Medtronic PLC (NYSE: MDT) generated an outstanding return on equity of 5.6% over the past twelve months, while the Healthcare sector returned -35.1%. Even though Medtronic’s performance is highly impressive relative to its peers, it’s useful to understand what’s really driving the company’s strong ROE and how it’s trending. Understanding these components may change your views on Medtronic and its future prospects.
Medtronic’s Return On Equity
Return on equity represents the percentage return a company generates on the money shareholders have invested. Return on equity or ROE is defined as follows:
ROE = Net Income To Common / Average Total Common Equity
A higher return on equity suggests management is utilizing the capital invested by shareholders efficiently. However, it is important to note that ROE can be “manufactured” by management with the use of leverage or debt.
Medtronic’s historical ROE trends are highlighted in the chart below.
source: finbox.io data explorer – ROE
The return on equity of Medtronic has generally been declining over the last few years. ROE decreased from 7.4% to 6.7% in fiscal year 2016, increased to 7.9% in 2017 and decreased to 5.6% as of LTM Jan’18. So what’s causing the general decline?
What’s Driving Medtronic’s Declining Return On Equity
The DuPont analysis is simply a separate way to calculate a company’s ROE:
ROE = Net Profit Margin * Asset Turnover * Equity Multiplier
Created by the DuPont Corporation in the 1920s, the analysis is a useful tool that helps determine what’s responsible for changes in a company’s ROE. It highlights that a firm’s ROE is affected by three things: profit margin, asset turnover, and its equity multiplier or financial leverage.
Analyzing changes in these three items over time allows investors to figure out if operating efficiency, asset use efficiency or the use of leverage is what’s causing changes in ROE. Strong companies should have ROE that is increasing because its net profit margin and/or asset turnover is increasing. On the other hand, a company may not be as strong as investors would otherwise think if ROE is increasing from the use of leverage or debt.
So let’s take a closer look at what’s driving Medtronic’s returns.
Medtronic’s Net Profit Margin
The net profit margin of Medtronic has generally been declining over the last few years. Margins decreased from 13.2% to 12.3% in fiscal year 2016, increased to 13.6% in 2017 and decreased to 9.4% as of LTM Jan’18.
Therefore, the company’s decreasing margins help explain, at least partially, why ROE is also decreasing. Now let’s take a look at Medtronic’s efficiency performance.
Medtronic’s Asset Turnover
It appears that asset turnover of Medtronic has generally been increasing over the last few years. Turnover decreased from 0.28x to 0.28x in fiscal year 2016, increased to 0.30x in 2017 and increased again to 0.31x as of LTM Jan’18.
source: data explorer – asset turnover
As a result, the company’s declining ROE is not due to its asset turnover performance which has generally been increasing.
Finally, the DuPont constituents that make up Medtronic’s ROE are shown in the table below. Note that the table also compares Medtronic to a peer group that includes Abbott Laboratories(NYSE: ABT), Boston Scientific Corporation (NYSE: BSX), Edwards Lifesciences Corporation(NYSE: EW) and Stryker Corporation (NYSE: SYK).
source: finbox.io’s DuPont model
In conclusion, the DuPont analysis has helped us better understand that Medtronic’s general decline in return on equity is the result of a worsening net profit margin, an improving asset turnover ratio and declining leverage. Therefore when looking at the core operations of the business, Medtronic shareholders do not need to be too concerned due to the company’s general decline in profitability along with a general improvement in operational efficiency and declining leverage.
The DuPont approach is a helpful tool when analyzing how well management is utilizing shareholder capital. However, it doesn’t necessarily tell the whole story. For example, how do the company’s ROE trends compare to its peers or sector? How about in absolute returns? I recommend that investors continue to research Medtronic to gain a better understanding of its fundamentals before making an investment decision.
As of this writing, I did not hold a position in any of the aforementioned securities and this is not a buy or sell recommendation on any security mentioned.