We're glad to have the Medtronic CFO, Thierry Piéton here with us. So welcome. Thank you for joining us.
Thanks for having me.
Good. So you've been on the job kind of about six months now. So maybe if you think about the first six months and coming into Medtronic, I'm curious how you're thinking about the business today and how you want investors to kind of think about your plan for kind of shareholder value creation from here and sort of initial learnings here in the first six months.
Yeah. So look, one of the reasons or some of the reasons I decided to join Medtronic is first I had the perception that the company was about to live an inflection in terms of growth rate. And as I went through the selection process, we talked about some of the growth opportunities with the business leadership, cardiac ablation, RDN, Hugo, et cetera. And so I knew these would be present coming in. The second part is we talked about how with an automotive background I could help bring some incremental value in the way the business is performing. And I would say after six months in the position, it sort of comforts those two areas as the places where I can focus.
So I would say first of all we're about to have an inflection and the growth is about to accelerate in the second half and we can get into the specifics of some of those areas. The goal for us is to capitalize on those growth areas and turn around and create a flywheel where we use a portion of the benefits that we're going to get from those to reinvest in innovation both organically and from an M&A perspective to fuel the next generation of growth. So for me that's going to be the key focus. The second part is part of capitalizing on those opportunities is delivering average earnings.
Coming from a tough industry from a sort of margin rate perspective, I think I can, even though a lot of progress has been made by the company, I think I can still help in making sure that we improve the margins and ultimately we deliver a more leveraged P& L altogether.
One of the things, like you're already talking about high single-digit EPS growth for next year, and so it's been a focus for investors to kind of get Medtronic back to growing earnings. And so I'm curious on kind of one, the commitment, but also like the visibility to go ahead and say this early on that you're committed to high single-digit EPS growth this early in the year.
Yeah. So first, you know, it's a commitment. Right. So it's not, you know, we don't make or I certainly don't make commitments without having the right level of comfort and data behind it. So, you know, part of my onboarding with the business has been to look at the performance, to look at the roll up and to look at the construction that is going to be required to get comfortable that we had a clear path to achieve this. So number one, I think the math is there. More importantly, I think the question is around the algorithm and what we need to put in place to get that done. And if you take a step back first, it's about accelerated growth and I mentioned that already. And so that's going to help with the leverage.
We'll have higher growth, so better absorption of some of the overhead. The second part is delivering incremental gross margin. So if you look at the gross margin rate today, the gross margin rate today versus what it was prior to COVID, we're about 4 points lower. And you know, we have a solid path to going back and creating sort of having the actions to get us back to the margin rates that we had prior to COVID. And I can get into the detail of that. Then below that, we still have significant opportunity to deliver leverage at the SG&A level. And it's really mostly with G&A. We'll protect the selling side to make sure that we capture the growth opportunities that we have ahead of us.
So if you look at this accelerated growth, better gross margin and leverage from an SG&A perspective, we can then use a portion of that to reinvest in innovation, both organic R&D and M&A and sort of create this flywheel that I was talking about to fuel the future growth for the future. So that's kind of the algorithm and we can go into the detail of any one of those different items.
Yes, maybe starting with gross margin because it's revenue growth we'll get to in a bit, but the gross margin is probably a key aspect of the P&L leverage.
Yeah. So look, as I said, you know, we're about 380 basis points lower than we were prior to COVID. And so for us, the target should be to get back to where we were. And here's how I look at it. There are really two today. If you look at our performance from a gross margin perspective, there are two sort of opposing trends. One is operationally our performance is really improving. So if you look at pricing, we used to be a business that lost price on a consistent basis. Now we gain price on a year- over- year standpoint, thanks to better contracting, better pricing controls, et cetera, but also thanks to innovation, because our customers are ready to pay for highly differentiated innovation that have a material impact on the patient or on the hospital's economics. Right. So pricing is getting better.
And if you look at our Q1 performance, price was up between one and one and a half points, which delivered about 40 basis points of gross margin improvement. Second part is cost management. And in a similar way, the business is now in a position to deliver a sustainable net cost out to the tune of 1%- 1.5% on a yearly basis. And again, that translates into 30- 40 basis points of gross margin improvement year- over- year. And that's thanks to all the work that's been done by Greg Smith in terms of our global operations and supply chain. Improving manufacturing operations, improving relationships with suppliers. We used to have four manufacturing teams, now we have one. We used to have nine purchasing teams, now we have one.
So the team is really able to generate much better savings on the cost side. So you take those two things, pricing and cost outperformance, and they add up to about 80 basis points of gross margin improvement today. Today, that's being offset by business mix, and that's really driven by two things. One is diabetes that grows faster than the rest of Medtronic, but with lower margins. And as you probably all know, we're in the process of divesting that business. So that pressure point will go away sometime in second half of 2027. Right. So that'll give us about 50 basis points of gross margin right away and remove that sort of headwind that we've had in a consistent basis. The second part is cardiac ablation.
And first of all, it's a good problem to have because it's a business that is dilutive at gross margin, but very, very attractive from an operating margin perspective. But more importantly, today it's dilutive because the mix between capital sales and catheters is skewed towards capital sales because we're growing fast and building the install base. And in the second half of 20 27, that mix is going to start to shift and it will become a tailwind instead of being a headwind. So this mix pressure is going to disappear and the operational improvements that we're making in pricing and cost are going to start showing up at the gross margin level. And so we should be in a position to start delivering meaningful, sustainable gross margin improvement starting in the second half of 2027 .
Very helpful. And then how are you thinking about G&A leverage versus increasing R&D and increasing investments on the OpEx line?
Yeah. So again, if you look at what we spend in R& D today, we're at about 8%-8.5% of revenue. And we think the right level, based on the roll up that we've got internally and the projects that we'd like to fund in the midterm, it's closer to about 10% of revenue. Right. So we've got about two points to a point and a half of increased R& D to deliver as a percentage of revenue. A lot of that will be offset by, you know, more than offset by the gross margin improvement that I just went through. And we still have an opportunity to deliver significant leverage in SG&A.
If you look at the first quarter as an illustration, we grew R&D about 100 basis points faster than sales, but we delivered about 170 basis points of leverage on the SG&A line. We're more than offsetting the R&D growth with SG&A sort of cost control and we're going to continue to do that. You kind of have to split the S part from the G&A part. The S part today is hiring the mappers to capture the opportunity in cardiac ablation. It's about building the direct marketing for Ardian. We need to protect those budgets and continue to fund that. On the flip side, G&A is back office and there we still have an opportunity to generate savings through simplification, digitization, et cetera. That's kind of the algorithm that we're putting in place.
And then currency has been a thing that Medtronic had to kind of deal with and hedging and stuff like that. Curious how you're managing FX differently than Medtronic does. We're not kind of surprised on some of the FX movements.
Yeah. So there are a couple things. So first of all, the best way before you go into hedging is to avoid the FX pressure to start with. So we're looking at how we can move the cost base to have more matching between where our cost lie from a currency perspective and where the revenue lies more short term. We made a change last year, which is to measure countries that have high foreign exchange volatility on a USD basis. So essentially, if you're the general manager in Turkey or in Argentina, in a place where there's typically FX pressure, we're asking you to offset the devaluation with pricing. Right. And we started that last year. We've made it more systematic this year and it's paying off and it's contributing also to the fact that pricing is getting better.
So that eliminates a lot of the exposure in a way. And then with the exposure that's left, you need to have a good hedging program. And I think it's been the case, but it's been a little bit sort of on average it was on a three year horizon, which makes it difficult to explain externally. So we did some analysis and figured that we could get about the same efficiency from a hedging perspective, reducing the horizon to two years instead of three. So we're in the process of shifting in that direction. We'll get the same kind of coverage, but it will be a lot easier to explain externally for you and for the market.
Okay, helpful. One thing that kind of been consistent with Medtronic is like some of the historically execution and kind of visibility of the businesses and stuff like that. And curious what kind of discipline you're going to bring to Medtronic in terms of forecasting how much visibility you have in the business kind of day to day. So you can kind of set guidance with confidence. And so we're kind of getting back to the consistent execution that we want to see.
So look, first, you know, I think a lot has been done already. So you know, I mentioned some of the things that Geoff and the team have put in place over the last three to four years. It's been a change of the incentive systems to make sure it's a true performance based incentives as opposed to a profit share. It's been a change in the operating system where basically some of the critical to execution functions such as quality, procurement, manufacturing have been centralized. So as I said, we've got one manufacturing team under Greg Smith, we've got one procurement team under John Klein, who's under Greg. And so that's brought much better discipline. So for example, in manufacturing, every site I go has the same KPIs, the same operating mechanisms, the same review processes.
Greg's implemented what we call MPS, which is Medtronic Performance Systems, which is a translation of the Danaher system to Medtronic in a way. So that's already driven much better execution and it's also taken the weight of some of those problematic off the shoulders of the operating units. So they can now focus on innovation and performance from a commercial standpoint, which is ultimately what's going to make them successful. Right. So I think a lot of work has been done and you can see in the last 10 or 12 quarters that execution has been a lot stronger. There has been, you know, there have been those surprises from a supply chain perspective. So the company is in a much better place. That being said, there's still significant improvement for simplification of the supplier base.
There's still opportunity for optimization of the manufacturing footprint and there's still opportunity for design to cost, to get the cost of our products in the right place at the moment we launch them and to simplify them from an engineering perspective to reduce the potential for quality problems in the future. So that's still ahead of us, and this is something that I've lived through with automotive and that I look forward to working on with Greg and with Scott Cundy who runs quality and R& D now at Medtronic .
How long do some of the stuff take? Multi years or.
I think there is. It's obviously some midterm. Manufacturing footprint is hard in MedTech. Some of the design to cost is going to fully pay off in the next generation of products like in Sphere-360 for example and in cardiac ablation. But there are also short-term opportunities that we can work on, for example in the reduction of the number of suppliers that we've got, which is well underway. But still with a large opportunity ahead of us, there is a large short-term opportunity in terms of SKU reduction. So taking the list of products that we sell and analyzing which ones are low volume, high inventory carrying value tend to generate disruptions in our supply chain. We're going through those right now and each time we eliminate those we enable more focus and more stability in the ones that remain.
So you should expect to keep seeing that operational improvement right away, but in a continued fashion as some of the more midterm things start kicking in towards the end of 2027.
Using CAS as an example where you have Sphere-9 today and then the next gen catheter will be Sphere-360. And so you're basically saying that Sphere-360 will probably be a higher gross margin product because you're designing it for that.
That's exactly right. So the voyage is, you know, Sphere- 9 was originally difficult to manufacture and the team did a great job of stabilizing now. So the execution on Sphere- 9 and Affera is very good. So we have the right level of output. In the same time with the engineering team we're working on the design of Sphere- 360 so that when we launch it it comes out with a significantly better cost base than Sphere- 9.
Okay, helpful, maybe touching a little bit on your new investor or partner, if you will, Elliott, maybe just kind of give an overview of how that kind of came together.
Yeah, so look, maybe to tell the story. So Elliott contacted Geoff by email and said, hey, we like Medtronic. We've become a large investor. We'd like to talk to you. The second step was a meeting that we had with Geoff, with Ryan and myself and the Elliott team where we went through their view of Medtronic. And essentially what they said was, we love the company, we love the innovation, we really love the customer relationships that you've built over time and the trust that you've got with your partners. But the stock has been underperforming. At the same time, we can tell that you're at an inflection from a growth perspective because of CAS, RDN, Hugo, etc. And so we want you to do two things.
We want you to capitalize on those opportunities, so maximize the way you capture them, both from a revenue perspective and from a margin standpoint. So keep improving the margins, and we want you to use those opportunities to accelerate future growth. So we would like you to invest more both organically and from an M& A perspective, because you've done relatively less than the competition over the last years. And so we are sort of exactly in the same place. Right. So the reason the engagement has been very constructive so far is that a lot of things that they brought up are exactly in line with what we're focusing on internally.
They said, you know, to ensure that this capitalization and acceleration occur, we think you should bring more expertise, more MedTech expertise in the board, which again, we violently agree with because we used to have it and over time we lost it because people retired, et cetera. We were actually looking at bringing back MedTech expertise on the board. One of the individuals we were talking to is one of the individuals that we ended up bringing with the Elliott engagement. We agreed to it. We shared a list of potential candidates, and so we hired John and Bill to join our board. We're really excited about getting their perspective and getting their expertise to help us capture these growth opportunities and position the company for the future.
The other thing that Elliott said is we think you would benefit from having dedicated committees on the board to oversee, on one side, growth. So portfolio management, capturing these opportunities, how you drive innovation, et cetera, and maybe pruning the portfolio, and on the flip side, having a committee that focuses on operations. So how do you secure margin improvement? And so again, this corresponds very well to the way we run the business from an executive perspective. So you know, we implemented those two committees. We took the opportunity to simplify the board governance overall. So we eliminated two committees which we thought were starting to be redundant. And so now that's in place and I think we look forward to having the two new board members help out on those two specific topics.
Then when you think about the Elliott plan versus the Medtronic plan, it sounds like they're pretty similar. In terms of urgency, in terms of the speed at which you're actually executing this plan, is that maybe faster now because of the shareholders?
Well, look, I think it's always an incremental incentive, right? So you take the MedTech representation on the board. It was on the radar screen. We were talking to individuals. Elliott comes in and within a month we've got two that have joined. Right. So clearly it's helped accelerate that. I think the operating committees we had focus on those and the board generally speaking. But Elliott coming and saying, why don't you do this? We've seen it work well with other engagements we've had, so we quickly put those things in place. And so I think it's accelerated in a way, decisions that we would have made. And look, I think also going forward, if you look at, on the growth side, M&A and portfolio management and on the upside, things like manufacturing footprint optimization, et cetera, MedTech does have some specifics, right.
It's a little different from other industries. So having John and Bill come in and weigh in with their background, I think it's going to help.
How do you think the committees will probably add the most value in terms of the two new committees that are bringing in?
Yes. So again, I think certainly from our portfolio management and on the M& A side, having two key leaders that have been very successful in using those levers in their life so far, their professional life so far is going to help. And as I said, M & A and MedTech is a little bit different. There's various stages in terms of maturity of the targets that you go after that you have to take into consideration. There is, relative to other industries, more uncertainty in terms of the outcome of M& A. So having those two board members I think will help. And on the upside, it's similar. Right.
In terms of how to manage the speed of innovation, the cost of the products and the simplification sort of design for manufacturability and also optimization of manufacturing footprint, having two additional players that have lived it and know how it works in MedTech is going to be beneficial.
I think you talked about we'll see kind of a plan in kind of mid-2026. What do you think? Think that will entail? What's kind of the plan in terms of the plan? What's the plan for the plan? I guess, if you will.
So if I told you the plan right now, I would ruin the whole suspense for the event of next year. But look, I mean, as I said, we're going through an inflection. It gives us an opportunity to think about what's the next step after those. Right. So how do we invest after the first generation of CAs, after the first generation of RDN, how do we capture Hugo and robotics in a systematic fashion, et cetera. So what should the business be aiming for in the midterm? And I think part of that will also be sharing with you maybe a revised financial algorithm in terms of what you should expect in terms of financial performance in the midterm and what KPIs we're going to track and how we'll keep you posted on the progress that we're making towards those.
EPS leverage seems pretty important to you?
Yeah, right. Yeah, it's doubly important. It's important obviously in itself because we want to deliver value to the shareholders and improve earnings and dividends, et cetera, but it's also what pays for acceleration of innovation. And this is an innovation industry. And so being able to do the EPS leverage and improve the margins and sort of turn around and reinvest a portion of that and things that are going to make us successful in the future is really key.
And then you've talked a lot more recently on doing acquisitions, which is kind of new for Medtronic. It's been a little bit quiet there. So maybe just to start out, what's given you the reason to start talking about M& A and then kind of what should we expect to see from Medtronic there?
Yeah, so look, I think there has been a few years of slowdown in M& A for us and that has been deliberate. And it's a choice that was made by the management team so that they could focus on fixing some of the issues that I mentioned on supply chain and quality and things like that. So really the decision was let's fix those issues before we add a new layer of complexity. With M& A, there's still room for improvement, but most of these issues are now behind us. So we feel like we've earned the right to go back in offense in M& A. We also have a very strong balance sheet and we've got capacity to go do meaningful tuck in M&A for the future. So we made the decision to go back a little bit more in offensive.
The type of deal that we're going to target ideally is, I would say the sweet spot for us are companies that are just before commercialization or just after commercialization so that the outcome is relatively certain. Right, and we can have deals that have a meaningful impact on our growth rate and our performance. So we're talking about tuck in M& A with deals maybe between $1 billion and $4 billion that will make a significant impact on our WAMGR. They have to come with a few different attributes. Obviously they need to be in attractive markets that are growing, that are going to accelerate our WAMGR and where there is a significant profit pool, so a potential for future profits, that's obvious. Second thing is we need to have the right to win in at least one of three areas. One, having commercial synergies.
So typically a deal that we can add to the portfolio of an existing sales force, right? So we have great commercial coverage with Medtronic and so we have an opportunity to carry products in incremental markets without necessarily having to invest a lot, commercially speaking. So that's one criteria. The second one is synergies in R&D. So you know, we can help sometimes develop market products quicker or help startups or companies get clinical approval faster. So that would be a second type of synergy. And the third one is on supply chain. So supplement. Sometimes we see great companies that have a fantastic sort of product but that aren't able to scale it and we can help with that. Right. So attractive market, significant synergies and that's typically where we're going to attack. A perfect example for us would be Affera. Right?
It was a fantastic prototype made by an Israeli company and we came in and it took us some time but we fixed the manufacturability and now we're capturing a great part of the market. That's, I would say, the sweet spot. But we're also ready to do sort of more venture-type investments. To take a minority stake in companies that are in an earlier stage in their development, provided we see them as a meaningful future portfolio addition. And typically what we would do is a minority investment with a structured deal, meaning that we would maybe have a call option to be able to increase our investment if it reaches a specific milestone. It always has to be with a view of having a significant impact on the financials.
And one thing I wanted to touch on is you're talking about doing kind of earlier stage acquisitions which tend not to be too accretive to earnings. But you're also talking about high single digit EPS growth and EPS leverage. So how are you working on the balance of being able to do both?
Yeah, so for the first category, the sweet spot, you know, that's where potentially the short term dilution is bigger from the magnitude perspective, but it's probably shorter because the outcome is, is faster and more secure. So clearly for us there has to be this path to accretive earnings. And the amount of dilution that's caused has to be such that we can still deliver our commitments of high single digit EPS growth in 2027. Right. So it's not a either or. It has to be. And so we do the acquisition and we deliver the leverage at the earnings level. Again, when the outcome or the dilution is too long, then we will take this option of a minority investment until we have better visibility to what the outcome is going to be.
That sort of reduces the impact short term and allows us to get a foot in the door without feeling as much of a dilution as we would if we made a full acquisition.
Then I think one of the things that Elliott mentioned is free cash flow and improving free cash flow to help fund some of these acquisitions. Is there a plan here at Medtronic and what are you doing to improve your free cash flow generation?
Yeah, so first maybe to remove sort of what I would call an urban legend around your dividend is getting in the way of doing more R&D and more M&A . In fact, it's not right, it's just not accurate. We make over $5 billion of free cash flow and we've got a really strong balance sheet. And so for the type of acquisition that I'm talking about, we have significant capacity to do that without touching the dividend. We're committed to the dividend policy as it is today. That being said, we have opportunity to improve from a free cash flow generation perspective. The first obvious lever is the operating margin leverage that I talked about. So that will deliver better EBITDA. And I think we're pretty focused on working capital; receivables are improving. We're investing a little bit in inventory today to support the growth of CAS, for example.
But we have opportunity in inventory as well by eliminating some of the slower rotation type of activities we've got in the portfolio. So our goal is to get back over sort of the 80% conversion rate that we historically had as soon as 2027. And so that's a meaningful incremental cash generation that will come within a pretty short period.
One of the big drivers on the revenue growth is CAS, probably the biggest opportunity right now, at least in terms of here and now short term. You talked about getting to kind of $2 billion in revenue early next year. Maybe you put a time on it. But how are you thinking about kind of the opportunity here for CAS in the pipeline? Like you're still number four in the market. Is there an opportunity to get to 2, 3 in this EP market?
Hey look, our ambition is to be number one in this market and I think we're very well positioned to achieve that. We've got two very strong products today with PulseSelect on one hand and Sphere-9 for PFA on the other hand. On Sphere-9 the product is in super high demand. So we're building the install base of capital equipment and we're ramping up according to plan. But candidly, if we could ramp up quicker, we would sell quicker capital equipment. So there's still tension.
We're hiring mappers and we're, you know, to support the procedures with the clinicians and that's going well and but we're still in that ramp up mode and so we haven't had the sort of exponential effect that you get from the catheters once you've built the install base and that's going to continue to build up and so we're very, very excited about that. At the same time, as we mentioned earlier, we're working on Sphere- 360 and there's even more excitement on that product. If you take the time for procedure, for example, the in-heart time of Sphere- 360 is going to be around 11 minutes, which is significantly shorter than what it is with Sphere- 9 today, which is already a great product, and so the doctors have a super appetite to get this product as soon as possible.
We're going to go for pivotal trial this fiscal year and so we look forward to that next generation. So for us clearly the end game is to take market leadership in this area.
I want to ask about digital surgery in Hugo as well on the top three pipeline opportunities here. And we just had the opportunity yesterday to go visit the London headquarters and see a lot of the AI and stuff that's happening. So maybe just talk a little bit about Hugo and the rollout and when investors could start to see some impact on revenue.
Yeah, so maybe to start on why it's important in our portfolio, we have another business which is spine, so spinal implants. Right, and the CST business. And if you look at it a few years back, you could have looked at it and said it's a pretty commoditized implant type of business, very competitive, you're going to have a lot of pressure, et cetera. We built an ecosystem around it with the AiBLE, with the robot, with Mazor, with the C-arm and with imaging. Right, and so what that has achieved is really build an ecosystem that makes a ton of difference for the physicians and for the patients. And what could have been a commoditized, simple business has become a overperforming margin, accretive business for us where candidly, a lot of the competition is exiting. Hugo is about.
And the digital suite around Hugo is about achieving the same thing in MedSurg. Right. So we're market leader in surgery, we've got decades of experience in instrumentation, a ton of goodwill with the doctors and with the patients. And Hugo and the digital suite are an opportunity to make that sticky and to create the same ecosystem where the doctor can do pre-op procedures, can have monitoring of the operation, can do post-op analysis with AI to help him understand how to improve the outcome, how to improve the speed of the procedure, et cetera, thanks to this whole ecosystem. So that's what we're going for. And we're on. Hugo specifically, the robot has been on the market outside of the U.S. for a few years now.
We have an installed base in over 30 countries outside of the U.S. We've built the sort of understanding of what's going to make it successful as we anticipate to get FDA approval in the U.S. before the end of our calendar year. And so you should start seeing an impact if you go in the fourth quarter for us on the MedSurg numbers. And you should start seeing the impact on the full Medtronic numbers in fiscal.
Year 2027
and then RDN, kind of the third big growth driver you talked about, faster than WATCHMAN, but
so third but not least.
So here we have a business that has taken, I would say 15 years to come to market. And it's a testament to the resilience of the Medtronic team, I would say. But now we have a very, very unique position with a ton of clinical data in a field where in the U.S. alone there's 18 million patients. So I'll let you do the math. 1% of 18 million patients multiplied by a catheter worth $16,000. It's a very, very large opportunity for us. It's about to get final decision from a reimbursement perspective or officialization of that decision because the decision is made. And so we're about to commercialize the product. And that's for us, it's probably the biggest market opportunity Medtronic has had in decades.
Is there some type of demand there from patients that you're seeing since you've h ad it on the market?
So when we did the clinical trials, 80% of the patients self applied. Right. So which means that there is a demand. It's a procedure that has a material impact on the life of the patients with hypertension. And look, we're going to do some direct to consumer marketing to raise awareness of the therapy because that's key. At the same time, we're building the capability to carry out the procedures and building the system so that when a patient becomes aware of that possibility, he gets referred to a center where he can have it done as efficiently as possible. So again, you will start to see the impact pretty materially in the second half of this year. And the reference that you gave to WATCHMAN, so WATCHMAN was about $500 million after five years.
We anticipate a much faster ramp up than that.
Okay, very great. I think that's all the time we have. Well, thank you.
Thanks very much. Thank you.