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Medtronic, Inc. (MDT-NYSE)

SUMMARY

SUMMARY DATA

Risk Level * Low

Type of Stock Large-Blend Industry Med Products Zacks Industry Rank * 182 out of 267

Current Recommendation NEUTRAL

Prior Recommendation Underperform

Date of Last Change 09/05/2011

Current Price (02/19/14) $56.20

Target Price $59.00

Medtronic reported third-quarter fiscal 2014 adjusted EPS of $0.91, down 2% year over year and in-line with the Zacks Consensus Estimate. Revenues came in at $4.163 billion, up 4% at CER, closely beating the Zacks Consensus Estimate of $4.155 billion. After a several quarters of improvement, the company s core ICD and pacing segments posted disappointing sales. Spine revenues continue to maintain sluggish trend. However, strong CoreValve transcatheter aortic heart valve sales in the international market were encouraging. Besides, focus on portfolio expansion with objective to boost revenues from emerging markets is encouraging. We are also looking forward to the company s recent attempt to rebuild it as a health care service provider. However, looming headwinds such as currency headwinds, soft economic condition and tough competition keep us on the sidelines. Currently we are Neutral on the stock.

52-Week High $60.84 52-Week Low $43.88 One-Year Return (%) 27.55 Beta 1.00 Average Daily Volume (sh) 5,362,547

Shares Outstanding (mil) 998 Market Capitalization ($mil) $56,107 Short Interest Ratio (days) 2.06 Institutional Ownership (%) 29 Insider Ownership (%) 0

Annual Cash Dividend $1.12 Dividend Yield (%) 1.99

5-Yr. Historical Growth Rates

Sales (%) 2.8 Earnings Per Share (%) 5.6 Dividend (%) 8.5

P/E using TTM EPS 14.8

P/E using 2014 Estimate 14.7

P/E using 2015 Estimate 13.7

Zacks Rank *: Short Term 1 3 months outlook 3 - Hold * Definition / Disclosure on last page

ZACKS CONSENSUS ESTIMATES

Revenue Estimates (In millions of $)

Q1 Q2 Q3 Q4 Year

(Jul) (Oct) (Jan) (Apr) (Apr)

2012 4,049 A 4,132 A 3,918 A 4,297 A 16,184 A

2013 4,008 A 4,095 A 4,027 A 4,459 A 16,590 A

2014 4,083 A 4,194 A 4,163 A 4,588 E 17,018 E

2015 4,265 E 4,391 E 4,333 E 17,652 E

Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses)

Q1 Q2 Q3 Q4 Year (Jul) (Oct) (Jan) (Apr) (Apr)

2012

$0.79 A $0.84 A $0.84 A $0.99 A $3.46 A

2013

$0.85 A $0.88 A $0.93 A $1.10 A $3.75 A

2014

$0.88 A $0.91 A $0.91 A $1.12 E $3.82 E

2015

$0.95 E $0.99 E $0.99 E $1.17 E $4.10 E *Note: Quarterly EPS may not add up to the annual figure due to rounding-off.

Projected EPS Growth - Next 5 Years % 7

February 20, 2014

http://www.Zacks.com

Equity Research MDT |

RECENT NEWS

In-Line Earnings, Tighter Outlook at Medtronic

Feb 18, 2014

Medtronic s third-quarter fiscal 2014 adjusted EPS came in at $0.91, down 2% year over year but in line with the Zacks Consensus estimate. The year-over-year decline was primarily due to the non-renewal, this year, of a benefit of $0.03 from the extension of the U.S. R&D tax credit.

Also, high interest expense and the U.S. medical device excise tax lowered the bottom line in the reported quarter. However, without any one-time adjustments, the company reported net income of $762 million or 75 cents a share, both down 23% on year-over-year bases.

Revenues in the reported quarter were $4.163 billion, up 3% year over year (up 4% at constant exchange rates or CER). The result remained marginally above the Zacks Consensus Estimate of $4.155 billion.

International sales (generating 46% of total sales) grew 2% year over year (up 4% at CER) to $1.898 billion in the quarter. Based on Medtronic s focus on emerging markets, revenues from these regions experienced continued growth momentum and increased 10% (up 12% at CER) to $521 million. This region now represents 13% of the company s total revenue.

Segment Details

Medtronic earns revenues from two major groups

the Cardiac & Vascular Group and the Restorative Therapies Group. The former encompasses the Cardiac Rhythm Disease Management (CRDM), Coronary, Structural Heart, and Endovascular businesses; while the latter includes the Spine, Neuromodulation, Diabetes, and Surgical Technologies businesses.

CRDM sales were up 1% year over year (up 2% at CER) to $1.184 billion. Revenues from Implantable Cardioverter Defibrillators (ICD) increased 1% at CER to $655 million on the back of strong adoption ofthe Viva XT CRT-D that drove growth in Western Europe and Japan. Pacing system revenues edged down 2% at CER to reach $439 million. AF solutions on the other hand, grew 20% primarily due to a stupendous 30% improvement in the Arctic Front CryoAblation System.

Coronary revenues remained flat year over year at $436 million. On the other hand, Structural Heart and Endovascular recorded growth of 4% (to $281 million) and 4% (to $218 million), respectively, at CER. The company is benefiting from the sale of the drug eluting stent (DES), which grew 5% at CER driven by significant share gains of the Resolute Integrity drug-eluting stent worldwide.

Strong CoreValve transcatheter aortic heart valve sales in the international market led to growth in the Structural Heart business. As expected, in the reported quarter, Medtronic received U.S. approval of CoreValve for extreme risk patients. On the other hand, Endovascular growth was negatively impacted by the divestiture of a reentry catheter product line and elimination of a peripheral below-the-knee product from the market.

Spine revenues maintained the sluggish trend and fell 1% year over year (flat at CER) along with a flat Core Spine revenue growth to $631 million. Excluding sales of balloon kyphoplasty, Core Spine grew in the low single digits, both globally and in the U.S.

Moreover, BMP (bone morphogenetic protein) revenue declined 1% at CER to $113 million. According to Medtronic, after several quarters of drag in sales, the global and U.S. spine markets have started showing signs of stability.

Meanwhile, Surgical Technologies revenues were $386 million (up 10% year over year and up 11% at CER), while revenues at Neuromodulation were $478 million (up 7%, same at CER) and at Diabetes, $436 million (up 16%, same at CER).


Margins

Gross margin during the reported quarter contracted 41 basis points (bps) to 74.8%. Adjusted operating margin contracted 52 bps year over year to 30.1%, with a 3.8% increase in selling, general and administrative expenses (to $1.454 billion), a 4.3% decline in research and development expenses (to $360 million) and a huge 164.7% decline in Other expenses (to $45 million).

Guidance

Medtronic tightened its EPS outlook for fiscal 2014. The company currently expects full-year EPS in the range of $3.81 $3.83 (implying annualized growth of approximately 6%) from earlier prediction of $3.80 $3.85 (annualized growth of 6% 8%).

However, the company restated its revenue growth outlook for fiscal 2014 at 3% 4% at CER. The current Zacks Consensus Estimate for EPS stands at $3.82 (on revenues of $17.022 billion) and remains within the guided range.

VALUATION

Medtronic posted a mixed fiscal third quarter with in-line EPS and a revenue beat. After a strong fiscal second quarter performance with improvement in core CRDM and pacing segments, the company is again back on its sluggish revenue track with its core segments. The still sluggish CRDM sales with poor ICD and pacing revenues once again raised question on the company s statement of stability in core market. Margin pressure too poses a major cause of worry. Spine sales continued its sluggish trend. Moreover, headwinds such as unfavorable currency movement and global economic uncertainties remain. However, Medtronic is trying every means to boost growth. This includes penetration into the international markets, and expansion of portfolio and restructuring initiatives, which should benefit the company over the long term.

Meanwhile, Medtronic has increased its focus on the emerging markets and is targeting higher revenues from this region. The company is also committed to its aim of returning 50% of its free cash flow to its shareholders, along with undertaking suitable acquisitions, to augment growth. Given the challenges related to economic uncertainty and tough competitive landscape, we reiterate our Neutral recommendation on the stock with a target price of $59.00.

Medtronic s current trailing 12-month earnings multiple is 14.8x compared to the industry average of 27.2 and 18.0 for the S&P 500. Our target price is based on 14.4x our 2015 EPS estimate of $4.10.


Key Indicators

P/E F1

P/E F2

Est. 5-Yr

EPS Gr%

P/CF (TTM)

P/E (TTM)

P/E 5-Yr

High (TTM)

P/E 5-Yr Low

(TTM) Medtronic, Inc. (MDT) 14.7 13.7 7.0 11.9 14.8 15.0 9.7

Industry Average 26.1 69.8 15.0 26.7 27.2 N/M 12.6 S&P 500 15.7 14.7 10.7 14.9 18.0 27.7 12.0

Baxter International Inc. (BAX) 13.5 12.6 8.5 11.8 14.9 15.9 10.5 Covidien plc (COV) 17.8 15.9 10.2 13.7 18.1 17.3 10.7

TTM is trailing 12 months; F1 is 2014 and F2 is 2015, CF is operating cash flow

P/B Last Qtr.

P/B 5-Yr High

P/B 5-Yr Low

ROE (TTM)

D/E Last Qtr.

Div Yield Last Qtr.

EV/EBITDA (TTM)

Medtronic, Inc. (MDT) 3.0 3.6 2.2 21.1 0.5 2.0 10.0

Industry Average 34.3 34.3 34.3 N/M 0.3 0.3 N/M S&P 500 4.8 9.8 2.9 25.4

2.1


Earnings Surprise and Estimate Revision History

NOTE THIS IS A NEWS-ONLY UPDATE; THE REST OF THIS REPORT HAS NOT BEEN UPDATED YET


OVERVIEW

Medtronic, Inc. (MDT) is one of the world s leading medical technology companies, specializing in implantable and interventional therapy devices and products. Founded in 1949, the company is based in Minneapolis, Minnesota. Medtronic derives revenues from two broad groups

Cardiac and Vascular

Group and Restorative Therapies Group. While the former is comprised of Cardiac Rhythm Disease Management (CRDM), Coronary, Structural Heart and Endovascular businesses, the latter includes Spinal, Neuromodulation, Diabetes, and Surgical Technologies. In January 2012, Medtronic sold its Physio-Control business to Bain Capital.

The Cardiac and Vascular Group's products include pacemakers, implantable defibrillators, leads and delivery systems, ablation products, electrophysiology catheters, products for the treatment of atrial fibrillation, information systems for the management of patients with CRDM devices, coronary and peripheral stents and related delivery systems, therapies for uncontrolled hypertension, endovascular stent graft systems, heart valve replacement technologies, cardiac tissue ablation systems, open heart and coronary bypass grafting surgical products.

Products in the Restorative Therapies Group cover various areas of the spine, bone graft substitutes, biologic products, implantable neurostimulation therapies and drug delivery devices for the treatment of chronic pain, movement disorders, obsessive-compulsive disorder (OCD), overactive bladder, urinary retention, fecal incontinence and gastroparesis, external insulin pumps, subcutaneous continuous glucose monitoring (CGM) systems, products to treat conditions of the ear, nose, and throat, and advanced energy products. Additionally, this group manufactures and sells primarily image-guided surgery and intra-operative imaging systems.

Revenue breakup

30%

20%

11%7%

5%

10%

9%8%

CRDM Spinal

Coronary Structural Heart

Endovascular Neuromodulation

Diabetes Surgical technologies

56%

44%

US International

Source: Company reports


REASONS TO BUY

Signs of stability in core ICDs market:

Trends in the previous fiscal have been divergent for

Medtronic. While 75% of the business grew at 8%, almost 25% of the rest of the business declined 10%. However, management confirmed that both the global core ICDs markets are gradually stabilizing. This would result in easier comparisons and should improve growth over the coming quarters. More significantly, in the second quarter, ICD revenue growth was 4% at CER which outperformed the market growth rate of 3% (both the global and U.S. ICD markets). ICD growth was primarily due to the company s progress with shock reduction and lead integrity alert technologies along with long-term lead performance leading to stronger market acceptance. In addition the ICD implant volumes were sequentially stable for the sixth quarter in a row. The company was optimistic about Viva and Evera which showed good market adoption. Both Viva and Evera s shock reduction algorithms, including Medtronic s proprietary lead integrity alert were approved by the FDA recently for monitoring the company s competitors defibrillation leads. Added to that, the company encouragingly noted that, despite declining trend in the European ICD market due to deteriorating pricing in some key markets, it successfully gained share in this region. We expect continued acceptance and future growth from the Evera family of ICDs, which received CE Mark approval in Feb 2013 and U.S. FDA and Japan PMDA approval in May 2013.

Source: Company

Focus on emerging markets to add value:

Medtronic demonstrated that while growth in the rest of the world was low to declining, the emerging markets grew at a robust 13% (at CER) in the last reported quarter representing more than 12% of the company s total sales mix. Although the company experienced slower growth in this region, primarily with sequential slackening occurring in Greater China and Central and Eastern Europe, the fundamental demand in the end market is strong. The company is creating necessary infrastructure to participate in the next wave of growth

the emerging market value segment.

We are encouraged about the overall growth in this region following the encouraging trend. The recent data shows that, emerging markets on a whole for Medtronic represents a $5 billion annual opportunity for margins compared to developed markets. Management is targeting 20% of its revenues from the emerging markets adding incremental revenue of $2.5 billion over the next 5 years with mid-teens growth for the current fiscal.

Medtronic has currently decided to focus on globalization due to the opportunity rife in international destinations, especially in the emerging markets. Emerging markets continue to remain a key focus area of the company. Accordingly Medtronic is building infrastructure necessary for it to participate in


the next wave of growth

the emerging market value segment. As a part of this, in Aug 2013,

Medtronic opened a global Center of Excellence (CoE) for Business Model Innovation in Singapore. According to the company, this center will help it to address market-specific needs and barriers in Asia. Furthermore, the company acquired China Kanghui Holdings and formed a strategic alliance with China-based LifeTech Scientific Corporation. Medtronic believes these steps will lead to a platform of multi-tiered products, thereby strengthening its foothold in the huge underpenetrated Chinese market. It is expected that within the next decade, China will be the biggest health care market in the world, outpacing the U.S. Apart from China, Medtronic intends to focus on the Middle East which according to the company holds potential.

Product diversification holds promise: We are impressed with the company s efforts to augment/diversify its product range. We are optimistic that over the long term, stability in the US ICD market along with a deep pipeline/portfolio

CoreValve, Resolute Integrity, Atrial Fibrillation (AF), renal denervation and peripheral businesses

will be the driving factors for the company going ahead. Of these driving factors, renal denervation serves a very significant unmet clinical need in uncontrolled hypertension and deserves special mention, given its immense market potential. Hypertension is a primary risk factor for stroke and costs the global health care economy $500 billion a year. Even with optimal drug therapy, 30% of the patients remain in conditions of uncontrolled hypertension. Consequently, approximately 300 million patients would need some sort of additional therapy by 2020. Accordingly, this indication alone holds a $2 $2.5 billion market opportunity by 2020, excluding the other potential applications of renal denervation. The company is currently investing in developing referral networks, reimbursement, technology development, and clinical and economic evidence, to further strengthen its leadership position and grasp the long-term opportunities in hypertension. Medtronic expects to launch its next-generation Symplicity Spiral multi-electrode catheter to launch before the end of fiscal 2014.

Medtronic has also witnessed robust growth in the transcatheter valve business (over 60% compounded annual growth rate over the past two years) on the back of CoreValve. While the product is CE Mark approved, the company is working on its launch in the U.S., scheduled in fiscal 2015. Recently, data from the CoreValve U.S. pivotal trial for extreme risk patients were presented and the FDA decided it will conduct separate reviews for the extreme and high risk studies. It also determined that no panel review is necessary for extreme risk approval. Given these developments, the company expects U.S. approval of CoreValve for extreme risk patients by the end of fiscal 2014. For high risk patients, on the other hand, Medtronic expects the FDA approval should come in by mid-fiscal 2015. The transcatheter valve, valued at approximately $700 million last year, is expected to grow to $2.5 billion by 2020.

Prudent use of cash:

Medtronic exited the second quarter of fiscal 2014 with $1.26 billion in cash and cash equivalents and short-term investments, higher than $1.11 billion at the end of fiscal 2013. Free cash flow continued to remain robust with approximately $905 million in the reported quarter. Also Medtronic paid more than $279 million in dividends and repurchased $713 million shares. As of the end of the second quarter, the company had remaining authorization to repurchase approximately 68 million shares. A better-than-expected share repurchase activity could further drive the bottom line of the company. Meanwhile, having witnessed strong contribution from products that came from acquisitions, the company will be on the lookout for suitable tuck-in acquisitions (with mid-teens growth) with a product suite that is in sync with its portfolio.

Going by the long-term capital deployment policy, Medtronic expects to generate $25 billion in free cash flow over the next five years ($17 billion generated in the past five years) and will strive to return 50% to shareholders through dividends and share repurchases. Attempts would also be made to increase the proportion of cash generated in the US, as it is experiencing an imbalance with more cash being generated outside US markets. This situation has forced the company to borrow in order to meet its goal of returning 50% free cash flow to shareholders.


REASONS TO SELL

Spinal sales remained sluggish:

Medtronic s Biologics business suffered from continuous

declines in the sales of Infuse (following the publication of articles in The Spine Journal). The U.S. core spine market continues to decline in the low single digits, with flat procedural volumes and positive mix, partially offsetting price declines. Two systematic reviews, in articles published in the Annals of Internal Medicine in June 2013, concluded that Infuse is an effective therapy in certain types of spine surgery and that it entails a number of risks that should be considered by physicians and patients. However, the results may not be of any help to Medtronic. As per the study, Infuse showed no sign of being more effective than iliac crest bone graft. The researchers found that, at 24 months, rhBMP-2 increased fusion rates and reduced pain by a clinically insignificant amount and instead, increased early postsurgical pain. Evidence of increased cancer incidence is inconclusive. We believe this frail data from the Yale study can be a big blow for the spine product line in the coming quarters.

Excluding BKP, the core spine business was flat globally and declined 1% in the U.S., relatively in line with the overall market. However, core spine results were below the company s expectations as certain underperforming product lines offset the positive momentum that has been building from new product and procedural innovations. Revenues from BMP [comprised of Infuse bone graft [(InductOs) in the European Union) sales] declined 17% y/y at CER during second quarter 2014.

Legal Issues Hampering growth:

In Jul 2013, the German District Court of Mannheim declared that Medtronic s CoreValve and CoreValve Evolut systems infringe Edwards Spenser patent for transcatheter heart valve technology. This ruling forced Medtronic to recall and discontinue the sale of the products in Germany. On Aug 26, 2013, the injunction against Medtronic s transcatheter heart valves has gone into effect. Edwards posted a 50 million Euro bond, as mandated by the court, to enforce the injunction. On Nov 14, 2013, the appeals court in Karlsruhe stayed the injunction based on the likelihood that the Spenser patent would be found to be invalid. The European Patent Office (EPO) has scheduled a hearing on March 5-6, 2014 to determine the validity of the Spenser patent. Although, on humanitarian grounds, Edwards has allowed exceptions to the injunction ruling in patient cases where its Sapien XT valve is not indicated, Medtronic asserted that the injunction against CoreValve in Germany is a major setback and will hurt sales in the region. Any other adverse regulatory action, depending on its magnitude, may deter Medtronic from effectively marketing and selling its products.

We are also concerned about the recent U.S. Food and Drug Administration s (FDA) warning on certain Medtronic devices. As per the announcement, the company s recently initiated voluntary field action related to certain guidewires were classified as a Class I recall by FDA.

Competitive landscape:

The presence of a large number of players has made the medical devices market highly competitive. Medtronic earns the majority of revenues from CRDM, Spinal and Cardio Vascular segments. The company faces intense competition in the CRDM segment from players such as Boston Scientific Corporation, and St. Jude Medical. Players such as Johnson & Johnson, Stryker Corporation, Zimmer and NuVasive have made the Spinal segment highly competitive.

Economic uncertainty affecting procedural volume:

Macroeconomic conditions in many of the developed countries have led to reduction in healthcare budgets and increased pressure on utilization. This leads to fewer procedures, a trend that is expected to continue in the near future


and affect revenue growth of the company. Growth in Europe during the reported quarter varied with double-digit growth in France, the UK and Ireland, partially offset by softness in Southern Europe.

DISCLOSURES & DEFINITIONS

The analysts contributing to this report do not hold any shares of MDT. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1028 companies covered: Outperform - 14.2%, Neutral - 80.1%, Underperform

5.2%. Data is as of midnight on the business day immediately prior to this publication.

Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively.

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