About a month ago I wrote about Medtronic (NYSE:MDT) in my premium blog after they issued a voluntary recall of one of their products (see below). My simple thesis at that time was that MDT is a great company with excellent growth prospects and economic characteristics, but the Market was dumping it because of the uncertainty around the recall. I believed at the time that the recall would be unpleasant in the short-term but would not harm the business long-term.
It looks like my thesis is being validated even sooner than I anticipated as MDT announced better than expected earnings Monday night including lower-than-expected recall-related losses. Management sounded upbeat about the 2nd-half of '08, and the analyst reports I've seen so far are also quite positive now that the recall cloud has mostly lifted. The stock traded up 7% on Tuesday.
Reprint of premium entry from 10-18-07:
Last week, Medtronic announced a significant product recall and as typically occurs, Wall Street ran for the exits, knocking more than 12% of the stock. I First purchased MDT in some of my portfolios about a year ago on a similar pullback. Although the current recall is unpleasant for both patients, doctors, and shareholders, I do not believe it will significantly impair MDT's business beyond the near term.
MDT is one of the largest medical device manufacturers, with well-known franchises in heart disease treatment (pacemakers, valves, defibrillators). Over the past two decades MDT has broadened its portfolio into a variety of other chronic disease areas, including spinal, diabetes, and neuromodulation. More than 1/3 of its sales are outside the US.
Besides its size and experience, MDT possess a fantastic track record of innovation. It continues to develop new ways to treat chronic diseases which will become more and more prevalent as the population ages. I expect that MDT should be able to grow its top line for many years at a low to mid-teens rate, and grow earnings and free cash (which is approximately equal to net income in this case) at least as fast.
Nearer term, MDT should begin sales of its new drug-coated stent, Endeavor (recently recommended for FDA approval) and a new lumbar disc with no no competing products. These discs incorporate bone graft material and provide a superior solution to lumbar fusion procedures. Further out, expect innovations in treatments for diabetics, a fast-growing market. MDT has all of the technologies needed to produce the "holy grail" - an artificial pancreas. Another interesting device on the horizon is a small implantable neuromodualtion device which will control hunger in obese individuals.
The recent recall involved a product that has already been controversial, due to previous recalls by competitors. The device in question are ICD's which are small devices implanted beneath the skin and connected to the heart via electrical leads. They sense when the heart beats improperly, and automatically defibrillate the organ to prevent sudden cardiac death. The products clearly save lives, but the growth of the market was hurt by competitor's failures which required device removal. MDT's devices have performed well, but on last Monday they announced that the leads connecting to the heart were failing in a few cases, and may have been implicated in as many as 5 deaths. The leads in question are a newer, thinner model and have been implanted in more than 250000 patients. To make matters worse, the leads are not easily removable. If the lead fails, it is usually best to install a 2nd lead. The solution appears to be to reprogram the ICD devices to be more sensitive to lead damage so that any problems are caught early. It does appear that the company acted conservatively by issuing the recall, as the failure rate was still very small, and it is well known that implantable leads occasionally fail.
I was fortunate to participate in a conference call with an eminent cardiologist who said that this will not likely be a major problem for Medtronic beyond the near term, and that the company is otherwise well respected by physicians. I am also hearing that Doctors are very much looking forward to approval of the Endeavor (as reported on CNBC recently).
Clearly, the near term holds uncertainty, something Wall Street hates. Hence, I believe MDT is selling for about 75% of it's intrinsic value. You don't often get significant discounts on great companies like MDT, and I've learned that it often doesn't pay to wait for them to get even cheaper, because they typically don't. This is a premier franchise that generates 20%+ returns on capital, has excellent long-term growth prospects, and is selling at a market multiple whereas it's typically awarded a multiple north of 20. I think this will prove a good entry point longer-term, but if it does get notably cheaper I will consider buying more.
Disclosure: I am long MDT in several of my portfolios but positions can change any time.