Medtronic (MDT): A Dividend Aristocrat With Double-Digit Payout Growth Potential

Medtronic (MDT) is one of the largest medical device makers in the world and, with 39 consecutive years of dividend growth, one of the venerable dividend aristocrats here.

 

Even more impressive? Over the last 39 years, Medtronic has rewarded income investors with 18% annual dividend growth, making it not only highly reliable, but also one of the fastest payout growers on Wall Street.

 

Let’s take a look at what makes this medical blue chip stock so special and see if it’s likely to continue increasing its dividends at a double-digit clip over the coming years.

 

While Medtronic may not sport the yields offered by some of the best high dividend stocks here, it may represent one of the few undervalued high quality stocks in this otherwise potentially overvalued market.

 

Business Overview

Medtronic is one of the classic American success stories, having been founded in 1949 by Earl Bakken and his brother-in-law, Palmer Hermundslie, in a Minnesota medical equipment repair shop.

 

Over the past 68 years the company has grown into one of the world’s largest medical equipment device companies, with 85,000 employees now working out of over 480 locations in about 160 countries and helping to treat over 40 medical conditions and 70 million patients in 2016 .

 

 

Medtronic acquired Covidien for roughly $50 billion in January 2015 to expand its presence in faster-growing emerging markets, bolster the size and scope of its portfolio of hospital supplies, and avoid some taxes by relocating its headquarters overseas. The deal about doubled Medtronic’s revenue and should help it gain more leverage and prominence on hospitals’ supplier lists as they increasingly look to cut costs.

 

Prior to the acquisition, Medtronic was primarily known for its cardiac and coronary devices (e.g. defibrillators, pacemakers, valves, and heart stents), diabetes care, spinal fusion, and neural stimulation businesses. Covidien focused on hospital and medical supplies, equipment for surgeries (e.g. surgical staplers), and its vascular therapies.

 

The company’s diverse portfolio of products is organized into four main business units:

• Cardiac & Vascular group: pacemakers, implantable defibrillators, cardiac monitoring and diagnostic systems, and heart valves.
• Minimally Invasive Therapy group (formerly Covidien): electrosurgical tools, fixation meshes, blood vessel sealing technology, vessel ablation products (for prevention of heart attacks and strokes), and patient monitoring systems such as endoscopic devices.
• Restorative Therapies group: for helping patients with brain, pain, spine injury recovery, as well as specialty needs such as reproductive, and digestive problems.
• Diabetes group: real-time blood sugar tracking and insulin management pumps, as well as less invasive diabetes treatment systems.

 

 

Business Analysis

Medtronic’s success over the decades has largely stemmed from its unrelenting focus on continually innovating new medical products to meet needs of a fast-growing and aging global population.

 

That means a rich history of large R&D spending (7.4% of revenue over the last 12 months), which has led to over 4,800 patents for world-changing inventions such as the pacemaker in 1957.

 

More importantly for income investors, who have been attracted to the company’s impressive dividend growth record, Medtronic enjoys a wide moat, courtesy of its quest to diversify into treating a growing range of medical conditions in its core business units, which have relatively large switching costs.

 

This can be seen in the company’s large development pipeline and future technology plans, which cover everything from surgical robotics systems to vessel sealing instruments.

 

 

Given the price-sensitive nature of the healthcare industry, developing successful new technologies and medical devices is essential to maintaining market share and healthy profitability.

 

A lot of Medtronic’s medical devices also significantly impact patients’ quality of life and must be of extremely high quality. The company’s specialized products can offer superior performance in many instances, allowing it to maintain strong market share and profitability.

 

In addition, thanks to a disciplined and well executed acquisition strategy, such as its $49.9 billion acquisition of Covidien, Medtronic has been able to extend its sales reach into new promising treatment areas, as well as faster-growing emerging markets.

 

 

Just as importantly, Medtronic continues to make frequent, smaller tuck-in acquisitions to help it maintain and increase its lead in advanced medical technology.

 

 

This combination of operating in a defensive (i.e. recession resistant) industry and making smart acquisitions has allowed Medtronic to generate positive sales growth for more than 10 consecutive years, including 13.2% annualized sales growth over the last five years.

 

 

In addition, Medtronic has recently entered an exciting new business, operating room and catheterization lab management. The company uses its massive scale and relationships with global hospitals to gain a steadily growing number of contracts that result in steady, recurring cash flows that should make future dividend growth even easier.

 

 

Most importantly, Medtronic’s management team has proven to be a group of skilled capital allocators. As a result, Medtronic continues delivering on its long-term profitability goals, such as the $850 to $875 million in synergistic cost savings that were an important component of the decision to buy Covidien (as was the ability to move its headquarters to lower tax Ireland).

 

 

Combined with a willingness to part with slower-growing and less profitable businesses, such as selling its medical supplies business to Cardinal Health (CAH) for $6.1 billion in 2017, Medtronic has been able to achieve impressive, above industry average margins and returns on capital.

 

 

Most important for dividend investors is the company’s high free cash flow (FCF) margin, because free cash flow is ultimately what funds the company’s generous capital return program (buybacks and dividends) for shareholders.

 

 

Of course, a very friendly shareholder corporate culture, while necessary for a dividend aristocrat, isn’t sufficient. That’s because management has to strike a good balance between using cash flow to invest in the company’s future growth, maintaining a strong balance sheet, and rewarding income investors with the steadily rising dividend they’ve come to expect from the company.

 

Fortunately, Medtronic has a solid capital allocation strategy that should serve it well in the future. You can see that the company expects to use its free cash flow and healthy balance sheet to continue rewarding shareholders while selecting reinvesting in opportunities that allow it to maintain a healthy investment-grade credit rating.

 

 

All of which means that Medtronic, thanks to its large economies of scale, strong dedication to R&D and new product development, and growing international opportunities, should be able to continue its impressive dividend growth track record for years to come.

 

 

Overall, Medtronic’s primary advantages come from its ability to continuously develop specialized medical devices in high profit areas of the healthcare market.

 

The company’s diversified product portfolio and the recession-resistant nature of its products provide reliable free cash flow which can be reinvested into the business to drive future growth.

 

As the healthcare industry focuses more on taking out costs, larger vendors such as Medtronic should benefit because of their economies of scale, product breadth, unique technologies, and existing customer relationships.

 

Key Risks

Dividend aristocrats (and future dividend kings) are generally low risk stocks, given their long track records of steadily growing sales, earnings, and cash flow, long-term focused management teams, and shareholder-friendly corporate cultures. However, that doesn’t mean there aren’t risks to consider.

 

For example, because Medtronic’s sales are increasingly coming from overseas, the company has growing foreign exchange risk. Specifically that means that if the U.S. dollar is very strong, as it has been in the last two years, its sales and earnings growth can face substantial headwinds, which happened in 2016.

 

 

Next, while Medtronic has a generally good history of acquisitions, both large and small, investors need to realize that every deal comes with a substantial amount of execution risk. Specifically that means potentially overpaying for a company and/or failing to achieve the synergistic cost savings.

 

In fact, a 2012 study by KPMG found that 83% of large cap mergers fail to increase long-term shareholder value because of these challenges.

 

That can be especially true in the medical field where small bolt-on acquisitions, which make up the majority of Medtronic’s deal flow, are with privately held companies.

 

Not only is it harder to value such firms, but because many of their products are in early development, it can take several years and millions of dollars of further R&D before Medtronic sees any sales or earnings to recoup its investment.

 

Finally, we can’t forget the biggest risk of all, government regulation and potential changes to Federal healthcare policy.

 

For example, while the passage of the Affordable Care Act (i.e. ObamaCare) resulted in 17 million Americans gaining healthcare coverage, and thus increasing Medtronic’s customer base, the law also instituted a 2.3% medical products excise tax which lowered the company’s profits.

 

And while the Trump administration had promised to repeal this tax (one of several medical taxes), the current version of the Senate GOP healthcare bill keeps these taxes in place while potentially vastly cutting government healthcare spending that could result in millions (up to 23 million, according the the Congressional Budget Office) of Americans losing health insurance coverage.

 

In other words, Medtronic could be facing a scenario in which its slower future earnings potential (from higher medical taxes) is no longer offset by the increased demand created by more customers.

 

Most medical device markets are fairly ruthless as well, despite some of their high-tech innovations. Products generally have short life cycles, are notoriously price-sensitive, and require constant R&D to maintain their market share.

 

Medtronic has meaningful scale ($30 billion in sales), strong market positions in its key segments, and a highly diversified product portfolio, but the company still had to reduce prices meaningfully during 2010-11 as the economy was slow to recover from the recession.

 

Medtronic’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Medtronic has a Dividend Safety Score of 82, meaning that its appears to be very safe and dependable, which isn’t surprising given the company’s record of 39 consecutive years of payout growth.

 

The key to this strong dividend safety and consistency is three fold.

 

First, Medtronic’s business is highly stable because regardless of whether or not the economy is strong, demand for high-end medical products is pretty constant. In fact, Medtronic’s sales and free cash flow grew each year during the financial crisis.

 

Next, management has been very wise in its long-term payout growth rate, meaning that Medtronic keeps a moderate EPS and FCF per share payout ratio. You can see that the company’s dividend has consumed less than 40% of its free cash flow most years, which provides the business with a lot of financial flexibility.

 

 

Note that the apparent large increase in 2016 payout ratios was a temporary results of one-time charges, including merger-related costs from the Covidien acquisition. In the past 12 months Medtronic’s FCF payout ratio was a much lower and safe at 42%.

 

That indicates that the current payout is protected by a very nice safety buffer which ensures that the dividend is not only highly secure, but likely to keep growing in the future, even in the face of potential future economic or industry hardship.

 

The final protective factor is Medtronic’s strong balance sheet.

 

Now at first glance it appears that Medtronic may be overleveraged, thanks to the large amount of debt it took on to acquire Covidien. However, it’s important to realize that this is a highly capital intensive industry, which means that a company’s credit metrics need to be kept in context.

 

 

For example, when we compare Medtronic’s balance sheet to its peers, we can see that, while its leverage ratio (Debt/EBITDA) is still high, it’s actually inline with the industry average.

 

Meanwhile the debt/capital ratio is below average and its strong current ratio means that the company’s cash flows easily service its debt and other liabilities.

 

 

That’s why Medtronic, despite having over $33 billion in total debt, still enjoys a very strong investment-grade credit rating that allows it to borrow at very low interest rates (average debt cost of 2.2%).

 

And given that management has a firm long-term plan to pay down the company’s debts, Medtronic investors can rest easy knowing that the business has plenty of financial flexibility to keep investing in growth, while still delivering the kind of double-digit payout growth the company is famous for.

 

Medtronic’s Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Medtronic’s Dividend Growth Score of 73 indicates that investors can expect above-average dividend growth (relative to the S&P 500’s 20 year median dividend growth rate of 5.7%) for the foreseeable future.

 

That’s not a surprise given that, while Medtronic has never been a high-yielding stock, it’s famous for its impressive dividend growth rate over the decades. You can see that the company’s dividend has consistently compounded by around 15% per year over the last two decades.

 

 

Going forward management expects to increase the dividend in line with its long-term, low double-digit EPS and FCF per share growth target. That seems like a reasonable estimate given that analysts expect the company’s long-term organic sales growth to come in around 4% to 5% a year, while ongoing cost cutting (driven largely by Medtronic’s economies of scale) should allow further margin expansion to add 1% to 2% a year to the bottom line.

 

Combined with continued acquisitions and 1% to 2% annual share buybacks, which boost EPS and FCF per share, that should allow Medtronic to continue growing its bottom line and dividend at around 10% to 11% a year for the foreseeable future.

 

Valuation

Due to market concerns over the uncertainties surrounding the potential repeal of ObamaCare, Medtronic has underperformed the S&P 500 by about 15% over the past year. However, that means the stock might offer an attractive opportunity for certain investors.

 

That’s because MDT’s forward P/E ratio of 18 is about equal to the S&P 500’s 17.6, but below Medtronic’s 13-year median value of 20.8, according to data from Gurufocus.

 

And although MDT’s current dividend yield of 2.1% may not be that much higher than the S&P 500’s 1.9%, it is higher than MDT’s historic median yield of 1.9%. In fact, over the past 22 years Medtronic has only yielded 2% or above 23% of the time.

 

In other words, today could be a reasonable time for long-term dividend growth investors to give Medtronic closer consideration. While there are a number of real risks to monitor as the healthcare industry evolves, MDT appears to offer potential long-term annual total returns of 12.1% to 13.1% (2.1% yield + 10% to 11% annual earnings growth).

 

Conclusion

While Medtronic’s low yield may not make it right for all income investors, such as retirees living off dividends, the company is one of the fastest-growing and perhaps most appealing dividend aristocrats in the healthcare sector.

 

Not only has the company’s long track record of double-digit dividend growth proven its business model has staying power in all sorts of economic, political, and interest rate environments, but its future dividend growth potential remains among the most attractive of any dividend aristocrat or king.

 

With shares trailing the market over uncertainty surrounding government healthcare reform, contrarian investors might be interested in giving Medtronic a closer look.

 

After all, it’s hard not to like the company’s diversified cash flow generated from numerous product lines, Medtronic’s large scale, which makes it an even more compelling supplier for hospitals, and the company’s exposure to an aging global population, which will likely drive greater demand for medical devices over the coming years.