Michael N. Weinstein - JP Morgan Chase & Co, Research Division
Good morning, welcome, everybody. If everybody could take their seats. It's my pleasure to introduce our next speaker, the Chairman and Chief Executive Officer of Medtronic, Omar Ishrak. We will have a breakout session immediately following in the Porch room. Omar?
Omar S. Ishrak
Thank you, Mike, and good morning. It's good to be here, and I'm going to get to business straight away here.
We're going to talk today about a number of things. First, about our execution and short-term, near-term drivers and our outlook for the near-term. Also, how we're transforming the business and how we're looking at the changing health care landscape for the longer-term. We're doing a lot of things to our portfolio and I know that's of interest to a lot of you and I want to discuss that briefly. And then finally, a lot about our capital allocation and cash generation. So these are the 4 broad topics that I'm going to cover in the next 25 minutes.
First, in the last 18 months, we've begun to stabilize this business. And the numbers, the key metrics that we look at, or some of the key metrics that we look at, our revenue growth, market share, and EPS growth are all beginning to show some levels of consistency in their delivery of performance. I know it's very early, we've had a couple of quarters, 3 or 4 quarters of consistent delivery and that's good. But we know, as much as all of you, that this has to continue for a very long time for us to build a stable and reliable -- and a business that all of you can really bank on. The number of things that we've done, I mean, these things have gotten into the organization, which have, I think, resulted in some of this improved performance. First, really tight alignment amongst the overall team. It's a complex business with the regions and businesses and functions, and we put in a lot of effort in making sure that the teams are aligned well. We've had good execution on product launches, not only in delivery of the products on time but also the results that we've shown in terms of consequent commercial success. And then finally, a real change in the business team across Medtronic in taking accountability for our own markets. So just because the markets are down doesn't mean that we cannot grow or we cannot perform, that's not an acceptable excuse. It can happen, but that's not an acceptable excuse. Teams have to take on the responsibility because we are the market and we are market leaders to grow the market and make sure that we leverage the opportunities that we have.
Now I'm going to talk to you first about the near-term drivers and there's a number of items that I'll cover in sequence. First, about growth. And then, about our cost and capital positions.
And about growth, I want to start with market stabilization. As all of you know, the 3 main -- the 3 big markets, primarily in the U.S. where we've had pressure, and the industry, actually, has had pressure over the past 24 months or so, has begun to stabilize. And certainly, our revenue has began to stabilize. Most of this is the market, but also our own products have led to some degree of success. We've had sequential stability now for the last several quarters. If this trend continues, we see that just the stabilization itself will give us a point or so of differentiated growth between the last few quarters, last year and the upcoming second half of FY '13, fiscal year '13 for us. The 3 markets, U.S. ICDs, Core Spine and U.S. Pacing have got different drivers, but all of them right now are beginning to show stability in businesses which were previously declining. So these are good signs for us and something that we can build upon.
Now in addition to that, in addition to these markets stabilizing, we have multiple high-growth platforms which are delivering. Areas all the way from Advanced Energy, based on an acquisition that we did now about 18 months ago to atrial fibrillation where we've got unique technologies; to our O-Arm, which we're leveraging for imaging and guidance in ENT and neurosurgery; to diabetes and transcatheter valves. Across the board, we've got some really exciting growth platforms, which we think will contribute about 400 basis points of overall growth to Medtronic in FY '14.
Now looking more specifically at these businesses, we like to look at them in 3 big categories. First of all, products that have already been launched and will continue to give us future growth as we look into the second half of FY '13 and into FY '14. The Resolute Integrity, as you know, has had a -- given us a big step function growth in the U.S., that product was recently launched in Japan and we see growth trends continuing in Japan as a result of that. But in addition to the Resolute Integrity, there's a whole series of other products from our different businesses, all of which have been launched in the recent past, which we think will contribute to our growth going forward, about 100 basis points for the products in the left. The second category are products that we're going to launch and are getting ready for launch in the second half of FY '13, which we think will give us continued support in our growth line as we go forward. And then, in FY '15, we're looking at 2 really major product launches, one in transcatheter valves in the U.S. and the other, is the renal denervation system, also in the U.S. Both of these, as you all know, are the foundations of billion-dollar markets. And we think from FY '15, all these will be significant growth drivers for us. But in the interim, we've got plenty of other products across the rest of our businesses, which will support the growth levels that we've been delivering in the recent past.
Emerging markets continue to be another source of growth for us. It's an area where we've established a track record of around 19% to 21% in the last 4 years or so. We expect this general trend to continue based on the growth of these markets and based on the efforts that we're putting into there. We're putting efforts to accelerate this even further, but I'll talk to that a little later. But in terms of our baseline, we've got a pretty good range in FY '13 to come close to around 20% growth. Through these efforts in the upcoming years, we expect emerging markets to provide about 20% of our business as opposed to 10% that, that was the case in FY '12. This is significant. It's going to add about $3 billion over the next 5 years and about 150 to 200 basis points to our baseline growth in the next couple of years. Although the businesses are primarily in cardiology, the other businesses in endo and in structural heart, as well as in neuromodulation, are businesses that are high growth; and diabetes are high-growth. And over time, these will be big growth engines for us, and we expect them to take a bigger and bigger proportion of our emerging market growth. And also, the countries outside of China, India, in particular, but also Central Europe, Middle East and Africa, Latin America, all would be big growth engines. And over time, we expect China to grow as well, but the other countries actually, to grow even faster.
Now summarizing all of that, all of our growth factors, we have here, essentially, 3 categories in the way we look at our business. First, about 1/4 of our business, have been the markets in the U.S. that have been under pressure that I just talked to. And in the first half of FY '13, they have had a combined growth level of minus 4% and at the Medtronic level, this has contributed to about 100 basis points of pressure. As the market stabilizes, like we discussed, looking forward into the second half, we expect this to turn to a 1% growth story as opposed to minus 4% and it'll actually continue -- contribute about 20 basis points of positive growth to Medtronic. We look to the strength to continue into FY '14. The second segment, which is actually a pretty small segment, it's only 2% of our business, but has grown very rapidly and has had a lot of visibility so we thought we'd call to that, is our U.S. drug-eluting stent business, which has obviously grown a significant amount based on our launch of the Resolute Integrity but that will anniversary. And although we'll see some growth in the second half of FY '13, in FY '14, this will go back to -- we're assuming that it'll go back to market levels. And then finally, the remaining 3/4 of our business are actually a series of high-growth platforms, which I mentioned a little while ago. And we expect this -- the combined growth rate of these businesses to be around 6% or contribute about 400 basis points, and that's been happening. We expect that to continue into FY '13, and in fact into FY '14. Maybe even accelerate on the basis of accelerating new product launches that we expect in the upcoming 12 months. So this is essentially a triangulation of our growth story and it gives you some perspective as to the way in which we're looking at our business. These total up to about a 5% growth level for Medtronic and so we think that a 3% to 4% outlook for FY '13 is certainly achievable. And a mid-single-digit growth trajectory that we've committed ourselves to, looks like, is in the cards. And a lot of things can happen, but this is our game plan. And it's pretty grounded in the way we're looking at it.
Now if I move over to costs. Product cost reduction has been a big focus of Medtronic before I came, but in the last 18 months or so, I emphasized even more to the team that product cost reduction is something that doesn't go away. We saved $1 billion between FY '07 and FY 12, well, guess what, we have to save $1.2 billion between FY '12 and FY '17 and this will continue. And then another $1.0 billion to $1.5 billion in years after that. So we have to build a system through which we can deliver product cost reduction of long-term, as well as short-term initiatives. Long-term in terms of new product architectures, short-term in terms of supply chain optimization. And this cycle is a continuous cycle that will continue, and I think if you can make this -- put this into the culture of the business, which it is becoming pretty solid, solidly ingrained, we think that we can maintain the gross margins that we're used to, around 75% to 76% going forward as we grow into different segments of the market around the world. And then, at the same time, we continue -- some operating leverage in SG&A and our efficiencies do continue to improve. There's a lot of different initiatives that we have in place. And largely, we will keep investing in emerging markets while reducing costs in the developed markets because that's the nature of our business equation as we go forward. But we will make necessary investments in R&D or clinical affairs or wherever else that is necessary in whichever market that shows some promise.
Turning to cash. We built a history, again, in cash as well, of returning about 50% of our free cash flow to our shareholders and it's split pretty equally between our dividend and our share repurchase program. And this, as you know, has consistently increased over the years. We expect the same strategy to continue going forward, no change in this, both in terms of our dividend, as well as in terms of our share buyback. So you can expect this trend to continue. The way we do this, there's a significant amount of cash here. We have about -- we generate about 25% -- $25 billion of cash we expect to generate in the next 5 years. Most of it is outside the U.S. but a significant portion is in the U.S. But it's only from the U.S. cash that we can provide dividends. We provide about 50% of the free cash flow for dividends, that's our plan for the next 5 years, $12.5 billion. This gives us ample flexibility internally to make the investments that we still need, about $12 billion or so in the next 5 years for internal use; and about $12.5 billion returning to our shareholders. This is somewhat constrained by the fact that we are -- such a lot of our cash is generated outside the U.S. But we've got some strategies for generating more U.S. cash, which I'll share with you in the next few slides here.
But to summarize, therefore, the first phase of this presentation, which is essentially telling you what our baseline story is, which is very important, which I want to emphasize. First, our commitment is to deliver consistent mid-single-digit revenue growth. And as I said before, we'll do everything that we can to offset market pressures and everything else. Our goal is to provide consistent and reliable revenue growth in the mid-single-digits in the upcoming years. And we're going to do that quarter-after-quarter, and that's the singular and most important focus of the company to make sure that this is something that becomes in our DNA and in our muscle memory, and we can deliver every quarter systematically, and we have ways in which we can do that. Second, to consistently grow EPS, about 200 to 400 basis points faster than revenue. And third, to continue to return 50% of our fee cash flow to shareholders. This is our baseline and we want to be able to ground this and make this thing completely reliable.
Now aside from the baseline, we want to move -- well, before I get to that, some short housekeeping, which I almost missed here. As you know, the R&D tax credit is in place now and because of that, actually for FY '13, we are willing -- we're going to tighten our guidance as of today. We're moving it from $3.62 to $3.72 to $ 3.66 to $3.70, it's very mechanical. It's just removing the risk of the R&D tax credit away from our estimate, that's all this is. And because of that, the lower end of the guidance has been tightened and it's now $3.66 to $3.70. We expect about $0.03 in Q3 and about $0.01 or so from Q4 onwards as a result of the R&D tax credit coming through.
Now going forward and changing gears now, into upsides and longer term opportunities and really looking at Medtronic as to where it will be and how we'll transform this business to a new kind of business over the next 5 years, 10 years in the future. And there are 4 big things that I want to talk to you about. A different way of generating cash, a completely different level of cash generation than what we've been used to. Globalization, acceleration of that. Economic value, which I've talked about a lot publicly in the last year and I want to emphasize and give you more color as to how we're approaching that and what success rate we're getting. And then finally, a look at our portfolio and how we're looking at our portfolio between different segments and what markets are important for us, and then, how we align our strategies according to that.
First, U.S. cash. As I just mentioned, our ability to provide more back to our shareholders is constrained right now by U.S. cash. It's important for us to generate more cash. Now this is U.S. but some of these techniques and methods will give us more cash outside the U.S. too, which also helps. Essentially, there are 3 big things that we want to put a very heightened focus and emphasis on internally in our operating team. Improved demand visibility of our supply chain, minimized idle inventory because this is non-optimized, it's in a variety of places across the entire supply chain, from the factory to distribution centers, to the field, in Trungston [ph] which is not optimized at all. And finally, once we get a measure of this, to optimize the supply chain accordingly and build greater partnerships with the different suppliers and find new ways of improving our working capital. We think that these initiatives are, first, goals similar to the goals that we set in product cost reductions. We will want to point the organization in addition to product cost reduction, to working capital management and our initial goal is just to increase our inventory turns by 50% in the next 5 years which will generate $1 billion of inventory avoidance by the year FY '17.
The second is operating expense where the disproportionate amount of spend outside the U.S. will give us some leverage, and we think that this will give us about $500 million of annual U.S. cost savings by FY '17.
And then finally, something that's outside our control, but there is a lot of talk about tax policy. If that comes through and we are able to repatriate cash from outside the U.S., there's a considerable amount of cash that's sitting outside the U.S. and potentially, up to about $18 billion of earnings can be brought back if the tax policies are favorable. But this is something that's not in our control, and I'd much rather work on things that we can control and that's like working capital and operating expenses. And through that alone, we can start to improve our own position in terms of capital allocation and our flexibility as to what we give back to shareholders.
The second area in which we want to transform our business is globalization. And like I said, emerging markets, already, are providing us with roughly 20% growth, plus and minus. We want to accelerate this. And we want to accelerate this across the world to a certain system. As we look at markets around the world, particularly emerging markets, we can break them down into a Premium segment, which essentially is the market which can afford our present day products, which can have different tiers, but those older products are. But there's a whole class of the population out there who cannot afford these products that we sell today, and that is what we call the Value segment where lower-cost products or rising incomes will help affordability in that area. And then finally, there's the underserved segment. The way we want to approach this market is, first, to deepen the penetration in emerging markets in the Premium segment. Then, as we deepen this penetration through that process, we will create an infrastructure that is capable of reaching broader levels of the population. At the same time, we will work on lowering our costs and through that, we will enter the Value segment over the next 3 to 4 years on a continued basis.
And then finally, as this Value segment is established, we feel fairly strongly that this has the potential to disrupt the developed markets where there's continued cost pressures. And if there are ways in which -- new ways in which we can find lower-cost delivery mechanisms, they will come through back into the developed markets.
Focusing on the Premium segment, again, for a minute here, the reason we're so excited about this is because when we look at this thing carefully, we see that in emerging markets, amongst people who can afford our therapies, the penetration level of those therapies is only 8% compared to 22% of the same therapies in developed markets. These are people who can afford these technologies. These are not new products, this is not lower-cost products nor is it people who need more money or new reimbursements. This is simply a matter of breaking down the barriers of awareness, infrastructure and physician training. If you do that and we close the gap between the 8% and the 22% that we see in the developed markets, this is actually a $5 billion annual opportunity in emerging markets. So only tapping into a portion of this can give us incremental upside over the 20% that we talked about. And so that you all understand, our margins in these emerging markets, because we're selling these products is, in fact, comparable to developed markets. And as we go to the Value segment, our cost will go down in the ways that we talked about. So we expect to maintain margins in emerging markets.
Two specific markets that we're really focused on, and I won't go through the details of each, but only to point out that both China and India are big, they're both populations of over 1 billion people, but they are different. They're different in which the government looks at health care, they're different in which health care delivery is practiced, one is government controlled the other is private corporations. The government in India, for example, is focusing more on the underserved and the segment that cannot afford health care. While private corporations actually are delivering high-quality and low-cost standards of care that may, in fact, migrate to other countries around the world. So these are big opportunities for growth for us and we see about $2 billion in China by FY '18 and over $500 million in India by FY '18 as well. So 2 big markets for us, but like I said before, Latin America, Central Europe, Middle East and Africa are all exciting markets, but they're all different. And each one deserves its own focus, it's own understanding as to how we participate in those markets and we're focused in all of them, and through all of that, we expect to accelerate globalization.
Next, I want to shift more towards the overall market. And you've all heard about the Old World and the New World. And the Old World is the way in which health care is traditionally delivered, a pay-for-service model. This is true around the world. But particularly in the U.S., even more so. And let's focus in the U.S. for the purposes of this presentation and this chart.
Fee-per-service is gradually moving to pay-per-value. And fee-per-service really focuses on the product therapy and the costs. So for a given procedure, you get a fee. Pay-per-value is really around managing care over an extended period of time. Either over an extended DRG or over disease itself. So a way in which you approach the market as it changes from fee-per-service to pay-per-value is very important, the way in which we have our offerings, the way in which we approach our customers. We're changing from physicians only to more and more administrative buyers. Physicians remain important because they make the clinical decision but buyers, other stakeholders become increasingly important as well. In addition to that, economic value becomes very important and our ability to prove the value of our products in economic terms, as well as clinical terms, is extremely important. So as we go forward, economic value is central to our business. And what is economic value? Very simply, we want to take all our offerings, structure it first and then make sure we can deliver a quantifiable financial benefit to the target customer, whether it's a physician, an administrator, a CEO or the government or a payor. That's the way in which we define economic value in a very granular fashion. To do this effectively, we essentially have to transform our whole business and think of economic value not only when we sell but also when we design our products and we conceive our products to start with and we conceive of our business equation to start with. Specifically, in terms of commercialization, it means that products that we already have, we have to prove the economic value of these products as we go to market and make it meaningful for the different stakeholders along the chain. To do this, we need to pilot, then we need to scale within that hospital system because it's meaningful for that hospital system and then we need to expand across the market broadly. And through that, we expect to get disproportionate share because we will show economic value to the customers, as well as clinical value. And if there's economic value, I think hospital systems, in general, will be open to participating with us and partnering with us.
Next, we come to our overall portfolio. And where we are thinking of forming our business around cardiovascular, around neuro and ortho, which is roughly our Restorative Therapies Group and Diabetes. In each area, the buyers are different. In cardiovascular, we've got a consolidating buyer around the Cardiac Line Administrator. In neuro and ortho, the administrative component is not so well-established but there's linkage between customers and there's certainly linkage in technology. And it really revolves around spine, which is a big piece of both neuro and ortho. And then, in Diabetes, it's basically disease management where payors and patients are extremely important in the way we go to market. In each of these areas, we have specific economic value programs targeting each one of these customer groups. Now what's important, which I want to emphasize over and over again, is that independent of everything else that I talked about in terms of economic value and new stakeholders and so on, being #1 and having #1 leading positions and having a technology of choice through a clinical user is extremely important, and that is the foundation of what we have and something that we've got to maintain across all these segments.
As we look at our acquisition strategy, our inorganic strategy, it also follows these customer groups. We'll build around these customer groups, doing acquisitions to enable more and more commercial synergies, as well as technology synergies. We'll focus in Value segment expansion for globalization and integrated offerings across the care continuum for economic value.
Our guidelines remain that we want to provide mid-teens risk-adjusted return hurdles, no dilution to EPS, no net dilution, so the overall business should cover this. And finally, the 3 or 4 key questions as to whether we can win and what we can add value, both in terms of our existing portfolio and in terms of future acquisitions are also questions that we already have. Certain foundations we never change, our mission, always important to us; our emphasis on quality and the linkage with physicians will always remain important to us.
So I want to conclude the talk by really summarizing what we talked about. Execution, which forms the foundation of what we'll do is something that we're beginning to deliver on, and we'll continue, and it stays central to us. Growth themes of economic value and globalization, we expect to convert to revenue over the future. And in globalization, expanding to the Value segment. And then finally, really get our portfolio geared around these 3 big customer groups, cardiovascular, neuro/ortho and diabetes, and think of our business in that way. We think we can transform Medtronic in a very exciting MedTech space. We think this is an opportunity as much as it's a challenge, and we think we're in the best position to leverage this opportunity. Thank you very much for your attention. Thank you.
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