In the moat report card series, we test for the presence of a moat by analyzing the returns a company generates on the funds it invests – its ROIC.
- Over time, has the company earned a sufficiently high ROIC?
- Is the ROIC of high quality?
- Is the company maintaining and growing the returns it earns on invested capital?
For a full explanation of the score card, click here.
Here is a look at Medtronic’s (NYSE: MDT) returns on capital to help us assess its moat.
ROIC history
Let’s see how Medtronic’s three-year rolling ROIC has changed over time and in relation to its nearest competitor, St. Jude Medical (NYSE: STJ):
|
Metric |
FY2008* |
FY2009 |
FY2010 |
5-Year Average |
|---|---|---|---|---|
|
Medtronic's rolling ROIC |
19.4% |
19.4% |
19.0% |
20.1% |
|
St. Jude's rolling ROIC |
15.9% |
16.3% |
17.5% |
17.3% |
Source: Capital IQ, a division of Standard & Poor's.
*Medtronic's fiscal year ends at or near the end of April of the named year. Comparable trailing-12-month periods are used in comparing to other companies.
Although Medtronic’s ROIC has declined somewhat over the past decade, it still generates impressive returns – well in excess of our 10% hurdle. Several years ago, Medtronic expanded beyond its stronghold in heart products and erected an empire in spinal and diabetes products. Those investments have played out profitably, and the company’s returns have consistently outpaced those of archrival St. Jude. Medtronic’s returns are on par with the other industry giants, Becton Dickinson (NYSE: BDX) and Stryker (NYSE: SYK), too, though they compete less directly.
ROIC quality
Just like return on equity, there are only so many ways a firm can juice its ROIC. The three levers are profit margins, asset turnover and leverage. Here are the data for Medtronic:
|
Metric |
2008 |
2009 |
2010 |
5-Year Avg. |
|---|---|---|---|---|
|
After-tax operating profit margin |
23.8% |
26.6% |
25.4% |
25.3% |
|
Asset turnover |
0.64 |
0.65 |
0.59 |
0.65 |
|
Operating ROA |
15.2% |
17.4% |
15.0% |
16.4% |
|
ROA contribution to ROIC |
82.5% |
83.7% |
85.2% |
84.8% |
|
Leverage |
1.21 |
1.19 |
1.17 |
1.18 |
|
MDT's ROIC with industry leverage |
20.0% |
22.9% |
19.8% |
21.8% |
|
Industry ROIC |
17.9% |
18.8% |
19.4% |
18.9% |
Source: Capital IQ.
Medtronic has done a masterful job executing its business operations. Over the past decade, operating profit margins have increased steadily. While its operating asset base has swelled because of increasing goodwill from acquisitions, operating return on assets has made up the bulk of ROIC (consistently more than 80%). Medtronic has maintained very modest leverage -- typically less than what the industry employs. Such excellent operational performance scores the company a perfect 5 out of 5 for ROIC quality.
|
ROIC Growth |
5-Year Average |
Score |
Weight |
|---|---|---|---|
|
Average 3-year ROIC growth |
(2.9%) |
4 |
10% |
|
ROIC growth vs. St. Jude |
0.7 |
5 |
20% |
Source: Capital IQ.
As noted earlier, Medtronic’s rolling ROIC has declined slightly over time due largely to increased competition. However, St. Jude’s rolling ROIC has suffered much the same fate, though it's managed to reverse that trend in the past couple of years. Even so, we can’t award Medtronic a perfect score if it isn’t increasing its returns, so it only scores 4 out of 5. In the industry overall, rolling returns on capital have been flat or slightly down. As the industry matures this trend may continue.
Pencils down!
With all the numbers in, here’s how Medtronic scored:
|
Weighting |
Category |
Criteria |
Final Grade |
|---|---|---|---|
|
30% |
Hurdle |
3-year average ROIC > 10% hurdle rate |
5 |
|
20% |
3- year average ROIC > competitor's ROIC |
5 | |
|
20% |
Quality |
High ROA contribution percentage |
5 |
|
10% |
Growth |
Rolling ROIC growth over time |
4 |
|
20% |
ROIC growth > competitor's ROIC growth |
5 | |
|
Total score (out of 5) |
4.9 | ||
|
Final grade |
A+ |
Medtronic’s dominant market position in heart devices (near 50% market share!) and impressive stake in spinal and diabetes markets has translated into pricing power and high returns on invested capital. With an A+ grade, we don’t need a stethoscope to hear the heartbeat of the company’s strong moat. Nevertheless, competitors large and small are working hard to get in on the profitable action.
So, remember to look forward and assess whether the company’s moat is enduring, buy at a reasonable valuation, and your portfolio will stand a better chance of surviving the scratches and flesh wounds the market dishes out.
