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Wednesday, June 8, 2011

Medtronic Is Shocking Under The Hood

Many conservative portfolios have dividend paying stocks as a bedrock of their assets and one stock Medtronic (NYSE : MDT), has been a good investment over the years. For those of you who are unfamiliar with Medtronic they are a medical devices maker and compete against other companies like:  St Jude (NYSE :STJ), Abbot Labs (NYSE :ABT), Boston Scientific (NYSE : BSX) and Guidant (acquired by BSX). In the past Medtronic has been a portfolio and hedge fund favorite because it delivered a 10.3% annual growth rate over the past 10 years, however, over the past 12 months the growth rate has gone negative 2.7%. So what’s an investor to do with Medtronic?

I am sure that if Medtronic was honest with itself about the past couple quarters and particularly this last earnings report it would have to admit that it could use one of its own devices to regulate itself or at least a new CEO. Wedbush Securities analyst Phillip Nalbone commented about the incoming CEO that takes over on June 13th ,Mr. Omar Ishrak, who is an outsider to the company. Nalbone’s logic is that Medtronic is so committed to turning things around that for the first time in 25 years they recruited from outside of their “comfort zone”. Of course looking at Medtronic’s past leaders the outgoing CEO Bill Hawkins came from Novasote back in 2002 so I guess he was no longer an outsider.

Can Mr. Ishrak turn things around at Medronic? I guess the answer to that question is we will have to see. Issues may have arisen in the company due to the corporate culture, which may have contributed to the less than stellar management decisions. People at Medtronic may not have questioned and went along with the decisions made, because they were comfortable under the guidance of an insider. Bringing in someone alien to the corporate culture can be the needed catalyst for change or it can also have a negative effect as there could be significant resistance. The bottom line is we will not know if Mr. Ishrak can turn the USS Medtronic away from the iceberg or if there will be a mutiny. I will say though that given the amount of time that the deterioration has taken place along with market factors working against Medtronic, Mr Ishrak is going to have his hands full.

Over the last quarter Medtronic’s earnings report was shall we say less than stellar. The last 12 months annualized growth rate for the company was a negative 2.7%. The flipside is that Medtronic competes in the medical devices space which is highly competitive and in the current health care environment you can expect pricing pressure on the items that Medtronic produces. Granted they manufacture a great many things that are life saving and were not even around a scant couple years ago like continuous glucose monitoring , drug coated stents and kyphoplasty, so it is not like they are a one trick pony. Additionally, Medtronics is continually developing new products as their R & D budget is on the order of $1.5 Billion per year, and for that kind of coin you should be able to come up with a gizmo or two per year. One has to keep in mind that Medtronic’s space is fiercely competitive and market share is there for them to lose. Moreover, the declines in revenue in the past report are related to one of Medtroinc’s highly profitable device called an implantable cardioverter defibrillator (ICD) and sales have been off due to an investigation by the DOJ, which ended up impacting earnings.

Normally I would be optimistic about a company like Medtronic that has a low forward PE ratio and all the key metrics like debt to equity and current ratio well within safe limits. Medtronic has an almost 20% and 28.5% profit and operating margin respectively and carries a beta less than the market at .96. All of his sounds good, but I have not even gotten o the dividend yet. The dividend is currently at 2.3% which is better than money markets but will probably fail to impress those seeking high yields even with a 31% payout ratio and the fact that the dividend has increased on the order of 80% over the past 5 years. Of course there is no guarantee that Medtronic can keep increasing the dividend at the rate of the last few years but if I had to guess they will do everything to keep it going.

 Medtronic has been trying to offset its lackluster performance by engaging in share buybacks which have recently risen to retiring 2.3% of the outstanding shares per year. The share buybacks are good for equity holders as they allow for earnings to be spread over fewer shares boosting returns, but it is also a way in which poor performance can be masked. Additionally, with earnings impacted now and going forward I believe it will be challenging for Medtronic to keep all the aforementioned items in check, the numbers will deteriorate.

So my problem is not with whether Medtronic can execute a turnaround from a corporate culture perspective, but I believe there are more serious issues lurking under the hood which will cause Medtronic much larger problems going forward.

All the device manufacturers that sell their products in the USA are tracked by the FDA with regards to the performance of their devices once they are implanted or used. One can track this information for themselves by using the following link to check on any company and the history of various products, just click here.  The report is the Manufacturer and User Facility Device Experience or MAUDE report for short.

 I ran a scan on Medtronic and some of its competitors (ABT, STJ, BSX and Guidant) using the basic parameter of all devices in which the report result was death, meaning the patient died as a complication of the device used or at least that is the designation reported. The result was that from the available reporting period of 1/1/2011 to 4/30/2011 Medtronic outpaced all the other companies with reports of fatalities related to their products by at least 3 to 1. You can see for yourself below the raw number totals.

Total Fatalities as a result of Medical devices by company for 1/1/2011 – 4/30/2011:

Guidant – 41

Boston Scientific – 91

St. Jude – 96

Abbot Labs – 793

Medtronic - 2899

I have been trying to figure out what causes the discrepancy but it seems that this number is disproportionately high for Medtronic. At first I thought maybe it was a market cap factor that they were just plain bigger than the others and that would explain it, however, Abbot is double the size and the others are only ½ to ¼ the size of Medtronic. Even on a size basis the numbers of deaths are way out of line since by that logic Abbot should have a number greater than Medtronic yet it is 1/3 of the size. If I had to conjecture it would seem to me that the problems with management have run very deep at Medtronic and they allowed it to affect the manufacturing and or quality process.

As I stated before the numbers above are only for the period of 1/1/2011- 4/310/2011 but what is more disturbing is to look at the full year totals from 2010 which I will list below:

Number of Fatalities reported 1/1/2010 – 12/31/2010:

Guidant – 126

Boston Scientific – 566

Abbot Labs – 322

Medtronic 2373

Even last year Medtronic was the leader in a category that a company surely does not want to be crowned king. Just looking at this year’s numbers versus this year’s, Guidant and Boston Scientific appear to be tracking roughly in line with the past. If the first four months of MAUDE reporting numbers are extrapolated this year than Abbot Labs should run somewhere in the neighborhood of 2000 fatalities which is bad enough but it is very troubling that Medtronic  looks to be poised to log in somewhere in 8- 9,000 fatality range.

 What I find amazing is that the FDA who is responsible for the MAUDE report has this information and can see the numbers, how come there has not been a peep from them at least not yet? Probably because no one with a platform from which to disseminate the information has done so until now. At some point the staggering numbers of deaths related to Medtronic devices is going to catch up with the company through continued market share loss because of perceptions of a lack of quality. Additionally, it should only be a matter of time before the FDA is motivated to at least inquire regarding the dramatic numbers revealed in the MAUDE report. Any exacerbation of the problems for Medtronic will lead to further declines in share price especially if they are found to be producing substandard products that kill patients will also kill earnings.

Looking at the chart for Medtronic one can clearly see that the latest quarterly results had an impact on the company and shares have sunk from the low $40’s to the high $30’s. On the daily chart Medtronic has violated an upward trend line that dates back to September 2010. The trend line is not quite yet broken on the weekly chart but given the downward bias of the market and Medtronic being in the position of having to turn things around quickly I would guess that trend line will fall as well.  To me the charts are starting to confirm the fundamentals and things not yet known by the public like this troubling MAUDE report.

For these reasons stated I am looking to short Medtronic on any bounce up to the $40 range as I believe the trend line it violated will keep a lid on the stock and it is likeier to decline than keep ascending as bad news and slow rates of management change will take their toll. My initial downside target is $34 which is roughly an 11% move from its current trade at $38.70. I would suggest using puts with at least a 6 month time horizon for a couple reasons: 1) you need to give time for the decline to build and 2) if you short the stock you will be required to pay the dividend which would impact your return.

Disclosure : Short MDT via puts




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