FOOL ON THE HILL
An Investment Opinion
NOW 50 component Medtronic (NYSE: MDT) has several lines of medical devices, and is perhaps best known as the company that produces more than half of all pacemakers used in the world. The company was founded in 1949 with a 100-year business plan. One hundred years! Try this exercise for a minute: Whatever business you are in, or know most about, try to jot down a business plan that encapsulates developments through the year 2100. You quickly find yourself trying to imagine things that don't yet exist, and then coming up with applications based on those nonexistent things, and then finally new improvements based on these processes. It's not impossible to do, but it requires a deep well of knowledge and creativity.
That's exactly what Earl Bakken, founder of Medtronic, had in spades. In 1949 Medtronic was founded when Bakken and a partner discovered that medical engineers were not capable of servicing and repairing some of the newer laboratory and testing equipment. In the first few years, this was the main line of business for Medtronic, and according to the company's official history, the company earned $8 in total revenues its first year. Even adjusting for inflation, this is not an amount of money that would have been sufficient to run a company for a year. Or even a day.
But Bakken had his plan. He envisioned a time in which electronic devices would be implanted in human beings to assist in healing. Although this seems commonplace now, in 1949 this type of thinking was nothing short of science fiction, the stuff of Orson Welles or Lon Chaney. Bakken believed that such devices would be beneficial in healing every part of the body, and he just needed time to develop them. As such Medtronic began operating as the local representative for other medical equipment manufacturers, deriving enough revenues to keep the company in operation long enough for Bakken to develop the first of his devices.
Within four years Medtronic got its chance, as the first open heart surgery was successfully performed by Dr. John Gibbon in 1953. Such rapid developments in treatment of heart disease produced a ready-made and unaddressed market for their first product -- a battery powered pacemaker, which Bakken designed at the request of another medical pioneer, University of Minnesota's C. Walton Lillehei. This product was introduced in 1957. In their initial form, pacemakers were large boxes that had to be worn externally. This box had wires that ran from it, through the chest wall, and to mounts on the heart where electric shocks could be administered. As you can imagine, this form of therapy did not exactly engender much excitement in many patients, who had long learned that contact with electricity was a bad thing. According to a recent Fortune article about Medtronic, critics predicted that the pacemaker market would never grow to more than 10,000 people.
This type of forecasting did not gibe well with Bakken's 100-year plan. Instead, Medtronic sought to continually improve the functionality of the pacemaker. Today it is a watch-sized, fully implanted device. An estimated 250,000 people annually receive Medtronic pacemakers. Medtronic has been called the "best medical device company in the world," and even the "Microsoft of the medical device industry." Investors in the company have been suitably rewarded, with a compound annual growth rate (CAGR) of 22% since inception. Over the last 10 years it has gained 34% per year, one of the best-performing Fortune 500 companies over that length of time. The company's market capitalization is currently in excess of $64 billion.
The company's operating results are a testament to Bakken's plan. Medtronic now has annual revenues of $4.1 billion. But Medtronic has not continued to rely upon the pacemaker for the majority of the business; more than 70% of its revenues come from products introduced since 1998. The company now has several areas of concentration: "cardiac rhythm management," neurological and spinal surgery, cardiac surgery and vascular -- each with dozens of products.
So, is this a good investment? I'd go so far as to call Medtronic a Rule Maker. It has gross profits of 73%, net profits of 29%, almost zero debt, and a return on equity of 24%. It also is without question the dominant player in a growing market, with 10-year annualized revenue growth of 18%, but 59% revenue growth in 1999.
Those are some gaudy numbers. The problem facing Medtronic is that the pacemaker and defibrillator markets are no longer high growth, with pacemaker growth dropping to 4% per year. Also, the company lies in a market with mercilessly short product cycles, since doctors must (by virtue of their roles as life-savers) use the most advanced technology available. At any point, Medtronic will have several generations of the same product in various development stages at the same time.
The biggest worries for Medtronic are twofold: 1) It is forced to go out and buy certain technologies to round out its product offerings, something it had never done before, and 2) it is moving into areas in which it does not have the same experience as it does in cardiac care. Medtronic thus suffers from the same uncertainty that pharmaceutical companies are constantly running against: They spend millions in research and development without any assurance that the Food & Drug Administration will approve their products. Once this has taken place, the real work of persuading physicians to use the technology begins.
All of this for markets that do not yet exist. Given the advanced nature of Medtronics' products, the company can never be sure it has much of a market until its product hits the streets. In this regard, the therapy defines the user base, not the other way around.
Still, Medtronic has built its reputation on decades of excellence. And moving into new areas of concentration is nothing new to the company. It was founded upon an audaciously forward-looking plan, and sought to address markets that did not yet exist.
Seems pretty Foolish to me.
Bill Mann, TMFOtter on the Fool Discussion Boards