Medical device maker Medtronic (NYSE:MDT) reported year-over-year (y-o-y) operational sales growth of 3.3% in the second quarter of fiscal 2014 driven by strong sales of its new products. Its largest division, Cardiac Rhythm Disease Management (CRDM), returned to growth after a flat first quarter and other divisions such as Cardiovascular, Neuromodulation and Diabetes also registered solid growth. Gross margins for the quarter declined by 100 basis points y-o-y to 74% primarily due to rising costs related to new product launches.
When Medtronic comes out with its Q3 fiscal 2014 earnings on February 18, we expect operational sales to continue to grow in the low single digits. Most of the company's major businesses are likely to sustain their growth momentum as new products have found good acceptance. We also expect gross margins to remain stable near 74% as Medtronic's cost saving efforts under its five-year $1.2 billion cost reduction plan offset growing pricing pressures.
Our price estimate for Medtronic's stock is currently around $57, which is about in line with the market price.
New Products To Continue Driving CRDM Sales Growth
Cardiac Rhythm Disease Management (CRDM), primarily consisting of defibrillators and pacemakers, is Medtronic's largest division, accounting for about 30% of total sales. Weak demand for defibrillators and pacemakers in the U.S. has had a noticeable impact on the division's results in recent quarters. However, its sales are gradually stabilizing as macroeconomic headwinds weaken and new products gain acceptance.
In the last quarter, the CRDM division's sales grew 5% on a constant currency basis, driven by higher inventory replenishment at hospitals and growing sales of its new products such as the Evera implantable cardioverter defibrillator (ICD) and Viva CRT-D (ICD with pacing capabilities). In Q3, we expect the division's sales to continue to increase, albeit at a slightly lower rate than the second quarter due to moderate inventory replenishment at hospitals.
Neuromodulation Sales Likely To Sustain Growth
Medtronic's Neuromodulation segment sales increased 6% last quarter to $479 million on the back of strong global sales of its Activa Deep Brain Stimulation (DBS) system as well as growing U.S. sales of its PAINSTIM SureScan MRI spinal cord stimulator system. We expect similar growth in the third quarter as well, especially from its MRI stimulator system in the U.S., which is being received well.
Drug Eluting Stents and CoreValve Likely to Boost Cardiovascular Division Sales
Cardiovascular consists of the Coronary, Structural Heart and Endovascular businesses, which offer products such as stents, heart valves and renal denervation systems for treating hypertension. The Cardiovascular division, contributing over 20% to Medtronic's sales, reported about 2% operational sales growth y-o-y in the fiscal second quarter. Sales of drug eluting stents (DES) increased 8% on an operational basis driven by strong global sales of the company's Resolute DES. We expect this to continue in the third quarter as well.
CoreValve Transcatheter Aortic Valve (TAVR) systems, part of the Structural Heart business, saw strong sales in international markets in Q2. Medtronic's CoreValve, leading the European TAVR market, is likely to maintain this performance worldwide in Q3 as well. The company received an earlier-than-expected FDA approval to sell its CoreValve system in the U.S. in the later half of the third quarter. Although its impact on Q3 sales is likely to be marginal, CoreValve could generate U.S. sales of as much as $50-$70 million by the end of CY 2014 (read our note Medtronic's CoreValve Gets Early FDA Approval, U.S. Sales Likely To Get A Boost for further details).
The Endovascular business grew 5% on a constant currency basis last quarter, driven by growing sales of its stent graft systems such as the Valiant Captivia thoracic system and the Endurant II Abdominal Aortic Aneurysm (AAA) system. We expect low single-digit revenue growth in the global markets to continue, especially in Japan where the AAA stent graft system was introduced in Q1 fiscal 2014 and continues to perform well.
Spinal Division Sales Expected To Decline Again
The only business that is expected to weigh on Medtronic's revenue growth is the spinal division. Sales have been declining for the past several quarters due to growing efficacy concerns about a key product - bone graft paste Infuse (read Medtronic: Independent Review Raises Doubts On Benefits Of Infuse Bone Graft). Revenues in this division dropped 3% on a constant currency basis to $746 million last quarter, owing to declining sales of Balloon Kyphoplasty (BKP), Bone Morphogenetic Proteins (BMP) and Interbody devices. The spinal business is expected to continue its low single digit decline in the third quarter as the company was unable to launch any new breakthrough products to ward off growing competition.
Gross Margins Likely To Remain Stable
According to Medtronic, new product launches significantly reduce the demand for older products, leading to higher obsolete inventory and write-offs. This increases the cost of sales and puts pressure on gross margins. With several new products being launched recently, Medtronic's gross margins should remain under pressure. In Q2, the impact on margins due to new product launches was estimated to be around 20 basis points. Additionally, Q3 gross margins are likely to be impacted by adverse foreign exchange movements. However, the company's plan to reduce $1.2 billion in costs over the next five years is starting to bear fruit, which should help offset any pressure on margins in the third quarter.
Disclosure: No positions.