Brian Miller
August 18, 2010
miller.4923@osu.edu
419 651 8193
Medtronic Inc
Ticker
MDT
Stock Rating Buy
Industry
Cautiously Attractive
Current Price
12-month Target
Projected Upside
$37.33 as of 8-9-2010
$56
50%
Investment Thesis: Medtronic (MDT) is the world’s largest pure-play
medical supply technology company based on total sales, operating profit
and market capitalization. Based on an aging demographic, attractive
valuation, strong free cash flow and focus on R&D and innovation, MDT is
a buy over the next 12 months with a price target of $56.
Risks: While MDT typically is seen as a high-quality, defensive name,
risks include loss of market share as a result of pricing pressures from
severely competitive markets within medical equipment. Other risks
include litigation, unfavorable patent rulings and the overhang from health
care reform.
Key Information
Ticker
MDT
Price
$36.98
52 week high
$46.66
52 week low
$34.42
Market Cap
$39.6B
Dividend Yield
2.40%
Annual Dividend $0.90
Trailing PE
11.40
Forward PE
10.70
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COMPANY OVERVIEW
Medtronic, located in Minneapolis, Minnesota, is the world’s largest pure play medical
supply technology company based on total sales, operating profit and market
capitalization1. Medtronic was originally founded in 1949 by Earl Bakken and his
brother-in-law Palmer Hermundslie under the premise of a medical equipment repair
shop. Since then Medtronic has grown organically and through acquisitions,
transforming the way diseases are treated.
Medtronic was originally put on the map for their wearable, battery powered pace
maker. This was the foundation for many of their future therapies that helped reshape
the way people lived their lives with chronic diseases.
By 1960, Medtronic was established as producer of medical devices as their external
pacemakers were used across the United States and selective pockets across the
world. The primary use came from patients recovering from open heart surgery.
However, physicians started to take notice of how well a tool like this might be used in
helping chronic heart block2.
Since the early days in a garage and apartment, Medtronic has grown through organic
growth, innovation and acquisitions. It currently focuses globally on seven business
segments:
-
Cardiac Rhythm Disease Management
-
Spinal
-
Cardiovascular
-
Neuromodulation
-
Diabetes
-
Surgical Technology
-
Physio-Control
The following charts represents the percentage of revenue for each segment based on
their $15,817million in sales3:
1
Standard & Poor’s Medtronic Stock Report, June 14, 2010
www.medtronic.com
3
2010 Medtronic Annual Report, pg 18
2
2|Page
Net Sales – Fiscal Year 2010
Net Sales
CRDM
Spinal
Cardiovascular
Neuromodulation
Diabetes
Surgical Technology
Physio-Control
$
$
$
$
$
$
$
$
Fiscal Year
2010
2009
% Change
5,268 $
5,014
5%
3,500 $
3,400
3%
2,864 $
2,437
18%
1,560 $
1,434
9%
1,237 $
1,114
11%
963 $
857
12%
425 $
343
24%
15,817 $ 14,599
8%
(dollars in millions)
Going forward, Medtronic looks to expand its global presence by expanding into more
emerging countries, such as Asia and China as visibility is clearer in these areas as
compared to Developed Europe. The growth potential is also greater in these emerging
economies. Below is a graph representing their gradual shift into overseas markets4.
4
2010 Medtronic Annual Report, pg 43
3|Page
Global Exposure
US Net Sales
Non-US Net Sales
Net Sales
2010
$
9,366
$
6,451
$
15,817
Fiscal Years
2009
$
8,987
$
5,612
$
14,599
2008
$
8,336
$
5,179
$
13,515
(dollars in millions)
Not only will MDT be able to capitalize on growing markets overseas, but they will also
be helped by their strong position and strong cash flow within the market. Being an
industry leader with very strong free cash flow, Medtronic has the financial flexibility to
pursue acquisitions or stock buy backs in order to leverage EPS growth.
Business Strengths
Medtronic has recently come under pressure, as have many health care names in the
market due to the overhang from health care reform and the negative sector rotation
that has occurred away from health care as high beta stocks have driven performance
over the last 12-18 months. Recently, names with higher leverage and lower credit
quality ratings have rallied the most, as these were the names that were pricing in
bankruptcy during the liquidity crisis of 2008 and early 2009. However, through this
Medtronic has stuck with their core competencies which should be rewarded once the
market decides that quality companies with strong cash flows are relatively underpriced.
These competitive advantages included the following:
1) Size and Scale – Medtronic is the largest pure play medical supply
technology company based on total sales, operating profit and market
capitalization. This size has enabled them to have a diverse product
mix and has also allowed them to grow via acquisition. The diversified
product mix will help provide downside protection for MDT as they are
able to benefit from several different revenue streams and not solely
dependent on one product. Growing via acquisitions is also another
strong point for MDT. This will help them leverage the profitability of
their top three business segments (~75% of sales) and move into faster
growing niche markets.
2) Global Footprint – As mentioned earlier, playing overseas is a big part
of Medtronic’s top and bottom line. Going forward, they look to use the
expertise they have gained in the US and Developed Europe to
increase their exposure to Emerging Market countries, specifically
China and Asia areas. Currently, this area represents ~8% of sales.
Increasing their exposure to these types of growing areas will help
offset stresses occurring from their exposure to Developed Europe and
4|Page
the weak Euro. Currently, their growth rates in EM are above that of the
corporate average in the industry.
3) Strong Cash Flows – Medtronic has been able to generate strong
cash flows in the medical equipment industry as they operate with
margins around 75-76%. With this strong free cash flow, Medtronic will
(and has been) able to grow via acquisition. They also possess the
ability to leverage EPS growth with this strong free cash flow. Over the
past years, MDT has continued to buy-back shares from the open
market.
4) Strong Pipeline – Knowing that nearly 75% of their revenue comes
from three of their seven business segments, Medtronic realizes a shift
needs to occur in which money is directed towards their faster moving
business segments. This also stems from the fact that CRDM, Spinal
and Cardiovascular are more mature markets that Medtronic operates
in. Focusing on Neuro and Diabetes will also help diversify their
revenue streams going forward5.
Upcoming Earnings Reports
August 25, 2010 – Annual Shareholders Meeting6
5
6
Citi Investment Research & Analysis, MDT 2010 Investor Day, June 8, 2010
www.bloomberg.com
5|Page
MACRO ENVIRONMENT
I. Aging Demographic
With America’s baby boom generation reaching retirement ages, Medtronic looks to
capitalize on the increased customer base that can gain benefit from Medtronic
products. Each of Medtronic’s seven business segment is targeted towards providing
medical equipment to this older age demographic. As you can see from the table
below, the population continues to age as the percentage of citizens over the age of 50
has increased gradually over the last 10 years7. Currently, 31% of the population is 50
or above compared to just 27.3% in the year 2000. With Medtronic’s diversified product
mix and focus on the aging population, this should create a tailwind for MDT
performance going forward.
2009
Population over 50
% of Total Population
Annual Estimates of the Resident Population for the United States
Population Estimates
2008
2007
2006
2005
2004
2003
2002
2001
2000
96,118,930 93,854,500 91,497,262 89,122,665 86,939,721 84,743,433 82,732,433 80,811,247 79,000,912 77,257,888
31.308%
30.835%
30.339%
29.848%
29.396%
28.918%
28.496%
28.079%
27.712%
27.380%
II. Health Care Reform
Currently, Health Care reform is the big unknown in the health care industry. While the
possibility of an increased customer base is appealing, cost pressures will arise from
capacity expansion. Costs will also be influenced from the excise taxes being
proposed. Currently, Medtronic is expecting an annual $150 to $200 tax on medical
devices starting in 20138. While this is manageable for a company like Medtronic with
their strong revenue and cash flow, it does present a headwind for the sector in general.
A lot of the reason why the Health Care industry looks so attractive currently is because
of this health care reform overhang. Once more visibility is available on the future of the
reform, expect the best of breed health care names to trade higher. Until then,
investors should remain cautious when dealing with health care stocks, even with
undervalued valuations.
7
8
www.census.gov
www.seekingalpha.com
6|Page
INVESTMENT THESIS
I. Fundamental Drivers
As stated earlier, Medtronic has consistently been an industry leader among health care
equipment providers as they are the industry leader in total sales, operating profit and
market capitalization. Medtronic has historically ranked among the most consistent
generators of revenue, cash flow and net earnings growth within the large cap medical
device industry. This growth has come through organic expansion and strategic
acquisitions. One current initiative for MDT is to reevaluate its cost structure. Currently,
MDT operates one of the highest gross margins among the industry, averaging about
75-76% over the past 5 years. To accompany this, Medtronic has put into action a plan
to reduce costs of goods sold, at least through 2012. Below are the most recent results
in their effort to reduce their cost structure and continue to bolster their profit margins 9.
Costs of Goods Sold
Research and Development
Selling, General & Admisinistrative
Special Charges
Restructuring Charges
Certain litigation charges, net
IPR&D and certain Acquisition-related Costs
Other Expense, net
Interest Expense, net
2010
24.1%
9.2%
34.2%
0.0%
0.3%
2.4%
0.1%
3.0%
1.6%
Fiscal Year
2009
24.1%
9.3%
35.3%
0.7%
0.8%
4.9%
4.3%
2.7%
1.3%
2008
25.5%
9.4%
34.8%
0.6%
0.3%
2.7%
2.9%
3.2%
0.3%
Although Medtronic has looked to reduce its cost structure, R&D still remains a very
high priority for the firm as they look to capitalize on new markets and also realizing the
fact that the majority of their revenue streams is coming from maturing markets (CRDM,
Spinal and Cardiovascular). Going forward, R&D allocation will be comprised of 1015% to existing technology into new markets; 10-15% for new technology to new
markets; 30-35% to grow share in existing markets; and 45-50% to expand into new
markets10.
While still being a market leader in CRDM, Spinal and Cardiovascular, areas such as
Neuromodulation remains a key growth driver going forward. While growth has
decreased slightly over the past year in this segment, MDT holds a dominant market
position in the pain stim market and incontinence market. Below are growth projections
9
2010 Medtronic Annual Report, pg 30
Morgan Stanley Research North America, Medtronic Inc – Size Matters, pg 2
10
7|Page
going forward for each business segment, noticing growth is coming from areas not
necessarily at the top end of their revenue generation11.
Segment
CRDM
Spinal
Cardiovascular
Neuromodulation
Diabetes
Surgical Technologies
Physio-Control
Total Sales
Medtronic Growth
FY10A
FY11 Guidance
5%
2-5%
3%
4-7%
18%
10-15%
9%
9-11%
11%
9-11%
12%
6-9%
24%
10-15%
8%
5-8%
Market Growth
3-6%
7-9%
2-5%
10-12%
10-12%
6-9%
7-8%
4-7%
II. Financial Analysis
A. Projections
Below is an estimate of projections for earnings and revenue growth going forward as
compared to consensus12:
Medtronic (MDT)
(in millions, except per share data)
Net sales
Per Share of Common Stock:
Basic earnings
Diluted earnings
EPS Growth Rate
Consensus
2013
Projections
2012
2011
2010
2009
Actuals
2008
2007
18,132
18,235
17,604
17,178
16,766
16,333
15,817
14,599
13,515
3.50
3.49
10%
3.66
3.31
3.30
9%
3.33
3.08
3.07
9%
3.05
2.80
2.79
1.85
1.84
1.89
1.87
2006
2005
12,299
11,292
10,055
2.35
2.32
2.09
2.07
1.49
1.48
Projections reflect conservative estimates of future growth and a consistent cost
structure, even though Medtronic has taken steps toward reducing its cost structure.
Consistent revenue growth, which has been a mainstay over the past few years,
coupled with a declining cost structure should lead to favorable results against
consensus estimates going forward, especially knowing the MDT is priced, from a
historical standpoint, at a relative discount compared to its peers.
11
12
Morgan Stanley Research North America, Medtronic Inc – Size Matters, pg 5
Consensus estimates obtained from Thomson Baseline
8|Page
B. Peer Comparison13
Revenue % Change Trailing TTM
Return on Equity
Return on Revenue
EPS % Change
Last Qtr (Mar 10)
TTM
5 Year Hist Growth
% LT Debt to Total Capital
LT Future Growth Rate
MDT
8%
26%
20%
BSX
-1%
5%
N/A
STJ
9%
26%
17%
Industry*
5%
20%
-
9%
9%
10%
32%
10%
-54%
-15%
-45%
34%
10%
25%
16%
15%
32%
12%
10%
9%
10%
23%
12%
*Indus try i s Hea l th Ca re Equi pment
TTM - Trailing 12 months
Currently, Medtronic’s consistent revenue generation has helped it become an industry
leader within the health care equipment industry. Over the last 12 months, MDT’s
percent change in revenue ranks very highly against competitors and industry averages.
MDT uses its scale to average 8-10% revenue growth over the years. Return on equity
and revenue is outpacing St. Jude Medical Inc and Boston Scientific Corporation. While
STJ currently has higher EPS growth than MDT, we can see that MDT is more of a
mature company compared to its peers. MDT’s focus is on consistency is an everchanging health care environment. In general, health care names typically have very
consistent cash flows, a lot of the reason why the sector is considered defensive. MDT
has allowed to LT debt to stay around the industry average, allowing them to be in the
acquisition business while not being too highly levered.
C. Historical Perspective14
Medtronic (MDT)
Sales Growth
Gross Margin
SG&A to sales
R&D to sales
Operating Margin
2010
8.34%
75.90%
34.24%
9.23%
26.65%
2009
8.02%
75.90%
35.29%
9.28%
17.97%
Fiscal Year
2008
2007
9.89%
8.92%
74.50%
74.24%
34.83%
33.77%
9.43%
10.07%
20.54%
27.33%
2006
12.30%
75.07%
32.40%
9.86%
27.22%
Avg
9.49%
75.22%
33.75%
9.56%
24.09%
From a historical perspective, Medtronic has strived to keep their revenue and cost
structures fairly consistent. This can be seen with their gross margins fluctuating
between 74% and 76% over the past five years. This consistent cost structure, along
13
14
Figures obtained from finance.yahoo.com and Thomson Baseline
Percentages calculated from figures within Medtronic 10-k
9|Page
with consistent revenue growth, helps MDT produce consistent cash flows, typically a
trait of a more defensive equity name.
III. Valuation Metrics
A. Sector Valuation (Health Care)15
Absolute Basis
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
19.3
18.6
4.3
2.0
14.5
Low
9.9
10.0
2.2
1.0
7.6
Median
16.5
15.3
3.5
1.7
12.1
Current
11.5
11.0
2.9
1.1
9.5
Relative to SP500
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
1.2
1.2
1.6
1.5
1.4
Low
.68
.69
1.3
1.0
.9
Median
1.0
1.0
1.4
1.2
1.2
Current
.78
.82
1.5
1.0
1.1
When looking at Trailing P/E, Forward P/E, Price to Book, Price to Sales and Price to
Cash Flow, the Health Care sector is extremely undervalued. This is occurring both on
an absolute basis and relative basis compared to the broad market S&P 500 Index.
Much of this stems from the health care reform overhang and the uncertainty that
comes with investing in the health care industry currently. It also has to do with the high
beta rally that has occurred in the broad market since the lows set in March 2009.
Since then, higher beta names have outpaced lower beta names. Names that typically
have more leverage and poorer balance sheets have outperformed because they were
priced to go out of business during the liquidity crisis of 2008. If the market starts to
reward quality, Medtronic and other consistent cash flow generators should outperform.
15
All valuation metrics obtained from Thomson Baseline
10 | P a g e
B. Industry Valuation (Health Care Equipment)
Absolute Basis
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
24.4
23.1
5.7
4.3
18.7
Low
12.1
11.8
2.3
2.0
8.7
Median
21.0
19.7
4.0
3.4
15.5
Current
13.8
13.2
2.6
2.3
10.3
Relative to SP500
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
1.5
1.5
1.9
3.0
1.7
Low
.82
.79
1.3
2.1
1.0
Median
1.3
1.3
1.5
2.4
1.5
Current
.93
.99
1.3
2.1
1.2
Just as with the health care sector as a whole, the Health Care equipment industry
looks very attractive from an absolute and relative basis. The same reasons outlined
above in the Sector valuation summary help explain why this industry is trading towards
the low end of its valuation range.
C. Company Valuation (MDT)
Relative to Industry
P/Trailing E
P/Forward E
P/B
P/S
P/CF
Relative to S&P 500
P/Trailing E
P/Forward E
P/B
P/S
P/CF
High
1.3
1.2
1.6
1.8
1.5
Low
.79
.77
1.0
1.1
.9
Median
.94
.89
1.2
1.3
1.1
Current
.84
.81
1.1
1.1
.9
High
1.8
1.6
2.4
4.6
2.5
Low
.68
.65
1.3
2.3
.9
Median
1.3
1.2
1.9
3.3
1.6
Current
.78
.80
1.4
2.3
1.1
Medtronic currently looks very cheap compared to its historical averages. Assuming
MDT can eventually trade at its historical averages, there is considerable upside in this
trade. Even if valuations do not revert all the way back to the median, there is still
considerable upside from its current $37 price.
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Absolute
Valuation
High
Low
Median
Current
Target
Multiple
P/Forward E
P/S
P/B
P/EBITDA
P/CF
25.6
6.9
6.7
22.75
25.7
9.4
2.3
2.5
7.70
8.4
17.9
4.6
5.0
14.09
16.8
10.7
2.6
2.9
7.85
9.5
16.1
4.1
4.5
12.7
15.1
Target
Value
/Share
2.80
14.25
13.1
4.84
4
Target
Price
45.10
59.10
58.95
61.37
60.48
Projections are based on valuation multiples reaching 90% of the median. With this
conservative estimate, MDT has significant upside when using historic valuation
multiples.
D. Discounted Cash Flow Analysis
Using the DCF Model, the intrinsic value for Medtronic is $56.38. The following
assumptions were made in the model (full model found in Appendix B):
 Revenue growth was a conservative 4% based on health care being a
defensive sector and Medtronic being a more mature company
 Margins were 74.1%, a conservative approach to their historical average
 The tax rate was 21% to reflect historical averages
 A discount rate of 9.5% was assumed to reflect MDT’s defensive
characteristics
 A growth rate of 4% to reflect MDT being more towards the mature end of
its business cycle
 Depreciation/Amortization cancels out Capital Expenditures over the long
term
Below is a sensitivity analysis using a range of different growth and discount rates that
are typically associated with the defensive Health Care sector. Price projections are
consistent with the valuation projections mentioned earlier.
3.50%
3.75%
4.00%
12 | P a g e
9.00%
$56.64
$59.20
$62.02
9.25%
$54.18
$56.51
$59.07
9.50%
$51.92
$54.06
$56.38
RECOMMENDATION
I. Catalysts
 P/E multiple is at a 5-10% discount; historical is 20-30% premium
 Increasing Emerging Market Exposure
 Currently ~8% of sales
 Focus on Asia / China
 More visibility in emerging countries than Developed Europe
 Strong Free Cash Flow
 Market will soon reward quality – has not been rewarded over last
18 months (high beta rally)
 Ability for acquisitions or further leverage EPS growth
 Slow growth economy should help lead HC as sector is recessionresistant
 Cost reduction in place through 2012
 R&D expenditures remain highest among peers
 Innovation will be key catalyst for individual HC stocks with reform
overhang
II. Risks
 Multiples contraction among the industry as a whole – health care
overhang, challenging environment for global implants
 Cardiac Rhythm Mgmt and Spinal (two largest segments) had the two
lowest growth rates among their 7 business segments (FY 2010 Actual)
 Strengthening US economy could lead to negative sector rotation
 Hospital capital equipment spending decreasing amid tight credit market
conditions and stressed municipal and state budgets
 Litigation Risks
 Elective procedure demands are falling due to consumer confidence and
unemployment
III. Price Target
The 12 month price target for MDT is $56. This was derived from the 6 metrics below
and weighting them as noted, putting the emphasis on the work of the Discounted Cash
Flow model. Based on the blended projections, MDT has approximately 50% upside
based on its current price of $37. Based on upside projections, MDT would be rated as
a STRONG BUY.
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Metric
Projection Weight
DCF
$ 56.38
50%
Price / Forward Earnings $ 45.10
10%
Price / Sales
$ 59.10
10%
Price / Book
$ 58.95
10%
Price / EBITDA
$ 61.37
10%
Price / Cash Flow
$ 60.48
10%
Projected Price
Current Price
Potential Upside
$
$
56.00
37.33
50%
100%
SUMMARY
 P/E multiple is at severe discount; historical is 20-30% premium
 Industry leader among medical supply technology companies based on
total sales, operating profit and market capitalization
 Strong free cash flow; will likely be rewarded in a slow growth market
environment
 Consistent revenue generation with an emphasis on cutting costs over the
next few years
 Price target of $56 using a blend of several different valuation metrics.
Price target indicates 50% upside.
14 | P a g e
APPENDIX A: Selected Financial Data16
16
Historical Financial data obtained from MDT 10-k
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APPENDIX B: Discounted Cash Flow Valuation
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