Should Pulses Race for Medtronic?

By Sharon Watson - August 27, 2012 | Tickers: BAX, JNJ, MDT 130518C00044000, MDT, STJ | 0 Comments

• Email
• Print

It’s ironic that keeping hearts beating at a steady pace represents more than half of medical device maker Medtronic’s (NYSE: MDT) business, given its stock price has dropped nearly 22% over the last five years. Not even a first quarter FY2013 earnings release showing net income growth of 5% over the previous year’s first quarter gave it much of a jump. (Unless otherwise noted, results used in this article cite Medtronic’s “constant currency basis” for clearer year-to-year comparisons.)

Medtronic stock was trading at 25.53 times earnings back in April 2008 (the company’s fiscal year end) and now trades at just under 12 times earnings, while the medical device sector’s aggregate PE is 18.42. Does Medtronic offer a value play?  

Value implies unrecognized good things are happening, and the company offers some bright spots to watch: its Surgical Technologies business, built out through the acquisitions of Salient Technologies and PEAK Surgical, grew 22%, with 11% of organic growth after the acquisitions.  The line is still small though, accounting for just 8% of Medtronic’s revenue stream.

International sales accounted for 44% of the quarter’s revenue, a 6% increase, with revenue from so-called emerging markets growing 14%. Management hopes to get growth from those countries to 20% annually. 

That said, total revenue across all business lines was down nearly 4% from the FY12 fourth quarter, which ended in April. Total U.S. revenues were down 3% from the previous quarter; international adjusted revenue was down 4.9% from the previous quarter.

During the company's August analysts’ call, executives said economic volatility around the world is an ongoing risk factor. The other business issues cited for a number of divisions were ongoing pricing pressures and better inventory management by hospitals, Medtronic’s key customer base.

Those characteristics highlight the very difficult markets Medtronic and its competitors operate in, where the mantra is “cut costs.” Healthcare providers increasingly see their supply chains as a place for economizing, as they told Modern Healthcare in a recent survey. 

This isn’t new thinking, but as more physicians and surgeons become their direct employees, healthcare providers have more leverage to force them to adopt a set of products backed up by strong clinical performance records versus keeping a range of manufacturers’ products available to suit each surgeon’s preference.

Medtronic management understands these trends. CEO Omar Ishrak wrote in the company annual report and reiterated to analysts that healthcare is looking for “economic value.” Parsing that, it means providers and payers increasingly demand evidence that a particular medical gadget does what it does as well as or better than competitors’ offerings, preferably at a lower price. That can also mean vendors will see lower profits even if they capture more market share in a category.

Ishrak noted Medtronic competitors typically can compete well on price in bulk purchase contracts so he’s not sorry to see these apparently fading as hospitals improve inventory controls. He told analysts the company would benefit more from “multi-line” deals. Medtronic has an array of surgical and disease management tools to offer so conceivably it can put together a package that meets provider inventory restrictions at an acceptable cost.

Nonetheless, the company is embarked on a plan to further improve its already impressive margins, anticipating the days in which those will be pressured. Gross margins (gross sales minus cost of goods) steadily run around 76%; its profit margins around 22.35%. For comparison, Johnson & Johnson’s (NYSE: JNJ) is 13.47%; Baxter International’s (NYSE: BAX) 16.3%; and St. Jude Medical’s (NYSE: STJ) 14.44%. Initially, its margins might give Medtronic greater pricing flexibility than its competitors.

But pressure from providers to lower prices will logically grow, given that the burgeoning Medicare and Medicaid programs typically “control” costs by announcing they’re cutting reimbursements to providers, squeezing hospital cash flows. And international governments are not interested in making up the difference, as Ishrak told analysts. Over time, then, it would be surprising to see Medtronic sustain such a large profit margin. In turn, thinner margins would affect free cash flow and financial flexibility, including resources available for international expansion, acquisitions and R&D. 

Still more operational efficiencies are necessary to carry out Medtronic’s twofold strategy of “creating economic value” and “accelerating globalization” while protecting its margins, Ishrak said. The specific goal is to cut $1.5 billion from product costs over the next five years.

Efficiencies are finite, though, and international competition is stiff. The strategy doesn’t sufficiently explain how Medtronic will achieve long-term organic growth with its largely mature product portfolio as healthcare providers reinvent their cost structures.

So, what’s the bottom line? The company raised its annual dividend in June by 7.2% to $1.04/share, for a current yield of 2.6%, and steadily repeats it's committed to returning 50% of its free cash flow to investors annually. Analysts calculate a stock target price ranging from $43-$48 per share. Buying in today, at around $40-$41, doesn’t seem like a bargain, unless you side with the more bullish analysts or like the dividend.

Ishrak told analysts Medtronic needs “several more quarters of dependable, consistent performance before we can claim any sort of success.” Investors should take those words to heart.

• Email
• Print
• Feedback