Medical devices account for 6% of worldwide health-care spending, and Minneapolis-based Medtronic is the behemoth of this $200 billion-plus market. The 40,000 employee company has $4 billion in annual cash flow and number-one market share in many of its product areas — not just in its well-known pacemakers, but in devices addressing cardiovascular disease, spinal deficiencies, diabetes, and neurological problems. Medtronic also has a robust new product pipeline, analysts say.

With the aging of the U.S. and world populations, Medtronic seems well positioned. But the medical-device industry at large has not been immune from the economic downturn. Patients are delaying procedures, while insurance companies are pushing back on coverage of some medical-device therapies, say analysts. In addition, the Food and Drug Administration may overhaul its process for approving some kinds of devices, possibly causing device makers to jump more hurdles as they shepherd therapies to market.

Gary Ellis, finance chief of Medtronic, recently talked with CFO about how the company strives to maintain profitability and how it has continued to grow its bottom line with the help of a multiyear cost-cutting plan. He also touched on the challenges Medtronic faces, from both a market and a regulatory perspective. An edited version of the conversation follows.

Where is Medtronic’s business growing the fastest?
Forty percent of our revenues come from outside the U.S., 60% inside. The faster-growing parts of the business right now are outside the U.S. — China and Brazil. China right now is about a half-a-billion-dollar business for us. It’s growing 25% to 30% per year, so there’s tremendous growth and tremendous growth opportunity. Brazil and India are also growing double digits. The European market is probably growing high single digit.

But if you go to some of the European countries or even the emerging markets, people who still need pacemakers aren’t getting them — the markets are underpenetrated. If you need a pacemaker, you’re pretty much getting it in the U.S. In other geographies, either they’re not prescribed yet or [hospitals] don’t have the infrastructure in place to implant them. So those markets could grow even faster.

Medtronic CFO

How did the economic downturn affect your overall business?
One of the problems we ran into here, even in this last quarter, was that unemployment benefits were extended but COBRA insurance benefits for many of the long-term unemployed stopped in March or April. [COBRA benefits extend coverage up to 18 months postemployment.] So we had almost four or five million families that all of a sudden were no longer covered under their previous health plan. As a result of that we’ve seen somewhat of a slowdown in certain procedures. So instead of having high-single-digit growth we’ve seen revenue growth fall over the past 12 months, to the 4% to 5% range.

Our bottom line is still growing, because we have taken out costs. In fiscal year 2008, we started a five-year companywide initiative to reduce product costs by 25%, or over $1 billion, by the end of fiscal year 2012. We knew the pricing environment was going to get tougher, and these proactive measures would allow us to maintain industry-leading gross margins. We have had great success, taking out $600 million in costs in the first three years. Our savings have come from a number of initiatives, including designing for reliability and manufacturing, lean manufacturing, developing a comprehensive manufacturing strategy, and working closely with our suppliers.

Did you cut research and development spending during the recession?
No. That’s the last place we tend to go, because innovation is so critical. We are spending about 10% of our revenue on R&D, and we expect that to continue. This past year we spent between $1.5 billion and $1.6 billion on R&D. It’s a lot of investment. Innovation, creating new technology, and coming out with more value-added products are critical for us to maintain growth and an edge on pricing.

If we see a slowdown in our markets, it tends to be because we haven’t had new technology coming out. I’ll give you an example. The average selling price of a pacemaker today in the U.S. is probably about $4,500 or $5,000. That’s about the same as it was 10 or 15 years ago. But what the device does [today] is dramatically different. When the pacemaker first came out, they would program it at 70 beats per minute. So if you were active — jogging, for instance — obviously that didn’t work. And in some cases, if you were sleeping, [70 beats per minute] was too much.

Now, a pacemaker will adjust to what your body is doing. If you’re active, it’s going to pump faster. And then it also communicates remotely to your doctor. So you could be sleeping at night and not realize that your heart did something, and it sends a message to the doctor. We have to keep coming out with new technology that supports our pricing, but more importantly provides more value to the patient and to the physician customer.

How can Medtronic have very large gross margins if the price of a pacemaker hasn’t changed in such a long time?
The majority of our products are sold directly to hospitals. Our hospital customers are then reimbursed by private and public payers to cover the cost of the entire procedure, which includes the cost of our devices. Payer reimbursement can indirectly affect our pricing, but pricing and the premium that our products get in the marketplace are also a function of competition and innovation. When we introduce new, innovative products to the market with the appropriate clinical and economic evidence that demonstrate the value our products provide, we get higher prices.

In many cases the new device is compared against the alternative therapy. Right now if your heart valve has an issue, they make a big incision, crack your chest open, stop your heart, cut your heart open, cut out the old heart valve, sew in a new heart valve, sew your heart back together, restart your heart — it’s major, major surgery. We’ve come out with a product now where there’s a small incision in the leg, [we insert] a valve that’s actually crimped down on a catheter that goes up through the artery, up through the old valve in the heart. We release it, it pushes the old valve against the heart wall, and you have a new valve with no major incision. You’re maybe in the hospital two days at most and you’re back to work right away. We can charge a high price for that product even though the cost of the product itself might not be as high, because what we’ve replaced was obviously very, very expensive.

Did you purposely build up cash to combat the faltering economy?
Cash has accumulated because while I have $7 billion in cash and cash equivalents, I have about the same amount in debt. A big portion of that cash is outside the U.S. Of the $4 billion of free cash flow that we generate, it’s about 50% outside the U.S., 50% inside. Unless I can figure out a way to bring it back into the U.S. without paying the tax penalty, it accumulates [outside the U.S.] and I end up borrowing in the U.S.

Do you think the U.S. government should make it easier to repatriate that cash?
No question about it. Any global company with high profits is going to run into this issue. The U.S. has one of the highest corporate tax rates in the world. The only one that’s higher is Japan’s, and that’s by about half a percent. And we’re one of the few countries that taxes worldwide income. All you’re doing is making U.S. organizations less competitive. Because if I’m competing against a Swiss drug company, for example, obviously the income they make in the U.S. is taxed at 35%. But profits they make in Ireland are taxed at 12%, and even in Switzerland they’re paying 25% tax. If I bring back the cash it doesn’t matter that I earned it in Ireland, the U.S. government wants me to pay 35%.

How has the regulatory approval process for medical devices in the U.S. changed?
It’s longer, and there are more clinical trials required. You have to make sure that the product works effectively. There’s higher scrutiny once you get the product approved than what you had previously, under the Food and Drug Administration. I think it’s because basically the marketplace is saying we want more input on quality and everything else. Previously, in Europe a product would come out and then maybe a year later it would launch in the U.S. Now it’s two, three, four years before you see the same product in the U.S.

It’s not that the regulatory cycle in Europe is easy. They focus on, is the device safe? Is it going to hurt the patient? That’s easier to prove. The FDA [asks] not only is it safe, but does it do what you say it does? That may require a four-year trial because they want to see the long-term effects. We’re not saying either one is right or wrong. It just means that in the U.S. it will be two or three years later before [patients] can benefit [from a new device] versus somebody in Europe.

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