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 (NYSE: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 (NYSE:MDT) and then triangulate the result against a review of the fundamentals compared to Baxter (NYSE: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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