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Medtronic Inc.’s (MDT - Analyst Report) second-quarter fiscal 2014 adjusted earnings per share (EPS) came in at 91 cents, up 3% year over year and a penny ahead of the Zacks Consensus estimate. However, without this adjustment, the company reported net income of $902 million or 89 cents a share, up 40% and 41%, respectively.  

Revenues in the reported quarter were $4.194 billion, up 2.4% year over year (up 3.3% at constant exchange rates or CER). It also remained above the Zacks Consensus Estimate of $4.173 billion.

International sales (generating 45% of total sales) grew 3% year over year (up 6% at CER) to $1.867 billion in the reported quarter. Based on the company’s focus on emerging markets, revenues from these regions experienced continued growth momentum and increased 11% (up 13% at CER) to $513 million. This region now represents 12% of the company’s total revenue.

Segment Details

Medtronic earns revenues from two major groups – the Cardiac & Vascular Group and the Restorative Therapies Group. The former encompasses the Cardiac Rhythm Disease Management (“CRDM”), Coronary, Structural Heart, and Endovascular businesses; while the latter includes the Spine, Neuromodulation, Diabetes, and Surgical Technologies businesses.

CRDM sales were up 4% year over year (up 5% at CER) to $1.273 billion. Revenues from Implantable Cardioverter Defibrillators (ICD) increased 4% at CER to $713 million on the back of continued signs of stability in the market. Pacing system revenues increased 2% at CER to reach $477 million.

Coronary, Structural Heart and Endovascular recorded growth of 1% (to $427 million), 4% (to $281 million) and 5% (to $218 million), respectively, at CER. The company is benefiting from the sale of the drug eluting stent (“DES”), which grew 8% at CER driven by significant share gains of the Resolute Integrity drug-eluting stent worldwide.

Strong CoreValve transcatheter aortic heart valve sales in the international market led to growth in the Structural Heart business. Medtronic expects U.S. approval of CoreValve for extreme risk patients by the end of the current fiscal. Endovascular growth was based on strong Aortic and Peripheral businesses. The strong global acceptance of the Endurant II aortic abdominal stent graft remained a major upside.

Spine revenues maintained the sluggish trend and fell 5% year over year (down 3% at CER) along with a 1% decline in Core Spine revenue to $636 million at CER.The Thoracolumbar, Cervical, and Other Biologic product lines displayed growth both in the U.S. and worldwide. However, this was offset by declines in Balloon Kyphoplasty and Interbody devices.  Besides, BMP (bone morphogenetic protein) revenue declined 17% at CER to $110 million.

Meanwhile, Surgical Technologies revenues were $377 million (up 11% year over year and up 10% at CER), while revenues at Neuromodulation were $479 million (up 6%, same at CER) and at Diabetes were $393 million (up 3%, up 4% at CER).

Margins

Gross margin during the reported quarter contracted 108 basis points (bps) to 74.0%. Operating margin expanded 57 bps year over year to 30.1%, with a 1.5% increase in selling, general and administrative expenses (to $1.438 billion), a 3.8% decline in research and development expenses (to $372 million) and a 47.6% decline in Other expenses (to $33 million).

Guidance

Medtronic reiterated its outlook for fiscal 2014. The company expects full-year EPS in the range of $3.80−$3.85 (annualized growth of 6%−8%) on revenue growth of 3%−4% at CER. The current Zacks Consensus Estimate for EPS stands at $3.82 (on revenues of $16.937 billion) and remains within the guided range.

Our Take

After a disappointing start for fiscal 2014, Medtronic managed to beat estimates in the second quarter of fiscal 2013.  

We are encouraged with the signs of improvement in Medtronic’s core CRDM and pacing segments. Besides, Medtronic witnessed strong CoreValve transcatheter aortic heart valve sales in the international market. This led the upside in its Structural Heart business. We are also impressed with several recent growth initiatives taken by Medtronic which includes the company’s attempt to rebuild itself as a health care service provider.

On the tepid side, gross margin pressure still remains a major concern. We are also concerned about the recent U.S. Food and Drug Administration’s (FDA) warning on certain Medtronic devices. As per the announcement, the company’s recently initiated voluntary field action related to certain guidewires were classified as a Class I recall by FDA. Class I recall implies a situation where there is a reasonable probability of serious health hazards or death occurring from the use of a violative product.

Currently, Medtronic retains a Zacks Rank #2 (Buy). Medical device companies such as Align Technologies Inc., (ALGN - Analyst Report), Cardinal Health, Inc. (CAH - Analyst Report) and Natus Medical Inc. (BABY - Snapshot Report)  which carry a Zacks Rank #1 (Strong Buy), are also expected to do well.

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