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Barron’s Is Wrong On Medtronic

in FP: Latest/Stock Analysis by

I love Barron’s.  I really do.  I read it from cover to cover, and I truly believe it is one of the few business publications that knows the difference between a good company and a good stock.  Now that I’ve sugared it up, let me tell you this: its article on Medtronic is wrong!  Here are some arguments the Barron’s article made that require my rebuttal:

“The stock looks cheap, trading at about 8.2 times expected forward earnings, but the company’s 10% long-term-earnings growth rate is below the industry average…

At 8.2 times earnings, the market prices in zero growth.  If any growth is produced, even half of its “below-industry-average” growth, the stock will not be trading at 8.2 times earnings, but at a much higher valuation.  Ironically, today’s low valuation gives MDT earnings a yield of 12%.  If MDT remains at this valuation for a long time, it can buy back 12% of the company year after year, and this in itself would result in 12% earnings growth.

“… and it carries a fair amount of debt….

The amount of debt seems high at first, at $10.5 billion; but the company has $3.9 billion in cash and short-term investments, thus net debt is closer to $6.6 billion.  MDT generates $3.4 billion of free cash flows – it can pay off ALL of its net debt in less than two years.  Also, don’t confuse MDT with low-quality, highly cyclical stocks that were in vogue in the first half of 2010.  This is a company that maintained a return on capital of over 20% for decades – an indication of a significant moat.  Its revenues are extremely predictable, cash flows are very stable, and thus debt levels are very reasonable.  Medtronic’s stock was punished with a 10% decline for lowering its guidance by an astonishingly minor 2%.

“The stock is also a historical underperformer, turning in losses year-to-date, as well as in the last one-, two-, and five-year periods that are greater than its peers in the Dow Jones U.S. Medical Equipment Index and the overall market….

This argument fails to draw a distinction between fundamental performance and stock performance.  Over the last ten years, MDT grew both sales and earnings per share at 14% a year.  It increased dividends 17% a year.  These are not the vital signs of an “underperformer.”   As the article pointed out, MDT’s stock has gone nowhere over the past decade – that is true, but not because MDT was mismanaged or failed to grow, but rather because at the turn of the last century MDT was trading at almost 50 times earnings.  Medtronic is a typical sideways-market stock: it was severely overvalued at the end of the secular bull market, thus its earnings and cash flows grew while P/Es contracted.  This happened to a battalion of stocks, from Wal-Mart to J&J to Pepsico.  In fact when I hear the statement that a stock has “not gone anywhere,” I immediately start looking at the stock to see if it is a buy.

“Nor do there seem to be any new products in Medtronic’s pipeline that will reach the market in time to reverse the company’s near-term lackluster sales.”

I was surprised to read this because Barron’s is usually one of the few investment publications that has a time horizon beyond “near-term.”  Over the last several decades MDT has demonstrated its ability to innovate and come up with viable new products.  Will that happen again “near-term”?  Don’t know.  Longer-term? Likely.

The Barron’s article painted Medtronic as a bad company and a bad stock.  It is neither.

My firm has a position in MDT.

Vitaliy N. Katsenelson, CFA, is a portfolio manager/director of research at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing: Making Money in Range-Bound Markets” (Wiley 2007).  To receive Vitaliy’s future articles by email, click here.


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10 Comments

  1. Great article. I bought MDT yesterday at $30.90 which is a steal. Lots of growth stocks have gone nowhere the last 10 years as was pointed out. They are likely about as cheap as they are going to get in this cycle.

  2. I'm always curious about the net debt argument as I see it as mostly a theoretical claim, not something that would actually happen or has happened in a company using all its shares to repurchase its debt (would be interested to see cases where I am proved wrong of course!). Do you think that using Net Debt can be misleading in these cases or that using it solely against what it would actually need to pay in the near term (ie st-debt) would be more accurate? Understandably my question is not central to the thesis, I haven't looked at the stock much myself but the case seems interesting just looking to get some clarity on the net debt issue.

  3. Problem with MDT is it is now at the awkward stage — not growth stock and not beloved stalwart. Buying MDT is no longer an investment in a premium priced growth story. It will never again get investors to pay prices at PEs of 40 to 50 as it did the past decade

    That does not mean it's a bad company and Barron's has failed to appreciate that management is very cognizant of the shift and is working to diversify and realize better growth in diabetes, neuromodulation. They also failed to read the comments about a reasonably good pipeline and keeping R&D spending strong going forward.

    They are cheap but it is the beginning of a cycle not the bottom. Long-term growth is likely to come in around mid-single-digits rather than high teens and investors are going to have to find a comfort level with the new reality. I think they are rather absurdly cheap now too, but expect the next year or two will not see much better numbers so be prepared to wait. MDT has some hope of coming in with earnings that are less disappointing than Q1 2011 and this may give some impetus to the stock price moving up.

  4. I agree with almost everything you say, Vitaliy. Revenues have nearly tripled in the last 10 years. FCF has grown nearly 11% (CAGR), as has shareholder equity. The annual CROIC for the decade averages better than 15%. Gross margins are over 80% and the median net margin for the past 5 years is nearly 20%. Your remark that MDT is priced for zero growth is dead on.

    I've had MDT on my watch list for some time, but I've taken my eye off the ball. Looks like time to act.

    Oddly enough, the fellow who delivers my copy of Barron's every Saturday left me the Saturday WSJ by mistake and here's where I disagree. I don't find Barron's to be the must-read publication it once was (although I especially enjoy the columns by Abelson and Donlan). Equally good, if not better information is readily available on the web (here, for example). My subscription runs out in November and I'm leaning strongly toward letting it lapse.

  5. Pete: I spend more time reading financial blogs than reading main street newspapers.

    Depj: Net debt refers to total debt less cash. The point is can company payoff its net debt if it really has to from free cash flows and how much time it will take. Also it is another way to judge company's true indebtness.

  6. I noticed your post on the Excel smf-addin group a while back. Still using the add-in? I don't know what I'd do without it….

  7. Barron's says:

    “Nor do there seem to be any new products in Medtronic’s pipeline that will reach the market in time to reverse the company’s near-term lackluster sales.”

    But Zacks says:

    “Moreover, the company’s strong pipeline has the potential to drive revenues going ahead.” I guess that's what makes a horse race, although Zacks put a SELL(4) rating on MDT.

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