Medical-device maker St. Jude (NYSE:STJ) boasts a favorable industry backdrop and a growing dividend (1.7% yield at the time of this writing). The company's Valuentum Dividend Cushion score is north of 2.5, signaling excellent dividend coverage with future cash flow and strong balance sheet health. St. Jude estimates that the markets it operates within are collectively $20 billion in size and growing at a combined 4% CAGR. Let's assess the investment potential of St. Jude's shares and evaluate the firm via the Valuentum style.
But first, a little background to help with the understanding of some of the terminology in this piece. At our boutique research firm, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money manager's focus, the Valuentum process covers the bases.
We liken stock selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking common sense.
At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. Apple posts a Valuentum Buying Index score of 4, reflecting our "fairly valued" DCF assessment of the firm, its attractive relative valuation versus peers, and bearish technicals. A score of 4 is not great, and we'd view this as slightly below average. The new money is probably not rushing to add shares to their portfolios at this time. However, let's take a look at the firm's long-term potential.
St. Jude's Investment Considerations
- St. Jude earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 39% during the past three years.St. Jude remains dedicated to investing in research and development and is fully committed to delivering earnings-per-share expansion without sacrificing innovation expenses. Net income growth looks solid.
- St. Jude has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 23.4% in coming years. Total debt-to-EBITDA was 2.2 last year, while debt-to-book capitalization stood at 45.8%.
- St. Jude's product portfolio includes implantable cardioverter defibrillators (ICDs), cardiac resynchronization therapy devices, pacemakers, electrophysiology catheters, mapping and visualization systems, vascular closure devices, structural heart products, spinal cord stimulation and deep brain stimulation devices.
- The firm is trading at attractive valuation multiples relative to peers, but our discounted cash flow (DCF) process indicates a less compelling opportunity. We'd wait for a clearer signal on valuation before jumping into the firm's shares.
Let's evaluate its business quality and offer an assessment of the firm's cash flow generating capacity before we dig into our DCF assumptions that drive the company's intrinsic value estimate.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. St. Jude's 3-year historical return on invested capital (without goodwill) is 39%, which is above the estimate of its cost of capital of 9.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. St. Jude's free cash flow margin has averaged about 16.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures,
please visit our website. At St. Jude, cash flow from operations decreased about 25% from levels registered two years ago, while capital expenditures fell about 28% over the same time period.
Our discounted cash flow model indicates that St. Jude's shares are worth between $51-$85 each. Shares are trading just shy of $66 at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $68 per share represents a price-to-earnings (P/E) ratio of about 27.3 times last year's earnings and an implied EV/EBITDA multiple of about 13.4 times last year's EBITDA. These are some hefty valuation multiples, but we note they are backward-looking. We'll dig into a forward relative valuation assessment shortly.
Our DCF model reflects a compound annual revenue growth rate of 3.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 2.1%. Though management believes a mid- to- high-single digit rate of expansion is possible as a result of new product launches during 2015, we think St. Jude will grow in-line with the pace of market expansion (~4%) during the five-year discrete horizon. Our model reflects a 5-year projected average operating margin of 26.2%, which is above St. Jude's trailing 3-year average. Most of our expectations for margin expansion are driven by St. Jude's decision to shift manufacturing to lower-cost regions, and this will take some time to unfold. Management has noted that it has identified further opportunities to take costs out of the business, and our valuation model reflects this opportunity.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For St. Jude, we use a 9.9% weighted average cost of capital to discount future free cash flows. Both the long-term growth rate and discount rate are average compared to other firms across our coverage universe.
We understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earnings-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. For this exercise, we compare St. Jude to peers Intuitive Surgical (NASDAQ:ISRG) and Waters (NYSE:WAT), among others.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $68 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for St. Jude. We think the firm is attractive below $51 per share (the green line), but quite expensive above $85 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate St. Jude's fair value at this point in time to be about $68 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of St. Jude's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $88 per share in Year 3 represents our existing fair value per share of $68 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements