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Buy Medtronic Inc. And Sell A Covered Call For Income

|Includes: Medtronic plc (MDT)

04/15/13/ Covered Call Pick: Medtronic Inc (NYSE:MDT)

Medtronic Inc. (MDT) is the world's largest medical technology company, engaging in the development and manufacturing of medical devices focused towards pain alleviation, health restoration, and the extension of life. The Minneapolis-based company develops products such as implantable cardiac rhythm devices, spinal implants, insulin pumps, and neuromodulation systems. With these devices, the company helps treat some of the most prevalent and debilitating chronic diseases and conditions in millions around the world.

Medtronic has a market capitalization of $47.85 billion with 1.01 billion outstanding shares.

Medtronic currently pays a $0.26 quarterly dividend for a current yield of 2.2%.

With a beta of 0.97, MDT currently trades with a volatility similar to the market.

Medtronic is one of the companies we like to call "Legacy Investments". This does not mean that the company itself has a long and valued history (although Medtronic would fit into that description) but rather it is an investment that we consider worth holding across generations as its long-term prospects for wealth generation are very good. Why do we think MDT is a great long-term investment? Simple - we're all growing older. As the baby boomers start to grow into retirement age, a large portion of our population will be on the upper end of the age range. Unfortunately just like cars, the older we humans get, the more things tend to break. While Mr. Baby Boomer might decide to stop drinking Pepsi, going to McDonald's, or even buying a new car, he's not gonna have much a choice when he needs a pacemaker or a new heart valve. That is where Medtronic comes in.

MDT is focusing on the development of medical technology that treats chronic diseases. The company already has a strong history in the treatment of cardiovascular conditions and heart disease, being the first and still only company in the United States to have a MRI-compatible pacemaker approved by the FDA. This product in particular is very indicative of Medtronic's development thought process. Pacemakers are not new technology by a long shot, but MDT recognized that 1/3 to 1/2 of all patients that require a pacemaker will also need at least one, if not multiple, MRIs. The company found a hole in the currently available technology, and developed a product to solve a practical problem that troubled a large subsection of the population.

Alongside solving heart conditions such as atrial fibrillation, failing heart valves, and drug-resistant hypertension (poorly treated conditions the company has just made recent acquisitions to help develop for) MDT also develops products like insulin-pumps for the treatment of diabetes, which is arguably one of the most prevalent diseases afflicting Americans today. The company's most interesting development line involves neuromodulation - an emerging treatment market that involves the triggering of large portions of neural systems through the use of drug-based neurotransmitters. Complicated to be sure, but what is important is that the general therapeutic practice is being applied to treat conditions such as epilepsy, Parkinson's, depression, and other such neural conditions for which there are few efficient options for treatment.

For more on the growth track, the company is expected to dive further into expanding in the emerging markets. MDT was one of the first medical devices companies to achieve a foothold in China - a huge, mostly untapped, market with a massive population that is aging just as fast as the rest of us. With steady expansion into the country expected over the next 10 years, MDT has a lot of room to run before their markets are considered saturated.

There are risks associated with an investment in Medtronic, just like any other investment. While the company benefits from a wide economic moat (meaning that it is difficult for a new start-up to come and take market share), the Medicare reimbursement cuts that are on the horizon will be a burden on all device makers. Providers are expected to pass the entirety of the 2% cut to reimbursements to MDT, who has an estimated 23% of revenue generated from such reimbursements. If the company can't offset the cut in revenue with lower manufacturing or operating costs, or if the cuts end up being much deeper than anticipated, the company could see some impact to their bottom line. Innovation is what will keep the company profitable, but even with a talented R&D department, it is not a guarantee.

In the end though, we believe that the rewards outweigh the risks for Medtronic. The stock pays a decent dividend yield, with an expected dividend increase coming in June. The current P/E of 13, and the Forward P/E of 12 are both at a discount to the market valuation, and the company just increased their 2013 earnings estimates up to 9%. Additionally, the last twelve months has seen the number of mutual funds with ownership of MDT increase by 6.8%, showing support for the company even through the stock's tepid second half of last year.

For a Covered Call strategy for MDT, we are recommending the November 2013 $48 Call. While we believe that MDT is an investment we want to hold for a long time, we also recognize a growing weakness in the current market. For us as active managers of portfolios, if we see a pullback in the stock in the next seven months, we will buy back our Call on its price contraction. Then we will sell another Call to continue to erode our cost basis, generate income, and keep the stock in our portfolio. Yet even if you are not an active investor, selling the $48 Call will net you a nice premium, and if the stock gets called away come November you will receive a nice yield for your time, and then generate a new position in the stock. That is why we are recommending buying MDT and selling the November 2013 $48 Call.

Scenario:

 

  • Buy 100 shares of MDT @ $47.15 = $4,715 + Commission ($12.95) = $4,727.95
  • Write 1 MDT November 2013 $48 Call @ $213 - Commission ($8.70) = $204.30

Note: Prices may vary from the time of post. Actual commissions paid will vary returns.


Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration

(2.04 + (2*0.26))/47.28 X (365)/214

= 9.24% Static Return


If-Called Return:
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration

(2.04 + (2*0.26) + 48 - 47.28)/47.28 X (365)/214

= 11.83% If-Called Return


Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.

Posted by OaktreeAdvisors at 4/15/2013 10:13 AM
Categories: Weekly Picks

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Disclosure: I am long MDT.

Additional disclosure: As active money managers we have positions in MDT and have sold covered calls on MDT. We will continue to add to these positions.