It was fun while it lasted. Shares of Medtronic (MDT) had an excellent start to 2013, rising nearly 15% year-to-date before Tuesday, a strong bull run for the low-beta health-care supplier. That strength, however, may have built in higher expectations for today's fiscal third quarter earnings report, which led to a 2.6% decline as of this writing despite beating analyst earnings estimates for the quarter.
As Bloomberg noted, the intraday drop reached as high as 4.5 percent earlier in the day, the stock's biggest one-day fall since December 2011, with weakness in Europe appearing to be the catalyst. In an interview, CFO Gary Ellis admitted that weakness in Europe, where sales fell 1 percent year-over-year, "has a meaningful impact." "A lot of that happened in January, and that gives us more pause," he added.
With the stock trading near its highest level in more than four years, post-earnings weakness -- and perhaps some profit-taking -- is hardly surprising. But today's results also underscore the fact that Medtronic's medium- and long-term goals remain reasonably intact, while its future plans for shareholder returns offer a compelling case for a long-term investment.
When CEO Omar Ishrak -- hired from GE Healthcare Systems (GE) in May 2011 -- made his debut on a Medtronic earnings call in August of that year, he outlined a three-pronged approach to boosting earnings: execution, innovation, and globalization. On the execution front, the company has made modest progress that has been outweighed by foreign currency movements, notably the Euro's strength off lows last year fueled by the sovereign debt crisis on the Continent. According to CFO Kelly on the post-earnings conference call, Excluding forex impacts, SG&A as a percentage of revenue fell 30 basis points, while R&D spending was 9.3% of sales, and projected to fall to 9% in Q4, down from 10% levels a year ago.
The performance of the company's new products was a mixed bag; the MiniMed 530 insulin pump is nearing FDA approval and should boost revenue in the diabetes segment. But Kelly noted that many new devices, notably renal denervation devices used to treat high blood pressure, were trailing expectations. He told listeners this was "due primarily to the lack of broad reimbursement and limited funding for new technology in nearly every European market," with doctors and insurance companies overseas apparently waiting for additional data from US trials before prescribing -- and paying for -- Medtronic's new products.
Meanwhile, the company's international focus continues to pay modest dividends, with international revenue growing 5 percent, and 7 percent when excluding currency effects. Emerging markets (along with Japan) created most of that growth, growing 20 percent year-over-year. On the conference call, CEO Ishrak emphasized the opportunity in emerging markets, noting that only 8 percent of potential patients were currently Medtronic customers and estimating that moving penetration levels to those comparable to developed markets could boost Medtronic's revenue by as much as 30 percent. Ishrak added that he felt the 20 percent growth rate was sustainable in the long-term.
Of course, even with that growth, Medtronic shareholders can hardly expect explosive top-line improvement over the next few years. The company itself is targeting mid-single digit growth in revenue, with stock repurchases creating 2-4% leverage in EPS growth over the same period. But that low growth is seemingly priced in; Medtronic trades at just 12 times the midpoint of its FY13 guidance.
Medtronic's valuation on a free cash flow basis is roughly similar; but the company has aggressive plans to return much of that cash flow to shareholders. The company expects to generate $25 billion in free cash over the next five years -- over half of its market capitalization -- and return 50% of that to shareholders via dividends and share repurchases. At current levels, those payouts would represent nearly 5% return on a compounded annual basis.
That doesn't sound all that impressive; but when you add in the modest growth, the potential for targeted bolt-on acquisitions, the defensive nature of Medtronic's business, Medtronic has the potential to provide solid, if likely unspectacular returns, going forward. And when you compare the return from Medtronic to the 5-year Treasury -- currently offering just 0.87% annually -- the 2.3% dividend and accompanying repo activity look much brighter. Today's earnings did little to change that case, despite the short-term drop.