MDT - Medtronic

[tombgrt]

Hi

I will try to explain why I think MDT looks like a great investment to me.
Notice that I am VERY new to investing, and value investing in particular. My expertise goes as far as a couple of months of reading about it.
None the less, I'll do my best and see this as an exercise. I would appreciate it if you would destroy my idea if you think it's rubbish. 
I took a lot of my (temporary) valuing methods from the book Rule #1 by Phil Town as I have only read this one and The Intelligent Investor and The Little Book thus far. I know it will have serious flaws but I believe it has at least some of the basics in it.

First off, MDT has a great moat. It is the biggest medical-device company in the world since many many years. Also, it isn't cyclical and in devices instead of pharmaceuticals which makes it more predictable. Thanks to future negative health care changes in the sector, this company is in an out-of-favor sector and all exaggerated expectations for the future were erased.

I looked at the past growth numbers for 10 years back and got to the following numbers, I hope they are correct  :
- ROE of around 22%
- BV/share growth of 11,30% (10y average), 10,4% (5y average), 11,6% (1y)
- EPS growth of 12,85% (10y average), 5y average not relevant or very useful due to crisis?
- Sales growth of 11% (10y average), 9,4% (5y average)
- cash from operating act. (FCF not very useful here, right?) around 14% (5y average)


This years earnings (bookyear 2011) will be around 3,38-3,44$, lets make it 3,35$. I'll take a 9% annual EPS growth rate for the next 10 years which seems conservative and realistic to me. Historical PE is quite high (around 20-25 I think) so I'll just take 2 times the growth rate, PE of 18.
At 9%/year, At earnings of 7,93$ in 10 years from now and at a PE of 18 that would translate in a stockprice of 142,75$ (That would be an annual return of 15,46%.).

If I would consider the rule #1 idea of going for a 15% annual return, I have to divide 142,75$ into 4 to get the "sticker price". This would be 35,70$.
Because MDT isn't just a random company with barely any moat, I would say 15-25% margin of safety on this price would be enough, or am I making a big mistake here? (Help me out on this thought please?)
This brings me to a final price in the range of 26,75$ to 30,33$.

It might also be notable that MDT is currently in the magic formula list if you get the market cap up high enough, but that shouldn't be a real surprise.

I haven't mentioned management but I think I don't have a very clear view on this part. Are there any free websites where you can find an accurate overview of insider ownership btw?

So, what are my mistakes? 

[Myth465]

Whats wrong with FCF? and Size INMO is no moat.
Perhaps the relationships and brand names could be a moat. If I was putting a device in or around my body I wouldnt go cheap and would want something with a great brand name.

15% - 25% MOS, means you would only make 15% - 25% on reflation, and would rely on buying and holding for the rest of your return. I dont know if thats a good way to approach it. If you have millions of dollars and want a steady eddie investment then it makes sense. If you are looking to grow your base then I dont think this is the best way to do so.

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I would say you need to consider your goals / needs before looking at ideas.

What are your investment goals?

Also models - garbage in, garbage out. What makes you think they wll grow at 9% a year and keep growing at 9% a year until they get a PE of 18. Would you pay 18 times earnings for this?

Where is the qualitative side of things? What do you think of Management? What are they doing with the cash (are they setting it on fire by buying crap at high prices thus destroying value)? Are they gaining share or losing it? How do they plan on growing at 10% a year indefinitely? How much stock do they own?

[Myth465]

I guess I sort of just beat you up without offering much.

Bruce Greenwald says you need 3-4 things to properly invest. I tend to agree with him.

An Investment Framework / Allocation Plan.
A Search Strategy.
A valuation Engine / Template for reviewing investments.

I recommend coming up with these 3-4 things for yourself. I have pieced together info for each of the items listed above and try to invest within that model.

In terms of the valuation engine, You should probably develop a checklist / framework. I have stolen Buffetts and added quite a bit to it. I think about it and have things mapped out before investing but, hardly ever write things up until long after the fact. Mohnish has a fairly detailed checklist, and I believe Parsad said he doesnt use a checklist (I am guessing he has a model in his mind or on paper though). You have to find something that works for you.

Here are 4 questions you should always answer for an Investment. Dont thank me, thank Buffett. I tend to steal vs. Innovating. I added one filter which was stolen from someone else. There are a few other things I look at - ratios, analytics, some qualitative questions, a basic model - but this is the main driver of whether I invest or not.

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Buffet's 4 Filters Plus 1

We make quick decisions because we have filters before we get to the point of making a decision.

Filter #1 – Can we understand the business?

Note - Warren Buffet, "To understand a company is to understand its products, its competition, and its earning power." Do you know what drives cash flow and is it sustainable?  Do you understand what factors drive the stock price & the firm's bottom line in both the short and long term? What will it look like in 10-20 years?


Filter #2 – Does the business have a durable competitive advantage?

This is why I won’t buy into a hula-hoop, pet rock, or a Rubik’s cube company. I will buy soft drinks and chewing gum. This is why I bought Gillette and Coke.

Since 1972 we have made no change in the marketing, process etc. Take See’s candy. You cannot destroy the brand of See’s candy. Only See’s can do that. You have to look at the brand as a promise to the customer that we are going to offer the quality and service that is expected. We link the product with happiness. You don’t see See’s candy sponsoring the local funeral home. We are at the Thanksgiving Day Parades though.


Filter #3 – Does it have management I can trust?

Note -Bruce Berkowitz, Has management been tested by rough business cycles and are they rational owner-managers with skin in the game. Does management over deliver or over promise? Is management significantly selling shares or diluting ownership through aggressive stock options? What does management plan to do with FCF?

Also check the proxy to see how Management is compensated, does the plan make sense?

Note - You own this business but, do not control it so make sure that Management is smart and focused on its owners. It helps if Management owns a lot of stock because they will then have similar interests as you. Make sure Management is properly allocating FCF and responsibly managing the business. Also ensure that Management understands ROIC.


Filter #4 – Does the price make sense?

Note - Warren E Buffett "If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety…"

No Growth Valuation - Monish Pabrai regarding FCF calculation. "There is no need for Excel. If a business has zero growth and consistent stable cash flow, that business is worth 10x FCF plus any excess capital."  This assumes approximately a 10% discount rate and results in a 10% free cash yield. 

Conservative Growth Valuation - Monish Pabrai regarding FCF calculation. If there is growth, depending on how much and how consistent, I’d be willing to value it at 12-15x plus excess cash.

Filter #5 – What did I miss, Why is this so cheap?

Did you browse the 10k, read the 10k notes, and read the proxy for compensation info?

An additional filter based on Li Lu's lecture at Columbia business school. Also covers Munger's Invert Invert Invert.

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Major Holders and Insider Ownership - http://finance.yahoo.com/q/mh?s=MDT+Major+Holders
Warren Buffet - A public-opinion poll is no substitute for thought. With that said, I like when people who are much smarter then me are buying.

I always review the presentation - Its like a cliff notes for the investment. http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NjI1ODl8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

After a 5 minute review, it appears to be a decent enough company. They make a few acquisitions, buy back stock, pay a decent dividend, and are in a great industry. The question is inmo will it give you the returns you want?

[ExpectedValue]

The problem with the Pabrai approach to multiples, I think, is that he is not weighing the discount rate issue as much as he should. Just slapping on a 10% discount rate seems a bit imprudent. I would apply a 10% rate to a great business and then scale up from there.

To help think about multiples, view the following chart:


via: Distressed Debt Analysis (Amazon)

I think in distressed businesses you'll see investors seeking a higher discount rate (15%+ in this environment) and if you are assuming that the business is 0 growth, you'll end up with a 6.5x FCF valuation (instead of the 10x advocated by Pabrai). That should have implications on the kind of purchase price you decide to seek out.

The chart above fails to take into account the ways FCF might grow at different periods, so it's best used for a rough approximation/mental math when quickly looking over companies.

[Bronco]

Moat to me means strength against competition.  Size could indeed invite competition.

Sears has size.  No moat.

I haven't done any work on MDT but the key will be how the new health care legislation will impact sales.  And I have no idea.  Quite frankly, the health care sector holds no interest to me due to the government.  If anything, I would invest in JNJ or ABT, which do have some moats perhaps.

[Myth465]

Thanks alot Tariq. I have added the chart to my model, Its nice to have all the math worked out, one just needs to correctly pick the right number. To be fair to Pabrai, I am probably crappily paraphrasing. He did emphasis that one has to be certain about the cash flows for 10x.

For me I mentally adjust the multiple down if I dont think the business is strong or its too cyclical, or if I generally have no idea how much they will make.

ATSG has been worth 4x-8x for me (Due to Debt and Uncertainty) and inmo is now probably closer to 10x FCF due to the reoccurring nature of the earnings and the long term contracts in place. FBK isnt worth anywhere near 10x, I tend to put 5x - 7x on it due to my low faith / knowledge of pulp prices.

I think the qualitative is much more important, and if one looks at a business and asks himself whats a reasonable price he will typically do well. You would except 10% in a low inflation environment if that 10% was fairly certain. To me that seems like a fair return. To invest in an FBK or ATPG you want alot more than 10% because you are alot less certain about the investment / range of outcomes.

[tombgrt]

Thanks for the comments, especially you Myth. And you aren't to hard on me, I can take it.  

I'll have to answer quick because I actually have to go. FCF is a problem because they invest a lot in recent years and then cash flow almost turns to negative although cash from operating act. is doing great. Can't I just look to that then?

Maybe I didn't explain myself enough on the moat. To me MDT has a great moat because it has a brandname that is known all over the world and especially for things like health both doctors and patients have the tendency to stick with what they know and what they always liked. For doctors and hospitals, switching to another brand isn't that easy. I also believe they have "some" moat because of their know how for example. Not sure how they would do in terms of pricing. A new competitor that would take a big chuck of MDT's marketshare could possibly always show up, but it never ever did in the past so I don't really see why there could be a very large threat in the first coming years. Or is that just naive?

Good point about margin of safety, but wouldn't the duration until reflation also provid a good growth in earnings in the meanwhile? Maybe I am just a know-it-all and I should truly look for that 50% regardless of the company's strength. ;x

Ill try to formulate my opinion on the rest of your remarks later. Thanks again!

[biaggio]

Tombgrt, thanks for posting idea.

Myth , thanks for post above.

Tombgrt, I use gurufocus.com to get quick overview re insider trading, financial statements etc...checkout site for MDT

http://www.gurufocus.com/StockBuy.php?symbol=MDT

Appears to have some significant insider trading,as well some purchases by well respected investors which is reassuring but agree with myth that it is ok to copy but you have to do your own homework.

I have been trying to use a checklist as well. Here is some check points that I have borrowed from elsewhere(sorry to the author, I cant remember where I got it from):


Core Investment Checklist

Do the Pre Work

Preliminary Background Reading

   •   Read previous thesis on Blogs / Investing Sites / Forums / Alerts
   •   Read news headlines
Valuation

Financial Statement Analysis

   •   Go through line by line

•   Income statement + competitive advantage analysis
   •   Balance sheet + competitive advantage analysis
   •   Cash Flow statement + competitive advantage analysis
   •   Quality of Earnings (Inventory, tax, EPS)
Competitor comparison
Verify 15 value investing metrics and ratios
Discounted Cash Flow/ Graham’s Value/ Earnings Power Value/ Multiples/ Sum of Parts

Dirty Work 

   •   2 annual reports
   •   3 quarterly reports

•   specific attention to footnotes at the end of the report
   •   managers discussion – consistency, candidness
2 letter to shareholders
   •   compare words, numbers to annual report numbers
Latest proxy
   •   CEO compensation (% of sales)
   •   Greed factor (bonuses, reimbursements, planes, boats, family donations)
   •   Insider ownership
Search CEO history, track record, personality



Emotional Check 

   •   Write down how you are feeling
   •   Beware of

•   wanting to just buy and study later
   •   hindsight bias
   •   overconfidence
   •   obligation to buy due to amount of research
   •   reluctance to accept differing opinions
   •   social proof bias
If required, take a break and clear your mind. Get away from the excitement and noise. 

Final Evaluation 

   •   What can go wrong?
   •   What are the risks? How likely are the risks?
   •   How can you lose money?
   •   How would you categorise this investment?
   •   How attractive is this idea compared to the other holdings? (There can only be ONE best idea. Not 2 or 3.)
   •   What is the expected holding time frame?
   •   What should be the portfolio sizing?
   •   What price will you sell?



[tombgrt]

Biaggio, thank you for the reply. It's also very useful.  

I have read the posts more thoroughly now and realize I will need a REAL Checklist and solid valuation engine if I want to keep learning and actually get results.

The fourth book I was going to start reading is Value Investing From Graham To Buffett And Beyond. Is it any good if I am hoping for some more framework that the other three books didn't really offer (although I did learn a great deal from them)?

[Myth465]

Thanks for the comments, especially you Myth. And you aren't to hard on me, I can take it.  

1. I'll have to answer quick because I actually have to go. FCF is a problem because they invest a lot in recent years and then cash flow almost turns to negative although cash from operating act. is doing great. Can't I just look to that then?

2. Maybe I didn't explain myself enough on the moat. To me MDT has a great moat because it has a brandname that is known all over the world and especially for things like health both doctors and patients have the tendency to stick with what they know and what they always liked. For doctors and hospitals, switching to another brand isn't that easy. I also believe they have "some" moat because of their know how for example. Not sure how they would do in terms of pricing. A new competitor that would take a big chuck of MDT's marketshare could possibly always show up, but it never ever did in the past so I don't really see why there could be a very large threat in the first coming years. Or is that just naive?

3. Good point about margin of safety, but wouldn't the duration until reflation also provide a good growth in earnings in the meanwhile? Maybe I am just a know-it-all and I should truly look for that 50% regardless of the company's strength. ;x

Ill try to formulate my opinion on the rest of your remarks later. Thanks again!

1. INMO FCF or Owners Earnings is the most important metric for non financials (I dont like asset plays, though I am in 2 right now).

Lets say you own a company. Free and clear, Its yours, even named after you. Lets call it Biglari I mean Tombgrt Holdings. Lets also say you are really smart but prefer reading and playing golf all day. You find this genius to run the company, but he makes you agree to never bother him about operations, and will also decide how to allocate all of the earnings. He may write you a letter each year if he has time, but it will probably be something the PR department cooked up. The photos will be nice though.

This is what its like being a public shareholder, except you own .000000000001% and the company isnt named after you. In the situation above wouldnt you want to know what he does with your earnings each year? What does it matter if he makes a ton of money but then literally throws a party with a bunch of hot chicks and his buddies. They sit around and smoke cigars using your earnings to get the cigar going. Would you feel better if he told you he made a ton of money, look at the income statement, but he used it all to buy companies because you pay him by the size of the company and his friend has a bigger company. The companies dont make much money. But they need a bigger building, and now he has 3 Operating Presidents vs. 1. They also need a new plane to fly around to visit all of the new companies and acquisition targets.

This is what happens when you dont look at FCF or Owners Earnings. So what if they make alot of money. The question is will you make alot of money, based on what they do with the money. See the next post for more detail.

2. AIG was a great insurer. GM was the number 1 auto maker in the world. There was never a significant leak of Hydrocarbons in the Gulf (US Side) prior to 2010. Barrack Obama had a high approval rating. The past is just the past. Its no indication of the future. Knowing next to nothing about MDT, I would say that they will likely stay on top, as an Investor I would need a bit more in terms of a moat / or idea about the future. I think the relationships with Drs. is a start. Now that I think about it I dont think patents care or will know the difference between 1 pace maker or another. The patents and Drs. are the key here.

3. I think your assumptions are fine. Its really about what you know and what you want. I dont know much about a company (even when I know alot). Everything is so clean when you look at a P&L / BS but companies are big hot messes. Many moving parts and ways to lose. MOS for me is a catchall, it protects me from my mistakes (there are many), Management mistakes (I like to think more are here), and finally those famous BP style black swans. When you haircut MOS you are saying you know alot and things shouldnt go wrong. I dont know much, things go wrong, and the economy sucks (sometimes when things are moving up you get bailed out of bad decisions). You also have significant regulatory risk. I was at an Acct seminar today and a health care expert spoke. He said on its current trajectory a family of 4 who made $80k would be spending 25% of their income on health-care in 10 years. That isnt going to happen. Someone is taking a haircut. These guys have a good lobby but so do Drs, Big Pharma, and Big Insurance - that wealth or bite is going to be spread around. Wouldnt you want some MOS in case its bigger for MDT. With that said alot of my Owner Manager ideas are at 70% - 90% FV. I like the Managers and hope they will create  value for me. For holdings where Management is crap or barely passable (FBK, ATPG) I want a serious MOS. I just hope those guys make it to work on time, and dont leave the door unlocked.