Monday, April 23, 2012

Medtronic Stock Analysis

I ran Medtronic (MDT) through my screening process to see where it currently stands. MDT closed on Friday 4/20/12 at $37.61.

Company Background:

Medtronic, Inc. manufactures and sells device-based medical therapies worldwide. It provides implantable cardioverter-defibrillators, cardiac resynchronization therapy devices, and cardiac pacemakers for the diagnosis, treatment, and management of heart rhythm disorders and heart failure; AF products; diagnostics and monitoring devices; and patient management tools. The company also offers percutaneous coronary and peripheral vascular interventions, and renal denervation for the treatment of coronary artery disease, peripheral vascular disease, and hypertension; endovascular stent grafts to treat abdominal and thoracic aortic aneurysms; and heart valves, arrested and beating heart surgery, and surgical ablation for various heart valve disorders. In addition, it provides external defibrillators, including defibrillator/monitors used by hospitals and emergency response personnel; and automated external defibrillators used in commercial and public settings for the sudden cardiac arrest treatment. Further, the company offers medical devices and implants for treating spine and the musculoskeletal system, such as thoracolumbar, cervical, and biologics products; and integrated diabetes management solutions, professional CGM, carelink therapy management software, and blood glucose meters. Additionally, it provides neurostimulators for chronic pain; implantable drug delivery and deep brain stimulation systems; and urology and gastroenterology devices. In addition, the company offers products and therapies to treat diseases and conditions of the ear, nose, and throat, as well as certain neurological disorders; and image-guided surgery and intra-operative imaging systems that facilitate surgical planning during surgeries. It markets its products to hospitals, clinics, third-party health care providers, distributors, and other institutions through a direct sales force and independent distributors.

DCF Valuation:

Analysts expect MDT to be able to grow earnings at 6.35% per year for the next five years and I've assumed they can continue to grow at 3.00% per year thereafter. Running these numbers through a DCF analysis with a 10% discount rate yields a fair value price of $56.26. This means that at $37.61 the shares are undervalued by 33%.

Graham Number:

Over the last 12 months, MDT's EPS were $3.18 and it's current book value per share is $16.50. The Graham Number is calculated to be $34.36 which means that at $37.61 the shares are overvalued by 9.5%. If you calculate the Graham Number based off the expected EPS, $3.45, for the fiscal year ending this April and keep the book value per share constant you arrive at a fair value price of $35.79 meaning it's overvalued by 5%. Either way MDT is overvalued according to the Graham Number calculation.

Average High Dividend Yield:

MDT's average high dividend yield for the past 10 years is 1.48% and for the past 5 years is 2.09%. Using the 5 year rate, MDT's fair value price would be $46.44 and the 10 year rate would give a price of $65.62. Therefore shares are undervalued by approximately 19% and 43%, respectively. I think that a 3.00% high yield is where Medtronic will settle into for the future barring a major growth catalyst for the company. Calculating the price off a 3.00% high yield would be $32.33 meaning it's overvalued by 16%. The following chart shows the historical high and low dividend yield as well as the current yield for the years 2001 to 2012.


Average Low PE Ratio:

MDT's average low PE ratio for the past 5 years is 15.43 and for the past 10 years is 23.68. This would correspond to a price per share of $53.23 and $81.69, respectively, based off the projected 2012 fiscal year earnings of $3.45. The 5 year and 10 year low PE price targets are undervalued by 29% and 54%. I think for the future the 10 year low PE is skewing the numbers and that the 5 year low PE is more realistic for calculations.

Average Low P/S Ratios:

MDT is currently trading at a P/S of 2.47. Ideally you want it to be closer to 1 or less than 1. Less than 1 is a great bargain but is going to be hard to find for large well-followed companies. Historically, MDT has traded at a 5 year average P/S of 2.44 and and 10 year average P/S of 3.85. The target price based on the 5 year P/S is $37.13 and the 10 year is $58.72. The 5 year seems like a more reasonable ratio to expect since MDT's forecast revenue growth is fairly low. On the 5 year target price shares are currently trading at fair value.

Dividend Discount Model:

For the DDM I assumed that Medtronic will be able to grow dividends for the next 5 years at the minimum of 15% or the lowest of the 1, 3, 5 or 10 year growth rates. In this case that would be 9.76%. After that I assumed MDT can continue to raise dividends at the rate of long term earnings growth, 3.00%, and used a discount rate of 7.5%. Based on this MDT is worth $26.20 meaning it's overvalued by 44%. I am fairly conservative in my DDM valuation by assuming they can only continue to grow at the elevated rate for 5 years, personally I feel that you will see a slightly higher 5 year growth rate over a longer period but being conservative in your assumptions allows room for errors. These calculations also assume there would be no expansion in the payout ratio which would allow for a higher dividend growth rate.

P/E Ratios:

MDT's trailing PE is 11.83 and it's forward PE is 10.25. The CAPE for the previous 10 years is 19.58. Compared to it's industry, MDT seems to be significantly undervalued versus their competitors BSX (17.42) and JNJ (17.47), as well as to the industry as a whole (21.73). All industry and competitor comparisons are on a TTM EPS basis.

Fundamentals:

MDT's gross margin for FY 2009/10 and FY 2010/11 were 75.90% and 75.45% respectively. The gross margins are awesome to see at 75%+. Their net income margin for the same years were 19.59% and 19.43% respectively. The net income margins almost double what I like to see which is 10%. The cash-to-debt ratio for the same years were 0.20 and 0.17. The cash-to-debt is the one thing that worries me and I would like to see management address this issue.

Share Buyback:

MDT's shares outstanding have been falling thanks to a significant buyback program..


Dividend Analysis:

MDT's dividend growth rate has had a great run thus far in the 2000's. Its growth rates for the past 1 year, 3 year, 5 year and 10 year are 8.7%, 14.4%, 17.8% and 15.8% respectively. Medtronic has increased dividends for 34 years now. The payout ratio has been fairly stable around the 27% mark which is very encouraging since it would allow for expansion of the payout ratio to boost their dividend growth rates is earnings growth stalls.


Their FCF payout ratio has been all over the place. Three times since 2001 the FCF payout ratio has been over 100% and as high as 216%. I also don't like to see that even the most recent fiscal year 2010/11 had a FCF payout ratio over 100%. I am curious to see how they will fare with their next earnings release and closing of the fiscal year.

Return on Equity and Return on Capital: Invested

MDT's ROE and ROCI have fluctuated quite a bit since 2001. Their ROE seems to be around a minimum 22%. The ROCI has been trending downwards since 2001 which is troubling. Hopefully they can start to make progress on that front.


Average Price and EPS:


MDT's average share price tracked their EPS fairly closely until 2005. Since then there's started to be a PE multiple contraction which accounts for the disconnect in the average share price and EPS.

Forecast:


The chart shows the historical high and low prices since 2001 and the forecast based on the average PE ratios and the expected EPS values. I have also included a forecast based off a PE ratio that is only 75% of the minimum average low PE ratio for the previous 5 years or 10 years or 16. I have changed it to this calculation and will probably keep it so in the future because many of the companies that I've looked at so far had outrageous PE multiples in the early 2000's which skew the average PE ratio higher. I like to the look to buy at the 75% Low PE price or lower to provide for additional margin of safety. Currently Medtronic is trading $2.31 less than this value.

Conclusion:

The average of all the valuation models gives a value of $47.72 which means that MDT is currently trading at a 21% discount to the fair value. Overall I think that MDT is undervalued at today's prices, but as with most companies there are some issues I'd like to see management make some progress on.

While I do like the growth prospects with an aging population here in the US and most developed countries, the most promising thing from a dividend growth perspective is that Medtronic has been able to grow their dividends at a high rate while keeping the payout ratio around 28%. With a low current payout ratio management can continue to increase dividends at an elevated rate despite lower earnings growth.

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