Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...
Medical device maker Medtronic (MDT 1.92%) won a new buy rating on Wall Street this morning. But is that rating justified?
Here's what you need to know.
Why like Medtronic?
Piper Jaffray is the analyst singing Medtronic's praises this morning. In a write-up carried on StreetInsider.com (subscription required), Piper lists a whole host of reasons why it likes the stock: "the best [free cash flow] in all of med tech," "a very strong balance sheet," and "considerable margin expansion in front of the company."
Put all together, Piper argues that Medtronic's stock price, currently $80 and change, fails to reflect its "upcoming product cycle, which we view as quite strong." According to the analyst, Medtronic "can beat expectations on the top- and bottom lines in the coming quarters," yet sells for "a discounted multiple versus the peer group."
That's quite a bit of praise to unpack, so let's get to it, tackling Piper's assertions one at a time.
Free cash flow
Medtronic last reported earnings in February, for its fiscal third quarter 2018. In that report, CFO Karen Parkhill confirmed that the company had generated positive free cash flow (FCF) of $3.6 billion. Viewed as a run-rate, that might imply that Medtronic is on track to generate about $4.8 billion in FCF for the full year.
In fact, though, the company has generated only about $4.3 billion over the past year, and Parkhill told analysts on her post-earnings conference call that FCF for this full year will also be "approximately" $4.3 billion.
Mind you, that's still a pretty good number. Medtronic only reported GAAP earnings of $2.8 billion over the last 12 months, so free cash flow is rolling in at a rate appreciably faster than reported income.
But now let's see what the balance sheet tells us. With a $109.2 billion market capitalization, Medtronic has $14.4 billion in cash and $28.8 billion in debt on its balance sheet -- thus $14.4 billion in net debt. That's not exactly something I would characterize as a "strong balance sheet." Nor does it yield a particularly appealing valuation. Medtronic stock is trading for an enterprise value-to-free-cash-flow ratio of 28.7 -- which is far from cheap.
Piper is right about this one. Operating profit margin at Medtronic is clearly expanding, growing from 20.5% in 2016 to 22.9% reported over the past 12 months. What's more, Medtronic has generated margin as high as 28.8% over the past five years, so there is room for expansion.
Still, margins today are a far sight from 28.8%. Medtronic has its work cut out for it if it's to return its margin to its former glory.
Piper Jaffray says that Medtronic's "upcoming product cycle" is "quite strong." That being said, the company only grew its sales at a modest 7% last quarter, with similar growth in "non-GAAP operating profit" of 8%. What's more, in last quarter's conference call, Parkhill herself predicted sales would only grow about 4% or 5% this year, and profits perhaps 9% or 10%.
Those numbers are a bit more optimistic than the 8% compound annual earnings growth rate that analysts surveyed by S&P Global Market Intelligence predict for the company over the next five years. However, they fall far short of the upper-20s percentage growth I'd ordinarily want to see for a stock selling for nearly 29 times free cash flow before calling it a buy.
I think Piper Jaffray is wrong to recommend this stock at this price.