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.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.

Compare Brokers