Sector : Medical Appliances & Equipment

 

Description :

• Health Care is one sector which is a necessity to every human being.
• People can live without iPhone, people can live without Coke,
  but in order stay healthy to enjoy those things, everyone needs
  medical attention.
• Here're few of the categories:-

Cardiovascular	Heart Valve	Replacement of Heart Valve
	Pacemaker	To regulate the heart beat which beats too fast
Orthopedic	Joint replacement	Replace wear/tear joints such as hip, shoulder, knee, etc
	Spinal Disk Replacement	Replace the injured spinal disc
Medical Instruments	Hospital Daily used instruments	Syringe, needles, etc ...
	Other high tech stuff	Diagnostic systems, devices used by other pharmaceuticals/bio-scientists, etc ...

 

 
Economic Moat :

High Switching Cost	Each company builds their own prototype of devices (hip joints, heart valve, etc ...) The installation process is different from company to company. Surgeons needs time to really relearn how to install a new brand of hip joint if they were to change to another new brand of device, which is very time consuming.
High Entry Barrier	It's not cheap to build a start up company that has to compete with all the existing huge ones.   Most hospitals/surgeons are reluctant to change from using the old, reputable and trustworthy brands rather than going for a newly launched brand product.

 

 

Growth & Profitability :

Pricing Power	Companies have great pricing power. Because they know that the high switching cost for their customers are what matters. After all, most customers (hospitals, surgeons, or even patients) don't really care how much they pay for their product. The bills are footed by the Insurance Companies (which is why insurance companies are not a so wonderful investments)
New/Unique product Features	Companies holds patents to their unique products' features. Product line gets their features enhanced and improves on every new roll out. With every new feature, this will attract more sales, and market shares. Which makes this another reason why it has high entry barrier for new startup companies, because it's extremely difficult (if  even possible) to start with a new product which could surpass the technology of a product which have gone thru 10-20 years of revisionary improvement.
Acquisition	One of the ways for companies of this sector to grow is to buy Patents thru acquiring other companies which holds useful patents. Acquiring small companies tends to perform better than buying over large ones. Often, companies will acquire another small companies which are having their product still under the R&D phase (product is not launched yet). The extra premium paid for this company will be charged under the Income statements IPR&D(In process R&D) category. Do take note.

 

 

Financial Health:

• Due to the fact that companies here have great pricing power, they too have high profit margins, mostly around mid teens or more (>15%).
• And because of that, most companies should have a decent amount of free cash flow pouring in every year.
• Which makes them somewhat a very good cash cow machine.
• And as such, there shouldn't be too much of a debt burden seen in companies here.
• but sometimes,taking debts are unavoidable in everyday business.
• So long as the debts are manageable, it should be fine.

 

 

Companies :
A few companies that are worth mentioning are listed below:-

• Zimmer (ZMH)
• Stryker (SYK)
• MedTronic (MDT)
• Becton Dickinson(BDX) (though not really a direct competitor, it does fall into the Medical Instruments Supplier industry too. Worth a check)

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MedTronic (Financial Metrics)

 

Industry : Medical Appliances & Equipment

 

Business :
Medtronic, Inc. (MDT) is a global player in medical technology. The Company operates in seven segments that manufacture and sell device-based medical therapies:

• Cardiac Rhythm Disease Management,
  
• Spinal,
  
• CardioVascular,
  
• Neuromodulation,
  
• Diabetes, Surgical Technologies
  
• Physio-Control.

Through these seven segments, the Company develops, manufactures and markets its medical devices in more than 120 countries. Its primary products include those for cardiac rhythm disorders, cardiovascular disease, neurological disorders, spinal conditions and musculoskeletal trauma, urological and digestive disorders, diabetes, and ear, nose and throat conditions. The primary markets for products are the United States, Western Europe and Japan.

 

 

Economic Moat :

10 year average:-
ROE	> 15%
ROA	> 10%
Net Margin	> 15%
FCF/sales	> 15%

Installing most of these implantable devices into human bodies requires a vast amount of time/effort to be learned. It's a way of locking customers to their own brand once the customers (hospitals/physicians/surgeons) are used to one brand, because switching to another brand will be a painful process, and very costly in terms of time and sometimes money wise.

 

 

 

 

Growth :

M&A	Acquiring small companies which are within their realm of expertise.
New product/services	Through acquiring new businesses, this allows them to widen their product base and variety. New product feature can be implemented into current existing products too.

 

 

 

 

Profitability :

• Free cash flow & Revenue has been growing steadily.
• But not the case with Net Income & Net profit margin.
• R&D spending has been consistent
• But SG&A expenses growth has been out pacing the Revenue.

 

 

 

 

Financial Health :

Long Term Debt	Long term Debt = $6.7B Last year's net income at $2.1B, it'll take MDT 3 years + to repay back the loans. Although it's not at the conservative side, it's still an acceptable number.
Short Term Obligations	Interest Expenses = $182M (for year 2010) Last year's net income = $2.1B Interest Coverage Ratio = 11x Still Acceptable

 

 

Competitors :
There are companies which falls within the same business field.
A few of those that are worth mentioning are listed below:-

• Zimmer (ZMH)
• Stryker (SYK)
• MedTronic (MDT)
• Becton Dickinson(BDX) (though not really a direct competitor, it does fall into the Medical Instruments Supplier industry too. Worth a check)

 

Summary :

• These are the Other Expenses in year 2009, which sums up to around $1.6Billion !!!! (Almost 73% of Net Income !)
• 
• 4 charges we made against MDT, (3 from J&J and the other one, i forgot already)
• Sales has not been growing Fast enough (9% for the past 5 years), compared to it's expenses growth in (12% for the past 5 years!)
• Company is currently spending on restructuring.
• but, there's so much a company can do in cost cutting. Themost important thing here is to focus on improving into top line (Revenue growth).
• I'm not very comfortable with the deteriorating numbers shown right now.
• Will still keep this company in my watchlist for future if it's condition improves.

 

 

Intrinsic Value :

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As most of the fundamentalist prefer using the Discounted Cash Flow in their Company valuation, I personally uses this particular method, which I call it, the Discounted EPS method.

Valuating a company's value is not an exact science.

As a person which is not from a financial background, I personally find the Discounted EPS method makes more sense to me, and thus, I just stick to this way.

 

 

 

Basically, the brief idea of the whole method is listed below:-

1.	Estimated the future EPS growth rate.	Look for the past 10 years EPS growth rate. Based on your own judgement, determine a growth rate which you think the company will be growing in the next 10 years.
2.	Calculate the estimated EPS in year 10 from now.	Use the current latest EPS. Compound it with the estimated growth rate for 10 years. We want to have a feel of what will be the EPS of this company after 10 years from now.
3.	Decide an average PE value.	Look back on the past 10 years PE value for this company take the average PE value.
4.	Calculate the estimated Share Price in year 10 from now.	Multiply 'Step 3' & 'Step 2', and we will get the estimated share price in year 10. That's the share price most likely the company will be trading at after 10 years. Get a feel of it.
5.	Decide an annual return rate that you want to get from this investment.	This is basically the same as the Discounted Rate mentioned in the Discounted Cash Flow. My personal goal is to earn a 15% return consistently every year from all my investment, thus, 15% is the discounted rate which you will see me using in all my stocks valuation.
6.	Calculate the Company's Intrinsic Value by discounting the year 10 stock price back into present value.	Use your rate of return that you've decided in step 5 as your discount rate. Calculate the present value of the stock using the Discounted rate. This will be the Stock price that you should be paying if you want to get a consistent annual rate of return that you have decided in step 5.

 

 

 

Easy to understand, right?

It really makes more sense to me.

To me, the money that I pay for the company (Buying price) is directly related to how much return rate I'm willing to accept.

If I'm willing to accept a lower rate of return, then the price of the stock can be anything higher.

But, if I want to earn a higher rate of return, then the company's stock price has to be at a very low price in order for me to achieve that.

Make sense?

 

 

Step 1 - Step 4 actually forecast where will the stock price be trading 10 years from now.

While Step 5 & Step 6 determines what price you should be buying this stock, assuming that you want to achieve the rate of return that you've determined, and that the stock will actually trade as your forecasted price after 10 years.

 

 

We do not really care what's the value of the company.

What matters most to us, is how much rate of return that we will be getting!

 

 

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Let's go through a real case study, by using the same company as we've used for the DCF method, Apollo Group.

 

 

 

 

1. Estimated the future EPS growth rate.

Here's the Earnings Per Share for Apollo Group for the past 10 years.

Let's calculate the past 10 years annual compounded growth rate for APOL's EPS.

Using the compound calculator, we get that the annual compound growth rate for APOL's EPS is a whoooping 26% !

 

 

 

 

2. Calculate the estimated EPS in year 10 from now.

By using the same Compound calculator to calculate the future EPS, we get that the future year 10 estimated EPS for APOL will be at around $42.

 

 

 

 

 

3. Decide an average PE value.

A look into the average PE for APOL for the past 10 years ...



... and we can say that, the average PE for APOL for the past 10 years is somewhere around 30.

 

 

 

 

4. Calculate the estimated Share Price in year 10 from now.

Thus, getting an estimated share price for APOL in 10 years from now will be easy.

EPS x PE == Share Price

And that will be $1260.

 

 

 

5. Decide an annual return rate that you want to get from this investment.

For me, that will be a 15%.

 

 

 

 

 

6. Calculate the Company's Intrinsic Value by discounting the year 10 stock price back into present value.

Now, this is getting interesting.

We need to Discount the future 10 year's $1260 stock price back and reflect it's present value, so that we know what is the price that we should be buying this stock in order for us to achieve a 15% rate of return.

By using back the same compound calculator, we can the Present Value of $311.

 

 

 

7. The easy way out.

Now that's for you to understand the whole process of this method.

Once you are pretty familiar and comfortable with it, you can skip by all the pain of using the compound calculators, and dive straight into using the Discounted EPS Calculator that I've created.

Just plug in the correct numbers and values, and this is the final thing that you will get. :)

 

 

 

 

 

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Calculating the intrinsic value of the company will be the last step in our Stock Valuing Process.

There's definitely no reason for use to overpay for a company's stock no matter how good the prospect of the company may look.

And thus, we need a valuation method to calculate the Intrinsic Value of a company.

 

 

 

There are 2 methods which I'm aware of.
- The Discounted Cash Flow (DCF)
- The Discounted EPS (DESP)

As I'm someone which is from a non financial background, I personally find the DCF concept a bit hard to grasp. 

I personally uses the Discounted EPS  method, as I find it making more sense to me.

 

 

Anyway, you may use both, as I believe both of them should work well if you truely stick with realm of expertise.

I chose to share the DCF first because it's the one method that are most widelyly used in today's findamental analysis.

 

 

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Here are the 5 steps for calculating a company's FCF.

 

We are working on a 10 year FCF modal.

1.	Forecast Next 10 years' FCF (using an estimated growth rate based on past FCF growth)	1st, we need to know how much FCF will the company be able to generate for the next 10 years. In order to do that, we need to estimate the possible consistent FCF growth for the next 10 years.
2.	Discount these FCF to Present Value (using a discounted growth rate value)	After having all the FCF that we estimate the company will be able to generate for the following 10 years, we need to discount it to present value. That's because, if the company is able to earn $1100 FCF next year, the value of that $1000 this year is only worth  $1000, assuming on a 10% growth rate. Imagine that, if you were to save $1000 in a bank right now which gives you a 10% interest, what would you get back next year? Exactly. $1100. That is why, a $1100 generate by a company which is expected to grow at 10% rate, is only worth $1000 today. Just think of the Discounted Growth Rate as the annual compound growth rate that you are willing to settle for.
3.	Calculate the Discounted Perpetuity Value (using a perpetuity growth rate)	A stock can't grow are a high value infinitely. It will come to a time whereby that is the furthers the company could ever grow, and things start to get saturated. That will be the time when the company's growth will start to drop, and get steady, almost inline with the economic growth of it's individual industry. Most of the steady industry has a consistent growth of 3%. That will be the perpetuity growth rate we will be using for most of the companies. As for companies which falls in already extremely matured industry, we will use 2% as the perpetuity growth rate.
4.	Calculate Total Equity Value (which can be also briefly assumed as the Enterprise Value)	Now we need to know after 10 years, what is the TOTAL FREE CASH that this company is able to generate for us. That's what matters. Therefore, we need to add all the FCF generate by the company throughout the next 10 years. ... and also the Perpetuity Value. Remember that everything we use to calculate the Total Equity Value needs to be Discounted to it's present value, because that's what we are interested at.
5.	Calculate Per Share Value	After having the Total Equity Value, we now will need to divide it with the total outstanding shares. This will give us the per share intrinsic value, which we can use it as a gauge to compare with the current market price of this company which is currently trading in the open market.

 

I know.

It is not easy, and pretty difficult to grasp.

The whole concept of this doesn't seem to be making a bit of sense at all. It happened to me too.

But once you continue practicing, the understand will grow deeper, and you will slowly see the story bit by bit.

 

 

 

 

Let's take a real case study from a company.

Let's take a look into Apollo Group's Financial Metrics. 

 

 

 

 

1. Forecast Next 10 years' FCF (using an estimated growth rate based on past FCF growth)

Here's the snapshot of the FCF for the past 10 years.


By using the compound calculator, we get an compound annual growth for the past 10 years as 26.15%.

By using an excel spreadsheet, we need to calculate for all the next 10 years estimated FCF that the company will be able to generate.

 

 

 

2. Discount these FCF to Present Value (using a discounted growth rate value)

By using an excel spreadsheet, we managed to calculate the FCF for each and every year, for the next 10 years that APOL will be generating.

We even discounted it back to their respective Present Value, based on a Discounted Rate of 15%.

Anyone that follows my blog knows that my goal for long term investing is to achieve a 15% compound annual growth, and that is why I chose the Discounted Rate of 15%.

Here's how it looks like
(the forecasted FCF is using an estimated growth rate of 26.15%, while the Discounted FCF is using a discounted rate of 15%)

 

 

 

3. Calculate the
Discounted Perpetuity Value (using a perpetuity growth rate)

Perpetuity Value = year 10 FCF x (1 + g) / (R - g)

where
g = perpetuity growth rate (3%)
R = Discounted rate (15%)

 

Plugging in the values, and this is what we get:-

Perpetuity Value	= $6880 x (1 + 0.03) / (0.15 - 0.03)
	= $7086.4 /0.12
	= $59056

Discount it back to Present value, with the 15% discounted rate (using the compound calculator again), and we get a Discounted Perpetuity Value = $14,598.

 

 

 

4. Calculate Total Equity Value (which can be also
briefly assumed as the Enterprise Value)

Now this is easy.

Total Equity Value	= Discounted Perpetuity Value + Total Discounted FCF
	= $14,598 + $11,615
	= $26,213

This will be the Enterprise Value of APOL.

If someone were want to acquire APOL right now, this will be the value that they at least have to come up with, to take over this company.

 

 

 

5. Calculate Per Share Value

Now, divide the Total Equity value by the Total Outstanding shares:-

$26,213 / 154.7 = $169

This will be the intrinsic value that we have reached, based on our 10 year modal Discounted Cash Flow on Apollo Group.

 

Well, APOL is currently trading at $50, which is like a 70% discount to it's Intrinsic Value (if all the number's we've plugged into our modal is what we truly believe in).

 

 

 

6. The Final Step

Was there a final step? I thought you said there were only 5 steps?

Well, you are right. :)

The previous 5 steps are just something that we need to understand how the entire DCF modal works.

Once you've understand how it works, we don't need to go thru the entire painful process every time we want to calculate the intrinsic value for a company.

Because I've come up with a Discounted Cash Flow Calculator.

^_^

 

 

 

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After looking at all the reasons for investing in a particular stocks (Step #1 - #4), we now look for reasons for NOT investing in a particular stock.

No matter how good the stock's industry is, 

No matter how wide the company's moat is,

No matter how good it's growth and profitability is,

If it is sick .... financially, there is no guarantee that it's gonna survive the next wave of influenza.

Ok. So how do I look at a company's financial health?

 

 

 

 

 

Basically, I look at a company's financial health the same way as I look at a normal person's balance sheet.

These are the 2 golden questions that you should be asking:-

• Is the company capable of paying of it's Short Term Interest(Installment) obligation?
• Is the company capable of paying back it's Long Term Debt?
  

 

 

Let's go through the above 2 points with a case study by looking into a balance sheet of a normal person, a working employee, an engineer, PinkPig, with a net saving of $2000 a month after deducting all basic expenses(food, accommodation, rental, etc)  and other loans (study loan etc).

Let's say, PinkPig just bought a new car, which cost $100k.

He puts up 10% as down payment ($10k), and took a $90k loan from the bank.

He needs to pay $1875/= as monthly installment to the bank.

So far, this is the information that we've got:-

PinkPig's annual savings	$24,000 ($2000 salary x 12 months)
PinkPig's annual Installment obligation	$22,500 ($1875 monthly installment x 12 months)
PinkPig's total Long Term Debt	$90,000 (loan from bank)

 

Now, let's start drilling into PinkPig's financial health by asking the above 2 golden question, using these financial metrics:-

 

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1. Long Term Debt Payback Time

Long Term Debt Payback Time = Long Term Debt / EBIT

This is basically a measure so that we get a feel of whether the company is REALLY capable of paying back all it's debt that it is owing the bank.

For PinkPig's case:-
- PinkPig owes the bank Long Term Debt of $90k.
- PinkPig's Annual Savings (EBIT) is $24k.

If PinkPig were to save up all his annual savings, how long will it take pinkpig to repay the total loan?

$90k / $24k, and we get around 3.75 years.

Anything which spans around 5 years or so is still an acceptable (and comfortable) number for me.

The key to this is just to have a feel whether the company is really capable of repaying back the Long Term Debts if they were to use up all it's Net Income into repaying their loans.

If you want to have a feel of what it looks like, take a look into Ford Motor's Financial Health here. 

In year 2009, Ford had a net income of $2 Billion.

You might say "WOW!!!"

Wait till you take a look at it's Long Term Debt .... which is standing at a whooping $133 Billion.

It takes Ford at least 66 freaking years to pay back it's Long Term Debt, by plowing back all it's net earnings into the bank.

And this is by assuming that Ford is capable of earning $2 Billion year in and year out, no matter what.

 

 

2. Times Interest Earned (Interest Coverage Ratio)

 (EBIT = Earnings Before Income-Tax)

PinkPig's Times Interest Earned(TIE) is
= PinkPig's Annual Savings / Annual Installment
= $24,000 / $22,500
= 1.067

 

 

The golden question number 1:-

• Is PinkPig capable of paying of it's Short Term Interest(Installment) obligation?
  

Yes. He is capable. Only if nothing unusual happens to him.

If something were to happen to him, and his saving drop by a mere 10% to  $21,600, he will have problem with that.

Either he will have to sell of something to repay the bank installment, or he will have his car confiscated back by the bank.

This is very crucial to companies, especially those that can't meet their short term debt obligation.

The only way for them to meet this short term obligation is to liquidate their assets, which will in turn eat into their core business, and eventually affect their long term business growth.

We definitely do not want to be put into a nasty situation like that.

Look for a TIE ratio which is pretty high.

The higher the better.

A company which has a TIE ratio of 10x means that it is capable of meeting it's short term obligation even if it's earnings were to drop 10x due to any unforeseen disaster (eg:- economy crisis).

Once a company is seriously wounded, it's really hard for them to be able to regain back their previous glory, not to even mention about fending of competitors and defending their once-used-to-be-market-leader status.

 

 

 

 

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