Company Description (Source: SEC 10-K)
Medtronic (MDT) engages in research, design, manufacture and sale of products to alleviate pain, restore health and extend life. It manufactures and sells device-based medical therapies. It operates in two segments: Cardiac and Vascular Group, which includes Cardiac Rhythm Disease Management, CardioVascular, and Physio-Control; Restorative Therapies Group, which includes Spinal, Neuromodulation, Diabetes, and Surgical Technologies.
Medtronic is a dividend aristocrat with 34 consecutive years of increasing dividends.
Vital Statistics (Source: Google Finance)
- Recent Price: $37.60 (as of 03/09/2012)
- 52-Week Range: $30.18 - $43.13
- Market Capitalization: $39.86B
- Shares Out.: 1.06B
- P/E Ratio: 12.09
- EPS: $3.11
- Yield: 2.55%
A 10-year summary of Sales, Earnings Before Interest and Tax (EBIT), Earnings per share (NYSEARCA:EPS), yearly high and low stock price, corresponding high and low P/E (calculated by dividing the high and low price by the EPS for the year), and average P/E (average of high and low P/E) is shown below.
Key 10-year data for Medtronic
Year | Sales (in Billions) | EBIT (in Billions) | EPS | High Price | Low Price | High P/E | Low P/E | Average P/E |
2011 | 15.93 | 3.72 | 2.86 | 42.7 | 31.2 | 14.9 | 10.9 | 12.9 |
2010 | 15.82 | 3.97 | 2.79 | 46 | 32.5 | 16.5 | 11.6 | 14.1 |
2009 | 14.6 | 2.44 | 1.84 | 46 | 24.9 | 25.0 | 13.5 | 19.3 |
2008 | 13.52 | 2.74 | 1.87 | 56.5 | 29.9 | 30.2 | 16.0 | 23.1 |
2007 | 12.3 | 3.52 | 2.41 | 56.6 | 45.7 | 23.5 | 19.0 | 21.2 |
2006 | 11.29 | 3.16 | 2.09 | 59 | 43 | 28.2 | 20.6 | 24.4 |
2005 | 10.05 | 2.54 | 1.48 | 59 | 50 | 39.9 | 33.8 | 36.8 |
2004 | 9.09 | 2.8 | 1.6 | 53.3 | 46.9 | 33.3 | 29.3 | 31.3 |
2003 | 7.67 | 2.34 | 1.3 | 52.1 | 53.3 | 40.1 | 41.0 | 40.5 |
2002 | 6.41 | 1.52 | 0.8 | 49.5 | 36.2 | 61.9 | 45.3 | 53.6 |
Source: MSN Money; SEC 10-Ks.
From these data, we can plot Sales, EBIT, and EPS versus Year, as shown in the chart below.
Sales (in Billions), EBIT (in Billions), and EPS versus Year for Medtronic, 2002-2011
As evident from the chart above, MDT has demonstrated reasonable predictable sales and earnings over the past 10 years, which allows us to project EPS in the near future, say in five years (i.e. Year 2016), using the logarithmic regression equation for EPS = 2.082E-97 * exp(0.1112*2016) = 4.77. This projection assumes 11 percent annual EPS growth.
A conservative average P/E estimate for the stock can be obtained as follows:
Signature P/E: A well established stock has a signature P/E, an average P/E it commands in the market based on its business. We calculate this by averaging the Average P/E over the past 10 years, excluding any outliers (data points that fall significantly beyond the other data points). Excluding the abnormally high values from 2002-2003, we average the Average P/Es from the past 8 years to arrive at a signature P/E of 22.9.
High P/E estimate: a conservative high P/E estimate can be calculated by averaging the five lowest High P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest High P/Es from the past 10 years gives 21.6.
Low P/E estimate: a conservative low P/E estimate can be calculated by averaging the five lowest Low P/Es of the 10 High P/Es from the past 10 years. Averaging the 5 lowest Low P/Es from the past 10 years gives 14.2.
Average P/E estimate: this takes the average of the High P/E estimate and the Low P/E estimate, as calculated above, to give a conservative estimate of an average P/E for the stock we can expect. Averaging 14.2 and 14.2 gives us 17.92.
Target Price
Multiplying our EPS projection for 5 years hence by the average P/E estimate gives us a projected average price for the stock: $4.77 * 17.92 = $85.42, which represents an annual stock price return of 22.8 percent from the current price = $37.60. When we add in the 2.5 percent dividend yield, the total return expected is 25.3 percent a year, which means an investment in MDT today is expected to double in about 3 years.
Using a discount rate of 10 percent, our projected price of $85.42 in 5 years translates to a target price = $53 in today's dollars, which provides 29% margin of safety from the current price of $37.60, suggesting the stock is undervalued right now. For a good margin of safety, investors are well advised to buy only if the current price is at least 20% below the target price, which means a buy price of $42.40 and under.
Intrinsic Value
The intrinsic value of Medtronic can be estimated using a discounted cash flow model. The company's operating cash flow, capital expenditure, and free cash flow (difference between operating cash flow and capital expenditure) for the past 5 years is shown below. All figures are in millions of dollars.
2007 | 2008 | 2009 | 2010 | 2011 | |
Operating Cash Flow | 2979 | 3489 | 3878 | 4131 | 3741 |
(Capital Expenditures) | 694 | 606 | 663 | 635 | 548 |
Free Cash Flow | 2285 | 2883 | 3215 | 3496 | 3193 |
Source: MSN Money.
These data are plotted below.
Note that the free cash flows over the past 5 years fit reasonably well a logarithmic regression, allowing us to project free cash flow over the next 5 years, using the logarithmic regression equation 1.851E-72 * exp(0.0862*Year). This assumes that operating cash flows grow at a rate of 8.6 percent a year over the next 5 years.
Let us apply a conservative discount rate of 10 percent, and assume that the company will grow at a terminal growth rate of 2 percent a year after 5 years. From the most recent balance sheet, Medtronic had $2345 million cash, $8248 million debt, and 1055 million common shares outstanding. With these inputs, we get an intrinsic value of $57.70 per share. The results are shown below.
Note that total DFCF is sum of discounted free cash flow from years 2012-2016. Residual value = (DFCF from Year 2016) * 1.02 / (1.1 - 1.02). Total EV (enterprise value) is the sum of the total DFCF and residual value. Adding back cash and subtracting debt, we get equity value. Dividing by shares outstanding gives us intrinsic value per share.
2012 | 2013 | 2014 | 2015 | 2016 | |
Free Cash Flow | 3881.587 | 4231.024 | 4611.919 | 5027.104 | 5479.666 |
Discounted FCF | 3881.587 | 3846.386 | 3811.503 | 3776.938 | 3742.685 |
Total DFCF | 19059.1 | ||||
Residual value | 47719.24 | ||||
Total EV | 66778.34 | ||||
Cash | 2345 | ||||
Debt | 8248 | ||||
Equity Value | 60875.34 | ||||
shares | 1055 | ||||
Intrinsic value | 57.70174 |
This suggests MDT is undervalued at $37.60, with 35 percent margin of safety. The caveat is that discounted cash flow analysis is very sensitive to the inputs. If we merely change our discount rate from 10 percent to 12 percent, for example, the intrinsic value would drop to $45.51, in which case the stock is still undervalued, but the margin of safety would narrow to 17 percent.
Current P/E Compared with Signature P/E
The stock's current P/E should be compared with its signature P/E, since established stocks tend to revert back to their respective signature P/Es over the long term. The current P/E of 12.09 is 53% of the stock's signature P/E of 22.9, suggesting the stock is undervalued right now. Ideally, we should look to buy when the current P/E is 80% or less of the stock's signature P/E, so Medtronic is currently cheap compared to its historic P/E.
Medtronic's P/E Compared with Competitors' P/Es
It is helpful also to compare Medtronic's valuations with those of its competitors. Current P/E and Forward P/E are tabulated below for the company and its main competitors.
Stock | Current P/E | Forward P/E |
Medtronic (NYSE:MDT) | 12.09 | 10.3 |
Boston Scientific (NYSE:BSX) | 20.69 | 12.77 |
Johnson & Johnson (NYSE:JNJ) | 18.58 | 11.92 |
St. Jude Medical (NYSE:STJ) | 16.42 | 11.15 |
Stryker (NYSE:SYK) | 15.44 | 11.86 |
Mean | 16.64 | 11.60 |
Median | 16.42 | 11.86 |
Source: Yahoo Finance; MSN Money.
Medtronic is selling at a discount compared to its competitors. Given its solid track record and business model, Medtronic appears to offer an attractive opportunity for investors to capitalize on the misplaced market pricing, as compared to peers.
Historically, for the past 10 years, Medtronic has underperformed the S&P 500 and all its peers, except for Boston Scientific. While this performance is disappointing, investors appear to have now factored much lower expectations for the stock compared to 10 years ago when the stock's average P/E was 53. With lower market expectations, Medtronic appears ready to outperform from current levels.
Risk Index
Lastly, we calculate the Risk Index, calculated as (Current Price - Forecast Low Price)/ (Potential High Price - Forecast Low Price) to give an estimate of the risk: reward ratio. Risk index less than 20% is desired, which gives us +200% potential returns for every risk of 50% loss we assume.
The Forecast Low Price is calculated by multiplying the Low P/E estimate by the Forecast Low EPS, to give a conservative estimate of low price for the stock in 5 years, assuming zero EPS growth and low valuation. Forecast Low EPS is estimated by averaging the EPS over the past 5 years. For growth stocks with predictable earnings growth, EPS in 5 years should not be any lower than this conservative estimate. For MDT, the forecast low EPS is equal to 2.354, so the Forecast Low Price = 14.2 * 2.354 = $33.45.
The Potential High Price is calculated by multiplying the High P/E estimate by the projected EPS in 5 years, giving us a price in 5 years, should the stock command a high P/E. For MDT, this equals 21.6 * 4.77 = $103.10.
Thus, the Risk Index = ($37.6 - $33.45) / ($103.10 - $33.45) = 6%. Since this is below 20%, the stock has a favorable reward to risk ratio at the current price.
Conclusion
Medtronic, currently selling around $37.60, has a target price = $53 and estimated intrinsic value = $57. The current price provides adequate margin of safety with a favorable risk index, and the stock is selling at a discount to both its historic valuations and those of its peers. Therefore, I rate the stock a BUY at the current price, as a long-term investment.
Disclosure: I am long JNJ. I may initiate a position in MDT within a month or two.
Disclaimer: Use this information as a starting point for your own due diligence, before buying any stock. Past performance does not guarantee future returns, and the stock price may go down from current levels. If you do buy, be sure to read any annual reports (10-K) and quarterly reports (10-Q) to ensure that the fundamentals remain good and the stock is on target to reach its projected price. After holding for five years, repeat the analysis detailed in the article to decide whether to continue to hold, add, or reduce your position. While I rate Medtronic a buy, please see my other articles for other stocks I would consider buying now, such as Becton-Dickinson, Walgreen (WAG), Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Johnson & Johnson , and Procter & Gamble (NYSE:PG). Adequate diversification, with no single stock or sector comprising more than 10-20 percent of one's portfolio, is essential.