One exciting niche market in healthcare is the medical device industry. While the competition is intense, inelastic demand stabilizes streams of free cash flow. Abbott's (ABT) decision to retain its medical device segment within the supercentenarian business while spinning off its pharmaceutical segment has created newfound interest in this attractive industry. In this article, I will run you through my DCF model on Medtronic (MDT) and then triangulate the result against a review of the fundamentals compared to Baxter (BAX) and Abbott. I find all three meaningfully undervalued. For an industry as safe as medical devices, you would expect little upside. Shockingly, however, all three of these producers have double-digit upside.
First, let's begin with an assumption about the top-line. Medtronic finished FY2011 with $15.9B in revenue, which represented a 0.7% gain off of the preceding year. I model 6.3% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures, and taxes. I model cost of goods sold as 24.3% of revenue versus 34.5% for SG&A, 9.4% for R&D and 4% for capex. Taxes are estimated at 20% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 1.5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10% yields a fair value figure of $45.95, implying more than 20% upside. The market seems to be factoring in a WACC of 11.5%, which is much too conservative in light of the market's inelastic demand.
All of this falls within the context of strong operating performance:
This morning we reported third quarter revenue of $3.9 billion, which represents 2% growth as reported, and 1% on a constant currency basis. Q3 non-GAAP earnings of $888 million and diluted earnings per share of $0.84 increased 8% and 9%, respectively, after adjusting for the onetime tax benefits in Q3 of last year. From a revenue perspective this was a challenging quarter. But looking down the P&L, we saw solid performance in our gross margin, and our team executed to deliver the bottom line.
From a multiples perspective, Medtronic is also attractive. It trades at a respective 12.3x and 10.4x past and forward earnings versus 13.7x and 11x for Baxter and 19.2x and 11.6x for Abbott.
Consensus estimates forecast Baxter's EPS growing by 5.1% to $4.53 in 2012 and then by 8.4% and 7.5% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $4.88, the stock would hit $63.44 for 17.3% upside. This safe return is complemented by a 2.5% dividend yield and a "buy" recommendation on the Street (according to the NASDAQ).
Consensus estimates forecast Abbott's EPS growing by 7.9% to $5.03 in 2012 and then by 6.6% and 6% in the following two years. Assuming a multiple of 13x and a conservative 2013 EPS of $5.32, the stock would hit $69.16 for 11.5% upside. The dividend yield of 3.3% is very compelling during these uncertain times. Moreover, 16 of the last 19 revisions to EPS have been made upwards.
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