Medtronic reported improving results yesterday, and reiterated its FY18 revenue and EPS outlook despite production disruptions. This was well perceived by the market, as MDT had become a low expectation story in the recent quarters. Price target unchanged at $88.
Current Price: $82.66 Price Target: $88
Position size: 2.83% Performance LTM: +12.31%
Thesis intact. Key takeaways from the quarter:
1. Quarter review:
a. 1Q17 reported sales -4% (organic sales +3.1%, including an 80bps impact from Hurricane Maria)
b. Operating margins -100bps y/y due to:
i. spending ahead of its new product launches
ii. lower sales in Diabetes (supply issue)
iii. a product recall
iv. the Hurricane Maria
c. The Covidien synergies partially offset the margin decline
d. Adjusted EPS grew 5% y/y ex-FX excluding the Hurricane impact ($0.03)
e. Net debt to EBITDA now 1.7x from 2.25x prior
2. FY18 performance affected by natural disasters and supply problems this year:
a. Hurricane Maria damaged all four of the company’s manufacturing facilities in Puerto Rico on September 20th, amounting to a ~$60M loss in sales and a negative 40-50bps impact on operating margins
b. Wildfires in Northern California impacted four facilities (two were in an evacuation zone)
c. Computer outage in the first quarter disrupted sales
d. Shortage in diabetes sensors impacted their newest insulin delivery system (back on track early 2018)
e. Despite all those events, MDT reiterated its FY18 guidance, which is a testimony to the company’s extensive product offering and geographical range
i. FY18 sales growth guidance of 4-5% is maintained, implying a 4.5-6.5% growth in 2H even with tough y/y comps, which assumes:
1. the recovery of lost sales from Hurricane Maria
2. Diabetes growth expected in the mid-teens from LSD thanks to a return to full capacity in 4Q
3. a yearend inventory stocking, as the company is entering an acceleration in its innovation cycle (which boosted growth in the past, as the graph below illustrates)
ii. EPS growth ex-FX +9-10% is maintained, which this year is being helped by a lower tax rate that added $0.12 in EPS year to date
f. The management team provided some FY19 color: expecting MSD sales growth with operating margin expansion, leading to robust EPS growth
3. What to watch for in the coming quarters:
a. Competition:
i. MDT has a 2 year lead on automated insulin pumps in the US, but capacity is constrained until early 2018, limiting its advance over competitors. Diabetes pumps account for 6% of total sales
ii. Pressure in 2019 on its trans catheter heart valves, defibrillators and stents (3% of sales), as Abbott Labs and Boston Scientific are launching new products next year. Abbott Labs gained 10% market share in the last couple of years as it sold its stent for 6% cheaper. In May, MDT launched Onyx in the US in an effort to regain shares
iii. While MDT is the market leader in the MRI-safe defibrillator with 45% market share (8% of total MDT sales), Abbott is set to launch its own device and might put a dent in the 2018 sales growth
b. Covidien synergies still driving operating leverage: this may boost margins by 90bps. The company is guiding to margin expansion through 2021 but 2018 should be impacted by new product launch spending
4. Valuation unchanged
a. We are valuing the stock on a 17x forward P/E (past 2 years historical average post Covidien acquisition), which we see as fair for a good quality stock that still has potential to grow MSD and delivering low teens EPS growth but is facing competition in the coming 2 years
b. However, multiple expansion is possible in the coming quarters as expectations are currently low, giving the company a chance to deliver on its sales growth target. The Medical Devices group currently trades on a 25.7x forward P/E, while MDT stands at 16x
MDT Thesis:
• Stands to benefit from secular trends (1) increased utilization from Obamacare (2) developed populations age
• Strong balance sheet and cash flows. Increased access to non-cash should allow MDT to meaningfully increase their dividend
• 6% normalized Real Cash yield provides solid total return profile over next 2-3 years
• Ownership interest aligned. Management incentivized to maximize shareholder returns – 14% 10yr average ROIC