1 Summary
In this analysis, I am looking at Medtronic (MDT, Financial) as a long investment opportunity. A quick review of MDT’s financials attracted me to the company:- Strong cash flow generation
- High returns on equity and acceptable return on assets
- Good dividends and buybacks with an overall good potential for intrinsic returns
- Ok Balance Sheet despite some leverage
- Relatively low valuation on a cash return and P/E basis
The analysis will first evaluate the company’s performance which in turns informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.
You can find a pdf version of my spreadsheet at the end of the analysis for your information.
2 Company Analysis
2.1 Company overview
Medtronic is one of the largest Medical Device companies in the world. It develops and manufactures therapeutic medical devices for chronic disease, including pacemakers, defibrillators, heart valves, stents, insulin pumps and artificial spine disks. The company has 7 operating segments:- Cardiac Rhythm Disease Management (33% of sales)
- Spinal (22% of sales)
- CardioVascular (18% of sales)
- Neuromodulation (10%)
- Diabetes (8%)
- Surgical Technologies (6%)
- Physio−Control (3)
MDT operates across the globe and its international sales represent 41% of its total $15.2B revenue. MDT’s vision is to complement its historical stronghold in heart disease (MDT still has ~50% market share in its core heart devices) with a growing presence in chronic diseases. Throughout the 1990’s, MDT invested in Spinal, Neuromodulation and Diabetes technologies 3 areas that now account for over a third of MDT’s sales.
Medtronic depends on continued innovation, either from internal R&D or through acquisitions and has proved over time to be skilled at both. MDT recently made some acquisitions in the atrial fibrillation and transcatheter heart valves that have shown significant growth potential in the recent months. Moreover over the next couple of years MDT is set to roll out new products in the cardiac rhythm management and spinal operating segments.
A rapid look at MDT’s recent news confirms its focus on product development and tuck in acquisitions as well as maybe give us an idea of why valuation appeared low in my quick review: a soft year in terms of growth (although both revenue and EPS are still trending upwards) and general concerns about healthcare reform. As I have already mentioned in my analysis of JNJ, while the HC reform is an overhang on the industry, device companies would be at most affected by the 2.3% excise tax somewhat counterbalanced by the increased number of patient with access to care and hence MDT’s products.
2.2 Profitability and Growth
Over the last 5 years, MDT’s growth averaged 8.8%, and was very consistent year over year, growing between 8% and 10% year after year. 2010 is proving more challenging and on a TTM basis, MDT is essentially flat. Some of MDT’s growth has been fueled by acquisitions as mentioned earlier, with about $4B spent in 2002 and 2008 and $2.6B in 2009.In terms of margins, Operating Income is currently at 28%, in line with the average performance over the last 10 years. Net income, now at 22% is slightly above the 10-year average of 19%. For both margins, 2009 seems to have been a challenging year with margins clearly below the “usual” range. This below trend performance seems – looking at the 10-K – driven by litigation charges as well as purchased in-process R&D and acquisition costs. Overall the current performance seems to be in line with historical results.
As a result of the revenue growth and fairly constant margins, Operating Cash Flow and Free cash Flow have grown consistently over the past 5 and 10-year periods. In 2006 FCF declined before recovering to trend in 2007 due to some swings in working capital.
EPS has been a bit volatile over the last 5 years, declining in 2008 but has nevertheless grown nicely over time.
| $ millions, except per share data | Growth Rates | |||||||||
| 2006 | 2007 | 2008 | 2009 | 2010 | TTM | 3-yr | 5-yr | 10-yr | ||
| Revenue | 11,292 | 12,299 | 13,515 | 14,599 | 15,817 | 15,658 | 8.2% | 8.8% | 12.2% | |
| Op. Income | 3,341 | 3,711 | 3,656 | 2,594 | 3,969 | 4,447 | 4.2% | -0.1% | 8.3% | |
| Net Income | 2,547 | 2,802 | 2,231 | 2,169 | 3,099 | 3,483 | 17.9% | 1.4% | 11.8% | |
| OCF | 2,207 | 2,979 | 3,489 | 3,878 | 4,131 | 4,315 | 8.8% | 16.4% | 10.2% | |
| FCF | 963 | 2,285 | 2,883 | 3,380 | 3,558 | 3,784 | 11.1% | 35.1% | 11.0% | |
| EPS | 2.09 | 2.41 | 1.95 | 1.93 | 2.79 | 3.20 | 19.6% | 3.6% | 13.2% | |
| Note: Growth rates calculated using log-normal regression and exclude LTM | ||||||||||
Looking forward, I will be using a conservative growth rate of “only” 6% over the next 5 years, which is below historical revenue performance of 8-10% on average over the last 5 years, and lower than what the company has experienced in any given year except for the last 12 months. This is also more conservative than analyst consensus of 9.9%.
Turning to cash flow and evaluating a “starting point” for our discounted cash flow (DCF) below, I will be using MDT’s Trailing Twelve Month performance, which is slightly below the regression numbers over the 3 year timeframe and in line with the 10 year regression. While FCF growth appears at first to be volatile with a standard deviation vs. trend of 43%, however this is driven by the 2006 “outlier” without which the standard deviation falls to ~20%. This also explains why the 5 year regression leads to a much higher FCF figure. Overall except for 2006 MDT has been consistent which gives me confidence in our starting FCF based on the latest TTM available.
Turning to returns, MDT’s ROE’s performance has been strong with returns consistently in the 15% to 25% and averaging 20% over the past 10 years. ROA has consistently been between 9% and 14%, with an average of 12%, a bit low but still acceptable (cf. my what I look for when reviewing a company). In addition due to acquisitions in the 1990’s the company carries about $10B in intangibles and goodwill on its balance sheet – making ROE and ROA lower than they probably are on an operating basis. It is actually reassuring that MDT is able to generate good ROE and ROA despite the large intangibles, reflecting that MDT has probably been able to get decent returns from its acquisitions.
Based on this, I will be using the 5-years average of 2% for return on equity going forward as an input to the sustainable growth rate calculations. In addition, taking into account MDT’s good returns, good revenue growth and high cash generation, I believe that Medtronic has a business moat. In addition, FCF has been very stable with one exception which leads me to using a margin of safety of 35% (I would have used 30% if not for the 2006 ‘outlier’) in order to evaluate the attractiveness of the stock.
Tomorrow's part II will cover financial health, uses of cash, stock returns and valuation. You can find some investment ideas, more one-page “stock reviews” as well as more in-depth “stock analysis”, including valuation and copies of my financial model on my investment research blog: Margin of Safety Investing.
Many happy returns!
Ben
