Medtronic Worth The Wait

While technology and industrial companies enjoy a resurgence in growth and high commodity prices draw investors to the materials sector, the health care sector is something of a no-man's land these days. As Medtronic's (NYSE:MDT) latest earnings report highlights, there is a decided lack of growth in the sector and that has led many investors to cash out and chase faster prey. Although there is nothing to suggest a quick turnaround is on the way, patient value investors may nevertheless want to nibble on some of the leaders in expectation of an eventual turnaround.

Another Mediocre Quarter
Perhaps the most positive thing that can be said about Medtronic's fiscal second quarter is that it likely will not disappoint anybody to any significant degree. Revenue (net of currency) was weak, climbing just 2%, but that is all that many analysts had in their models. Though the quarter was stagnant on the whole, there were pockets of strength. Diabetes and the company's defibrillator business (Physio-Control) both saw double-digit revenue growth, and surgical technologies and cardiovascular were both up in the high single digits. The company's two largest businesses, though, were both weak as cardiac rhythm management and spine were both down about 1%. (For more, see A Checklist For Successful Medical Technology Investment.)

Although one quarter proves nothing about a company, it may be the case that Medtronic has come close to maxing out its operating leverage. Gross margin was down slightly this quarter, and operating income fell about 2% (dropping the operating margin below 31%). That is not a bad level in and of itself, but the absence of further improvement will be another obstacle to getting the stock moving again.


Easy Growth Won't Be Back Again
Medtronic has grown so large that there is little that management can do to produce the growth that some investors still remember - an acquisition of Intuitive Surgical (Nasdaq:ISRG) or Edwards Lifesciences (NYSE:EW), two of the fastest growing medical device companies, would just barely lift revenue growth to the double digits. Accordingly, while the company's acquisition of Ardian and its intriguing catheter-based technology for hypertension (the Symplicity system) is a good strategic move, it is not going to transform the company.

Medtronic is not exactly alone in that respect. Companies like Covidien (NYSE:COV), Boston Scientific (NYSE:BSX), and Becton Dickinson (NYSE:BDX) have found growth to be harder to come by, and only a handful of large companies are doing all that much better (Abbott (NYSE:ABT) among them).


The Bottom Line
Even in the absence of high growth, it is not all that difficult to make an argument that Medtronic shares deserve a better multiple. The company does a very good job of converting revenue into free cash flow and although medical technology is a very competitive marketplace, the twin barriers of intellectual property and the FDA's regulatory process tend to work in the favor of the large players. (For more, see Investing In Medical Equipment Companies.)


While doctor visits and healthcare procedure counts have dropped more in this recession than in prior cycles, this should reverse in time and Medtronic should be able to consistently deliver at least low-to-mid single-digit free cash flow growth. Though the company could be threatened by a concerted effort to control healthcare costs and curtail reimbursement levels, the political will for such a radical move seems absent. Thus, an assumption of future free cash flow growth at just 3% not only seems safe, but is enough to produce a target price more than 30% higher than today's level. (For related reading, check out Great Dividend Payers In Medical Technology)

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