In a pretty richly valued med-tech space, it takes some setbacks to uncover value and opportunity. Medtronic (MDT 0.29%) has certainly seen setbacks, as the company has abandoned renal denervation, has lost some momentum in CRM, and may not be as competitive as hoped in drug-coated balloons. On a more positive note, transcatheter heart valves look like a viable growth driver and Medtronic has several opportunities in areas like neuromodulation, diabetes, and atrial fibrillation.

Some weak spots in the third quarter
It's often dangerous to read too much into any single quarter, and it is not as though Medtronic's was that bad. Revenue rose about 4% on an organic basis, which was good for a very slight beat versus the Street. Surprisingly, the company missed in cardiac rhythm management (CRM), as sales were up only 2% and that was largely due to an acquisition that boosted the AF results. Cardiology was up about 2% and spine was flat, while neuromodulation was up 7%, surgical tech rose 11%, and diabetes sales rose 16%. 

Margins were OK. Gross margin fell about half a percentage point from last year, but that was more or less as expected. Operating income rose about 4% and missed expectations by a basically trivial amount (1%).

In CRM, the competition has caught up
It has happened all that often in recent memory, but St. Jude Medical (STJ) and Boston Scientific (BSX 1.39%) have closed a bit of the gap with Medtronic in pacemakers and ICDs. Where Medtronic saw ICD revenue up 1% and pacing revenue down 2%, St. Jude was up 7% and 1% and Boston Scientific was up 1% and 7%.

Looking ahead, I don't see it getting any easier for Medtronic. St. Jude will be launching its new Quartet NXT leads and will likely give a lot of marketing support to its Nanostim leadless pacemaker. For Boston Scientific, it's about the S-ICD product that offers reliable sensing and therapy without the need for transvenous leads. Medtronic has not been ignoring the CRM space, as it has been working on a leadless pacing system and has been ahead of the curve with MRI-safe devices, but it looks as though Boston Scientific has finally righted the ship and St. Jude has established some legitimate momentum in the space.

Disappointments in the clinic
Investors were rightly disappointed when Medtronic's IN.PACT Amphirion drug-coated balloon (DCB) failed in a trial for below-the-knee peripheral vascular disease. That puts even more pressure on strong results from the pivotal study of the IN.PACT Admiral DCB in the superficial femoral artery, with data expected soon. While Bard's initial trial data for its Lutonix balloon in the SFA was disappointing and confusing, I believe one-year follow-up for the Lutonix will be positive and will establish a tough hurdle rate for Medtronic in a market that could be worth up to $1 billion with good pricing. 

Far and away the bigger disappointment was the failed efficacy trial in renal denervation and the very uncertain future for this product. Rival Covidien has punted on this space and it is unclear how Boston Scientific and St. Jude will proceed from here. At a minimum, the once-gaudy projections of a $3 billion for renal denervation in 2020 are likely null and void.

CoreValve is a core growth opportunity
In contrast to those clinical setbacks, Medtronic's transcatheter heart valve (CoreValve) looks like the real deal and a serious threat to Edwards Lifesciences (EW 0.41%). The CoreValve was approved for sale by the FDA faster than expected, and the clinical data have been compelling. Although patients who get the CoreValve seem to require pacing at a higher frequency than that seen in studies of Edwards' Sapien, the major stroke and paravalvular leak rates have been impressive.

At one month, 2.4% of CoreValve patients considered "extreme risk" for surgery experienced a major stroke, versus 5% for the Sapien (Edwards) and around 2% for Lotus (Boston Scientific). The one-year rates also favor CoreValve over Sapien (4% versus over 10%). On the subject of moderate-to-severe leaks, the one-month leak rate for the CoreValve was 11.5% (declining to 4.1% at one-year), while the Sapien patients have seen a one-month rate of 16.9% and a one-year rate of 20.9%. Lotus seems to really excel here, with a one-month leak rate of 1.9%.

There are a lot of sub-markets (high risk, moderate risk, et. al) within transcatheter valves and a newer Edwards product (the Sapien XT) to consider, but I think the point holds that Medtronic has a competitive product here and good odds of a multibillion dollar annual revenue opportunity. That assumes that Edwards does not win injunctions blocking them from the U.S. market for patent infringement, but the history in the U.S. suggests Edwards may win royalty payments instead of an outright banning of the CoreValve from the market.

The bottom line
I'm only looking for slightly more than 3% annual revenue growth for Medtronic over the next decade, which is meaningfully less than what I expect from St. Jude (5%), Boston Scientific (4%), Edwards (5.6%), Bard (3.8%) and other large med-techs. I likewise see relatively less incremental margin or FCF generation potential for Medtronic, but FCF growth of slightly more than 3% still supports a fair value of about $60.50 today for Medtronic shares.

As I discount cash flows on a required return basis, I believe Medtronic is priced to generate annual total returns of around 12%, and that is well above the typical returns of the S&P 500. That makes Medtronic an interesting value call today in a market sector that is seriously lacking in major value these days.