All Eyes on ICDs at Medtronic

Investors will be keeping a close eye on the implantable cardioverter defribrillator business.
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Medtronic's

(MDT) - Get Report

implantable cardioverter defibrillator (ICD) business will be the focal point for investors this quarter, as cautious comments from competitors have raised concerns over the state of the entire ICD market.

On its earnings call last month,

St. Jude Medical

(STJ)

reported disappointing ICD sales and indicated a slowing in overall market growth to 15%-16% from the 20% pace from earlier in the year. Part of this weakness is because of heightened safety concerns among physicians with ongoing ICD product recalls from

Guidant

(GDT)

.

Although Medtronic and St. Jude were big beneficiaries of Guidant's problems in the early part of last year, the recurrence of product mishaps has begun to take a toll on confidence and the pace of anticipated market penetration. As the leader in this segment with over 50% market share, the near-term performance of Medtronic stock will continue to be highly dependent on the results and future market outlook for ICDs.

Last quarter, Medtronic reported a very strong performance in ICDs, with 34% growth and $733 million in sales, as the company's overall market share increased to 55%. This quarter, management has been adamant in its claims for at least 20% growth in ICD sales. Market forecasts are a bit more aggressive in the mid- to high-20% growth range, but have begun to come down following St. Jude's comments and fourth-quarter report.

There is currently a relatively wide range of market forecasts between $730 million and $790 million. I expect that sales in the top half of this range -- $760 million or above -- will be viewed very favorably by the market. Sales in the lower half of this range are likely to support ongoing concerns on the ICD market and remain a drag on the stock for at least another quarter.

In addition to the Cardiac Rhythm Management business, which includes ICDs, Medtronic's results should continue to be driven by healthy midteens growth in the spinal, diabetes and neurostimulation product lines. Two of the more likely swing factors in the quarter will be the performance of the Endeavor drug-eluding stent (DES) and the PhysioControl business.

Last quarter, the Endeavor drug-eluding stent enjoyed a good entry in the European market with about an 8% market share and $36 million in sales. This quarter looks a bit tougher for Endeavor with the market entry of a second generation product from

Boston Scientific

(BSX) - Get Report

expected to cut Medtronic's European market position. I expect results for Endeavor to come in at the lower end of the $45 million to $56 million range of market forecasts this quarter. I expect management to face some tough questioning on the outlook for its DES product line, as an additional competitor,

Conor Medsystems

(CONR)

, recently entered the European market and

Abbott Labs

(ABT) - Get Report

gained the much more competitive Guidant stent platform from its recent deal with Boston Scientific.

Although PhysioControl's ERS business is a minor contributor for Medtronic overall, the performance was severely hampered last quarter by vendor supply problems. These delays led to a 21% drop in the sales of this business segment and created some pressure on the company's overall gross margin. I expect the negative effects from PhysioControl to be reversed this quarter and to help bring the gross margin back in line with the company's 75%-76% target range.

Medtronic has reported results in line with consensus forecasts the past few quarters, and I believe the company will continue this trend in its fiscal third-quarter report.

Although there are a few areas of uncertainty on the top line and a continued headwind from currency, I expect a recovery on the margin line to provide the company with the flexibility to meet current earnings forecasts (shown below).

I don't believe the company will show much earnings upside in the quarter -- additional marketing programs have led to sales force additions, which are likely to keep SG&A spending on the high side. The consensus earnings number of 55 cents a share corresponds to nearly 20% year-over-year growth, and is within management's tight 55- to 56-cent guidance range. On the revenue line, the market is forecasting 14.5% growth to $2.89 billion, which is nearly in line with the company's 15% growth target.

Fiscal 3Q 2006

Guidance

FC Consensus

EPS

$0.55 to $0.56

$0.55

Revenues

~ $2.91 billion

$2.89 billion

Full-Year Fiscal 06

Guidance

FC Consensus

EPS

$2.18 to $2.23

$2.23

Revenues

$11.1 to $11.6 billion

$11.5 billion

Management's current full-year and longer-term earnings objectives are summarized below:

Fiscal 2006 guidance is in a range of $11.1 billion to $11.6 billion in sales and $2.18 to $2.23 in EPS. The First Call consensus is currently at the top end of this full-year forecast.

Fiscal 2007 guidance is in a range of $12.2 billion to $13.3 billion in sales and $2.37 to $2.47 in EPS.

Fiscal 2008 guidance is in a range of $14 billion to $16 billion in sales and $2.70 to $2.90 in EPS.

The company's long-term financial objectives will provide 15% growth in both revenues and earnings over any five-year period. Management intends to provide a 20% or better average return on equity and a 20% cash dividend payout of the company's prior year's earnings.

MDT's fiscal second-quarter earnings were reported exactly in line with consensus expectations at 54 cents a share for a 23% year-over-year gain. Total company revenues advanced 15% to $2.77 billion. The gross margin line contracted 90 basis points sequentially to 74.8%. The company cited currency hedging costs, the scale-up of new manufacturing facilities and the disruption in PhysioControl supplies for the shortfall. The bottom line also benefited from a temporarily reduced 24% tax rate in the quarter.

The fiscal second-quarter sales performance by division is shown below:

CRM revenues grew 17% year-over-year to $1.289 billion. ICDs were stronger than expected (+34%) to $733 million, while Pacemakers gained 5% to $459 million.

Vascular sales jumped 12% to $225 million, with the first full quarter of the Endeavor DES on the market contributing $36 million in revenues.

The PhysioControl ERS business experienced a 21% decline in sales to $81 million, with delayed shipments from a third-party supplier.

Spinal/ENT revenues improved to $609 million for a 19% year-over-year gain. Spinal revenues led the way with a 20% advance to $516 million.

The Neurological & Diabetes segment gained 13% to $487 million. Diabetes products showed good momentum with a 17% sales increase, while Neuro increased at a more modest 11% pace.

The Cardiac Surgery group posted flat 1% growth.

Michael Latwis is Director of Health Care Content at TheStreet.com Professional Products. Michael has 10 years of investment experience, most recently with Barclays Wealth management division where he was Associate Director of Research. His responsibilities included portfolio management and research of global pharmaceutical stocks as a senior equity analyst. Michael covered companies in the pharmaceutical and specialty pharmaceutical sectors as well as biotech, medical technology, and healthcare services. He has also covered retail and media stocks and was previously associated with Lazard Freres and Fiduciary Trust. Michael has an MBA from Pace University.