Health care companies have been caught in a state of limbo since the passage of Obamacare. The market is still sorting out who wins and who loses from the landmark health care overhaul. Meanwhile, Congress has plans to repeal or amend parts of the law. All of this leads to uncertainty about these companies’ futures. However, the market’s indecisiveness poses as an opportunity for enterprising investors to scoop up bargains.
The market is right to be uneasy in that the impact of the overhaul is not yet clear for many health care-related companies. However, long-term investors can still make good investments based on reasonable assumptions about companies in the industry. Doing so reveals more than one potential bargain.
Three potential bargains
A simple backward-looking analysis reveals three potential bargains in the medical device space. A bipartisan effort to repeal a tax on medical devices is currently underway in both houses of Congress; a successful repeal would bolster medical device companies’ future net income, thus increasing the value of the affected companies.
Although the market has had plenty of time to digest news of the effort to repeal, Medtronic, Inc. (NYSE:MDT), Boston Scientific Corporation (NYSE:BSX), and St. Jude Medical, Inc. (NYSE:STJ) remain inexpensive based on past operating performance.
The most conservative way to judge these companies’ performance is to look at how much cash they have generated in the past. More specifically, I want to know how much cash each earns for every dollar of sales it makes; this will help me determine how much cash each company should generate based on its current sales level.
Over the last ten years, Medtronic, Inc. (NYSE:MDT) has turned each dollar of sales into $0.21 in cash that it can distribute to shareholders, St. Jude Medical, Inc. (NYSE:STJ) turned each dollar of sales into $0.17, and Boston Scientific (NYSE:BSX) turned each dollar of sales into $0.13. These are the companies’ free cash flow margins.
To understand how much cash the companies should generate based on their current level of sales, I simply apply their free cash flow margin to the last four quarters of sales. Doing this, we get $3.5 billion for Medtronic, Inc. (NYSE:MDT), $965 million for St. Jude Medical, Inc. (NYSE:STJ), and $939 million for Boston Scientific Corporation (NYSE:BSX). So, I would expect Medtronic, Inc. (NYSE:MDT) to earn $3.5 billion in free cash flow in a normal year if its current operations (including its competitive position) remained exactly the same from now into eternity.
Now I take each company’s free cash flow figure and divide it by its current market capitalization to determine each company’s free cash flow yield. Doing this gives the following figures: Medtronic, Inc. (NYSE:MDT) 7.96%, St. Jude Medical, Inc. (NYSE:STJ)11.01%, Boston Scientific 8.30%. If Boston Scientific stayed exactly the same forever and returned all of its free cash flow to shareholders, investors who buy in today would receive an 8.3% annual return on investment.