My investment standpoint
Medtronic (MDT) has been suffering from years of stagnant margins and poor return on capital, therefore, I welcomed the Mazor Robotics acquisition of last December as a hope of real improvement by going deep into the robotic and AI field. The recently released earnings for its fiscal year 2019 which ended in April gives us some clues which I will examine. By putting together Medtronic's and its peers' earnings, I note that Medtronic doesn't excel in any efficiency and profitability metric. However, the more balanced product portfolio and its recognized leadership make Medtronic the right choice for a dividend-oriented investor due to its reliable distribution payout. Unfortunately, the current shares' lofty valuation has wiped out the opportunity to buy the stock at an attractive risk-reward ratio.
The goodwill burden
Medtronic's balance sheet has the heaviest concentration of goodwill assets among its peers.
Source: latest 10-K filings.
Also, if I look at Medtronic’s total intangible assets to total assets ratio, I get an excessive 69%. It reminds me of GE Healthcare’s (GE) goodwill to assets ratio of 61% in December 2018, which is significantly higher than Johnson & Johnson (JNJ) Medical Devices’ Division ratio of 28%.
The most significant increase in the goodwill line happened in 2015 with the Covidien merger. Although the merger increased Medtronic’s revenues by 42.3% in FY 2016, it also reduced overall profitability, as I am going to check now.
Besides, I find another ugly trend: though tangible assets cover total debt well by 1.11x, the interest coverage ratio stays at the historically minimum levels above 4x, putting pressure on the company to pay interest debt from its operating profit.
Source: Company filings.
Return On Invested Capital Comparison
I also need to check if this excessive goodwill has negatively affected the company's efficiency ratios.
To evaluate if these goodwill assets are providing real returns to shareholders or if they are restraining earnings growth, I apply the ROIC ratio. Medtronic’s ROIC ratio has been steadily declining since 2009, and significantly fell by more than half in 2015 to mid single digits. FY 2019 marks the first time that Medtronic’s ROIC has seen any real improvement, but is still below its historic levels.
Source: Medtronic's financial statements.
In addition, if I match Medtronic’s returns with its peers over the last few years, I discover an inferior performance. Based on these findings, I feel that Medtronic doesn't excel in its returns and that it’s unable to match its competitors’ performance.
Source: Companies' SEC filings.
The performance of the last twelve months marks the first change in this trend, almost achieving the 8x ROIC. This shift may be fueled by a rebalanced portfolio following Medtronic’s recent acquisitions and its sale agreement with Cardinal Health (CAH).
Earning Margins Analysis
A look at the income statement shows me similar poor metrics over the last decade. Revenues have been steadily growing, driven by inorganic acquisitions. However, the gross margin has been deteriorating since the Covidien merger, from the 77% highs of 2009 down to 70% of FY 2019.
If I compare it to the peers' latest gross margin ratios, Medtronic’s performance is only average and far from the high 70s of a decade ago.
Source: Companies' SEC filings.
Digging into the operating margin performance, we do not see any margin expansion. Once the Great Recession of 2009 was overcome, Medtronic managed to keep its operating margins in the mid-twenties, but since 2014, it has been struggling to maintain margins of 20%. The seemingly recent improvement in 2018 is due in part to a special item gain on the sale of a business for $697 million. So if I subtract it from the $6,651 million operating profit, I come up to 20% of operating margin, instead of the 22% released.
Source: 10-K filings (calculation for FY2018 adjusted).
This stagnant margin is because of the inorganic acquisitions’ integration with relation to SG&A expenses. The $5.8 billion of overhead costs in 2014 have almost doubled to $10.4 billion in the last fiscal year. I check that this operating margin weakness matches with last year's significant increase in SG&A expenses. This increase breaks the trend initiated in 2011 of streamlined overhead as a percentage of total revenues. I think Medtronic has a lot of work to do in improving efficiency in operating costs.
Source: 10-K filings.
Due to Medtronic’s size and scope, we’d expect it to have economies of scale and be more profitable than smaller competitors. However, Medtronic doesn’t really stand out among its peers and is in a relatively average position.
Medtronic's Cash Flows
We see the same pattern concerning Medtronic’s free cash flow margin. Medtronic is mainly in line with its peer group, making 19% of FCF from its revenues, for the FY 2019.
The good news for dividend growth investors is that dividend expense comprised only 46% of the free cash flow. Thus, there is ample room to grow the dividend, which Medtronic is committed to doing.
Latest Earnings Enhancement
Medtronic’s latest annual earnings may have marked the first inflection point that the company needed. Behind the rather skimpy 2% YoY revenue growth lies a more promising engine of growth hidden by the impact of forex rates. Medtronic made 47% of its revenues from markets other than the US, so US dollar reporting blurred the picture. In terms of constant currency, revenues for FY 2019 have grown by 5.5%, growing across all segments as the company has been very active on the R&D front and introducing new devices.
Source: Company's FY 2019 earnings presentation.
It's essential to note the double-digit growth in brain therapies inside the Restorative Therapies Group, and the strong starting momentum of Mazor X Stealth Edition, with 26 Mazor system sales in the fourth quarter.
Regarding the lagging segment of the Cardiac and Vascular Group, whose revenues grew the least, its growth rate should be improved in the coming few quarters as the purchase of EPIX Therapeutics has been completed. This acquisition will reinforce Medtronic's portfolio to treat patients with cardiac arrhythmias.
It's also worth noting the impressive growth in emerging markets, growing YoY in the last fourth quarter (on a constant currency basis) by 9.8% in the Cardiac and Vascular Group, 13.1% in the Minimally Invasive Therapies Group, 14.6% in the Restorative Therapies Group, and 14% in the Diabetes Group.
The conclusion that I draw studying its financials is that the Covidien acquisition worsened Medtronic's profitability and efficiency metrics. However, since the divestiture in 2017 of three businesses (Patient Care, Deep Vein Thrombosis, and Nutritional Insufficiency) partially acquired in the Covidien merger, I see an improvement in returns and capital efficiency allocation. The recent acquisition of Mazor Robotics should strengthen Medtronic's leadership in spine surgery, and also give the company an edge in robotic-assisted operations. As this new robotic-based surgery methods require costly staff training, it creates a moat for competitors once a hospital institution decides to introduce this fully-integrated solution into its procedures. Moreover, the EPIX Therapeutics acquisition just completed in the last quarter should also boost the slower-growing Cardiac and Vascular division.
Though Medtronic’s profitability is below peers like Intuitive Surgical (ISRG), this is offset by a more diverse and balanced portfolio of products and solutions, which lowers the risk of investing in the name.
Anyway, I need to check if the recent improvements and entering into the robotics field translate into a long-term enhancement of Medtronic’s operating profitability. The current earnings multiple is too lofty to justify a buy at this time. The current P/E ratio of 27.4x, the price to FCF multiple of 21.6x, and the price to sales multiple of 4.1x doesn't make a compelling purchase case. We should be cautious considering a company which has been growing for a decade at the expense of margins, and also has problems with forex exchange volatility converting into USD since a significant portion of its business is done abroad. Surely, Medtronic's leadership and diverse product solutions make it a good play for any diversified portfolio, but at this price, I consider it a poor investment. As the whole medical devices sector is trading at a relatively high P/E multiple, I deem the market is anticipating too much enthusiasm. I'd rather wait for better entry points if these high expectations don't materialize as predicted, especially in the context of the current stock market volatility.
Disclosure: I am/we are long MDT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.