Medtronic's Growth Looks Good, But Can It Last?

By Stephen D. Simpson, CFA | November 19, 2012 AAA

Generally speaking, Medtronic's (NYSE:MDT) in the same boat as every other large-cap med-tech stock, where valuation has been compressed by worries about long-term growth prospects. Like Covidien (NYSE:COV), Johnson & Johnson (NYSE:JNJ) and a handful of select others, Medtronic seems to be past the worst of the growth lull, and the company has several potentially major products lined up in the pipeline. Now the real question for investors is the extent to which this quarter's growth can be sustained and whether the Street will come back and take a fancy to the significant cash flow this company generates.

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Fiscal Second Quarter Results Good on Growth, but not Margins
Medtronic reported 2% growth for its fiscal quarter (ex-Physio), while organic growth was a strong 4.5%. Medtronic's three largest businesses were pretty mixed; cardiac rhythm management (CRM) was flat in constant currency terms (with ICDs just positive and atrial fibrilation up more than 20%), Cardio was up almost 13%, and Spine was down more than 5%.

Medtronic's smaller businesses all delivered pretty solid growth. Neuromodulation was up about 10%, Diabetes was up almost 6% (with international sales up in the mid teens), and SurgTech was up 17% (and up 13% organically).

Medtronic's margin performance was less stellar. Gross margin missed management's guidance and the average sell-side estimate by about half a point, dropping about 40 basis points from last year and 60 from the prior quarter. That miss basically flowed through the operating line, as operating income fell more than 2%, operating margin contracted by half a point and Medtronic missed the average Street bogey by about 70 basis points.

Is This Growth Sustainable?
Perhaps the biggest concern for this quarter is whether this gaudy (for a large med-tech company, at least) organic growth is sustainable. Medtronic saw about 34% growth from its drug-coated stent business, and the launch of the Resolute stent appeared to account for almost half of the reported organic growth.

With that sales burst likely to fade, and rivals Abbott Labs (NYSE:ABT) and Boston Scientific (NYSE:BSX) certain to respond, it's a worthwhile question. Likewise, while Medtronic gained share from Boston Sci and St. Jude (NYSE:STJ) in CRM and is seeing better conditions in spine, I'm not sure these three large enterprises are ever going to be major growers again.

By the same token, I don't also don't think CRM and spine are likely to get much worse. That opens the door to ongoing improvements in other businesses. Neuromodulation and diabetes care continue to be growth opportunities for Medtronic (Medtronic saw good OUS growth in diabetes at a time when many rivals, including Abbott and JNJ are having their challenges), and so too does SurgTech.

The bigger question(s) for Medtronic shareholders probably revolve around transcatheter heart valve implantation (TAVI), renal denervation and emerging markets. On the TAVI side, Edwards Lifesciences (NYSE:EW) isn't surrendering an inch on the IP litigation front, while budgetary worries in Europe appear to be pressuring growth right now. Renal denervation still looks like a multi-billion dollar opportunity, but St. Jude, Covidien, Boston Sci, and (likely) JNJ are not going to give Medtronic any breathing room. On the emerging market side, Medtronic made an aggressive but expensive move in acquiring China Kanghui, but there's still work to do in markets such as Brazil, Russia, and India.

The Bottom Line
For a little while now I've been bullish on Medtronic's stock, as I do believe the company is close to a point where the CRM and spine businesses are likely to turn around. What's more, the company is exceptionally profitable and ridiculously good at converting revenue into free cash flow. Medtronic is going to have work increasingly hard to grow revenue, but I see the company as being more apt to continue to do relatively smaller deals (like CoreValve and Ardian) as opposed to bigger splashes like JNJ's deal for Synthes or Hologic's (Nasdaq:HOLX) deal for Gen-Probe.

Right now, I build my discounted cash flow model for Medtronic around the assumption of 2-3% long-term revenue growth and improvements in free cash flow conversion sufficient to add another 1-2% to free cash flow growth. With that sort of growth, fair value would seem to lie in the mid-$50s, making Medtronic a stock worthy of consideration for value, GARP, and dividend growth investors.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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