Alarming DSOs

Ellis, 45, says the wake-up call came in October 1999, when DSOs hit 88, causing several Wall Street analysts to sound warning bells. Medtronic's competitors had DSOs in the low 80s, Ellis says.

Ellis and his treasury staff responded with a campaign to cut receivables and inventories and stretch out accounts payable. Over the last two years, they've had considerable success. DSOs plummeted by 14 days to 74 at the end of Medtronic's first fiscal quarter in July, even as CFO Robert Ryan was putting the finishing touches on the company's $3.7 billion purchase of MiniMed and Medical Research Group. (The deal will add diabetes to the roster of disease devices that the company makes.)

Ellis' balance-sheet cleanup effort is all the more relevant these days because Medtronic is paying cash for MiniMed, in a break from its practice in recent years of doing big deals with stock. "As we continue on our path of doing more and more acquisitions, and especially if we use more cash, we need to be a little bit more diligent about our cash processes," the treasurer says.

Medtronic has not disclosed its plans for financing the Mini-Med deal, but it is likely that the company will issue debt for the first time in its history to close the gap between its $2 billion of cash on hand and the deal's $3.7 billion price tag. Officials acknowledge that they are in the process of obtaining debt ratings.

Scouting the Market

After some small acquisitions in the early 1990s, Medtronic's appetite grew at the end of the decade. Since 1998, it has purchased eight companies with a total value of $9.46 billion. (That excludes MiniMed, which was expected to close in late August.)

Despite the expansion, Medtronic has kept the earnings coming. In fiscal year 2001, the NYSE-listed company's profits totaled $1.046 billion, almost double the $530 million it reported in 1997.

Investors appreciate the strategy. The company's split-adjusted mid-August stock price of $44.95 represents a gain of about 223% since 1996. And in the last year and a half, while the S&P 500 has lost 14.7% of its value, Medtronic is down just 1.1%.

Investors have focused primarily on Medtronic's exemplary acquisition track record. "The primary thing they're known for is identifying good acquisitions, incorporating them into the business and then utilizing the technology across all the existing businesses," says Chad Simmer, an associate research analyst at John G. Kinnard in Minneapolis.

DIY Deals

Ryan, 58, who says he's Mr. Outside to Ellis' Mr. Inside, takes pride in the fact that much of the acquisition engine is home-bred. Investment bankers come calling all the time, but neither Ellis nor Ryan can recall an occasion when they touted a candidate the company hadn't already considered.

Medtronic's 10-person corporate development group, composed of employees with finance, technology, engineering and marketing backgrounds, is always scouting. Ryan says that in many cases, Medtronic officials have known target company executives for years since the medical technology is a small one.

To be sure, he adds, investment bankers are helpful in alerting Medtronic to changes in status at companies on the hit list. "In large deals, we'll obviously need investment bankers to give us fairness opinions," adds Ellis, "but a lot of the [negotiations] we do ourselves."

In the case of MiniMed, Goldman Sachs worked on the negotiating andfinancing, and provided the fairness opinion, though Medtronic did a lot of the financial analysis and due diligence itself, he says.

The MiniMed deal well illustrates the company's acquisition process, which starts with the desire to enter new and promising markets. "Going back a few years, diabetes was one that stood out," Ryan says.

The team also looks for companies with compatible technologies. MiniMed makes insulin pumps, and its long-term goal is to build an artificial pancreas that senses the amount of insulin needed and then releases it. Medtronic has sensor technology that could aid that project.

From a balance-sheet perspective, do-it-yourself (DIY) deals have their rewards. Ryan estimates that typical investment banking fees for a $3 billion deal like MiniMed would range between $12 million and $15 million.

While he wouldn't say how much of that cost his corporate development group helps him avoid, he estimates that the group itself costs Medtronic $2 million to $3 million a year. And, he adds, it is capable of doing more than one big deal a year.

CFOs, Take Warning

While Medtronic usually retains most of an acquired company's senior officials, it always dispatches a home-grown person to be the acquired company's CFO. The policy doesn't reflect on personal qualifications, Ellis says, but underscores the crucial role that Medtronic's finance group plays in integrating acquisitions.

Making a deal work requires someone who "understands Medtronic's systems, understands Medtronic's policies and procedures, our financial controls and what's important," he says.

When it comes to financing acquisitions, Medtronic has turned 180 degrees. A vigorous proponent of using the pooling method of accounting for acquisitions, it opposed the Financial Accounting Standard Board's plan to abolish pooling. Five of the eight deals it completed since 1998 (representing $9.13 billion of the $9.46 billion it paid for them) used pooling.

But now that FASB has essentially abolished the requirement to amortize goodwill–the chief stumbling block to cash acquisitions–Medtronic appears satisfied. As it turns out, a key element of the MiniMed deal was Medtronic's ability to pay in cash, Ryan says. The fact that it will now receive favorable accounting makes the deal sweeter.

Receivables Round-Up

While Ryan woos the Street (he estimates that he spends a third of his time on investor relations), Ellis rolls up his sleeves. Problems with receivables, payables and inventories, he says, caught his attention in 1999 as Medtronic was integrating its $4.2 billion purchase of Arterial Vascular Engineering and its $3.3 billion deal for Sofamor Danek. At the time, the company was also in the process of centralizing collections for all its subsidiaries.

The secret to Medtronic's success in reining in sloppy balance-sheet practices was "focus," Ellis says. "If you're calling, if you're making sure your invoice is at the top of that pile that has to be paid, you're going to get the collections."

Treasury caught the attention of sales representatives by linking 10% to 15% of their bonuses and those of their managers to accounts receivable levels. Another 10% to 15% of bonuses are now tied to inventory levels.

To get the job done and keep the metrics on people's minds, Medtronic feeds data on A/R and inventories into its salesforce's Palm Pilots. By the same token, sales reps now use the Palm Pilots to alert the company's billing department to special deals that they strike with hospitals. Ellis says the failure to communicate such deals in the past messed up billing and fueled the receivables build-up.

Cardiologists as Collection Agents

Medtronic rarely uses collection agencies for fear of antagonizing the hospitals. But it has had some success over the last year in getting bills paid by letting key doctors know that their institutions haven't paid up.

"The chief of cardiology pulls a lot of weight in these hospitals," Ellis says. "It was surprising: By even letting them know that there was an issue, it helped us on our collection efforts."

Medtronic sells about 35% of its product outside the U.S., a fact that continues to hamper its DSO effort. At the end of July 2001, domestic DSOs were in the low 50s, down from 67 to 68 days in 1999. However, outside the U.S., they remain in the 90- to 100-day range.

Overseas receivables are almost equivalent to sovereign debt, Ellis explains, because most non-U.S. hospitals are government-run. And as with sovereign debt, quality is all over the map. Northern European countries generally have DSOs in the 40- to 50-day range, while DSOs in southern Europe range from 120 to 200 days.

"In those countries where they have longer DSOs, we tend to have higher prices," says Ellis, who worked for 11 years at a predecessor to PricewaterhouseCoopers before joining Medtronic. Nevertheless, the company is adopting some of the bill-collecting techniques that it uses in the U.S. overseas.

Even as it has been stepping up collections, Medtronic has been working hard to slow down payables. When Ellis turned his attention to Days Payable Outstanding (DPOs) in October 1999, they were in the low 40s. Today, they average 53.

Ellis says Medtronic was a victim of its own success in failing to better manage its payables. Its strong cash flow encouraged its A/P staff to pay bills too promptly. The workers were so efficient, "we were literally paying bills before they were due," he says. "We obviously stopped that."

Medtronic has negotiated longer payment terms from its vendors or arranged discounts for paying early.

The company puts its extra cash to work with five external money managers. They invest it in fixed-income instruments with an average duration of a year.

The Inventory Gremlin

Medtronic is still struggling with the third leg of its working capital management processes: inventory levels. Despite its new sales-incentive plans, it continues to run up against long-established practices on the part of sales reps and hospitals.

Inventory turnaround was at 1.3 to 1.5 in 1999, a level that Ellis describes as "not very good," and has not budged since then. He takes little comfort in its being on a par with the company's peer group.

Medtronic historically has been lenient about inventory levels because its gross margin of 75% made it reluctant ever to miss a sale, he says. The problem is exacerbated because so much of its supply of finished goods is held on consignment by hospitals, which pay on an as-used basis. Sales reps also hold on to samples of each device they sell and the number proliferates because new models are constantly being introduced.

The problem is that hospitals need supplies on hand because of emergency surgeries. In addition, doctors often do not know exactly which Medtronic part or device they will need–for example, the company makes six sizes of heart valves–until after surgery starts.

To make inroads in inventory control will require changing attitudes, Ellis says. "We have to gain their confidence that they will get the product on a timely basis," he says of salespersons and hospital staff.

Medtronic this year hired Jeff Balagna from GE Medical Systems as chief information officer. His first project: Improving supply chain management. Medtronic is installing Ariba demand-forecasting systems into most of its businesses as well as J.D. Edwards manufacturing systems in many of its facilities.

Another challenge in the inventory picture is the limited number of suppliers of the specialized materials Medtronic uses. Its purchases are fairly small, so few are motivated to cooperate with the company's just-in-time production efforts, Ellis says. Moreover, new suppliers are hard to find because they fear product-liability lawsuits from patients.

In spite of the obstacles, Ellis aims to get inventory turns up above 2, and notes that a few Medtronic units are nearing the 3 turnaround level. "We believe that for our type of business, that's probably where we should be going," he says.

The Lifeblood of Medtronic

In 1949, Earl Bakken, a graduate student in electrical engineering at the University of Minnesota, joined his brother-in-law Palmer Hermundslie in opening a repair shop for electronic medical equipment.

They also made custom devices for doctors. In 1957, Dr. C. Walton Lillehei, a pioneer in open-heart surgery at the University of Minnesota, told Bakken about two children who died following open-heart surgery when the hospital's power failed. At the time, the pacemakers used during the surgery had to be plugged into a wall socket. Four weeks later, Bakken had devised a battery-operated model, and Lillehei successfully tried it on a patient.

Medtronic, which has never lost its lead in the pacemaker market, spawned a crowd of descendants in the Minneapolis area. Minnesota has the second-biggest concentration of medical technology businesses in the U.S., behind Northern California. Many were founded by Medtronic alumni.

–S.K.

Financing Implants

Medtronic Treasurer Gary Ellis has some interesting projects in mind as he surveys the growing trend for cosmetic surgery. Would consumers who spend freely for tummy tucks and vision correction surgery be willing to foot the bill for devices used to correct serious problems that are not yet covered by insurance or Medicare, he asks.

Medtronic makes a device to treat essential tremor, a disabling, involuntary shaking of body parts. But in part because the device is generally not covered by insurance, it reaches only 5% to 6% of those who could benefit.

"Is there a way to lease a pacemaker or a stimulator?" Ellis asks.

He admits that there are some "unique challenges" associated with leasing implanted medical devices, such as what to do in cases of nonpayment.

Medtronic is already dipping a toe into financing with a program to lease its Automatic External Defibrillators to municipalities. Some police departments are placing the devices, the size of a Kleenex box, in all patrol cars so police officers can more quickly treat cardiac events. –S.K.