Medtronic Marking Time

By Stephen D. Simpson, CFA | August 20, 2013 AAA

These aren't the glory days for med-tech giant Medtronic (NYSE:MDT), as fiscal 2014 will be a pretty weak year from a growth perspective ahead of some significant new product launches in 2015. Even with a high-quality name like Medtronic, that lack of growth can lead to shares languishing as investors are attracted to (or distracted by) more impressive-looking stories in the short term. Although I'm not a passionate bull on Medtronic shares by any stretch, the stock is pretty much what passes for a bargain these days in the larger segment of this industry and I think it's a respectable core holding.

Quarterly Results Pretty “Meh” For Medtronic
There wasn't a lot to complain about in Medtronic's fiscal first quarter, but then neither was there much to celebrate. Like many others in this sector, it was a workmanlike quarter for a market still weighed down by adverse pricing, reimbursement, and utilization trends.

SEE: A Checklist For Successful Medical Technology Investment

Revenue rose 2% as reported, or about 3% on an organic basis – very slightly below the average of sell-side estimates. Margins were likewise okay-ish. Gross margin was down about 70bp from last year and either 10bp or 50bp below the average (I've seen two different “consensus” figures). Likewise, operating income rose 3% and operating margin expanded slightly (40bp), but that was either just barely above expectation, or a bit below where sell-side numbers were.

If there was one bright spot to the quarter, it was in the international business. Medtronic's international sales rose 15% on a constant currency basis this quarter.

Segment Results Mixed As Well
Not unlike the overall results, Medtronic's line-item results were mixed this quarter.

Overall cardiac rhythm management (CRM) sales were up about 2%, or just slightly below expectations. While pacemaker sales were stronger than expected (up 6%), analysts stubbornly refuse to accept that St. Jude (NYSE:STJ) and Boston Scientific (NYSE:BSX) are doing alright in ICDs and I think the company's “weak” performance (down 2%, but 3% below expectations) has less to do with the business than those expectations. On a brighter note, atrial fibrilation-related sales were up 22%.

Spine was weaker than expected (down 1%), as the company continues to suffer from its problems with the orthobiologic Infuse. Excluding Infuse, Medtronic isn't doing terribly relative to Johnson & Johnson (NYSE:JNJ) or Stryker (NYSE:SYK), but given that biologics are a large part of most spine care businesses, I wouldn't agree that you should exclude it.

Cardio was solid, up 6% and 5% ahead of expectations, as CoreValve continues to do well and the stent business is alright. Neuro and diabetes were more mixed – not bad relative to expectations, but not great in absolute terms (up 3% and 1%, respectively), as the new Boston Scientific Precision Spectra gained some traction and the diabetes business suffered from deferrals ahead of the new 530G pump.

One bright spot was the Surgical Tech business – up 13% and well ahead (more than 10%) of expectations. With the sluggishness in diabetes, Surg Tech could move Diabetes down to the smallest reported segment momentarily (though I expect the 530G pump to ultimately revive sales).

Holding Its Own For Now
All things considered, this is a good enough result for Medtronic. The company is certainly suffering from the launch of new products from rivals and the erosion of the Infuse business, but none of those were (or should have been) unexpected developments. Moreover, I do believe that the company can gain strong initial share with its Simplicity renal denervation product in 2015, as well as the Admiral drug-eluting balloon. I'm a little less certain about the CoreValve launch in the U.S., given Edwards' (NYSE:EW) disappointing U.S. sales, but I still believe it will be a significant product that moves the needle on revenue growth.

SEE: Compound Annual Growth Rate: What You Should Know

The Bottom Line
Medtronic has a trailing free cash flow CAGR of 7%, but I'm forecasting less than half that growth rate for the next decade, as the company faces more challenging headwinds from reimbursement, competition, and its own size. Even so, a 3% free cash flow growth rate supports a fair value in range of the high $50s to low $60s, and that appreciation potential isn't too bad for the sector these days. Factor in the company's commitment to establishing itself as a player in emerging markets, and I think you can make a decent enough case for buying Medtronic shares today.

Disclosure – At the time of writing, the author did not own shares of any company mentioned in this article.

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