This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Amnesty for a turkey?
Down 9% versus a 3% loss for everyone else, shares of medical-equipment maker Medtronic (NYS: MDT) have underperformed the Dow Jones Industrial Average (INDEX: ^DJI) since July. In the spirit of the season, I suppose you could call this stock a real turkey. But heading into National Turkey Day on Wednesday, Bank of America granted amnesty to Medtronic and announced that it was upgrading the shares to "buy." Why?

The analyst cited a number of factors that have it feeling optimistic about Medtronic. "CRM improvement," "top line growth," and valuation relative to competing companies to name a few. And there's something to that. Looking at Medtronic today, we see a stock that sells for less than 11 times earnings, versus share prices of 15, 14, and 13 times earnings, respectively, at Johnson & Johnson (NYS: JNJ) , Boston Scientific (NYS: BSX) , and St. Jude Medical (NYS: STJ) . So relatively speaking, yes, Medtronic looks cheap. But is it cheap for a reason?

I don't think so. In fact, I think Medtronic just might be cheap for no good reason at all -- and I agree with Bank of America that this just might make it a good place to put some of your money.

Valuation matters
Consider: On the surface, Medtronic already looks close to properly priced. Its near-7% projected growth rate outpaces those of both J&J and Boston Sci. Combined with a generous 2.8% dividend, it comes pretty close to justifying Medtronic's 10.6 P/E ratio.

And in fact, Medtronic may be even cheaper than it looks. The company already generates nearly $3.8 billion in free cash flow annually, after all. That's 10% more cash profit than the accounting profits Medtronic reports under GAAP accounting standards. It means the stock actually sells for less than 10 times annual free cash flow.

Better and better
Granted, even a 10 P/FCF ratio offers only a modest discount to 7% growth and a 2.8% dividend yield. But what if Medtronic grows faster than Wall Street thinks it will? Earlier this week, Medtronic did just this, exceeding analyst expectations for fiscal Q2 sales and earnings. Even better, management sent some strong signals that this kind of outperformance will continue in the future.

Noting that Medtronic has already cut $1 billion off its production costs over the past five years, Chief Financial Officer Gary Ellis promised that Medtronic will slim down by a further $1.2 billion over the next five years. The company is streamlining its logistics, making shipping and sales more efficient, and otherwise lowering costs. The goal: to make its products more affordable when competing for sales in developing markets against low-cost producers such as China's Mindray Medical (NYS: MR) .

Foolish takeaway
According to analysts, the average company in the medical-equipment industry is expected to grow at better than 16% over the next five years. Medtronic, however, looks to me like a better-than-average company. Between its past and future plans to lower costs and the potential to achieve greater sales -- and profits -- I believe the company will prove its skeptics wrong and grow faster than expected. If Medtronic can achieve earnings growth anywhere near the average for this industry, I believe in a few years we'll be looking back at today's 10 FCF valuation and see it for the real bargain it was (is.)

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At the time this article was published Fool contributorRich Smithdoes not own (or short) shares of any company named above. You can find him on CAPS, publicly pontificating under the handleTMFDitty, where he's currently ranked No. 311 out of more than 170,000 members.The Motley Fool owns shares of Medtronic, St. Jude Medical, and Johnson & Johnson.Motley Fool newsletter serviceshave recommended buying shares of Johnson & Johnson and creating a diagonal call position in Johnson & Johnson. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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