Rising Star Buy: Medtronic

This article is part of our Rising Star Portfolios Series.

Many gross potato chips have been eaten because of the wildly silly "five-second rule," which deems food suitable to eat if retrieved within five seconds of hitting the floor. Heck, I'm buying medical technology giant Medtronic (NYSE: MDT  ) for the Un Portfolio because of it. Of course, if that chip lands in a puddle of filth even for a millisecond, I'd pass; drop that chip on my guest bedroom floor (which sees no foot traffic) and I may well chow down.  

Un-vesting works the same way. Stocks fall on the floor from time to time, they collect some dirt and it's up to us to determine if that debris can be shaken off or if it has ruined the investment. With a little time and a flick or two, I think Medtronic -- just 10% off its 18-month low -- is a floor-touched chip worth eating. I'm putting 5% of the Un-Port's capital to work.

Allocating 5% to Medtronic The Five Rules Checklist
Know the BIG THREE
Identify the “Un”
Margin of Safety
Father Health vs. Father Time
Diversify

Curious about the Five Rules checklist? I won't un-vest without it. Get the details here.

In the business of pain
Medtronic is truly a great American success story. From its roots in 1949 as a medical equipment repair shop, it has grown into the world's largest independent medical technology company. Along the way, it has become the standard of care for products used in such areas as heart and spine surgery, diabetes, and nerve stimulation (for Parkinson's, epilepsy, and more).

We're talking cool stuff here: MRI-safe pacemakers, systems so a doctor can monitor a patient's implanted devices remotely, and mesh to patch up damaged skulls. The company sells more than 5,000 different products to hospitals and clinics worldwide.

The BIG THREE reasons I'm buying

1. Culture of innovation and deep pockets. Innovation is built into Medtronic’s DNA. The company has 4,500 engineers focused on innovation (400 have a PhD or MD). With research success a key component in determining bonuses, it should be no surprise that the company expects to launch 60 new products in the near future. Each year, Medtronic's dominance grows because it invests significantly more in research and development than its peers:

Company

Trailing 12-Month R&D Spending*

For Every $1 It Spends, 
Medtronic Spends

Zimmer Holdings (NYSE: ZMH  ) $215 $6.81
Stryker (NYSE: SYK  ) $373 $3.92
St. Jude Medical (NYSE: STJ  ) $592 $2.47
Boston Scientific (NYSE: BSX  ) $971 $1.50
Medtronic $1,460 --


Source: Data from Capital IQ, a division of Standard & Poor's. 
*In millions.

2. Three powerful macrotrends. The aging of the baby boomers, rising wealth in developing nations, and increasing access to health insurance are all huge trends that create a tailwind for Medtronic's business. The 60+ age demographic is expected to grow at an annual rate of 2.9% over the next decade; only 7% of Medtronic's business comes from emerging markets; and the majority of Medtronic's products are of the nonelective type that get great acceptance from insurance companies. The interaction of these three waves should buoy sales growth for years to come.

3. Shares are on sale. Paying nine times free cash flow and 10 times next year's expected earnings for a company of Medtronic's quality makes good, Foolish sense. The company generated nearly $19 billion in free cash flow over the past five years -- that's half its market cap! It's also been buying back shares, raising its dividend, and scooping up acquisitions and it is in great financial shape.

What's so "Un" about Medtronic?
Medtronic falls squarely into the "unloved" bucket of the investing world and has dropped 19% since the beginning of the year. While the drop hasn't been limited to Medtronic, the company's recent lowering of earnings guidance has drawn even more attention to the industry's three primary issues.

  • Depressed patient procedure volumes due to high unemployment, expiring COBRA transition coverage, and financial difficulties.
  • Increased development costs and lengthened new product cycles.
  • Uncertainty regarding the impact of health-care legislation.

Ti-i-i-ime, it's on your side (yes it is)
It's clear the market doesn't like Medtronic when we assess the 10-year expectations built into its stock price: revenue growth less than 3%, collapsing returns on capital, and very little success coming from the company's hefty investment in research. Lucky for us, the company's balance sheet looks great. A manageable debt load and nearly $4 billion in cash and investments mean we've got time on our side for Medtronic to perform and for Mr. Market to adjust his pessimistic view.

Risks
Medical technology generates high returns on capital. New competition and intellectual capital naturally want in on the action and firms have to defend their turf at high costs. Maintaining market share requires new products to be innovative and timely, but the costs of bringing those products to market is lengthening and rising because of new efficacy and testing demands from regulatory bodies. Such demands can slow a firm in responding to a competitor's product stealing market share.

On top of competitive pressures, playing nice with the insurance industry is a must because the industry relies on insurance companies to accept and pay for the surgeries that use its products.

That's a buy
Sure, things are tough for Medtronic right now: Economic, regulatory, political, and competitive challenges are making investors flee the stock. This is exactly the sort of opportunity the Un Port seeks out and why I'm excited to pick up shares. As we choose additional stocks, we'll be sure to watch our health-care exposure, but for now the Un Port has a clean (and cash-filled) slate that Medtronic fits into like a surgical glove (cue latex snapping noise)!

Share your thoughts on Medtronic's addition to the Un Portfolio here.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Stryker is a Motley Fool Inside Value recommendation. The Motley Fool owns shares of Medtronic and has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 17, 2010, at 11:46 AM, naandrews wrote:

    Medtronic might be a good value, but it could also be a value trap. Separating the company from the stock, the stock has done nothing in a decade (except go down). The three trends you mention -- aging of the baby boomers, rising wealth in developing nations, and increasing access to health insurance -- haven't all these trends been operative over that last decade? Why will they move the stock in the next decade if they haven't moved the stock in the last decade?

    Personally, I like (and own) Stryker better -- correct me if I'm wrong, but they have faster growth rates, and the stock has actually done well over the past decade.

    Neil

  • Report this Comment On November 17, 2010, at 1:11 PM, TMF42 wrote:

    Neil,

    You're right -- Medtronic (the stock) has done very little over the past few years. Investors have clearly stated that they're willing to pay less for a dollar of the company's earnings and cash flow than they were five years ago.

    But operationally, Medtronic has grown very impressively over the past decade. And now, the company is so cheap that its share price should at least move in tandem with its ability to generate earnings and cash flow.

    Stryker is a solid company as well. I prefer Medtronic because of its diversified portfolio.

    Thanks for commenting!

    Bryan

    TMF42

  • Report this Comment On November 17, 2010, at 6:31 PM, stan8331 wrote:

    What I'm seeing thus far suggests that the poor performance of Medtronic's stock over the past decade is more a situation of a strong company that experienced explosive growth in the 90's and is now tending to its long-term future, rather than being an indicator of endemic weakness. We are inevitably going to have to make significant cuts in what we spend on health care as a percentage of GDP, but those cuts will be balanced by the powerful macro trends mentioned in the article.

    I briefly held a small position in Stryker sometime back, but decided to sell when I ran across some accounts of questionable business practices. My account is underexposed to health care right now - I'm thinking Medtronic might make a nice addition.

  • Report this Comment On November 18, 2010, at 11:04 AM, nonzerosum wrote:

    I bought some today. The "10 year" comments by Neil apply to most blue chips, e.g. MSFT and Intel, and the markets in general, so I don't think Medtronic management did anything "bad" to deserve the stock decline.

  • Report this Comment On November 18, 2010, at 11:23 AM, TheDumbMoney wrote:

    "Medtronic might be a good value, but it could also be a value trap. Separating the company from the stock, the stock has done nothing in a decade (except go down)."

    Such comments always mystify me. Ten years ago, MDT sported a P/E of 62, a price to cash flow of over 50, and a high PEG ratio. Where did you expect it to go from there? Shooting skywards?

    The point I would make about MDT is that I worry it has in fact been losing some significant market share in its core, heart-related-devices business -- I just remember reading an article that mentioned that, that's literally all I know. In that sense it could be a value trap I suppose, and since I'm interested in the stock I would love to hear more from someone who knows something about that.

  • Report this Comment On November 18, 2010, at 1:44 PM, TMF42 wrote:

    dumberthanafool:

    You're spot on -- most investors are concerned and focusing on the troubles in some of its heart- and spine-related strongholds.

    My take on these things has three parts:

    1. There is some natural ebb and flow to which company has the "top product" at any given point in time. St. Jude, right now, has the new must-have, as it turns out. However, if you look at Medtronic's marketshare over time, it has retained its #1 position by a wide margin, even though its actual share may tick up or tick down in any given quarter/year.

    2. It's imporant to understand the sales process for these types of products. In most cases, we're talking implantable devices -- cutting open a human and putting a high tech device inside. Talk about risks! Doctors don't want to screw this up (there are huge lawsuits, not to mention bad patient outcomes if they do). As a result, switching to a new product is a tough sell and gives massive advantages to incumbents (like Medtronic) with a dominant position and many installed devices. But, Medtronic can't rest on its laurels.

    3. The long-term success in this industry will be determined by innovation. As my article notes, I think Medtronic has the edge because of its size -- it can invest more dollars than anyone else. I also like how innovation is tied throughout the culture of the company.

    Bryan

    TMF42

  • Report this Comment On November 18, 2010, at 3:26 PM, naandrews wrote:

    Dumberthanafool, MDT has been a chronic underperformer (again, separating the stock from the company), not just from a lofty valuation from the early 2000s but from pretty much all timepoints. For instance, it has underperformed the market over the past 1, 3 and 5 years. You'd have been much better off investing in an index fund than in Medtronic during any of those time points.

    While past (under)performance is no assurance of future (under)performance, I personally don't like to invest in stocks with long histories of underperformance. I'm a long-term buy and hold investor, but I'm not willing to be so long-term buy and hold that I put up with another decade of underperformance; there are just too many other compelling opportunities out there. The opportunity costs of investing in a chronic underperformer can be huge.

    My main point, though, is that, as I wrote earlier, the same factors that people point to -- aging baby boomers, more access to health insurance, etc. etc. -- have all been operative over the past 1, 3, 5, 10 years. But they haven't moved the stock.

    Why will they move the stock over the next ten years?

  • Report this Comment On November 27, 2010, at 1:06 PM, aleax wrote:

    @naandrews, the "chronic underperformance" of the MDT stock is exactly why you can buy it at such good prices today. It's unlikely to soar dramatically and even less likely to plummet, and pretty fairly valued, so a good candidate for writing prudent, fairly OTM, shortish-term covered calls on.

    As is pretty typical for MDT, right now I can write Feb 11 calls, strike 36, for about 0.66 -- so on each 100 stocks (one contract), costing me $3384, I make $66 in 3 months, plus the $22.5 dividend coming in early Jan, make it $88 total income, 2.6% in three months -- 12% annualized returns. That, as I said, is pretty typical of this stock.

    If assigned (30% probability gauging by the delta), there's another $216 in capital gains, i.e., another 30% annualized gain; you can expect that to happen about one time in three (again, look at the delta), boosting overall returns, albeit quite unpredictably. (Of course, then you can switch to writing puts -- or, often, you'll have lucrative opportunities to roll up and forward -- but accepting exercise's OK too of course). Stock price gains, over 3 months, below the 6.4% gain needed to put the call in the money, just go to your unrealized capital gains, just like stock price declines are unrealized capital losses, and the two effects roughly balance each other for a sufficiently "sleepy" and fundamentally sound stock like MDT.

    Overall, a buy-write strategy (probably complemented by writing OTM puts when your calls get assigned) on a rather sleepy, fundamentally sound stock, with a moderate dividend, like MDT, can give you 12% - 20% yearly returns -- with somewhat lower risks than just owning the stock outright. Not a "get rich quick" strategy by any means (and tax-wise your returns are all short-term capital gains, except for the dividends, which are qualified) -- but there's space for some of that in a well-diversified portfolio, without any of the "huge opportunity costs" you think are there.

    If you're really hungry for somewhat higher returns, consider boosting yours with some modest amount of margin: if you use margin at all, it's much less risky to do so on less-volatile stocks than on "high fliers" (still somewhat risky of course -- look at the fall of 2008 as an example... if your margin equity can't survive a 50% fall of the whole market, i.e., if the margin call for such a fall would wipe you out, then you're over-margined no matter how sleepy and conservative your stocks;-). ((Margin is ONLY recommended, if at all, to experienced investors who know very, very well what they're doing -- and the same applies, in the general case, to options, although writing OTM covered calls on sound, sleepy, dividend-paying stocks is in fact a very conservative strategy)).

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