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Medtronic Looks A Little Woozy
Diversification is a great thing ... but what does a company do when none of its top divisions do very well? That is the dilemma for Medtronic (NYSE:MDT) and its investors, as this one-time darling of med-tech struggles through a low point in its growth trajectory.
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The Quarter That Was
Revenue fell about 4% this quarter, missing the consensus estimate by almost $200 million. Most concerning was the fact that the company's two largest businesses, Cardiac Rhythm Disease Management (pacemakers and ICDs) and Spinal, were two of the worst performers. CRDM saw sales fall about 8%, while spine revenue dropped 9%. Worse still, these were poor performances relative to the wider markets, suggesting that companies like St. Jude (NYSE:STJ) and Stryker (NYSE:SYK) are taking away market share.
Medtronic investors accustomed to this company's long history of operating efficiency might also be a little concerned about the performance below the top line. Gross margin did tick up a bit from last year, but SG&A expenses moved up a bit as a percentage of sales. All in all, operating income fell 5%, but EPS actually rose 1% as the company benefited from a lower share count and lower "other" expenses.
The Road Ahead
Unfortunately, there is really no bright side of the story at this point. The company's diabetes business continues to do well against the likes of Abbott Labs (NYSE:ABT), and Medtronic's transcatheter heart valve business seems to be at least holding its own versus Edwards Lifesciences (NYSE:EW). Unfortunately, those are relatively small businesses compared to CRDM and spinal care.
Likewise, Medtronic is not making the sort of acquisitions that would seem to really stimulate near-term growth. The CoreValve deal is certainly an exception, but the acquisition of businesses like ATS Medical, Osteotech (Nasdaq:OSTE) and Invatec seem more like back-filling spots of weakness than real growth initiatives.
Still Confident?
All that being said, this is still Medtronic. The company is on pace to spend over $1.2 billion in R&D alone this fiscal year - a figure that nearly matches up-and-coming spine-care competitor NuVasive's (Nasdaq:NUVA) entire market capitalization. That should give investors a certain amount of confidence that Medtronic will stay a leader in the med-tech space for years to come and there is no reason to believe that the med-tech space is not still an attractive place to be. (For more, see A Checklist For Successful Medical Technology Investment.)
These are pretty lousy times for healthcare in general, and there are plenty of cheap stocks out there (predicated on the assumption that procedure volumes will rebound with the economy). Instead of considering how cheap Medtronic may be in price target terms, consider looking at the other side and seeing what the current price discounts.
The Bottom Line
The average of Medtronic's free cash flow over the last three years results in a sum of $3,305 million. Assume zero growth forever more, discount it at 9%, and subtract $1.6 billion in net debt and the result is a price target of $31.50. That is precisely the last quote on Medtronic's stock as of this writing. In other words, to consider today's price as fair it would seem that an investor must assume Medtronic never shows free cash flow growth again. That seems implausible.
Perhaps St. Jude is the more dynamic option today, as it appears to be beating Medtronic and Boston Scientific (NYSE:BSX), or perhaps investors could take a look at smaller names like ZOLL Medical (Nasdaq:ZOLL). Whether or not there are better ideas out there in med-tech, it would seem that the expectations for Medtronic are so low that long-term investors have little to fear. (For more, see Two Under-The-Radar Reports In Med-Tech.)
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IN PICTURES: 9 Simple Investing Ratios You Need To Know
The Quarter That Was
Revenue fell about 4% this quarter, missing the consensus estimate by almost $200 million. Most concerning was the fact that the company's two largest businesses, Cardiac Rhythm Disease Management (pacemakers and ICDs) and Spinal, were two of the worst performers. CRDM saw sales fall about 8%, while spine revenue dropped 9%. Worse still, these were poor performances relative to the wider markets, suggesting that companies like St. Jude (NYSE:STJ) and Stryker (NYSE:SYK) are taking away market share.
Medtronic investors accustomed to this company's long history of operating efficiency might also be a little concerned about the performance below the top line. Gross margin did tick up a bit from last year, but SG&A expenses moved up a bit as a percentage of sales. All in all, operating income fell 5%, but EPS actually rose 1% as the company benefited from a lower share count and lower "other" expenses.
The Road Ahead
Unfortunately, there is really no bright side of the story at this point. The company's diabetes business continues to do well against the likes of Abbott Labs (NYSE:ABT), and Medtronic's transcatheter heart valve business seems to be at least holding its own versus Edwards Lifesciences (NYSE:EW). Unfortunately, those are relatively small businesses compared to CRDM and spinal care.
Still Confident?
All that being said, this is still Medtronic. The company is on pace to spend over $1.2 billion in R&D alone this fiscal year - a figure that nearly matches up-and-coming spine-care competitor NuVasive's (Nasdaq:NUVA) entire market capitalization. That should give investors a certain amount of confidence that Medtronic will stay a leader in the med-tech space for years to come and there is no reason to believe that the med-tech space is not still an attractive place to be. (For more, see A Checklist For Successful Medical Technology Investment.)
These are pretty lousy times for healthcare in general, and there are plenty of cheap stocks out there (predicated on the assumption that procedure volumes will rebound with the economy). Instead of considering how cheap Medtronic may be in price target terms, consider looking at the other side and seeing what the current price discounts.
The Bottom Line
The average of Medtronic's free cash flow over the last three years results in a sum of $3,305 million. Assume zero growth forever more, discount it at 9%, and subtract $1.6 billion in net debt and the result is a price target of $31.50. That is precisely the last quote on Medtronic's stock as of this writing. In other words, to consider today's price as fair it would seem that an investor must assume Medtronic never shows free cash flow growth again. That seems implausible.
Perhaps St. Jude is the more dynamic option today, as it appears to be beating Medtronic and Boston Scientific (NYSE:BSX), or perhaps investors could take a look at smaller names like ZOLL Medical (Nasdaq:ZOLL). Whether or not there are better ideas out there in med-tech, it would seem that the expectations for Medtronic are so low that long-term investors have little to fear. (For more, see Two Under-The-Radar Reports In Med-Tech.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!
by
Stephen D. Simpson, CFA
Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog, and can be reached there.
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