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 1|Page 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. 11 | P a g e 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. 13 | P a g e 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 15 | P a g e APPENDIX B: Discounted Cash Flow Valuation 16 | P a g e