Hearing on Pooling Accounting


Prepared Testimony of Mr. Robert Ryan
Chief Financial Officer
Medtronic

10:00 a.m., Thursday, March 2, 2000 - Dirksen 628

I. INTRODUCTION:

Good morning, I am Robert Ryan, Senior Vice President and Chief Financial Officer of Medtronic. Mr. Chairman, I am honored to speak to the Committee today, and pleased that you and Senator Grams invited me here to discuss my views on the FASB's proposal on business combinations with the members of the Committee.

Medtronic is the world's leading medical technology company, providing lifelong solutions for people with chronic disease. Medtronic just celebrated its 50th Anniversary. Earl Bakken and his brother-in-law Palmer Hermundslie founded Medtronic in 1949. We began in the humblest of circumstances in a garage in Northeast Minneapolis. From two employees and $8 in revenue in our first month, we have grown to $5 billion in annual revenues and 22,000 employees serving 120 countries around the world. Medtronic is pleased to have over 5,000 employees represented by eight members of the Committee.

Medtronic's mission is to contribute to human welfare by application of biomedical engineering in the research, design, manufacture, and sale of instruments or appliances that alleviate pain, restore health and extend life. People all over the world are alive today and living better because of pioneering therapies developed by Medtronic over the past fifty years. With our deep roots in the treatment of heart disease, Medtronic has grown, partially through mergers & acquisitions, to become the world leader in medical technology, providing a wide range of cost-effective products and therapies that restore life and hope to patients. Medtronic's products include pacemakers and defibrillation devices; coronary stents and balloons; devices for stopped and beating heart surgery; and, spinal implants, spinal stimulators and drug pumps. Every 30 seconds around the world, one person's life is saved or enhanced with one of our therapies.

I have been invited here today to discuss my views on the FASB's proposed change to eliminate poolings, as well as the likely consequences for the medical technology industry and users of accounting information. I have discussed the accounting for business combinations with executive management, operating management, investment analysts and shareholders. We wrote a comment letter to the Financial Accounting Standards Board on the Proposed Statement - Business Combinations and Intangible Assets. I have attached a copy of our letter as Exhibit I.

II. THE NEED FOR THE FASB TO SET THE FRAMEWORK BEFORE INSTITUTING SPECIFIC RULES:

We are supportive of independent accounting rules and the due process of the Financial Accounting Standards Board. We do however have some concerns regarding the FASB's proposal to eliminate poolings. We believe the FASB should address the issue of business combinations only after it has completed its project on reporting financial performance and it has addressed the whole issue of how to account for intellectual assets. We believe after setting the framework of how to account for intellectual capital, developed or acquired, the FASB may significantly change its views on accounting for business combinations. We are concerned about the effect of numerous accounting rule transitions on the marketplace and the investor confusion that will result.

We acknowledge that the theoretical issues with respect to business combinations are extremely complex. The FASB, Regulators, Preparers, and Auditors face enormous challenges in modifying existing accounting concepts, rules, and practices that were created in a time when tangible capital items were the critical assets of enterprises, to concepts, rules, and practices that are relevant in the age when intellectual capital items are the critical assets of enterprises. Technology has been developing at a rapid pace, and all of us involved in accounting and financial reporting have been working diligently to attempt to have our reporting keep pace. We commend the FASB for its oversight of accounting rule setting and the SEC for its oversight of our capital markets. Clearly, the United States has the most efficient markets in the world.

III. THE MEDICAL TECHNOLOGY SECTOR:

Innovation in the medical technology sector is developed by numerous sources, including mature companies and physician innovators. Many medical innovations are pioneered and commercialized at a large company like Medtronic. The proposal will have no impact on internal innovation at Medtronic. However, many therapies are developed by physician innovators that need venture money to advance their ideas. It is this innovation that will be disrupted by the FASB proposal. I am always amazed by the creativity of people in the United States to solve life's problems. I am convinced that creativity is a key factor in the economic prosperity of the United States.

It is these physician innovators and relatively small companies that act as incubators in the development of break-through medical technologies. Individuals invest their time and livelihood and venture capitalists invest their funds in the hope of realizing financial returns by selling their businesses to a larger enterprise. Although many of these "incubator companies" have life saving and enhancing ideas, they lack the infrastructure and capital to bring their technology to the mainstream medical marketplace. This is where a company like Medtronic steps in to provide such incubator companies with capital and expertise to fund the cost and develop on-going R&D, clinical trials, distributions systems, physician training and marketing. In addition, medical devices undergo incremental, but life saving and enhancing changes every six to eighteen months. The interplay among entrepreneurs, financiers, medical practitioners, and patients is delicately balanced and supported by a fragile ecosystem, which the proposal may very well disrupt.

In 1999, there were $200 billion in merger & acquisition transactions in the medical technology sector. Of the $200 billion in transactions, 70% were poolings. This compares to 21% of transactions in all industries being accounted for as poolings(1). The reason for the significant difference between technology companies and overall industry is the relative value of intellectual capital vs. hard assets in the respective industry groups. For instance, Medtronic has tangible net assets of $4 billion, but a market capitalization of greater than $45 billion.

Given the current environment, the elimination of poolings will have the unfortunate effect of diminishing Medtronic's ability to support medical innovation as an "acquirer" for an indeterminate period. In addition, it will impede the ability for the next Medtronic to be developed. The result will be reduced quality of life or, even worse, shortened life for tens of thousands of patients.

IV. THE MEDTRONIC STORY:

The proposed accounting appears to contradict the substantial value that we have created for our shareholders. At Medtronic, we were involved in $9.2 billion in merger and acquisition transactions in the past eighteen months. Of these transactions $8.8 billion were pooling transactions. I have attached a listing of the transactions as Exhibit II. We would not have been able to complete some of these transactions using the purchase method, because the resulting amortization of goodwill would have drastically reduced our reported earnings per share. We felt so strongly about the potential negative impact of a significant purchase that we completed a $700 million secondary stock offering for the sole purpose of allowing pooling accounting.

I have provided in Exhibit III financial schedules that indicate our concerns. Here is a summary:

Our pooled entities' revenue growth is 27% in our most recent quarter ended January 28, 2000 vs. the comparable quarter last year. Due to market dynamics, this growth is substantially above Core Medtronic. Our pooling transactions have created substantial shareholder value by diversifying the company. Previously, almost two-thirds of our revenues came from our cardiac rhythm management product line. Now, less than half of our revenues come from cardiac rhythm management. The operating margins and cash flow of Core Medtronic and the Pooled Entities are consistent.

Medtronic currently has 1.2 billion diluted shares outstanding. Approximately 20% of these shares relate to shares issued in our recent pooling transactions. We earned $.23 per diluted share in our most recent quarter ended January 28. If we had accounted for these transactions as in the FASB's proposal, we would have reported $.14 per diluted share(2). I ask you, why when we are (i) diversifying the Company, which intuitively adds to shareholder value through reduced overall risk; (ii) earning similar cash flows on each share issued in the poolings to those previously outstanding; and (iii) intend to stay and grow in the markets that we have entered; would you show "earnings" below the levels we were reporting two years ago before these transactions were even contemplated? The financial results reported under the proposal do not appear to be the most logical.

At Medtronic about 70% of our current revenues come from products introduced in the last eighteen months. The statistics are very consistent between Core Medtronic and our Pooled entities. The FASB believes that "goodwill" acquired in a business combination is consumed subsequent to the combination and regenerated via the creation of new intellectual capital. We would ask the FASB to ponder whether it would make sense for an entity to recognize on its balance sheet the value of its market capitalization and arbitrarily expense its market capitalization over twenty years? This does not appear to make sense, but is essentially what the FASB is suggesting in its proposal. While all entities continuously reinvent themselves, the intellectual capacity for an organization to do so is why companies pay what they do for an acquired business enterprise.

We all realize that the economics of the transactions are unaffected by the FASB's proposal. At Medtronic, we value transactions using projected cash flows, not earnings. However, we are all participants in the US public capital markets - and Earnings Per Share matters! When we acquire a company at Medtronic, we have no intention to have the value of that enterprise diminish over time, and therefore disagree with the concept of expensing the value of our acquisitions over an arbitrary 10 or 20 years.

If we had accounted for our recent poolings using the FASB's proposal our trailing twelve months price earnings ratio would need to be 83 times in order to preserve our current stock price. This would represent a 60% increase over the 50 times under current Generally Accepted Accounting Principles. We would certainly need to educate our investors and the market about why this difference exists and that cash flow has been unaffected.

III. CONCLUSION:

We urge the FASB to defer decisions on the accounting for business combinations until the whole issue of reporting financial performance is addressed. We think that the FASB's position relative to business combinations may change. We believe that the current proposal will create confusion in the marketplace, and uncertainty creates

volatility. We have been told that investment analysts will train the market to ignore goodwill amortization. I believe we should be providing the market with meaningful and useful information and not something that will create confusion and be ignored.

Thank you for the opportunity to speak to the Committee and I welcome your questions.




Notes:

(1) Source Securities Data Corp.

(2) For illustrative purposes only. Assumes all value over historical cost net assets is goodwill, which is amortized over 20 years.



Home | Menu | Links | Info | Chairman's Page