Medtronic Investor Day 2010—Diabetes remains a key driver for growth; business focuses on improved CGM and traditional pumps for FY2011 – June 8, 2010

Medtronic hosted its annual investor day yesterday (June 7); the meeting was led by CEO Bill Hawkins. Medtronic’s discussion on diabetes, although brief, suggested that Medtronic clearly continues to see the Diabetes Business as a key driver of growth. Chris O’Connell, executive vice president and group president of newly-named restorative therapies, characterized the diabetes segment as a high performance and high potential business. For the year ahead, CFO Gary Ellis projects 9-11% growth for Medtronic Diabetes—below projected market growth of 10-12% (it’s harder for Medtronic to grow as fast since its base is substantially higher). We note this is lower than last year’s projection of 10-14% and that although Medtronic met its forecast at 10% growth, it achieved the low end of the range. This compares to a projected 5-8% growth rate for the company as a whole in FY2011. We learned that year over year growth for the insulin pump segment of the business was 7% while year over year sensor growth was 47% in FY2010 – like with J&J’s report last week, where we learned that SMBG had declined 3% operationally and Animas had increased 27%, these “splits” in the business tend to be closely guarded numbers and we were very happy to get this data although disappointed to see that pump growth had fallen more than we had realized, presumably due to weakness in the US market. The company emphasized that it occupies the number one spot for pumps (as it has for the last 25 years, 20 years as MiniMed) and its market share estimate was 65% (this matches our model exactly - $1.1 billion of a $1.7 billion global market for calendar year 2009). Management clearly expressed interest in pursuing emerging markets, noting that there are just a few thousand pumps in these markets currently and there is substantial opportunity for growth. The company can leverage their global scale here better than anyone. By no means will the developed world be left out of the plans for growth; Jean-Luc Butel, executive vice president and group president of international, obliquely discussed an example of Medtronic improving penetration in the German market (a price-sensitive, mature market for medical devices overall) through targeting reimbursement obstacles. We would not be surprised if Medtronic continues to make headway in this challenging environment in the coming year; we were pleased to hear that there are now 217 million lives with covered access to iPro2 and 175 million covered lives with personal CGM access in the US. Notably, CGM was emphasized as one of five new emerging technologies expected to experience ~45% incremental revenue growth over the next four to five years.

On the product and pipeline front, the iPro2 was launched in conjunction with the meeting in 49 countries around the world. We wrote extensively about the iPro2 in our ATTD 2010 report (see Closer Look April 16, 2010), where the new six-day retrospective diagnostic CGM was widely discussed – this is a major improvement over the official three-day consumer product. O’Connell suggested that the iPro2 should be available in the US by fall 2010. Notably, we learned during Q&A that it appears that the international release date for the patch pump is now expected in FY2012—this product has been delayed several times and while little commentary has been offered on the nature of delays, O’Connell emphasized today that the patch pump market is more of a niche market and not as large as originally anticipated. O’Connell suggested that Medtronic is currently fine-tuning the device to respond to lessons learned from patch pumps currently on the market. They had announced at its meeting a year ago that launch plans would be expected around June of this year; presumably FDA’s more challenging environment is also reflected in the new estimate. Also of note is that fiscal year 2011 will bring a new range of products across the diabetes business, not only in the form of the newly familiar Veo and Revel systems, but also in a new infusion set targeted at a pediatric audience (the Mio), a next generation sensor currently named Nexsensor, and a brand new sensor product that is half the size and twice as accurate as sensors currently on the market (according to management) called the Comfort Sensor. Management characterized the Comfort Sensor as the first step towards the ultimate goal of replacing SMBG and, in our view, an important milestone in the development of the closed loop. We do believe patients with Medtronic’s combined pump/sensor will relish an improved sensor and that this should fulfill a major unmet need. From an industry perspective, we also like to see investment in moving CGM ahead. Notably, Medtronic also discussed treat-to-target and overnight-closed-loop systems—two new projects that have recently moved into the product development phase, also exciting to hear. In other news, in FY2011, a $100 million fund will be devoted to innovation at Medtronic—a portion of which is slated to go towards obesity and hospital glucose management.

Over and over, O’Connell emphasized scale as an important asset of Medtronic; it was interesting to see from this meeting on balance a greater focus on improving traditional pump offering through sets (a defensive move) and CGM and delaying the patch pump presumably to “get it right” – on balance, presumably these moves will increase revenue and profitability of the traditional business and will increase satisfaction and growth of CGM. We also assume that since patch pumps will presumably be a lower profit business for Medtronic to start, it makes sense for the company to get it right.

FINANCIALS & BUSINESS STRATEGY

• Medtronic Diabetes grew 10% on a constant currency basis in FY2010 and growth is projected to be 9-11% for FY2011. This is slightly lower than was projected last year (10-14%). Market growth is projected to be just slightly higher than business growth at 10-12% (pumps grew 12% in 2009 according to our model; we note it is difficult to project Animas, Roche, and “other”). The company estimates that it occupies the number one spot and 65% of the market share in diabetes (as noted this matches our model exactly and is below the “70-80%” estimates heard in years earlier). The US achieved 10% growth, while Europe and Central Asia reached 12%, and the rest of the world 9% (all on a constant currency basis). We learned that year over year growth for the insulin pump segment of the business was 7% while year over year sensor growth was 47% in FY2010—these figures are not typically broken out during quarterly reviews and our own internal estimates were running slightly higher on the pump segment and lower on the CGM segment although it isn’t clear how the “breakout” works at the company; we believe CGM revenue is calculated as about 1/6 of new pumps and presumably all sensors, but we’re not sure is any of the set revenue if reflected in the CGM business. Notably, CGM was emphasized as one of five new emerging technologies expected to experience ~45% incremental revenue growth over the next four to five years. We are impressed that the CGM business is growing so robustly, especially considering the innovative competition that Medtronic is facing in that segment. The insulin pump revenue growth is slightly lower than we had anticipated, although, we some of this could be attributed to the cycle of product renewal—much of Medtronic’s consumer base will have potential to upgrade as they are coming up to their four-year warranties this year (just in time for the new Veo and Revel). Our thoughts on this are difficult to untangle; in the industry, it’s been widely thought over time that there are about 30,000 new pumpers each year. We’re not actually sure about this number, but directionally, if this is right, this is much lower than the presumably 80,000 people on average that Medtronic Diabetes has to persuade each year to upgrade to the next pump. Historically, Medtronic has done a very, very good job persuading its current pumpers to remain with the franchise and presumably as there is more competition, it has become slightly harder to keep retention so high and it has been harder to persuade as many new pumpers to choose Medtronic. Our dQ&A data for the last quarter shows that while a majority of new pumpers chose Medtronic, 30% of new pumpers selected Animas, and nearly 20% selected Insulet, and the majority of the balance – so (relative) upstarts Animas and Insulet are garnering a proportionately higher percentage of new pumpers, while it is more difficult for Medtronic (understandably) to maintain its market share in new pumpers. (For more information on recent switcher and new pumper data please contact richard.wood@d-qa.com.) That said, Medtronic will have an excellent opportunity to retain parents of pumpers with the new CGM and set, and our guess is that its new CGM will enable it to win more new pumpers who didn’t like its old CGM as well as to retain patients who liked everything about the product except the CGM. We believe with its strengthened focus on CGM, this will also increase the CGM market overall, perhaps substantially. It will also make it a better competitor in CGM, where we believe it has been strong historically primarily due to the integration with its pump rather than due to its CGM features alone.

• Management sees both emerging markets and developed markets as opportunities for growth in diabetes. Although no specific plans were discussed, Jean-Luc Butel, executive vice president and group president of international suggested that there are only a few thousand pumps in emerging markets, and much more unsatisfied need. It seems that Medtronic envisions emerging markets as a ripe opportunity for its diabetes products, but we are unsure what plans the company has in store to actualize these visions. We were impressed by J&J’s recent Analyst’s Day call in which management discussed strategies to tap into emerging markets (i.e., developing new devices specifically targeting emerging market populations, to be offered at market appropriate prices). We hope to learn more about Medtronic’s strategy in emerging markets for its diabetes products in the future—presumably, these high-cost advanced products may face more challenges in emerging markets than other products such as SMBG. Butel also commented on Medtronic’s prowess and experience at growing in developed and mature, price-sensitive markets, albeit in a non-diabetes specific context. He touched upon the example of Germany, where Medtronic employed specialists to work with German insurance companies to work to increase access to its products. In a four-year period, the company saw a 20% growth in access. Of course, Medtronic has already been making progress in this domain in diabetes with 217 million lives covered with access to iPro CGM and 175 million lives covered for personal CGM. Slides suggest coverage for pumps has increased 140%, but we are not clear on the benchmark or baseline for this figure.

• Customer service continues to be an important pillar in Medtronic diabetes’ formula for success. According to O’Connell, there are more than 2,500 people in customer service and a new customer service center in San Antonio will help the company meet its standards of patient assistance. In total, the San Antonio center will employ 1,400 to serve diabetes patients including the Pump Order Sales (POS) department, Supply Order Sales (SOS) department, 24-Hour HelpLine team and the training department. This sounds like a high number but we estimate this is only about one per 1,500 pumpers. We see customer service as a major strength of the organization; needs for new companies can be hard to estimate. We will be striving to estimate customer service efficiency across the pump industry through our dQ&A survey; in our next surveys, we will be asking about frequency and quality of customer service.

• The diabetes business at Medtronic has been reorganized to fall under the umbrella business of “Restorative therapies” led by Chris O’Connell. In September of 2009, Medtronic announced several internal leadership and organizational changes designed to promote the company’s One Medtronic initiative and better leverage technologies and customers. The company’s various businesses were consolidated into two operating groups; one operating group consists of the Diabetes, Surgical Technologies, Spinal and Biologics, and Neuromodulation businesses while the other operating group is comprised of the Cardiac Rhythm Disease Management (CRDM), CardioVascular, and Physio-Control businesses. At that time, Chris O’Connell left his position as President of Medtronic Diabetes to assume the newly created position of executive vice president and group president for the new operating group containing the Diabetes business (Restorative Therapies). Katie Szyman has replaced O’Connell as the President of Medtronic Diabetes and has won rave reviews since she began this role. Clearly, Szyman entered the business at a challenging time for the business in the US, but we believe she will do much to propel the $1.1 billion franchise. We note that diabetes was discussed last during the restorative therapies overview, and overall more time was spent on other segments of the business (particularly compared to a year ago), but it is clear that diabetes continues to play a central role in the future of Medtronic and O’Connell still certainly discusses the topic with verve. As far as we can tell, diabetes is likely to remain a central component of the restorative therapies business. We would like to see the franchise think more carefully moving forward before making projections about when new products would emerge since patients get excited about projections made; that said, we understand business decisions need to be made and we also must say that the changes in focus to defending the core business, expanding CGM, and investing in the closed loop before moving to patch pumps make a lot of sense from a business perspective. On balance, we would like to better understand whether it was a decision based more on holding up the higher margins of the traditional business or on making a better first-generation patch pump.

PRODUCT PIPELINE

• O’Connell suggested FY2011 would usher in a complete refresh of the product line in diabetes while we wait for more significant break-though products in the works. In the meeting, announcements were made that the patch pump should be expected in FY2012 and that the company has shifted both a treat-to-target sensor augmented system and overnight closed loop system from research into product development. Throughout the presentation, O’Connell continued to emphasize the importance of scale and size in the diabetes industry—the prowess Medtronic exhibits in these considerations is a huge advantage over competitors. This has clearly represented a barrier to entry for new companies historically; the sheer number of Medtronic salespeople and customer service is daunting by any definition, particularly in such a customer-focused business.

• Two new major products have already been launched in several markets—both the Paradigm Veo (in Europe) and Paradigm Revel (in the US) are the next generation sensor-integrated pump offerings set to take off in FY2011. The Veo (Medtronic’s low- glucose suspend sensor-integrated pump) has certainly begun to prove itself on the market place and contributed to growth in FY2010, with management specifically sighting the expanded launch of the Veo in Europe and Asia as a driver for growth (notably, international pump sales had a record quarter in F4Q10). The Revel (a sensor-integrated pump with predictive alerts) was launched in the US in F4Q10 and is expected to compliment the Veo’s progress overseas in the coming months. (For more details on benefits of the Revel over the previous generation, see diaTribe’s review at http://www.diatribe.us/issues/23/test-drive.php.)

• Medtronic’s 2010 investor day coincided with the launch of the iPro2 six-day retrospective diagnostic CGM sensor in 49 countries. Last year, the investor day marked the launch of the Paradigm Veo in the UK. O’Connell mentioned that the iPro2 should be available in the US by fall of this year; we believe this will continue to both expand its pump business and help patients as this enables patients to move closer to personalized therapy. As discussed earlier, reimbursement for the iPro is now available for over 200 million patients and we expect that similar market access will be applicable to the iPro2. O’Connell suggested that patients who have used the iPro sensor are two times more likely to eventually end up on pump therapy. We note that the iPro2 will be a helpful tool in diagnoses and in therapy alterations, particularly for type 2 patients. While several well-known physicians characterized retrospective CGM as “taking a step back” compared to real-time CGM at ATTD 2010, we believe “walking before running” should be emphasized for many patients; while a hyperintensively managed type 1 or type 2 patient can go straight on to CGM, patients that are newly diagnosed will benefit significantly from a tool like iPro2, as will patients who have struggled with management. Additionally, we believe type 2 patients on oral meds would benefit from going on iPro2 regularly, perhaps each year, to see how their management is evolving – this is particularly important as type 2 is a progressive disease, but therapy often doesn’t change is as frequently as it should. Regular CGM (using iPro2) may well enable better refinement in therapy overall. We do note that iPro2 offers “blind” CGM measures and at ATTD 2010, we sensed a strong sentiment from the audience that they would prefer to use RealTime CGM even in settings when diagnoses or therapy alterations were being made. We are not sure if this is a more European sentiment or if it translates to the US as strongly. In any event, we wonder if the iPro2 may ultimately be available in both visible and blinded data.

• Although not discussed in detail until Q&A, slides showed that Medtronic’s patch pump has been delayed until FY2012 (for international release). O’Connell did not comment very specifically on the timing, but noted that the patch pump market is “much more of a niche market and smaller than originally anticipated”. He implied that the company is taking time to learn from how the current market is responding to patch pumps and that in the meantime, the device will be fine-tuned to suit the unmet need in the market. It is still Medtronic’s goal to open up the patch pump market and grow it to the proportions it has the potential to achieve. While we have been eagerly awaiting the launch of this product, we assume that Medtronic’s first-generation patch pump will be strong given the change in timing; we also note that those wanting a patch pump will continue to be able to get the Insulet first-generation product. From our view, growth will depend on timing of Insulet’s second generation, which we believe will be attractive to a larger group assuming that it works as well as the first generation but is much smaller (about 40%) in size. Management did suggest that while the product is delayed, in the overall scheme of the portfolio it is still on track; still, we imagine that it may be further refined based on learnings.

• O’Connell briefly mentioned a new infusion set, called the Mio, an all in one infusion set system targeted at the pediatric population, recently launched during FY2010. We have heard very few details about this new system and O’Connell did not offer much news; however, we know a few details about the design of the product. It’s all in one design combines the infusion set and insertion device into one unit, with a 90 degree angle soft cannula (6 or 9 mm). This cannula design should make for more comfortable insertion and the all-in-one set design makes it so that needle insertion is more concealed (and the all in one is less to carry around). The line will also be produced in fun colors for kids (and adults).

• A next generation sensor, NexSensor, is also in the pipeline. This sensor is a new iteration of previous sensors and few details have been released, but it is distinct from the new product Comfort Sensor.

• The new Comfort Sensor is expected in the second half of FY2011. O’Connell suggested that the new Comfort Sensor will be twice as accurate but half the size of current sensors on the market. This would represent a major improvement in our view and has been deemed the “first step in reaching the ultimate goal of finger-stick replacement” with CGM, according to O’Connell. The FDA have begun to ask for more accurate SMBG, which has made patients more interested in accuracy as well – both of SMBG and in sensors. Patients would also undoubtedly like to see smaller sensors and we are happy to see Medtronic responding to this complaint with the next generation of sensor. In our last dQ&A survey, a sizable percentage of patients rated the sensor insertions as painful (approximately 30% for DexCom, 50% for Abbott, and 80% for Medtronic rated it an 8 or higher on a 1 to 10 scale for pain relative to SMBG) and we believe a less painful sensor would both improve how patients characterize the sensors broadly and would prompt patients to change the sensors more frequently – so we hope to see some change here as well. The lifespan of this sensor was not discussed—this is now one of the ways Medtronic is falling behind compared to competitors and clinicians (and patients) have begun to express frustration that the iPro2 sensor can be used for six days but current personal use sensors are still supposed to be replaced every three days (though on average patients use them longer).

• CareLink Beacon will be released in the near future. The newest iteration of CareLink software is designed to provide decision support to physicians. CareLink is a major advantage for physicians and we are interested to see how this will be improved over the last version.

• O’Connell emphasized that Medtronic is excited about closing the loop and that there are two new products recently pushed from the research phase to product development stage to this end. According to O’Connell, both a treat-to-target system and overnight closed-loop system have been moved into the product development process. If the improved sensor is released in H2FY2011, this could be a major advantage for Medtronic in the race to close the loop in some form in the next several years.

• While O’Connell declined to comment on the STAR 3 trial due to publication strategy, he encouraged the audience to stay tuned for the upcoming presentation at ADA. During the review, O’Connell also mentioned evidence is still building for the JDRF GuardControl and Real-Trend studies.

• In FY2011, a $100 million fund will be devoted to innovation at Medtronic—a portion of which is slated to go towards obesity and hospital glucose management. Last year, O’Connell spoke about Medtronic’s aggressive approach to the hospital CGM market. The company planned to invest more then $8 million in this field in FY2010. Medtronic believes that CGM is the perfect tool to achieve tight glycemic control in hospitals and the company intends to leverage its ambulatory CGM experience as well as it’s expertise with technology for in-hospital use. We were surprised but pleased to see obesity as one of the area that will be receiving an allotment of the $fund—there has been growing interest in gut stimulators to treat obesity in the last year and we wonder if Medtronic will be seriously exploring this option.

Questions and Answers:

Q: You seem a little hesitant on the patch pump?

A: I don’t want you to misread our enthusiasm for the patch pump market. It turned out to be more of a niche that we have been watching closely. It’s important to make sure we have the right technology and right business model when we launch the product. It’s a little delayed from a year ago, but in terms of the overall portfolio, it is where we want it to be. We want to give our current products time to shine, the patch pump will come in later fiscal year 2012. Our goal in diabetes is to establish the cadence we want over the next 3-4 years leading up to the closed loop system.

Q: How do the different business stack up in terms of growth?

A: The diabetes business is on the upper end of growth with neuromodulation, in the range of 5-10% in we would expect that range to hold for the next five years of so. However, that mix might change in the future. We are working to invest in the overall portfolio.

Q: Are you concerned about the pricing pressures in Europe?

A: The pricing situation is fragmented in Europe. We have many contracts in Europe. A lot of our business is on tenders in Europe. These prices don’t move until the renewal of the contract. We have not seen any requests or movement or price erosion in any of the countries. Our key is to manage the product portfolio according to the pricing. We adjust the products and service—all the things that go into the contract. Pricing is only 50% of the consideration.

--by Jessica Swienckowski and Kelly Close