Undervalued Dividend Growth Stock of the Week: Medtronic (MDT)

January 1, 2017
By

I don’t have cable TV at home.

I do have a connection to the Internet, of course. And I have digital access to my local channels (NBC, ABC, etc.).

So I don’t feel like I’m missing out on anything I need to know.

But this is just one more way in which I live frugally, which has allowed me to routinely save excess capital to invest in high-quality stocks.

The routine I’ve developed whereby I save a very high percentage of my income and regularly invest in wonderful businesses has resulted in a real-life, real-money portfolio now worth more than $300,000.

More importantly, this portfolio is on track to generate more than $11,000 in dividend income over the next 12 months.

And because of that frugal lifestyle – I don’t need much money to pay my bills – I’m essentially retired in my early 30s.

But it’s because I invest in high-quality dividend growth stocks that all that dividend income is being generated.

I stick to dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of more than 700 US-listed stocks with at least five consecutive years of dividend increases.

I’m a dividend growth investor because I believe growing dividends is a fantastic sign of a quality business right off the bat.

Plus, as a part-owner in a company, I should receive my rightful share of its profit.

If a company can’t regularly grow its profit, it probably can’t consistently pay growing dividends to shareholders.

And if a company is able to regularly grow its profit, it should be sharing that with its shareholders.

Furthermore, the growing dividend income I’m collecting allows me to sleep really well at night.

While others who invest in stocks might be constantly worrying about the ups and downs of the stock market, looking at stock prices constantly, I have no such concerns.

While stock prices gyrate wildly from day to day, dividends are far more less volatile. And because dividends are sacrosanct for many companies, they’re fairly reliable.

So as someone who wants to be able to live off of my investment income at a young age, I’m relying on a source of income that is far more assured.

And that all brings me back to my original point about not having cable TV.

Even though I no longer have a day job, I don’t spend all day watching CNBC. I don’t pay attention to all the noise out there. I couldn’t even if I wanted to. Watching that stuff would require a subscription that would take money away from my investment capabilities, and the noise I’d be introducing in my life would be unnecessary and potentially harmful.

While others are busy watching stock prices scroll across their screen, I’m going about enjoying my life, knowing that my income doesn’t rely on volatile stock prices.

But as great as high-quality dividend growth stocks can be, one shouldn’t go out and buy any dividend growth stock at any price.

The first thing you want to do is analyze the business to make sure it fits your investment needs.

You want to make sure the business is in your circle of competence. And you want to make sure the quality is high enough.

The last thing you want to do is invest in a business that is on the cusp of cutting its dividend and/or start a long downward trend of profit reduction.

Beyond that, however, you also want to make sure you’re paying the right price.

What is the right price?

I’d argue the right price is as far below fair value as possible.

After all, price is just a number. Without knowing the value of something, price is practically meaningless.

Value gives meaning and context to price.

Price is what you pay for something; value is what you’re going to get in return.

So if a dividend growth stock is deemed to be worth $50, the right price is as far below $50 as possible. Paying, say, $30 for a dividend growth stock estimated to be worth $50 is probably going to turn out to be an excellent long-term investment.

That’s because, in this example, you’re buying an undervalued dividend growth stock.

And that undervaluation confers numerous significant advantages.

An undervalued dividend growth stock will likely come attached with a higher yield, greater long-term total return prospects, and less risk.

That’s all relative to what the same stock would offer at fair value or overvaluation.

The first benefit is present because, all else equal, a lower price equals a higher yield.

That higher yield gives a boost to the long-term total return prospects, since yield is a major component to total return.

Plus, total return is given a potential boost via the upside that exists between the lower price paid and the higher worth of the stock. That’s because capital gain is the other component to total return.

While a stock’s price can be very volatile over the short run, valuation tends to matter over the long run.

And if you paid far less than intrinsic value, the convergence of price and value is capital gain in your pocket.

Meanwhile, a long-term investor’s risk is lessened when paying less.

If you’re buying a static number of shares, you’re outlaying less cash.

And if you’re investing a static amount of capital, you’re buying more shares with the same amount of money.

Either way, you have a margin of safety on your hands when you pay much less than intrinsic value.

A lot of events can lower the value of a business (corporate malfeasance, new competition, etc.), but paying less means you have a lot of wiggle room before the investment becomes worth less than you paid.

As such, it makes sense to always aim to buy a high-quality dividend growth stock when the price is far below the estimated fair value.

While it might seem like this is a really difficult thing to do, it isn’t necessarily so.

For instance, there’s a (free!) tool right here on the site that makes valuing just about just about any dividend growth stock a breeze.

It’s part of fellow contributor Dave Van Knapp’s overarching series of lessons on dividend growth investing, and it’s definitely worth reading.

With all this said, I’m not going to just leave you high and dry.

I’m going to share some information on a high-quality dividend growth stock that appears to be undervalued right now…

Medtronic PLC (MDT) is a medical devices and technology company that develops, manufactures, and markets a variety of therapeutic products to hospitals, physicians, clinicians, and patients across approximately 160 countries.

A monster in the medical devices space, it became even more dominant after the acquisition of competitor Covidien in 2015 for approximately $50 billion. Covidien is seen as a complementary addition to Medtronic, since the former manufactures endomechanical instruments that should only bolster Medtronic’s cardiovascular and orthopedic offerings.

Medtronic provides products such as pacemakers, defibrillators, stents, heart valves, and insulin pumps.
With the world growing larger, older, and richer, the demand for access to high-quality medical devices is almost certain to grow over the long term.

And with Medtronic’s diversification, breadth, and expertise, it’s in a fantastic position to take advantage of this increasing demand.

But demand for their products isn’t the only thing increasing…

Medtronic has paid an increasing dividend to shareholders for 39 consecutive years.

Impressive already, it’s even more impressive when you consider that the 10-year dividend growth rate stands at 14.3%.

So this is a very large and very old company that’s still increasing its dividend at a rather rapid clip.

captureMeanwhile, the stock’s yield is sitting at 2.39% right now.

That’s a yield that’s higher than the broader market. It’s also twenty basis points higher than the stock’s own five-year average.

Plus, it’s a fairly appealing yield when considering the rate at which the dividend is growing.

While the payout ratio, at 57%, is moderate, it might indicate slowing dividend growth.

However, the company’s EPS has been severely impacted by the aforementioned acquisition of Covidien, which I’ll go over shortly.

Suffice to say, the “real” payout ratio of the company is well below 50%, when factoring in the true earnings power of the business.

So let’s get into that earnings power.

We’ll first take a look at what Medtronic has done, in terms of revenue and profit growth, over the last decade. And then we’ll see what a forecast for its near-term profit growth looks like.

Combined, this should give us an idea as to what Medtronic is capable of moving forward.

The company’s revenue grew from $12.299 billion to $28.833 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 9.93%.

Medtronic increased its GAAP EPS from $2.41 to $2.48 over this same time period, which is essentially no growth.

So what happened here?

Well, the recent acquisition has caused Medtronic’s GAAP EPS to take a hit.

However, this is just a short-term issue.

Factoring in adjustments, Medtronic’s EPS for FY 2016 would have been $4.20.

That would result in a CAGR of 6.37% for EPS over the last decade.

Looking out over the next three years, S&P Capital IQ believes that Medtronic will compound its EPS at an annual rate of 8%.

Medtronic believes that the acquisition of Covidien will ultimately prove to be accretive, so the acceleration of earnings makes sense here. Furthermore, Medtronic established its tax base in Ireland after the acquisition, which results in a substantially lower corporate tax rate.

The rest of the company’s fundamentals are really strong.

Medtronic’s balance sheet has historically been a sign of great strength, although the company did take on a lot of debt to fund the Covidien acquisition. Shares were also issued, however, resulting in some equity funding.

Still, the long-term debt/equity is sitting at 0.58.

The interest coverage ratio, though, is quite low right now, at just over 4.

But EBIT will surely rise after Covidien is fully integrated and Medtronic’s true earnings power is showing. I suspect the balance sheet will look even better in a few years’ time.

Profitability is similar in that it’s long been fantastic for Medtronic, but the numbers have been skewed negatively recently.

Nonetheless, the company has averaged net margin of 17.10% and return on equity of 14.04% over the last five years.

I think we’ll see these numbers look even better over the next five-year stretch.

So what we have here, in my view, is a high-quality company in transition.

The company’s diversification and breadth have only improved with Covidien. And a lower tax rate and accretive acquisition should only result in the acceleration of an already-solid earnings growth profile. Meanwhile, they’re positioned to take advantage of a world that will only likely place more demand on their core products.

But the stock is down ~17% over the last three months.

And I believe that has led to an opportunity…

Medtronic is expecting non-GAAP diluted EPS to fall between $4.55 and $4.60 for FY 2017. That would put the P/E ratio at 15.69 (using the midpoint). That compares very favorably to the five-year average P/E ratio of 18.0. It’s not a complete apples-to-apples comparison, however, due to the adjustment and use of guidance, but I think there’s a lot of merit to this perspective. Furthermore, the yield, as noted above, is higher than its recent historical average.

So it does look like an opportunity. But how great might this opportunity be? What is the stock likely to be worth?

I valued shares using a dividend discount model analysis. I factored in a 10% discount rate and a long-term dividend growth rate of 8%. That growth rate is much less than Medtronic’s 10-year dividend growth rate. And it’s in line with the forecast for their EPS growth moving forward. With a moderate payout ratio, I believe this analysis makes a lot of sense. Keep in mind, too, that the company just increased its dividend by more than 13% earlier this year. The DDM analysis gives me a fair value of $92.88.

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.

My valuation model indicates that Medtronic’s stock is worth much more than its current price.

But my analysis is just one of many. Let’s see how it stacks up to a couple other perspectives.

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.

Morningstar rates MDT as a 4-star stock, with a fair value estimate of $83.00.

S&P Capital IQ is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. 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 MDT as a 4-star “BUY”, with a fair value calculation of $88.00.

I came out a little high. But you can see a consensus here: the stock appears to be undervalued. Averaging out the three numbers gives us a final valuation of $87.96, which means this stock is potentially 23% undervalued right now.

mdt_chartBottom line: Medtronic PLC (MDT) is a high-quality company that may have become even more high quality with an accretive and complementary acquisition that also lowered its corporate tax rate. The company is likely to earn more and owe less in taxes. That leaves even more room for future dividend growth. On top of that, there appears to be 23% upside. Medtronic is positioned fantastically to take advantage of rising global demand for its products. It’s up to the investor to position themselves to take advantage of Medtronic’s upside and dividend growth potential.

– Jason Fieber

Dave Van Knapp: “I’m Investing $10,000 in These Dividend Growth Stocks on Tuesday, Jan 3″
As many of you know, Dave Van Knapp has been creating a general-purpose dividend growth “ETF” that the public can invest in. We’re excited to announce that as of January 1, 2017, it is now open for business. Click here for a sneak preview of the 29 dividend growth stocks in the “ETF”, as well as instructions on how you can invest in all of them at once for a trading fee of just $9.95.



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