot of work has been done, and you can see in the last 10 or 12 quarters, that execution has been a lot stronger. There has been -- there have been no surprises from a supply chain perspective. So the company is in a much better place. That being said, there's still significant improvement for simplification of the supplier base. There is still opportunity for optimization of the manufacturing footprint. And there's still opportunity for design to cost, to get the cost of our products in the right place at the moment we launch them. And to simplify them from an engineering perspective, to reduce the potential for quality problems in the future. So that's still ahead of us. And this is something that I've lived through with our automotive and that I look forward to working on with Greg and with Scott Cundy, who runs our quality and R&D now at Medtronic.

How long does some of this stuff take? Is it multiyears or?

I think there is it's obviously some midterm. So manufacturing footprint is hard in med tech. Some of the design to cost is going to fully pay off in the next generation of products like in Sphere-360, for example, in cardiac ablation. But there are also short-term opportunities that we can work on. For example, in the reduction of the number of suppliers that we've got, which is well underway, but still with a large opportunity ahead of us. There is a large short-term opportunity in terms of SKU reduction. So taking the list of products that we sell and analyzing which ones are low volume, high inventory carrying value and tend to generate disruptions in our supply chain. We're going through those right now. And each time we eliminate those, we enable more focus and more stability in the ones that remain. So you should expect to keep seeing that operational improvement right away, but in a continued fashion that some of the more midterm things start kicking in towards the end of '27.

It's like using CAS as an example, where you have Sphere-9 today and then the next-gen catheter will be Sphere-360. And so you're basically saying that Sphere-360 will probably be a higher gross margin product because you're designing it for that.

That's exactly right. So the voyage is Sphere-9 was originally difficult to manufacture. And the team did a great job of stabilizing now. So the execution on Sphere-9 and Affera is very good. So we have the right level of output. In the same time with the engineering team, we're working on the design of 360, so that when we launch it, it comes out with a significantly better cost base than Sphere-9.

Okay. Helpful. Maybe touching a little bit on your new investor partner, if you will, Elliott. Maybe just kind of give an overview of how that kind of came together?

Yes. So look, maybe to tell the story, so Elliott contacted Jeff by e-mail and said, "Hey, we like Medtronic. We've become a large investor, we'd like to talk to you." The second step was a meeting that we had with Jeff, with Ryan and myself and the Elliott team where we went through their view of Medtronic, right? And essentially, what they said was -- we love the company. We love the innovation. We really love the customer relationships that you've built over time and the trust that you've got with your partners, but the stock has been underperforming. At the same time, we can tell that you're at an inflection from a growth perspective because of CAS, R&D and Hugo, et cetera. And so we want you to do two things. We want you to capitalize on those opportunities, so maximize the way you capture them both from a revenue perspective and from a margin standpoint. So keep improving the margins. And we want you to use those opportunities to accelerate future growth. So we would like you to invest more both organically and from an M&A perspective because you've done relatively less than the competition over the last years. And so we are sort of exactly in the same place, right? So the reason the engagement has been very constructive so far, is that a lot of things that they brought up are exactly in line with what we're focusing on internally. So they said to ensure that this capitalization and acceleration occur we think you should bring more expertise, more med tech expertise in the Board, which, again, we violently agree with because we used to have it. And over time, we lost it because people retired, et cetera. And we were actually looking at bringing back med tech expertise on the board. One of the individuals we were talking to, is one of the individuals that we ended up bringing with the Elliott engagement. So we agreed to it. We shared a list of potential candidates. And so we hired John and Bill to join our Board, and we're really excited about getting their perspective and getting their expertise to help us capture these growth opportunities and position the company for the future. The other thing that Elliott said is we think you would benefit from having dedicated committees on the board to oversee on one side growth. So portfolio management, capturing these opportunities, how you drive innovation, et cetera, and maybe pruning the portfolio. And on the flip side, having a committee that focuses on operations. So how do you secure margin improvement. And so again, this corresponds very well to the way we run the business from an executive perspective, so we implemented those two committees. We took the opportunity to simplify the Board governance overall. So we eliminated two committees, which we thought were starting to be redundant. And so now that's in place. And I think we look forward to having the two new Board members help out on those two specific topics.

And then when you think about the Elliott plan versus the Medtronic plan, it sounds like they're pretty similar?

Yes.

But in terms of like urgency and in terms of like, the speed of what you're actually executing this plan, is that maybe faster now because of the shareholders?

Well, look, I think it's always an incremental incentive, right? So you take the med tech representation on the Board. It was on the radar screen. We were talking to individuals. Elliott comes in and within a month, we've got two that have joined, right? So clearly, it's helped accelerate that. I think the operating committees, we had focus on those and the Board generally speaking. But, Elliott coming and saying, why don't you do this? We've seen it work well with other engagements we've had. So we quickly put those things in place and -- so I think it's accelerated in a way, decisions that we would have made. And look, I think also going forward, if you look at on the growth side, M&A and portfolio management, and on the upside, things like manufacturing footprint optimization, et cetera, med tech does have some specifics, right? It's a little different from other industries. So having John and Bill come in and weigh in with their background, I think it's going to help.

How do you think the committees will probably add the most value in terms of the two new committees that are bringing in?

Yes. So again, I think certainly from a portfolio management and on the M&A side, having two key leaders that have been very successful in using those levers in their life so far, in their professional life so far is going to help. And as I said, M&A in med tech is a little bit different. There's various stages in terms of maturity of the targets that you go after that you have to take into consideration. There is relative to other industries, more uncertainty in terms of the outcome of M&A. So having those two board members, I think, will help. And on the upside, it's similar, right? So in terms of how to manage the speed of innovation, the cost of the product and the simplification, sort of designed for manufacturability and also optimization of manufacturing footprint, having two additional players that have lifted and know how it works in med tech is going to be beneficial.

What -- you talked about, we'll see kind of a plan in kind of mid 2026. What do you think that will entail? What's kind of the plan to -- in terms of the plan? What's the plan for the plan, I guess, if you will.

So if I told you the plan right now, I would ruin the whole suspense for the event of next year. But so, look, I mean, as I said, we're going through an inflection. It gives us an opportunity to think about what's the next step after those, right? So how do we invest after the first generation of CAS after the first generation of R&D and how do we capture Hugo and robotics in a systematic fashion, et cetera. So how -- what should the business be aiming for in the midterm. And I think part of that will also be sharing with you maybe a revised financial algorithm in terms of what you should expect in terms of financial performance in the midterm and what KPIs we're going to track and how we'll keep you posted on the progress that we're making towards those new goals.

And EPS leverage seems very important to you?

Yes. It's doubly important. So it's important, obviously, in itself because we want to deliver value to the shareholders and improved earnings and dividends, et cetera. But it's also what pays for acceleration of innovation, and this is an innovation industry. And so being able to do the EPS leverage and improve the margins and sort of turn around and reinvest a portion of that and things that are going to make us successful in the future is really key.

And then you've talked a lot more recently on doing acquisitions, which is kind of new for Medtronic. That's been a little bit quite there. So maybe, just to start out, what's given you the reason to start talking about M&A? And then kind of what should we expect to see in Medtronic there?

Yes. So look, I think there has been a few years of slowdown in M&A for us, and that has been deliberate. And it's a choice that was made by the management team so that they could focus on fixing some of the issues that I mentioned supply chain and quality and things like that. So really, the decision was, let's fix those issues before we add a new layer of complexity with M&A. There's still room for improvement, but most of these issues are now behind us. So we feel like we've earned the right to go back in offense in M&A. We also have a strong -- a very strong balance sheet, and we've got capacity to go do meaningful tuck-in M&A for the future. So we made the decision to go back in a little bit more in offensive. The type of deal that we're going to target ideally is, I would say, the sweet spot for us are companies that are just before commercialization or just after commercialization. So that the outcome is relatively certain, right? And we can have deals that have a meaningful impact on our growth rate and our performance. So we're talking tuck-in M&A with deals maybe between $1 billion and $4 billion, that will make a significant impact on our WAMGR. They have to come with a few different attributes. Obviously, they need to be in attractive markets that are growing, that are going to accelerate our WAMGR and where there is a significant profit pool, so a potential for future profits. That's obvious. Second thing is we need to have the right to win in at least one of three areas: one, having commercial synergies. So typically, a deal that we can add to the portfolio of an existing sales force, right? So we have great commercial coverage with Medtronic. And so we have an opportunity to carry products in incremental markets without necessarily having to invest a lot commercially speaking. So that's one criteria. The second one is synergies and R&D. So we can help sometimes develop market products quicker or help startups or companies gets clinical approval faster. So that would be a second type of synergy. And the third one is on supply chain. So sometimes, we see great companies that have a fantastic sort of our product, but that aren't able to scale it, and we can help with that, right? So attractive market, significant synergies and that's typically where we're going to attack. A perfect example for us would be Affera, right? So it was a fantastic prototype made by an Israeli company, and we came in and it took us some time, but we fixed the manufacturability and now we're capturing a great part of the market. So that's the, I would say, the sweet spot. But we're also ready to do sort of more venture type investments. So to take a minority stake in companies that are in an earlier stage in their development provided, we see them as a meaningful future portfolio addition. And typically, what we would do is a minority investment with a structured deal, meaning that we would maybe have a call option to be able to increase our investment if it reaches a specific milestone. So it always has to be with a view of having a significant impact on the financials.

And one thing I want to touch on is you're talking about doing earlier-stage acquisition, which tend not to be too accretive to earnings, but you're also talking about high single-digit EPS growth and EPS leverage. So how are you working on the balance of being able to do both?

Yes. So for the first category, the sweet spot, that's where potentially the short-term dilution is bigger from a magnitude perspective, but it's probably shorter because the outcome is faster and more secure. So clearly, for us, there has to be this path to accretive earnings. And the amount of dilution that's caused has to be such that we can still deliver our commitment of high single-digit EPS growth in '27, right? So it's not an either or it has to be and so we do the acquisition and we deliver the leverage at the earnings level. Again, when the outcome or the dilution is too long, then we will take this option of a minority investment until we have better visibility to what the outcome is going to be. And that sort of reduces the impact short term and allows us to get a foot in the door without feeling as much of the dilution as we would if we made a full acquisition.

Okay. And then I think one of the things that Elliott mentioned is free cash flow and improving free cash flow to help fund some of these acquisitions? Like is there a plan here at Medtronic and kind of what are you doing to improve your free cash flow generation?

Yes. So first, maybe to remove sort of what I would call an urban legend around your dividend is getting in the way of doing more R&D and more M&A. In fact, it's not, right? It's just not accurate. We may -- we make over $5 billion of free cash flow, and we've got a really strong balance sheet and so forth, the type of acquisition that I'm talking about, we have significant capacity to do that without touching the dividend we're committed to the dividend policy as it is today. That being said, we have opportunity to improve from a free cash flow generation perspective. The first obvious lever is the operating margin leverage that I talked about. So that will deliver better EBITDA. And I think we're pretty focused on working capital. Receivables are improving. We're investing a little bit in inventory today to support the growth of cash, for example, but we have opportunity in inventory as well by eliminating some of the slower rotation type of activities that we've got in the portfolio. So our goal is to get back over sort of the 80% conversion rate that we historically had as soon as '27. And so that's a meaningful incremental cash generation that will come within a pretty short period.

Okay. And one of the big drivers on the revenue growth is CAS, probably the biggest opportunity right now, at least in terms of short term. You talked about getting to kind of $2 billion in revenue early next year, maybe. You put a time on it, but how are you thinking about kind of the opportunity here for CAS in the pipeline? Like you're still #4 in the market. Is there an opportunity to get to 2, 3 in this EP market?

Look, our ambition is to be #1 in this market. And I think we're very well positioned to achieve that. We've got two very strong products today with PulseSelect on one hand and Sphere-9 for PFA on the other hand. On Sphere-9, the product is in super high demand. So we're building the installed base of capital equipment and we're ramping up according to plan. But candidly, if we could ramp up quicker, we would sell quicker capital equipment. So there's still tension. We're hiring mappers and we're to support the procedures with the clinicians, and that's going well. And -- but we're still in that ramp-up mode. And so we haven't had the sort of exponential effect that you get from the catheters once you've built the installed base, and that's going to continue to build up. And so we're very, very excited about that. At the same time, as we mentioned earlier, we're working on Sphere-360, and there's even more excitement on that product. If you take the time for procedure, for example, the -- in hard time of 360 is going to be around 11 minutes, which is significantly shorter than what it is with Sphere-9 today, which is already a great product. And so the doctors have a super appetite to get this product as soon as possible. We're going to go for a pivotal trial this fiscal year. And so we look forward to that next generation. So for us, clearly, the end game is to take market leadership in this area.

And I want to ask about kind of digital surgery in Hugo as well on the top 3 pipeline opportunities here. And we just had the opportunity yesterday to visit the London headquarters and see a lot of the AI and stuff that's happening. So maybe just talk a little bit about Hugo and the rollout and when investors could start to see some impact on revenue?

Yes. So maybe to start on why it's important. In our portfolio, we have another business, which is spine, so spinal implants, right, and the CST business. And if you look at it a few years back, you could have looked at it and said, it's a pretty commoditized implant type of business, very competitive. You're going to have a lot of pressure, et cetera. We built an ecosystem around it with the AI with AiBLE with the robot with Mazor, with the C-arm and with imaging, right? And so what that has achieved is really build an ecosystem that makes a ton of difference for the physicians and for the patients. And what could have been a commoditized simple business has become an overperforming margin-accretive business for us, where candidly, a lot of the competition is exiting. Hugo is about -- and the digital suite around Hugo is about achieving the same thing in MedSurg, right? So we're a market leader in surgery, we've got decades of experience in instrumentation, a ton of goodwill with the doctors and with the patients. And Hugo and the digital suite are an opportunity to make that sticky. And to create the same ecosystem where the doctor can do pre-op procedures, can have monitoring of the operation, can do post-op analysis with AI to help him understand how to improve the outcome, how to improve the speed of the procedure, et cetera, thanks to this whole ecosystem. So that's what we're going for. And we're on Hugo, specifically the robot has been on the market outside of the U.S. for a few years now. It's -- we have an installed base in over 30 countries outside of the U.S. We've built the sort of understanding of what's going to make it successful. And we anticipate to get FDA approval in the U.S. before the end of our calendar year. And so you should start seeing an impact if you go in the fourth quarter for us on the MedSurg numbers, and you should start seeing the impact on the full Medtronic numbers in fiscal year '27.

And then already in, kind of the third big growth driver. You talked about faster than WATCHMAN, but...

So third but not least. So here, we have a business that has taken I would say, 15 years to come to market, and it's a testament to the resilience of the Medtronic team, I would say. But now we have a very, very unique position with a ton of clinical data in a field where in the U.S. alone, there's 18 million patients. And so I'll let you do the math, 1% of 18 million patients multiplied by a catheter worth $16,000. It's a very, very large opportunity for us. It's about to get a final decision from a reimbursement perspective or officialization of that decision because the decision is made. And so we're about to commercialize the product and -- and that's -- for us, it's probably the biggest market opportunity Medtronic has had in decades.

Is there some pent-up demand there from patients that you're seeing since you've had earlier...

Yes. so when we did the clinical trials, 80% of the patients self-applied, right? So which means that there is a demand. It's a procedure that has a material impact on the life of the patients with hypertension. And look, we're going to do some direct-to-consumer marketing to raise awareness of the therapy because that's key. At the same time, we're building the capability to carry out the procedures and building the system, so that when a patient becomes aware of that possibility, he gets referred to a center where he can have it done as efficiently as possible. So again, you will start to see the impact pretty materially in the second half of this year. And the reference that you gave to WATCHMAN, so WATCHMAN, was about $0.5 billion after 5 years, and we anticipate a much faster ramp-up than that.

Okay. Great. I think that's all the time we have. Thank you.

Thanks very much. Thank you.