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The only standard by which this past quarter was good for the major med-tech companies was that it could have been worse. While Covidien (COV) did pretty well and Johnson & Johnson (JNJ) looked a little stronger, most of the reports carried a tinge of disappointment to them. Well, Medtronic (MDT) at least brings the reporting cycle to a positive end. While I'm not especially confident that this quarter marks a big turn in revenue growth, this does look like a high-quality med-tech stock trading too cheaply.

A Decent Start To The Fiscal Year

Although Medtronic didn't really blow away anybody's model, this quarter was a solid result and reasonable proof that the worst may be over.

Revenue rose a little less than 2% as reported, but a little less than 4% on an organic constant currency basis. Smaller business like neuromodulation (up 8%), diabetes (up 6%), and surgical tech (up 11% organic) were the growth leaders, but cardio (up 4%) and spine (down 3%) relatively solid, especially as core spinal sales rose 1%. Pacing continues to be weak, though, and CRM was down about 2% overall, while emerging market growth also slowed significantly.

Margins came in more or less okay. Gross margin improved just a tick from the prior quarter, and about a half-point from the year-ago. Gross margin remains a priority for management - the company just finished a $1 billion cost program and looks to be starting another one. Operating income did fell 2% this quarter, though, as both SG&A and R&D increased faster than reported sales.

Share Data Mostly Positive … Mostly

On the whole, Medtronic continues to look like the 800-lb gorilla in most of its markets. Although pacing performance was disappointing as the company anniversaried the Revo introduction, the ICD business is doing well. While St. Jude (STJ) continues to look like it has some momentum, Medtronic does appear to be picking up some incremental lead business. Boston Scientific (BSX) continues to look pretty hopeless.

The stent business is one to watch as the year goes along. Stent revenue growth was solid this time around with the new Resolute leading the way, but will launching the Resolute in Japan be enough to offset the tougher comps when they anniversary the U.S. launch?

I'm also wondering how Medtronic's diabetes business will play out for the rest of the year, particularly in the U.S. I don't really think that Abbott (ABT) or Johnson & Johnson has fundamentally shifted the business in their favor, but I do see a risk that the business struggles a bit until the new MiniMed launch (probably in fiscal Q4).

Still Waiting For An "All Clear"

Unfortunately, there seems to be little that is going to move Medtronic quickly or especially dramatically. The global CRM business just isn't likely to grow that fast anymore, and it's more than a quarter of the revenue base. Likewise, while I see more market growth potential in spine (nearly 20% of sales), I expect Medtronic to be more of a growth laggard here.

This sets up several challenges. First, the company is going to need to see better growth from emerging markets; fortunately, while this quarter was disappointing in that regard, Medtronic has put down some meaningful infrastructure. Second, emerging products like Ardian and CoreValve have to work. Third, the company may need to pull a page from the St. Jude/Boston Scientific playbook and consider more deals to recharge the long-term pipeline.

But let me be clear about the bottom line risk - I don't think Medtronic is going to fail, or spin into a Boston Scientific cycle. Rather, I see a downside that I'll call "the Duck Contingency" - Medtronic may find itself hard at work below the surface, but all anybody may see is very gradual motion at the surface … gradual motion that may disappoint investors and pressure multiples.

The Bottom Line

For those who read my healthcare writings frequently, this part will sound pretty old-hat - I like Stryker (SYK) and St. Jude, and wish Covidien were a little cheaper. Surprisingly (at least to myself), I'm also pushing Medtronic into that camp.

I think Medtronic will be hard-pressed to grow revenue beyond a 2-4% range for the foreseeable future, but I'm starting to think the big improvement seen last year in free cash flow conversion may be more or less sustainable. If Medtronic can hold a free cash flow margin in the mid-20's and produce long-term free cash flow growth of 3%, you can argue for a fair value in the mid-$50s. While I do worry that Medtronic could be a value trap (because of sluggish topline growth), I have to admit that there's more value here than I suspected.

Source: For Medtronic, A Little Improvement Is Still Improvement