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Could Medtronic Double Your Money?

Matt Koppenheffer
June 6, 2011

Let me start by saying that I'm not an expert on medical devices. Nor do I play one on TV. But like Warren Buffett, I want to own great businesses, and sometimes it's not necessary to know the nitty-gritty details of the next product launch to know when a company is simply very, very good at doing what it does. And I think Medtronic (NYSE: MDT  ) fits that bill.

Of course, finding a strong business is only half the battle -- you also need to know when it's priced attractively enough to buy. Does Medtronic pass that test? Let's take a closer look.

Earnings expectations
As I outlined in a previous article, a good way to get a baseline for growth expectations is to check on what Wall Street analysts expect and how fast the company has actually grown in the past.


Annual Growth Rate

Analysts' estimates 8.4%
10-year historical 10.3%
5-year historical 6.2%
3-year historical 6.7%
Last 12 months (2.7%)

Source: Capital IQ, a Standard & Poor's company. Historical growth based on operating earnings.

This isn't an overly encouraging picture. The growth over the past decade has been swell, but it fell markedly during the three- and five-year periods and the company actually saw operating earnings shrink over the past 12 months. Not only has the company faced tough times brought on by the tepid economy, but it's also seen growth slow drastically for its largest product segments.

Looking ahead, the company expects that products that have a peppier growth trajectory will become a bigger part of the revenue mix, which will boost overall growth. The company also has footholds in faster-growing emerging markets, and it expects that they will also contribute to a higher growth rate over time.

It's also notable that the Medtronic has steadily bought back shares over the years. Over the past decade, it reduced its share count by an average of 1.2% per year. Over the past five years, that's bumped up to 2.3%. That's great for shareholders because fewer shares mean more earnings are divvied up to each share.

Taking a conservative view of the company's future growth and adding in some impact from the ever-falling share count, I assumed that Medtronic would grow earnings per share at a 5% rate over the next five years. For my upside case, I used 7%, and I dropped it to 3% for my downside case.

Pinning down valuation
Valuations are a moving target that can be tough to predict, but, as with growth above, using a range of values can give us a view of our potential returns without requiring a Miss Cleo-type prescience.

In creating our range, a good place to start is where the stock is trading right now and what its historical trading range has been. Right now, Medtronic's stock changes hands at 13.7 times trailing earnings. This is all the way at the lower end of the range for the stock, as its annual average earnings multiple was between 15.7 and 66.5 during the stretch between 2000 and 2010.

For broader context we can also look at how similar companies trade.


Forward P/E

Estimated Growth

Baxter International (NYSE: BAX  ) 13.3 10.4%
Stryker (NYSE: SYK  ) 15.8 10.9%
St. Jude Medical (NYSE: STJ  ) 14.2 11.7%
Zimmer Holdings (NYSE: ZMH  ) 13.5 9.9%
Boston Scientific (NYSE: BSX  ) 19.5 9.5%
Edwards Lifesciences (NYSE: EW  ) 40.2 28.4%

Source: Capital IQ, a Standard & Poor's company.

Now you'll note that on the basis of analysts' projections, Medtronic is expected to grow at a slower rate than all of the companies above. However, its stock fetches a forward P/E multiple of just 11.3, which I think is a pretty sizable discount given the company's size and quality. Aside from that, I think that to some extent the group as a whole is suffering from an uncertainty discount due to the fog around future health care regulations in the United States. While there may be some merit to that discount, I think there may be more positives in favor of growth -- aging baby boomers, greater consumer access to health insurance, emerging market growth -- that offsets some of that concern.

For my model, I assumed that investors could get very excited and pay as much as 20 times earnings (on a trailing basis) for Medtronic's stock or get even more depressed and pay as little as 12 times. My base