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

There are a lot of ways to make money in this world.

But you know what? 

There are also a lot of ways to go broke in this world.

Unfortunately, many supposed business/investment ideas fall into both categories… simultaneously.

For instance, I now live in Chiang Mai, Thailand.

And I was just listening to a conversation yesterday from/about a guy who’s interested in opening a bar here in Thailand.

This older gentleman doesn’t seem to have a lot of money, but he believes this is a good idea.

Now, maybe it is a good idea. Maybe it’s not.

I’ve run into a few successful bars here.

But I’ve also run into very many unsuccessful bars, as well as bars that have been closed. And I’ve heard about a dozen sob stories from foreigners who come here with big investment dreams only to end up broke.

The thing is, many investment ideas can make you a lot of money, or they can lose you a lot of money.

Why play that game?

I instead put my capital to work with high-quality businesses that have a demonstrated track record of being very good at making money for shareholders like myself.

Better yet, they share that money-making prowess with shareholders directly, in the form of dividends that are regularly and reliably being paid and increased.

I buy these high-quality dividend growth stocks when they’re attractively valued. I hold for the long term. And I diversify myself across more than 100 of these businesses. 

This methodology has allowed me to build a real-money, real-life, six-figure dividend growth stock portfolio.

Most of my personal holdings have been culled from David Fish’s Dividend Champions, Contenders, and Challengers list, which is a document that tracks more than 800 US-listed stocks that have paid increasing dividends for at least the last five consecutive years.

And my portfolio generates the five-figure passive dividend income I need to cover my basic bills in life, rendering me financially independent in my 30s.

Plus, this dividend income is growing organically – completely by itself – due to the very nature of these stocks and how these businesses go about increasing their profit and dividends.

After all, when’s the last time you heard of someone going broke by building a diversified portfolio full of high-quality businesses that are wonderful at making and sharing profit?

You’ve likely never heard of this happening. I certainly have never heard of it. And that’s because it’s practically impossible.

A lot of business/investment strategies feature a high degree of both success and failure. Often, the higher the potential reward, the higher the chances of failure.

If you’re okay playing that game, go for it.

But I think I’d rather stick with a investment strategy that has an almost 100% chance at lasting wealth and growing passive income, with an almost 0% chance of failure. Plus, the potential long-term rewards are rather fantastic.

This all said, there are ways to improve upon what’s already at its core a very good way to approach your long-term financial planning.

While Mr. Fish’s list contains information on many high-quality businesses, not every stock is a good idea at all times.

Some businesses are run better than others. And some stocks are available at much better valuations.

You obviously first want to make sure you’re investing in a great business that you can reasonably understand. You want to see great fundamentals. And you want to see durable competitive advantages.

But perhaps even more important, you want to make sure you’re investing when the valuation is attractive.

You want to try to buy a high-quality dividend growth stock when it’s undervalued. 

While price is what something costs, value is what something is actually worth.

Confusing the two can get you in trouble, while being constantly cognizant of the difference in the two can potentially put you in a great spot.

When a high-quality dividend growth stock is undervalued (when its price is below its intrinsic value), it can lead to a number of strong benefits being conferred to the investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk. 

This is all relative to what the same stock might otherwise present an investor if it were fairly valued or overvalued.

It’s easy to see how this all plays out.

Price and yield are, first off, inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield positively impacts one’s potential current and long-term, aggregate passive income.

You could not only collect more income almost immediately, but you could be looking at a lot more income over the life of the investment.

In addition, this higher yield also positively impacts one’s long-term total return potential, as income (dividends or distributions) is one of two components of total return.

That’s more income leading to what could be a stronger total return over the long run.

Plus, the other component of total return (capital gain) can also benefit via the “upside” that exists when price paid is much lower than intrinsic value.

While the stock market isn’t necessarily all that great at pricing stocks appropriately over the short term, price and value tend to more closely align over the long haul.

It should be obvious that this reduces one’s risk.

That’s because one builds in a margin of safety when they pay less than fair value. And the further below fair value one pays, the larger the margin of safety.

If you estimate fair value at $50 and pay $50, you’ve got no margin of safety. You have no protection in case you’re unfavorably incorrect on your fair value estimate.

But if you pay $30 for this same stock, you have a lot of wiggle room in case some kind of negative event were to negatively impact the stock’s fair value.

With all of this in mind, one might expect these benefits to be hard to come by.

But that’s not necessarily true.

However, one must first be able to estimate fair value.

Fortunately, fellow contributor Dave Van Knapp has made this a relatively painless process, with his dividend growth investing “lesson” on valuation being an excellent primer on the subject.

Moreover, this very article is part of a multi-year series that highlights what appears to be an undervalued high-quality dividend growth stock, every week.

And we’ve got another compelling investment idea for you readers…

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.

One trend that is extremely “bankable”, allowing one to operate with a high level of confidence that they’ll continue to increase their wealth and passive income, is that the world is growing older, larger, and wealthier.

Our planet’s population continues to expand. Meanwhile, each new generation becomes significantly wealthier than the preceding generation. And this is all occurring as people live longer than ever.

While this global trend bodes well for most businesses in general, it will likely disproportionately positively affect companies in the healthcare space, as demand for high-quality healthcare products and/or services (those that are directly impacting the aforementioned longevity of humans) will likely increase from all three aspects of this trend.

After all, healthcare isn’t really a “discretionary” purchase. It’s many times a life-or-death choice. And if you want to live longer and/or live a higher-quality life, and if you have the available wealth, you’ll often spend whatever you have to in order to make that happen.

This is exactly where a company like Medtronic fits in, as its portfolio, including leading positions across the likes of pacemakers, defibrillators, stents, heart valves, and insulin pumps, positions it perfectly to capture and profit from rising demand for high-quality and life-prolonging/saving healthcare products.

But this would sound like a lot of bluster if Medtronic weren’t delivering increasing profit and sharing that increasing profit with its shareholders.

However, that’s not the case at all.

Medtronic has one of the most impressive dividend growth streaks in all of healthcare, with 40 consecutive years of rising dividend payments to its shareholders.

And lest you think they’re increasing their dividend at a pittance level just to keep some streak alive, keep in mind the stock’s 10-year dividend growth rate stands at 14.7%.

So that means 30 years into their dividend growth story, they spent the next decade handing out 14%+ annual raises.

This story isn’t over, though.

The payout ratio is 50.5%, which is pretty much a “perfect harmony” between retaining profit for business growth and sharing profit with shareholders (who are the actual collective owners of any publicly traded company).

That portends continued dividend growth for many years to come.

The only thing to keep in mind, though, is that the most recent dividend increase was 7%. That’s half the 10-year DGR, but it’s also still well in excess of inflation.

But this isn’t just a dividend growth story, as the stock also offers a fairly appealing mix of both income and income growth.

To that point, the stock’s current yield is 2.27%.

That’s higher than both the broader market and the stock’s own five-year average yield.

So the earlier point about undervaluation and higher yield is playing out here.

Plus, you’re looking at great potential for high-single-digit dividend growth for the foreseeable future, on top of that market-beating yield.

But in order to start building that dividend growth expectation, we must first build an expectation for overall business growth moving forward.

And there’s no better place to start than by looking at what the company has already done over the long haul (using the last 10 years as a proxy).

We’ll then compare those long-term results to a near-term forecast for growth.

Blending the past and the expected future in this manner should give us a reasonable idea as to what to expect from Medtronic moving forward.

The company has grown its revenue from $13.515 billion to $29.710 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 9.15%.

A very strong result here. For a large and mature company like Medtronic, I actually look for mid-single-digit (5% or so) revenue growth.

However, Medtronic completed the large acquisition of competitor Covidien in 2015, for approximately $50 billion. This complementary addition to the company (with Covidien focusing on endomechanical instruments, adding to Medtronic’s cardiovascular and orthopedic offerings) boosted the top line in a major way.

The bottom-line growth (especially in relative, per-share terms) over this same period gives us a better idea of Medtronic’s true growth profile. That’s not just because dividends will ultimately be funded by profit (or free cash flow, more accurately) instead of revenue, but also because Medtronic issued a lot of equity to fund part of the aforementioned Covidien acquisition.

Medtronic increased its earnings per share from $1.95 to $2.89 over this period, which is a CAGR of 4.47%.

We see that dilution affecting EPS growth here – the outstanding share count has increased from ~1.142 billion to ~1.391 billion. And we also see a dividend that has expanded much further than what EPS growth would usually allow for, which has expanded the payout ratio.

However, recent acquisitions (including Covidien) have forced Medtronic to log a number of related expenses against GAAP EPS. Adjusted EPS shows a much stronger result, with the company reporting adjusted EPS of $4.37 for FY 2017.

Looking out over the next three years, CFRA is anticipating that Medtronic will compound its EPS at an annual rate of 9% over that period.

This is a reasonable expectation for near-term bottom-line growth, in my view, as it’s roughly in line with the company’s current guidance for non-GAAP EPS growth for FY 2018.

And once the company’s GAAP EPS clears up a bit, the business will look even better.

The fundamentals we’ve looked at thus far are really strong, but that theme continues to repeat itself across the entirety of the business.

The balance sheet is a great example of that.

Medtronic has a long-term debt/equity ratio of 0.52, while the interest coverage ratio is just over 5.

The former number is clearly great, but the interest coverage ratio is surprisingly low. However, that number is impacted by some of the expenses just noted, as EBIT is used to calculate the interest coverage ratio. I believe the interest coverage ratio will look much better within the next year or two.

Profitability is, as likely expected, wonderful.

Over the last five years, the business has averaged net margin of 15.59% and return on equity of 11.48%.

While these numbers are strong already, the fact is that the averages over the last five years have been negatively skewed by recent acquisitions. The company’s true profitability is actually significantly higher than these numbers would indicate.

Overall, there’s a lot to like about this business.

You’re looking at a company that is highly likely to continue benefiting from long-term demographic trends playing out across the globe.

Their products are not practically discretionary by their very nature, making demand fairly inelastic.

They have leadership positions in a number of key markets, and recent acquisitions have seemingly only strengthened the company’s economic moat by simultaneously complementing the product lineup and bolstering its depth and breadth.

However, litigation, high R&D costs, and ongoing healthcare reform/regulation (especially in the US) remain key risks.

A dividend growth stock of this quality and legacy should probably be priced at a premium in this market, but I’d actually argue the opposite is occurring right now. 

The stock is trading hands for a P/E ratio of 22.53, which might not seem that cheap.

However, keep in mind that it’s below the stock’s five-year average P/E ratio of 23.9. And that’s using a ratio that’s hampered by GAAP EPS that isn’t totally demonstrating the company’s real earnings power.

Plus, this is a high-quality stock being priced at a below-market multiple.

In addition, the current yield, as noted earlier, is higher than its own recent historical average.

So the stock might be cheap here, but how cheap? What would a reasonable estimate of its intrinsic value be? 

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 DGR is admittedly on the high end of what I ordinarily allow for, but I think this stock warrants it.

The payout ratio (even against weak GAAP EPS) is quite moderate, the long-term demonstrated DGR is high, and the near-term picture for growth should allow for high-single-digit dividend growth for the foreseeable future.

With the company’s long-term tailwinds factored in, I think this is a rational expectation.

The DDM analysis gives me a fair value of $99.36.

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 analysis shows a high-quality dividend growth stock that is at least modestly undervalued. I don’t think the stock is an absolute steal here, but the quality of the business is unlikely to offer such an opportunity in this market. That said, it does look undervalued. My analysis, though, is limited to my own perspective, which is why I like to compare my viewpoint and valuation analysis to what professional analysts have concluded.

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 $97.00.

CFRA 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.

CFRA rates MDT as a 4-star “BUY”, with a fair value calculation of $86.36.

I came in very close to Morningstar, but there’s a consensus here that the stock appears to be worth more than it’s priced at. The average of these three numbers gives us a final valuation of $94.24, which would indicate the stock is possibly 15% undervalued.

Bottom line: Medtronic PLC (MDT) is a high-quality healthcare firm that is positioned extremely favorably in regard to long-term, global demographic trends. These tailwinds are powerful, and the company is poised to continue pumping out growing dividends for many years to come. With the potential that shares are 15% undervalued on top of market-beating income, this is a compelling long-term dividend growth investment idea in the healthcare space.

— Jason Fieber

Note from DTA: How safe is Medtronic’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 98. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, Medtronic’s dividend appears very safe and extremely unlikely to be cut. Learn more about Dividend Safety Scores here.

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