Medtronic – Market Volatility Medicine for your Portfolio

By Paul Franke - February 22, 2012 | Tickers: ABT, BDX, BCR, JNJ, MDT, STJ | 0 Comments

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Medtronic (NYSE: MDT) hits the mark for Quantemonics Investing (QI) as a terrific low beta, blue-chip investment idea that is both undervalued and defensive.  Using the Quantemonics C.R.E.D.S. formula, MDT has been an exceptional value for new investors, trading under $40 per share in 2011 and early 2012.  [Please read our Microsoft write-up for an explanation of QI’s proprietary scoring model.] Quantemonics has held Medtronic shares since the Relative Value portfolio’s inception on Covestor.com about a year ago, and we believe it is a strong asset worthy of consideration by all investors.

The company is suffering from the uncertainty of health care spending levels in the U.S., especially by the federal government, and whether  new regulations on medical related industries are in the offing.  We believe spending on life-saving medical products, like those manufactured and sold by Medtronic, will continue to grow at above average rates compared to the overall economy for years into the future.  The positive demographic trend of baby-boomers reaching the ages of 50, 60 and soon 70 will help support demand for MDT products, no matter what Washington DC decides.

Most old-timers on Wall Street think of Medtronic as a one or two product line company, but the company has smartly diversified their revenue and earnings stream into a variety of health care areas the last 20 years.  Medtronic’s medical product line-up includes implantable and external heart defibrillators, cardiac pacemakers, diagnostics and monitoring devices, patient management tools, coronary vascular interventions, endovascular stent grafts, heart valves, and automated external defibrillators used in commercial and public locations for emergency cardiac arrest treatment.  The company also offers medical devices and implants for treating the spine and the musculoskeletal system, diabetes management solutions, management software for consumers and professionals, blood glucose meters, neurostimulators for pain, implantable drug delivery and deep brain stimulation systems, plus urology and gastroenterology devices.  In addition, the company offers products to treat diseases of the ear, nose, and throat, as well as neurological disorders, plus imaging systems used in surgery.

Medtronic uses the cash it generates annually to buy other companies as its basic business growth strategy.  This acquisition strategy has been quite successful for MDT shareholders over the years to diversify away from heart-only treatments.  MDT’s growth model is slightly different than the typical company in the health care industry.  Most do not generally focus on external investment as the main growth driver.  For example, Abbott  Labs (NYSE: ABT) develops their products internally with higher levels of research, development and capital expenditures.  This strategy has a goal of inventing specific drugs and medical devices that solve health problems.  When newly developed products are made available to the public, the extra product sales and profits grow the value of the entire business.  While there are advantages and disadvantages to each strategy, MDT’s culture of active takeover and acquisition investment works for them.

Medtronic purchased Ardian for a total consideration of about $1 billion in January 2011.  Ardian develops catheter-based therapies to help treat uncontrolled hypertension.  During August 2010, MDT purchased ATS Medical, which focuses on heart valves and surgical cryoablation, technology for about $400 million.  MDT spent around $500 million in April 2010 for Invatec S.p.A., which researches products for the treatment of cardiovascular disease.  For 2011, MDT breaks down revenue into two major groups, the Cardiac and Vascular Group ($8.5 billion in yearly sales), and the Restorative Therapies Group ($7.5 billion in sales annually).  MDT’s revenue stream is very diverse, with thousands of wholesale vendors, millions of end customers, and hundreds of medical technologies sold in most every nation on earth.

In our humble opinion, Medtronic’s diversified product line and high free cash flow yield is not properly valued by Wall Street today.  Using trailing four quarter results, ended Oct. 28, 2011, the company’s simple free cash flow was $3.9 billion (Net income of $3.4 billion, add depreciation of $1 billion, and subtract capital spending of $500 million).  MDT’s present market capitalization is around $42 billion, at a $40 stock quote.  The current free cash flow yield is roughly 9.1% annually ($3.9/$42 billion).  You can do further research on MDT’s financials by reviewing the latest SEC 10-Q filing.

Medtronic’s stock price outlined an all-time high over $60 some 11 years ago, and has largely flat-lined in price with the stock market generally since then.  However, the underlying business value has steadily grown the past decade, and the company’s stock quote has moved from an overvalued to an undervalued reading during this span.  During 2001-2002, MDT had revenues of roughly $6 billion and after-tax profits for shareholders of $1 billion each year.  During 2011-2012, MDT generates $16 billion in sales and $3.4 billion in net income annually, or 3x BETTER than a decade earlier, while the stock price is 30% LOWER!  Basically, the company can be purchased today at a 75% discount to the simple financial metrics and multiples of 2001-2002.  On a per share reading, including the accretive effect of a 20% contraction in total shares outstanding through buybacks since 2001, MDT is quite undervalued vs. its past 10-year or 20-year history.

On a relative valuation basis to its history and the alternative investments in the Medical Products, Health Care and Pharmaceutical industries available today, Medtronic ranks in the cheapest 10% group for simple free cash flow calculations.  If you overlay their score with the rest of the stock market alternatives and factor in an honest growth trend for the business from here (PEG ratio for example), MDT scores in the top 1% or 2% of available stocks for low valuation.  Further, if an investor considers the company’s large and diverse product line-up, blue-chip brand name and defensive/steady business results historically during varying economic backdrops, Medtronic sits in the middle of a select group of 30-50 stocks when value, growth and safety characteristics are reviewed in combination.

Medtronic’s stable and rising dividend payout, around 2.4% annually for yield in February, represents about 25% of free cash flow and could be easily doubled in the next couple of years.  MDT’s balance sheet gets high scores for liquidity and safety.  The company has a tangible book value, $4 billion in working capital, and its long-term liabilities represent about two years of free cash flow.  Overall, MDT’s strong financial foundation and sizable net profit margin afford an ultra-high margin of safety for investors. 

Medical Products is one of our favorite sectors to own currently, alongside Energy related investments.  For safety and valuation reasons, we believe some of the best long-term buys available today can be found in the large capitalization choices in this sector.  We also own Abbott Labs, Johnson & Johnson (NYSE: JNJ) and Becton Dickinson (NYSE: BDX) in the Relative Value portfolio on Covestor.  St. Jude Medical (NYSE: STJ) and C.R. Bard (NYSE: BCR) also score highly on a combination of trailing valuations, projected growth and overall safety screens, although we do not hold them presently.

Using our computer modeling formula, under normal economic circumstances, with 10-year relative valuations for Medtronic vs. the S&P 500 company average as a foundation, and inputting 5-year and 10-year Treasury yields for discounted free cash flows, we come up with a FAIR VALUE estimate above $60 per share today!  Honestly, the MDT dividend rate is yielding better than the 10-year Treasury bond of 2.0%, and the company’s dividend payout will surely rise in future years as profits expand.

Of course, potential price fixing and cost controls in the health care area by the U.S. government, the likelihood of tax increases on big business to close the federal budget gap, alongside the high odds of weak economic growth generally the next several years, bring down Medtronic’s fair value number closer to $50 per share, in our estimation.

On the plus side, we believe MDT is a strong inflation hedge, much better than corporate or government bonds.  Rising rates of inflation and less meddling by the federal government in health care could actually INCREASE nominal profitability and cash flow growth measurably the next 5-10 years, beyond our current projections.  Given a better economy, with some inflation and less government intrusion than now expected, MDT could be a “safe” double or triple on your investment the next five years.

Chart courtesy of StockCharts.com

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