Undervalued Dividend Growth Stock of the Week: Baxter (BAX)

yield-stockphotoBuying equity in a wonderful business and holding on for the long haul is one of the smartest things an investor can possibly do.

Fantastic companies tend to grow revenue and profit like clockwork, and I like to use my own “sniff test” which revolves around questioning whether or not a company rewards shareholders with a piece of that growing profit pie.

And the easiest and most direct way to get a slice of that pie is via a dividend.

See, public companies operate for the benefit of shareholders.

Shareholders, as a collective, own a public company.

And as owners, we should expect to collect when a business is more and more profitable year after year.

Furthermore, we should expect to be paid more and more over time as profits rise.

That’s why I stick to investing in companies found on David Fish’s Dividend Champions, Contenders, and Challengers list.

This tracks more than 500 stocks that have increased their dividend for at least the last five consecutive years.

But there’s more than just finding a great company and then buying stock in it.

It’s extremely important that you buy at the right price.

Valuing a stock is part art and part science, and David Van Knapp has published an excellent piece on stock valuation.

Ultimately, it’s important to remember that price and value are not one and the same. Everything in life that you can possibly buy, stocks included, come with price tags attached to them. And sometimes these prices are reasonable. Other times they’re expensive. But once in a while you get lucky and score a sale.

Think of the last time you went to the grocery store and scored something you were already going to buy when it was 25% or 50% off. Feels pretty good, right?

Well, that’s what I attempt to do with stocks. I attempt to come up with a reasonable valuation on a stock, and then buy as far under that as possible. Ensuring I’m buying under the reasonable fair value range I come up with gives me a margin of safety, in case my assumptions are wrong or the stock market falls shortly after my purchase.

The cheaper I can buy a stock, the greater the chance I’m getting a deal. And the more likely it is that I’ll see outstanding long-term returns. Furthermore, cheaper stocks come with higher yields, which means the same dollar can buy more dividend income.

I routinely scan my portfolio and watch list for stocks that are undervalued, and I’m going to share one of those potential opportunities with you today.

Baxter International Inc. (BAX) is a global healthcare company. They develop, manufacture, and market a number of medical products and services that are designed to save and sustain lives.

Baxter has been great at sharing profits with shareholders, and I’d know that firsthand as I own a stake in the company.

They’ve increased their dividend for the last eight consecutive years, and the dividend growth rate over the last five years stands at 16.4%.

Meanwhile, the stock yields a fairly healthy 2.91%. And their dividend is definitely sustainable and most likely going to continue growing from here, backed by a payout ratio of 58.6%. I tend to look for payout ratios of 50%, which means a company is paying out half of profits to shareholders and keeping the other half to continue growing the business. BAX isn’t too far away from that harmonious balance.

BAXBaxter’s stock has trailed the broader stock market by almost 50% over the last 52 weeks.

Now, underperformance over overperformance compared to the S&P 500 index isn’t necessarily indicative of value all by itself, as there’s a lot of factors that go into a stock’s price.

However, substantial divergences from the broader stock market does give an investor something to think about.

Baxter’s share price is about $71.50 right now. Does that price compare well to its value? Is the stock worth more than that?

Let’s take a look!

I tend to look at how a company has performed over the last decade, which gives me some base to work from when attempting to estimate future performance. After all, a stock is only worth the amount of cash flow it can provide from now until eternity, discounted back to the present day.

BAX has grown revenue from $9.509 billion to $15.259 billion from fiscal years 2004-2013 (which end December 31). That’s a compound annual growth rate of 5.40%. Not too shabby, and it’s also noteworthy that the revenue has grown in a fairly secular manner over that time frame.

Earnings per share increased from $0.62 to $3.66 over this same time period, which is a CAGR of 21.81%. This is particularly impressive, although that’s coming from a low base in 2004 due to share issuance and some product supply issues.

S&P Capital IQ predicts EPS to grow at a 7% compound annual rate over the next three years, which I believe is actually a bit on the conservative side. For instance, the company has released guidance for 2014 EPS in the $5.10 – $5.20 range, which is a ~40% improvement on 2013’s numbers. Furthermore, BAX has been great at buying back shares, repurchasing more than 100 million shares since the end of 2008.

Baxter sports a slightly leveraged balance sheet, with a long-term debt equity ratio of 0.96 at the end of 2013. However, the interest coverage ratio is strong, at 17.4.

Profitability appears sound. Net margin has averaged 14.89% over the last five years. Return on equity ended 2013 at 26.13%. These numbers compare favorably to competitors.

One really interesting aspect about Baxter is that they’re spinning off its biopharmaceutical unit in 2015, which could provide further upside to this stock.

So let’s take these numbers and see what we can do with them. After all, even a great business can be a bad investment if one overpays.

What’s BAX worth?

The stock is trading for a P/E ratio of 20.15. This does compare somewhat unfavorably to its five-year average P/E ratio of 17. However, the company is guiding for much higher earnings for 2014. Using 2014 earnings guidance, the P/E ratio would be closer to 14.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. This growth rate appears fair, as it’s significantly below what the company has been able to grow both earnings and dividends over the last decade. It’s also in line with the predicted growth rate for the foreseeable future. And the payout ratio is low enough to warrant future dividend growth in this range. This gives me a fair value of $74.19.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

But I can understand if you don’t want to take just my word for it. Let’s compare what professional analysts think of BAX here.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.

Morningstar rates BAX as a 4-star stock, with a fair value estimate of $84.00.

I also like to compare my analysis to S&P Capital IQ, another professional analyst service. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates BAX as a 4-star “buy”, with a fair value calculation of $84.00.

It looks like the analysts are completely in sync with one another, which probably reduces the chances of uncertainty. It looks like my analysis might have been a little conservative. Averaging all three of these values together gives us a fair value on this stock of $80.73. That’s about 13% higher than today’s price, which indicates pretty solid upside from here.

bax scBottom line: Baxter International Inc. (BAX) is a global healthcare company that has shown an excellent ability to grow both the top and bottom lines, and they continue to reward shareholders with increasing dividends. And a spin-off that’s going to occur in 2015 could provide a catalyst for further upside. The stock looks to be more than 10% undervalued right now, which may provide an enterprising investor a unique opportunity.

— Jason Fieber, Dividend Mantra

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