In times of trouble, we look for a safe place to hide out.
This can be clearly seen right now in the stock market.
A lot of the unprofitable “innovation” businesses that saw their shares skyrocket during the pandemic have cratered this year.
At the same time, high-quality businesses that produce lots of real cash flow are seeing their shares holding up relatively well.
With rates rising, inflation still high, and the prospects of a recession jumping, it makes sense to continue seeking safe places.
So where does one go?
When I think of safe places in the market, I immediately think of high-quality dividend growth stocks.
These stocks represent equity in world-class businesses that pay reliable, rising dividends to their shareholders.
You can find hundreds of examples by perusing the Dividend Champions, Contenders, and Challengers list.
We’re not talking about ideas that may or may not pan out one day far off in the future.
Reliable, rising cash dividends are evidence of that.
A company requires the underlying profit necessary to fund such cash dividends.
I’ve personally invested in these stocks over the years, building the FIRE Fund in the process.
That’s my real-money portfolio.
It produces enough five-figure passive dividend income for me to live off of.
In fact, this portfolio and the passive dividend income it produces allowed me to retire in my early 30s.
My Early Retirement Blueprint spells out how I was able to retire so young.
A key pillar of the Blueprint is, of course, buying and holding high-quality dividend growth stocks.
Nothing is guaranteed in the market.
But these stocks could offer safety relative to unprofitable, low-caliber alternatives.
However, it’s also important to consider valuation.
Price is only what you pay. It’s value that you actually 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.
In a volatile market, it makes sense to seek safety in undervalued high-quality dividend growth stocks that have the ability to hold up well in short-term downtrends and also perform incredibly well over the long term.
Seeking undervaluation does mean one has to understand valuation in the first place.
But this isn’t an overly onerous endeavor.
Fellow contributor Dave Van Knapp has made it even less onerous, via Lesson 11: Valuation.
Part of a comprehensive series of “lessons” on dividend growth investing, it expressly lays out a valuation system that can be easily applied to pretty much 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) is a global developer and manufacturer of medical devices for chronic diseases.
Founded in 1949, Medtronic is now a $127 billion (by market cap) healthcare giant that employs 90,000 people.
The company reports results across four segments: Cardiovascular, 36% of FY 2022 revenue; Medical Surgical, 29%; Neuroscience, 28%; and Diabetes, 7%.
Medtronic’s product portfolio is comprised of a variety of life-saving and life-improving medical devices that include implantable defibrillators, heart valves, insulin pumps, glucose monitoring systems, pacemakers, stents, and surgical tools.
Healthcare is an area of the global economy that enjoys secular growth.
Healthcare needs do not correlate at all with economic cycles.
If one is sick, they won’t care about GDP figures or where inflation is at.
Human bodies are such that there’s constant base level of demand for care.
On top of it, the global population continues to grow.
Also, people are living longer, on average.
And worldwide wealth also continues to rise, on average.
So you have more older and wealthier human beings walking around, which naturally boosts demand for quality healthcare.
If that isn’t appealing enough, companies like Medtronic benefit from some degree of inelastic demand.
Spending on their products is almost always non-discretionary in nature, and there’s little time or room to worry about pricing.
For example, if you need heart surgery, the particulars over pricing of medical devices are not likely to be a high priority for you when you’re more concerned about surviving.
Medtronic thus benefits from constant demand, rising demand, and inelastic demand.
That trifecta is tough to beat.
But wait. There’s more.
Medtronic has carved out huge market shares in nearly every area in which it competes.
Morningstar states this: “Medtronic has historically held roughly 50% share in its core heart devices. It’s also the market leader in spinal products, insulin pumps, and neuromodulators for chronic pain.”
All of this adds up to a very compelling business model that should see its revenue, profit, and dividend rise at high rates over the decades to come.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Already, Medtronic has increased its dividend for 45 consecutive years.
This is an esteemed Dividend Aristocrat.
The 10-year dividend growth rate is 10%, which is strong.
Now, Medtronic’s more recent dividend increases have been in the high-single-digit range.
In fact, the company increased the dividend by 7.9% only weeks ago.
Still, that’s more than enough growth when you also consider the stock’s current yield of 2.8%.
That yield is twice as high as what the broader market offers, and it’s 70 basis points higher than its own five-year average.
And the payout ratio is a low 48.7%, based on midpoint guidance for this fiscal year’s adjusted EPS.
That indicates a very safe dividend that’s set to continue growing at least as fast as the business.
I like dividend growth stocks in what I call the “sweet spot” – a yield of between 2.5% and 3.5%, paired with high-single-digit (or better) dividend growth.
We can see that this stock is almost squarely in the center of the sweet spot.
Revenue and Earnings Growth
As sweet as these dividend metrics might be, they’re largely looking backward.
However, investors are risking today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later be instrumental when it comes time to estimate intrinsic value.
I’ll first show you what kind of top-line and bottom-line growth this company has produced over the last decade.
And then I’ll reveal a near-term professional prognostication for profit growth.
Lining up the proven past against a future forecast in this way should give us a reasonable idea as to where the business might be going from here.
Medtronic enlarged its revenue from $16.6 billion in FY 2013 to $31.7 billion in FY 2022.
That’s a compound annual growth rate of 7.5%.
Very good top-line growth here.
That said, much of this growth was a result of 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 in absolute terms.
Meanwhile, earnings per share grew from $3.37 to $5.55 (adjusted) over this period, which is a CAGR of 5.7%.
I used adjusted EPS for FY 2022, which nullifies certain issues that impact GAAP EPS and make comparisons difficult.
The bottom-line growth here is only okay, but I think two things have to be kept in mind.
One, Medtronic’s outstanding share count is up rather dramatically after the company used equity to help fund the Covidien acquisition.
This has made per-share growth more challenging.
Two, the pandemic has negatively affected Medtronic.
The global healthcare complex has been focused on COVID-19. Anything that could be delayed, such as elective surgeries, have been. Worse yet, key product launches were coinciding with the pandemic.
Delayed healthcare is likely causing pent-up demand, which could prove to be a strong growth driver for the business over the near term.
Adding in new products precisely when demand is rising could be doubly powerful for the business, turning a former headwind into a new tailwind.
Looking forward, CFRA believes that Medtronic will compound its EPS at an annual rate of 7% over the next three years.
Speaking on the points I just made, CFRA states this: “The pandemic negatively impacted MDT’s many recent product launches, but with a recovery well under way, we are confident that those product launches will support revenue acceleration.”
Moreover, they also add the following: “The key products to pay attention to, launched or soon-to-be launched, include Micra AVpacemaker, the renal denervation program, and most importantly, the Hugo robotic-assisted surgery platform.”
Regarding Hugo, CFRA notes: “In our opinion, the Hugo platform will be a key long-term growth driver for MDT given how vast the robotic surgery opportunity is.”
I see recent results from Medtronic representing a trough of sorts, setting the company up for a terrific recovery in revenue and earnings over the coming years.
The one-two punch of pent-up healthcare demand and new products looks very promising.
And that’s only speaking on the near term.
As I stated earlier, Medtronic has a fantastic business model for the long term.
I think CFRA’s 7% EPS forecast is very doable for Medtronic.
Actually, I find it likely that Medtronic will exceed this mark.
That sets the dividend up to grow at this 7% level, at least, which you’d be pairing with a near-3% yield.
I find it difficult to dislike that setup.
Moving over to the balance sheet, the company has a solid financial position.
The long-term debt/equity ratio is 0.4, while the interest coverage ratio is 11.
Both numbers have meaningfully improved for FY 2022 relative to FY 2021, as long-term debt is down and EBIT has risen.
Profitability is good, but I do think Medtronic can, and will, do better as a recovery plays out.
Over the last five years, the firm has averaged annual net margin of 13.5% and annual return on equity of 8%.
Pointing to better numbers with a recovery, net margin came in at nearly 16% for FY 2022.
Medtronic is running a great business that has done well for a long time and is likely to do even better over the coming years.
And with IP, R&D, switching costs, economies of scale, a global distribution network, high barriers to entry, and a diversified portfolio of entrenched products, the company is protected by durable competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Regulation and litigation risks are both elevated here relative to other business models.
Any changes in the way healthcare spending is managed, especially in the United States, would almost certainly impact the company.
Possible product recalls are a risk.
Medtronic’s products are fairly insulated from economic cycles, but a recession could cause a delay, or even outright cancelation, of elective treatments.
The company is exposed to technology risks. Any major technological changes in medical devices can alter the competitive landscape.
These risks should be carefully thought over, but I still believe that Medtronic is an appealing long-term investment idea.
And the 30% drop in the stock’s price from its 52-week high has created a level of undervaluation that makes it particularly appealing right now…
Stock Price Valuation
The stock’s P/E ratio is 17.3.
That’s based on adjusted EPS.
This is a very low earnings multiple for a high-quality Dividend Aristocrat.
The stock’s five-year average P/E ratio is 35.4, for perspective.
To be fair, that five-year average is using GAAP EPS.
Still, we can see a big disconnect here.
Moreover, the P/CF ratio of 17.7 is well off of its own five-year average of 21.6.
And the yield, as noted earlier, is significantly higher than its own 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%.
That’s a dividend growth rate I’ve consistently used for Medtronic over the years.
I used these same numbers when I last analyzed and valued the business in late 2021.
I’ve been afforded the opportunity to be so consistent with the valuation model because Medtronic has been so consistent with the dividend increases.
Indeed, the company just increased the dividend by 7.9% only weeks ago, which came in almost bang on my number.
With CFRA’s forecast for Medtronic’s near-term EPS growth being at 7%, the payout ratio being still low, and my own personal belief that Medtronic can do better than where CFRA is at, I don’t see a 7.5% dividend growth rate expectation as unreasonable.
The near term might be pretty close to this level.
But I think Medtronic’s EPS and dividend growth could accelerate nicely when looking out beyond five years.
The DDM analysis gives me a fair value of $116.96.
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.
I think I put together a sensible valuation model for the business, yet the stock clearly looks cheap.
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 $129.00.
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 12-month target price of $117.00.
I came out within pennies of where CFRA landed. Averaging the three numbers out gives us a final valuation of $120.99, which would indicate the stock is possibly 26% undervalued.
Bottom line: Medtronic PLC (MDT) is running a great business that has favorable demand characteristics and global demographics on its side. The pandemic caused a temporary lull in sales, but that only sets them up for a nice recovery and accelerating growth. With 45 consecutive years of dividend increases, double-digit long-term dividend growth, a low payout ratio, a market-beating yield, and the potential that shares are 26% undervalued, this Dividend Aristocrat is one of my top long-term ideas for dividend growth investors.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
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.
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