Why I'm Still Bullish on Medtronic

Medtronic has seen several setbacks, but the underlying free cash flow still supports a higher stock price.

May 20, 2014 at 6:30PM

It seems like there's a cottage industry on the sell-side in "What's wrong with Medtronic (NYSE:MDT)?" pieces, but the stock has actually done OK since I last wrote on the company in late February. With Covidien pretty much flat in that time and Boston Scientific (NYSE:BSX) and St. Jude Medical (NYSE:STJ) both down, drug-fueled Johnson & Johnson is one of the few peers to really exceed the company's performance (while Bard has basically kept pace).

I continue to believe that Medtronic is undervalued as a low-growth/high-quality med-tech supergiant. The company has unquestionably seen multiple significant setbacks over the last year or so, but the company still has lucrative franchises in CRM, spine, neuromodulation, and diabetes that throw off plenty of cash and allow the company to buy its way into future growth markets.

Results weren't good enough
This certainly wasn't an epic close to a fiscal year for Medtronic.

Revenue rose about 3% on an organic basis, good for a tiny beat relative to sell-side forecasts. Gross margin was a little underwhelming, falling 0.2% from last year and missing expectations by around one point. Operating income growth of 2% (and operating margin of 32.2%) was likewise weak and Medtronic missed expectations by about $0.09 per share at the operating line. The company recouped some of that with lower taxes, making for a low-quality "meet" at the EPS line.

St. Jude still gaining in CRM
As I've written in prior articles, St. Jude Medical and Boston Scientific have both put a lot of effort and financial resources toward improving the growth prospects of the CRM businesses, and I believe it is having at least a modest impact on Medtronic's business.

Medtronic reported overall Cardiac Rhythm Management growth of 2% this quarter, with ICD revenue down 2% and pacemaker revenue flat with the year-ago level. By comparison, St. Jude saw 3% and 2% growth, respectively, while Boston Scientific saw ICD revenue decline 3% and pacemaker revenue fall 1% in the first quarter.

St. Jude continues to do well with its quadrapolar devices, but Medtronic and Boston Scientific should be cutting into that growth fairly soon. That said, St. Jude does still have the recently approved Allure, Assurity, and Endurity products to help drive growth and Boston Scientific is still expecting big things from its S-ICD device. Medtronic is still a long way from "losing" CRM, and it still holds over 40% share of the global ICD market, but I think St. Jude and Boston Scientific have nevertheless made it clear that Medtronic has to fight (and continue to innovate) to keep what it has.

On a more positive note, Medtronic also reported 51% growth in its a-fib and "other" business (both reported as part of CRM). This growth was inflated by an acquisition and Medtronic is still weak in catheter-based abalation, but the company is doing well in surgical ablation and its new Reveal Linq implantable cardiac monitor is a solid little new product that has gone largely unmentioned by the Street.

Settling with Edwards likely the best (or only) option
Along with the fiscal fourth quarter earnings report, Medtronic announced a global patent settlement with Edwards Lifesciences (NYSE:EW) regarding litigation over transcatheter heart valves. Readers may recall that Edwards won a major legal victory in April when a U.S. court issued a preliminary injunction against Medtronic's CoreValve, agreeing with Edwards' claim that it infringed its '552 patent.

While Medtronic was granted a stay shortly thereafter, Medtronic was facing the very real risk of being barred from the U.S. market until 2016 or beyond, by which time the very competitive Sapien III valve would likely be on the market in the U.S.

Under this settlement and cross-licensing agreement, Medtronic gains the right to sell the CoreValve and the two companies will stop suing each other for at least eight years. Medtronic is clearly the losing party here; the agreement may officially state that neither party admits infringement, but Medtronic is the one paying $750 million to Edwards, as well as annual royalty payments on U.S. sales of the CoreValve collared between $40 million and $60 million. Given Street estimates regarding CoreValve sales, that works out to a roughly 15% to 20% royalty rate – on the high end of what is typical, but enough to still make selling the CoreValve worthwhile.

As an aside, Edwards shares have risen about $12 since the court victory, and the increase in market value is pretty close to the value of this settlement ($750 million plus eight years of $50 million/year royalties).

Still a decent opportunity
All of the bad news aside, there is still a very credible business at Medtronic. The company is well-positioned for emerging market growth (up 14% this quarter), and markets like spine, neuromodulation, surgical technologies, and diabetes should deliver many years of growth ranging from the low/mid single-digits to high single digits. CRM should also recover to a low single-digit growth rate, even with ongoing competitive efforts from St. Jude and Boston Scientific. Couple that modest long-term annual revenue growth (3%) with very efficient free cash flow generation (recent FCF margins of 20% to 27%) and Medtronic is likely to continue generating over $4.5 billion in free cash flow a year.

The bottom line
Add in a nearly 2% dividend yield and the prospect of further share repurchases and Medtronic offers credible potential for investors looking for a more sedate med-tech play. Given that the Street is fairly down on the company given its setbacks in the clinic, this could be a good opportunity to own shares in a proven performer going through a fixable lull.

Speaking of great dividends...
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That’s beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor’s portfolio. To see our free report on these stocks, just click here now.

Stephen D. Simpson, CFA has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and Medtronic. 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.

4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

So you can imagine how shocked I was to find out Warren Buffett recently told a select number of investors about the cutting-edge technology that's keeping him awake at night.

This past May, The Motley Fool sent 8 of its best stock analysts to Omaha, Nebraska to attend the Berkshire Hathaway annual shareholder meeting. CEO Warren Buffett and Vice Chairman Charlie Munger fielded questions for nearly 6 hours.
The catch was: Attendees weren't allowed to record any of it. No audio. No video. 

Our team of analysts wrote down every single word Buffett and Munger uttered. Over 16,000 words. But only two words stood out to me as I read the detailed transcript of the event: "Real threat."

That's how Buffett responded when asked about this emerging market that is already expected to be worth more than $2 trillion in the U.S. alone. Google has already put some of its best engineers behind the technology powering this trend. 

The amazing thing is, while Buffett may be nervous, the rest of us can invest in this new industry BEFORE the old money realizes what hit them.

KPMG advises we're "on the cusp of revolutionary change" coming much "sooner than you think."

Even one legendary MIT professor had to recant his position that the technology was "beyond the capability of computer science." (He recently confessed to The Wall Street Journal that he's now a believer and amazed "how quickly this technology caught on.")

Yet according to one J.D. Power and Associates survey, only 1 in 5 Americans are even interested in this technology, much less ready to invest in it. Needless to say, you haven't missed your window of opportunity. 

Think about how many amazing technologies you've watched soar to new heights while you kick yourself thinking, "I knew about that technology before everyone was talking about it, but I just sat on my hands." 

Don't let that happen again. This time, it should be your family telling you, "I can't believe you knew about and invested in that technology so early on."

That's why I hope you take just a few minutes to access the exclusive research our team of analysts has put together on this industry and the one stock positioned to capitalize on this major shift.

Click here to learn about this incredible technology before Buffett stops being scared and starts buying!

David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't 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.

©1995-2014 The Motley Fool. All rights reserved. | Privacy/Legal Information

Compare Brokers