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Medical Device Maker Is Too Cheap to Ignore

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If uncertainty creates investment opportunity, then there is plenty of opportunity in the healthcare sector. With provisions buried within Obamacare still coming to light and proposed cuts to Medicare making their way through Congress, it is difficult to know which companies will benefit and which will suffer at the hands of the federal government.

However, some companies are just too cheap to ignore despite the uncertainty. For instance, Medtronic (NYSE: MDT) trades at just 11x earnings and 10x free cash flow despite a strong history of innovation and a market-leading position in most of its devices.

Leading Market Share, High Profitability

Being the market leader has a number of advantages in the medical device industry. For one, doctors trust brands that have long track records of safety and reliability. Secondly, there is a high degree of customer stickiness; doctors usually do not switch from one brand to another unless there is an explicit reason to do so. As a result, Medtronic's market position is defensible.

Finally, a leading share of the market for a device also affords the company economies of scale in the production and distribution of that device. This is most evident in Medtronic's superior margins relative to its peers

Medtronic outpaced St. Jude Medical (NYSE: STJ) during most of the last decade before voluntary product recalls hurt Medtronic's bottom line. Meanwhile, St. Jude has been making strides in atrial fibrillation and other heart-related devices, which is Medtronic's bread and butter. However, despite St. Jude's long strides in the cardiovascular device segment; it is still too far behind Medtronic to make an attempt at becoming the market leader.

Boston Scientific (NYSE: BSX) has also suffered from product recalls, but its relative lack of diversification, in addition to operational missteps, did not shield it from posting losses. A number of its products are still under scrutiny even after its recall of all defibrillators just two years ago. For example, studies have shown that BSX's bare metal stents are not any more effective than a traditional aspirin regiment, which is a bad sign for the product. Medtronic, fortunately, has been able to sidestep many of the problems facing BSX.

Medtronic also has a size advantage over the two; it has over $16 billion in sales compared to $7.6 billion for Boston Scientific and $5.6 billion for St. Jude.

Medtronic's top-line will continue to grow at a fast pace if it can establish a foothold in chronic diseases. The company's chronic disease devices are experiencing rapid growth and will add much-needed diversification away from the company's stronghold in heart devices.

But the best reason to be interested in Medtronic is that its business and profitability will not change much over the next few decades. 'Innovation' in medical devices is not quite like innovation in the tech industry; it is more about making incremental improvements to products rather than discovering breakthroughs. This leads to more reliable R&D success than at your standard biotech firm as well as the reduced risk that a competitor will come up with a new groundbreaking device that completely transforms the industry. In other words, if Medtronic is the market leader today, it likely will be for years to come.

Valuation

Valuing a company that has a defensible market position, a long history of profitability, and will continue to do the same thing in the next decade as it has in the last is not a difficult task. Over the last three years, the company has averaged $3.5 billion in free cash flow. If we take $3.5 billion as the company's free cash flow base -- the amount that it will continue to earn if it stops growing -- and divide it by the company's market capitalization, we get a free cash flow yield of 7.74%.

In other words, the company's stock price should return 7.74% annualized before growth. However, there is enormous potential in chronic diseases, which leads me to believe that growth in free cash flow will easily clear 2.25% -- the growth needed to get to a shareholder return of 10%.

However, many investors are rightly concerned about the effect of health care reform and changes to Medicare on the company's profitability. This is where each investor's margin of safety comes into play. Investors who are extremely bullish on the chronic disease devices will probably feel safe buying the stock at current levels, but those not willing to pay for growth when there is legislative uncertainty may not be comfortable buying in quite yet. As with all investments, it’s up to each individual to decide for herself.

 


titans8904 has no position in any stocks mentioned. The Motley Fool owns shares of Medtronic and St. Jude Medical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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