Medical Device Link.

Originally Published MX May/June 2006

COVER STORY

Interview by Steve Halasey

When competing in one of medtech's hottest sectors, it pays to have a strong operating plan, a robust product pipeline, and a reputation for high integrity. Under the leadership of chairman, president, and CEO Daniel J. Starks, St. Jude Medical (St. Paul, MN) boasts all three.

Throughout 2005, as news of major cardiology product recalls dominated national headlines, St. Jude Medical remained a darling of the media. While other companies in its sector faced both public and regulatory scrutiny, St. Jude Medical was recognized by multiple national publications for its admirable management practices. Among its accolades in 2005, the company was named a "most admired company" by Fortune magazine. In addition, Forbes magazine selected St. Jude Medical as the best-managed healthcare equipment and services company, and Medical Device & Diagnostic Industry named the company as one of its medical device manufacturers of the year.

Amid age-old rumors of a takeover, Daniel J. Starks, chairman, president, and CEO of St. Jude Medical says the company is focused on execution Photo by GARY BISTRAM

As a result of its strong reputation—and arguably even stronger financials—St. Jude Medical has constantly been at the center of the medtech industry's ever-present acquisition rumors. Although none of the rumors pegging St. Jude Medical as a target have ever come to fruition, in recent years the company has been particularly active on the acquiring side. In 2005, the company executed a handful of complementary acquisitions, including its first outside the cardiovascular sector.

Starks, who has served in his current capacity since May 2004, joined the board of directors of St. Jude Medical in May 1996. He assumed the role of president and CEO of the company's cardiac rhythm management business in 1998, and in 2001 was promoted to corporate president and chief operating officer.

Since joining the company's board a decade ago, Starks has seen St. Jude Medical's annual sales catapult from $877 million in 1996 to nearly $3 billion as of last year. The company's 27% sales growth in 2005 capped a five-year period in which the company's compound annual growth rate exceeded 21%. And as far as Starks is concerned, the company is poised to sustain its top-tier performance for years to come.

In this excerpted interview with MX editor-in-chief Steve Halasey, Starks discusses the never-ending acquisition rumors surrounding St. Jude Medical, the company's strategy for continued growth, and the challenges currently facing the cardiovascular technology sector.

MX: St. Jude Medical has been rumored to be a potential takeover target for large, diversified companies seeking to reduce their reliance on an uncertain drug pipeline and increase their profile in medical devices. Is St. Jude Medical being courted by any particular companies?

Daniel J. Starks: Whenever I'm asked a question like this, my answer is always the same: these kinds of rumors and speculation come with the territory of being in the medical device business. In the 21 years that I have been in the medical device business, every single year there have been rumors about my organization—either as an acquirer or as an acquiree—and very often there are rumors on both levels going on at the same time. Rumors of this nature just come with the territory. They are characteristic of a company that is well positioned in a hot growth market, and this is certainly the case with St. Jude Medical.

Has St. Jude Medical's board or major investors expressed an interest in being acquired under certain conditions?

We don't think about it that way. We focus on maintaining our own independent growth plan for maximizing shareholder value. This growth program has been in place since I became associated with St. Jude Medical, and it is a five-year rolling plan. We update the plan at least annually, and we revisit it more than once every year between the formal annual updates.

If alternatives to our independent growth program were offered, we would, of course, consider them and compare them to our independent growth program. But as you know from looking at our record of growth over the last seven years, and as you can see from the communications that we have issued this year at our annual analysts' meetings, we have a strong record of growth as an independent organization. And we continue to provide an optimistic and confident growth program going forward. St. Jude Medical's growth program has set the bar very high for anybody who might try to present the company with a plan B.

Track Record, Projected

One of the reasons that St. Jude Medical is so often named as a potential takeover target has to be the company's strong record of growth over the past seven years. What do you consider the key measures of the company's financial success?

The company focuses on sustained growth and earnings per share. Over the past five years, St. Jude Medical's compound annual growth rate in net adjusted earnings per share has been slightly greater than 28% when adjusted for special items (therefore a non-GAAP measure). As a secondary financial measure, the company pays almost the same level of attention to its sustained rate of top-line growth. Again, when adjusted for special items, that rate over the past five years has been slightly above 21% on a compound annual basis. Those two factors are triangulated with the level of investment the company is making in future growth drivers and in refreshing its technology base.

We closely monitor the level of research and development (R&D) as a percentage of sales. Over the past five years, St. Jude Medical has increased its R&D as a percentage of sales more than 100 basis points. At the same time, top-line growth has been accelerating. R&D as a percentage of that accelerating level of sales has continued to increase. In 1998, St. Jude Medical invested less than 10% of sales in R&D, which was a little bit less than $100 million. In 2005, the company invested about 12.7% of sales in R&D—an investment of close to $400 million.

In a recent meeting with analysts, St. Jude Medical projected that it intends to sustain this level of performance over the next five years and continue improving its operational margins. What factors make the company believe this is possible?'

St. Jude Medical has a strong corporate culture of structured continuous improvement programs that is now pervasive throughout St. Jude Medical. The company has structured training programs, structured black-belt programs, green-belt programs, Six Sigma programs, lean manufacturing programs. Year after year, everyone on St. Jude Medical's management team understands that it is incumbent on each person to ensure that the company's list of priorities includes activities that look beyond the current year.

From time to time, the company must sacrifice a short-term goal in favor of a long-term investment. For example, when St. Jude Medical acquired Getz Bros. Co. in Japan in 2003, the company sacrificed a 12-month period of continued improvement in its net operating margin. However, the acquisition enabled the company to achieve strong improvement in its net operating margin the following year, which occurred on top of an acceleration in total sales growth. The acquisition positioned the company to achieve stronger sustained growth in the second-largest medical device market in the world.

Beyond the five-year range that you projected in your recent meeting with analysts, are you able to project further into the future? Can St. Jude Medical sustain that kind of growth pattern, and what changes might St. Jude Medical need to undertake to continue its growth?

Looking out five years from now to 2011, we can have a general idea of the relative maturity of some of our current and emerging growth platforms.

For example, in the case of atrial fibrillation, we anticipate that the growth in our atrial fibrillation platform will still be in the early stages of gaining momentum. We anticipate that five years from now the atrial fibrillation market will be in a growth phase very similar to that which we are currently seeing in implantable cardioverter defibrillators (ICDs). That population is very large, and the level of penetration of curative approaches to atrial fibrillation five years out will still be modest. Therefore, we have at least a pretty good sense now that we will still have a lot of growth available to us in the area of atrial fibrillation in five years. That would be one example.

We can make the same kind of observations with respect to some of our emerging cardiology growth drivers, particularly in regard to our patent foramen ovale (PFO) closure system, a technology that closes the small hole between the two upper chambers of the heart. We have given this technology special attention. On the regulatory side, St. Jude Medical anticipates that this technology could be fully released to the U.S. market by 2009. Looking forward to 2010 or 2011, one could anticipate a very large patient population for the treatment, and St. Jude Medical would just be starting to see the mainstream growth in that part of its product technology platform.

The same observations apply to the neuromodulation sector. The growth that the neuromodulation market will see over the next five years will pale in comparison to the growth that will be seen after 2011.

A Pipeline for Future Opportunities

You mentioned the long-term growth opportunity in neuromodulation, which is still a relatively new area. Can you describe St. Jude Medical's current activities in this sector and where you see the company five years from now?

Yes. Even though neuromodulation is relatively unknown and in its infancy, it is already a $1.3 billion market. The largest segment of the current neuromodulation market is chronic pain management. The technology that St. Jude Medical employs stimulates targeted areas of the patient's spinal column to relieve otherwise intractable chronic pain.

The chronic pain management segment of neuromodulation is currently about a $700 million to $800 million market, and it is growing about 15 to 20% a year. St. Jude Medical currently has a strong number- two share in the spinal cord stimulation for chronic pain management segment of the neuromodulation market.

Are there particular regional markets that you think offer an opportunity for St. Jude Medical? Perhaps ones that are underpenetrated or where St. Jude Medical has not previously been active?

One of St. Jude Medical's historic strengths has been its focus on global markets. The company currently participates in about 130 markets.

Over the last seven years, we have put in place direct operations both in remaining major markets and also in all of the hot-growth emerging markets. For example, the acquisition of Getz Bros. instantly made St. Jude Medical direct in Japan, which is the second-largest medical device market in the world. We went from seven direct employees to 400 direct employees as a result of that acquisition. St. Jude Medical's presence there is just one example of its global competitiveness. Others include the company's direct presence in China, India, a number of Latin American markets, and other emerging growth markets.

Issues, Issues, Issues

A number of cardiology companies have had serious product recalls in the past year. Are there general problems in the design and manufacturing of complex cardiology products with which companies are having trouble? What else is going wrong?

The progress and the continued advances and benefits of the technology that we have created have advanced to the point where people forget the context. They forget that the technologies started from nothing. The technologies become more and more helpful, and people start to expect perfection from them, it seems. That perfection is not likely to be possible in human affairs, and it is not likely to be possible in medical device technology.

If you look at data from the last five years, you will see that ICDs and pacemakers are definitely safer and more reliable than ever. Last year, product recalls became high-profile issues, and they received more mainstream media coverage. But if a person looks at the complete data, one clearly sees that medical devices continue to become safer and more reliable, rather than the reverse.

When a company produces a high-risk product and something goes wrong, how and when should a manufacturer notify physicians and patients? There is a lot of debate surrounding this issue. Manufacturers, healthcare professionals, and FDA are involved in developing policies to define when and how such notifications should be issued. Is St. Jude Medical involved in this effort? Do you have a view on what kind of guidance is needed?

Yes, St. Jude Medical is very engaged in the discussions. We think the process that has been organized by FDA and the Heart Rhythm Society is really a very good process. Those two entities are well suited to lead an objective, complete review of all of the associated public policy issues, and they are well suited to get all of the right input and to generate good information and appropriate updates to guidelines and regulations that serve all the various interests. Where St. Jude Medical is welcome, the company is very engaged in those discussions.

Last year, the Department of Justice issued subpoenas to a number of ICD manufacturers. It is rumored that DoJ is attempting to identify widespread industry practices that may be in violation of the antikickback statutes. Some companies have been lambasted for some of their payments to physicians. What do you expect will be the result of DoJ's inquiries?

The idea that there are very serious and well-grounded antikickback statutes and regulations is not at all new. Our company has longstanding programs of compliance. These include the St. Jude Medical code of business conduct, which helps communicate, ensure, and police the company's compliance with the requirements of the antikickback statutes in the United States. The company also has similar business practice regulations in place for its operations in other countries. St. Jude Medical updated its own internal code of business conduct by adopting the AdvaMed code of business conduct when it became finalized. Therefore, as the Department of Justice examines business practices, the state of codes of conduct, and the state of programs to educate and control business conduct inside St. Jude Medical, the company has very robust programs.

Growth Strategy

How much of St. Jude Medical's growth do you expect to accomplish organically?

Most of it. The vast majority of our growth will be accomplished organically. That has been the case over the last seven years, and that was the case in 2005, despite the attention that some of our recent acquisitions have received. When those acquisitions are put in context, it becomes apparent that most of the company's growth remains organic. About two-thirds of St. Jude Medical's revenue growth in 2005 came out of its ICD product line. That was entirely organic growth, and the vast majority of the company's other growth also came from organic sources. Certainly less than 10% of our growth in the past year has been acquired growth.

St. Jude Medical has also been active in growing via mergers and acquisitions. Can you briefly describe the company's recent acquisitions and how they fit into the company's overall strategy?

Our acquisitions have primarily been opportunities to accelerate organic growth programs. In the case of our acquisition of Getz Bros., we were already committed to going direct in Japan. St. Jude Medical already had an infant direct organization consisting of only seven people. When the acquisition of Getz Bros. became available to St. Jude Medical, it was a very natural accelerant of a growth initiative to which the company was already committed.

The situation was similar in St. Jude Medical's acquisition of Velocimed (Maple Grove, MN). In that case, Velocimed and its technologies were directed toward interventional cardiology, and St. Jude Medical has internal development programs in a number of those same areas. The main initiative was PFO closure. We had a two-year-old internal R&D program in the area of PFO closure; therefore, the acquisition was a very synergistic strategy and accelerant of a growth initiative that had already been a multiyear program for St. Jude Medical.

Surprisingly, neuromodulation is another example of that same opportunity to accelerate an internal R&D program through an acquisition. We knew for some time that it was going to make sense for St. Jude Medical to leverage the low-voltage stimulation technology platform that supports the company's pacemaker product line into noncardiac low-voltage stimulation for neuromodulation. The company had an internal development program for several indications to expand its low-voltage stimulation technology into neuromodulation before it came to an agreement to acquire Advanced Neuromodulation Systems (ANS; Plano, TX). The acquisition accelerated that whole initiative.

Is that the reason that St. Jude Medical's acquisitions tend to be integrated into the company rather than being allowed to exist as self-standing units?

I am flattered by your observation of integration because that means everything looks seamless from the outside. But actually, St. Jude Medical is very flexible in its internal structure and organization. The company may be more decentralized and it may have the opportunity for more entrepreneurial activity than is obvious from the outside. For example, when St. Jude Medical acquired Getz, the president of Getz became the president of Getz Bros., a St. Jude Medical company. Following the acquisition, Getz continued to operate almost entirely the way that it had before the acquisition.

St. Jude Medical operates under a mantra similar to the Hippocratic Oath, in which a physician says, 'Do no harm.' When the company works to integrate acquisitions, it starts with the idea that it is making the acquisition because the acquisition target has a very talented group of people who have created a lot of value. We don't want to do anything to screw that up.

Are you satisfied that St. Jude Medical's planning has positioned the company for sustained growth?

We are enthusiastic about our growth opportunities going forward.

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