In times of uncertainty, it makes sense to focus on the certain.
The sun is still rising and setting, and the world is still turning.
No matter what’s going on at any one moment, there are a number of things that we can bet on with confidence.
As an investor, we can take solace in this.
And we can make a lot of money by betting on business models that offer certainty in all environments.
It’s a motto I’ve lived by as I built out my FIRE Fund.
That’s my real-money stock portfolio, and it generates the five-figure passive dividend income I live off of.
In fact, I went from below broke at age 27 to financially free at 33.
I did so by living below my means and following the dividend growth investing strategy, as I lay out in my Early Retirement Blueprint.
This strategy involves buying shares in high-quality businesses that pay reliable and rising dividends.
These businesses are able to pay growing dividends because, more often than not, they have built-in certainty.
This allows them to survive the tough times, and then thrive when the world bounces back.
You can see what I mean by perusing the Dividend Champions, Contenders, and Challengers list.
That list contains pertinent data on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Many of those companies are household names.
They’re blue-chip stocks.
But that list is just the start.
Any intelligent investor must do their homework, which includes fundamental analysis and valuation.
That last element is particularly critical.
Price is what you pay, but it’s value that you get.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
Price and yield are inversely correlated.
All else equal, a lower price will result in a higher yield.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.
It’s protection against the possible downside.
Investing in a business with a large degree certainty, and doing so when it’s undervalued, can lead to fantastic long-term investment results.
The good news is, valuing a stock isn’t as difficult as it seems.
Fellow contributor Dave Van Knapp has made that process even easier with Lesson 11: Valuation.
That’s part of a series of “lessons” on dividend growth investing, and it provides you with a valuation template that you can apply to just about any dividend growth stock out there.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
Medtronic PLC (MDT)
Medtronic PLC (MDT) is a developer and manufacturer of medical devices for chronic diseases.
Founded in 1949, Medtronic is a $132 billion (by market cap) healthcare behemoth that employs almost 100,000 people globally.
The company operates across four segments: Cardiac and Vascular Group, 38% of FY 2019 sales; Minimally Invasive Technologies Group, 28%; Restorative Therapies Group, 27%; and Diabetes Group, 8%.
Approximately half of their revenue comes from US sales.
Their product portfolio includes defibrillators, heart valves, insulin pumps, pacemakers, stents, and surgical tools.
I mentioned the importance of certainty during uncertain times at the outset of this article.
Well, it doesn’t get much more certain than the need to take care of a serious health matter.
If you need heart surgery, for example, that’s not something you’ll avoid.
Spending on healthcare is rarely discretionary in nature, meaning there’s a lot of certainty in the revenue and profit that healthcare giants like Medtronic generate.
This profit certainty translates into dividend certainty.
We see that play out with Medtronic’s fabulous dividend growth track record.
Dividend Growth, Growth Rate, Payout Ratio and Yield
They’ve increased their dividend for 42 consecutive years.
The 10-year dividend growth rate is a plump 10.2%.
That growth comes on top of the 2.35% yield the stock offers right now.
This yield is definitely better than what the broader market offers.
It’s also slightly higher than the stock’s own five-year average yield of 2.1%.
And with a payout ratio of 58.9%, the dividend is secure and in a great position to continue growing.
Indeed, Medtronic just raised its dividend by over 7% on May 21 – during a global pandemic!
That’s the kind of certainty in an uncertain environment that you want from your investments.
Revenue and Earnings Growth
The most important thing for investors, though, isn’t what Medtronic has already done; it’s what the company is yet to do.
We put money at risk based on future returns, and it’s future results investors are most concerned with.
I’ll now build out a future growth trajectory for Medtronic, which will later help us value the stock.
I will first show you what the company has done over the last ten years in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication of profit growth.
Blending the proven past with a future forecast like this should tell us a lot about where the company is going, allowing us to estimate growth and value with a reasonable degree of accuracy.
Medtronic has grown its revenue from $15.933 billion in FY 2011 to $28.913 billion in FY 2020.
That’s a compound annual growth rate of 6.85%.
Really impressive top-line growth; however, much of this was due to the acquisition of Covidien PLC in 2015 for almost $50 billion.
This complementary addition to the company (with Covidien focusing on endomechanical instruments, adding to Medtronic’s cardiovascular and orthopedic offerings) gave a large boost to the top line.
Bottom-line growth hasn’t been quite as strong, although the company’s GAAP EPS has routinely taken large hits after moving the headquarters to Ireland following the Covidien acquisition.
Earnings per share moved from $2.86 to $3.54 over this 10-year period, which is a CAGR of 2.40%.
For additional perspective, adjusted EPS for FY 2020 was $4.59, so you can see how the GAAP number has been impacted.
Moreover, we can look at free cash flow for a better picture of what’s going on.
Medtronic went from producing slightly more than $3 billion in FCF in FY 2011 to over $6 billion in FCF in FY 2020 – that’s nearly a doubling of FCF!
Obviously, this is a cash flow machine.
Looking forward, CFRA forecasts that Medtronic will compound its EPS at an annual rate of 6% over the next three years.
I think that’s a fair projection.
Of note, CFRA says this: “Despite our expectation of pandemic-driven weakness in FY 21 results, we think MDT is well positioned to emerge from the crisis stronger than before…”
This kind of bottom-line growth would portend similar, or even better, dividend raises.
I think Medtronic is one of the rare firms where dividend growth can actually exceed GAAP EPS growth for long stretches of time because of the FCF situation, as we’ve seen play out over the last decade.
I wouldn’t be surprised to see the company continue to hand out high-single-digit dividend raises for the foreseeable future.
Moving over to the balance sheet, Medtronic’s financial position is solid.
They used to have a fortress balance sheet, although the move on Covidien did negatively change that.
Still, they’re in good shape.
The long-term debt/equity ratio is 0.49, while the interest coverage ratio is over 4.
That latter number does concern me a bit, and I’d like to see them get the interest expenses lowered sooner rather than later.
Profitability for the company is robust.
Over the last five years, the firm has averaged annual net margin of 12.91% and annual return on equity of 7.46%.
These numbers did look better pre-Covidien, but I believe much of this is due to the way GAAP reporting has distorted their earnings power.
This is a high-quality company. And it’s a leader in an area where there’s a lot of certainty and a lot of money to be made.
Intellectual property, switching costs, scale, a global distribution network, barriers to entry, and its diversified portfolio all work to the company’s benefit, giving them durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
Litigation is a particular issue in healthcare, as recalls or product deficiencies can lead to legal issues.
The company’s position in healthcare can make it a political target.
Any changes in the way healthcare spending is managed, especially in the United States, would probably impact Medtronic.
The company is mostly protected from recessions. However, economic slowdowns can cause a delay in some treatments.
The risks seem to be far outweighed by the possible reward, in my view.
I believe the current valuation makes the risk-reward relationship even more favorable.
With the stock down 14% YTD, it now looks undervalued…
Stock Price Valuation
The P/E ratio using GAAP EPS is 27.85.
That might look high, but it’s actually lower than the stock’s five-year average P/E ratio of 34.0.
Furthermore, the P/E ratio using adjusted EPS is only 21.48, which is more than fair for a quality company like this.
If we look at cash flow, the present P/CF ratio of 18.4 compares well to the stock’s three-year average P/CF ratio of 20.3.
And the yield, as noted earlier, is also higher than its recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
This DGR is probably conservative, as the dividend raise that came in only days ago – during a global crisis – was in this range.
When the dust settles, Medtronic will get back to doing what it does best.
However, I’m weighing the long-term bottom-line growth potential against the balance sheet and an overall trend of slowing dividend growth over the last few years.
The DDM analysis gives me a fair value of $99.76.
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 rather cautious analysis concludes that the stock is close to fairly valued, if not slightly undervalued.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at.
This adds balance, depth, and perspective to our conclusion.
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 $118.00.
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 5-star “STRONG BUY”, with a 12-month target price of $121.00.
I came out on the low end. Averaging the three numbers out gives us a final valuation of $112.92, which would indicate the stock is possibly 16% undervalued.
Bottom line: Medtronic PLC (MDT) is a high-quality company that offers a lot of certainty in a very uncertain environment. The demand for their products isn’t going anywhere, despite what’s going on in the world. With 42 consecutive years of dividend raises, a market-beating yield, double-digit long-term dividend growth, a moderate payout ratio, and the potential that shares are 16% undervalued, this could be one of the best dividend growth stock opportunities in the whole market right now.
Note from DTA: How safe is MDT’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, MDT’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.
Source: Dividends and Income