Medtronic: Still a Keeper

Despite a recall of one of its medical devices, our pick for the best stock to own for the coming year still is a relatively safe investment.

In an environment of heightened caution about the safety of drugs and medical devices, Medtronic's recent admission that a component of its implantable heart devices was linked to five patient deaths came as a stunning blow to investors. The stock (symbol MDT) plummeted 11% that day and, at its October 24 close of $47.36, remains close to a 52-week low.

The news -- and the sharp drop in the stock -- stunned us, too. In The Best List cover story in the November issue of Kiplinger's Personal Finance magazine, we named Medtronic the "best stock" to own for the coming year, the one that we felt offered the best potential reward for the amount of risk involved.

Yet analysts are virtually unanimous in their judgment that Medtronic will recover most -- though not all -- of its short-term losses in market share for implantable cardiac defibrillators (ICDs), which regulate irregular heartbeats. In fact, even the most pessimistic 12-month price target among those offered by 19 analysts polled by Thomson/First Call is $52, an 11% improvement over the current price.

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Price targets, which reflect assumptions about future profitability that may or may not pan out, should be taken with a grain of salt. But they do reflect an honest attempt to quantify the damage from the voluntary recall of Medtronic's Sprint Fidelis leads, small wires that transmit a signal to the heart from ICDs. And the consensus seems to be that while Medtronic's better-than-50% pre-recall share of the U.S. ICD market-share percentage could fall into the mid-30s or low-40s over the next few quarters, the ultimate loss will be just a few percentage points.

Meanwhile, the Minneapolis medical-device giant expects to introduce a number of new products over the next few years, including artificial spinal discs and a drug-coated stent (a small tube that props open arteries), which should reduce its reliance on heartbeat-regulating devices. Medtronic gets 40% of sales from these devices, and the market for them has been growing slowly in recent years. Medtronic's sales of these devices were up just 2% for the fiscal year that ended last April 30.

Of course, there could be collateral damage to the recall. The market for ICDs had only just begun to recover from a series of product recalls in 2005. The latest incident could increase doctor skepticism about the devices. Citigroup analyst Matthew Dodds, for example, pared back his growth projections for the worldwide ICD market in 2007 from 6% to 2% and from 11% to 7% in 2008.

Medtronic's recall was voluntary, coming on the heels of data showing a 2.3% failure rate for the Fidelis lead after 30 months vs. a 0.9% failure rate for an older lead called Sprint Quattro. The apparently faulty leads associated with the five reported deaths are a small fraction of the 268,000 Fidelis leads that have been implanted.

Still, says Morningstar analyst Debbie Wang, the recall is an "appropriately conservative move on the company's part, especially in the current post-Vioxx regulatory environment, where the Food and Drug Administration is highly attuned to product safety issues."

The company must now ramp up production of its older Sprint Quattro lead, which is now used in only about 40% of its ICDs in the U.S. and even fewer internationally. Analysts say that could take several months. The Quattro lead, however, is not approved in Japan, so Medtronic will cede to its competitors some $20 million to $30 million in business there each quarter for now. (Leads and defibrillators from different manufacturers can be mixed and matched, but as a practical matter they usually are not.)

Medtronic says the recall will slash as much as $250 million from ICD sales for the quarter ending this October 31, and inventory write-offs and other costs will amount to as much as $40 million more. (The firm's total sales for heartbeat-regulation devices for the year ending April 30 were $4.9 billion.)

Morningstar's Wang projects a $600 million decline in ICD sales for the fiscal year that ends next April. She has lowered her estimate of the company's value by $2 a share, to $62, as a result. Looking at a worst-case scenario, she says that even if the company had to do without two full quarters of ICD sales, worth about $1.45 billion, that would knock another $4 off her estimate of Medtronic's value.

A number of analysts say they spoke with doctors who continue to express confidence in Medtronic's devices. That's one reason many expect market share losses to be limited. Jan David Wald, an analyst for Stanford Financial, an investment bank, forecasts Medtronic's ICD market share to fall temporarily to 36% in the U.S., from 53%, but to ultimately recover to 51%.

However, some analysts say doctors and hospitals may be more likely to spread their business among other manufacturers, including St. Jude Medical (STJ) and Boston Scientific (BSX), to reduce any damage from future recalls. Goldman Sachs analyst Lawrence Keusch sees Medtronic's ICD share falling by six percentage points in 2008.

The stock's recent travails closely mirror a similar event last summer, when Medtronic shares fell 10% in one day after the company warned of unexpectedly low first-quarter sales. The stock recovered the loss within four months.

There's no guarantee that will happen again, but Medtronic has a broad portfolio of products that can take up at least some of the slack left by the ICD business. The firm's vascular, diabetes, spinal and neurological products have been growing at double-digit annual percentage rates. And it expects to release its drug-coated stent in the U.S. market next year. That, says Citigroup's Dodd, will keep overall sales growth in double digits for 2008.

Meanwhile, the shares trade for a reasonable 17 times expected profits of $2.57 per share for the fiscal year ending next April, and analysts are looking for earnings to jump 16% in the April '09 fiscal year. In addition, the company generates mountains of cash, which it uses to pay a dividend that has increased every year since 1978.

The Sprint Fidelis recall vividly illustrates that even a stable, well-run market-leading company such as Medtronic can be a roller-coaster ride for investors, given potential product-liability issues in the health care sector. But the company's cash hoard, its size and market dominance, and its diverse portfolio still make it a relatively safe investment.

Contributing Editor, Kiplinger's Personal Finance