Medtronic (MDT, Financial) hiked its dividend by 25% earlier this year and has now increased its dividend for nearly 40 consecutive years. While Medtronic's 2% dividend yield isn't enough for investors living off dividends in retirement, the stock's double-digit annual total return potential is attractive in today's market environment, and we expect continued double-digit dividend growth in each of the next several years.
We like the diversity of Medtronic's sales mix, the recession-resistant nature of its medical devices, and the company's dominant positions in many of its key markets. With that said, we believe dividend growth investors need to have a positive view on Medtronic's $50 billion acquisition of Covidien and future regulatory changes impacting the U.S. healthcare landscape before buying the stock. Let's take a closer look.
Business overview
Medtronic was founded in 1949 and manufactures a diversified portfolio of medical devices used by healthcare institutions and physicians.
The company acquired Covidien for roughly $50 billion in January to expand its presence in faster-growing emerging markets, bolster the size and scope of its portfolio of hospital supplies, and avoid some taxes by relocating its headquarters overseas. Prior to the acquisition, Medtronic was primarily known for its cardiac and coronary devices (e.g. defibrillators, pacemakers, valves, and heart stents), diabetes care, spinal fusion, and neural stimulation businesses. Covidien focused on hospital and medical supplies, equipment for surgeries (e.g. surgical staplers), and its vascular therapies.
The deal about doubled Medtronic's revenue to $28 billion and should help it gain more leverage and prominence on hospitals' supplier lists as they increasingly look to cut costs. Investors considering Medtronic should be sure they are confident in this deal because it will impact the company (positively or negatively) for years to come.
Segments
Through the first six months of its fiscal year 2015 (including Covidien), Medtronic's sales mix by segment was: Cardiac Rhythm & Heart Failure 19%, Coronary & Structural Heart 11%, Aortic & Peripheral Vascular 6%, Surgical Solutions 18%, Patient Monitoring & Recovery 15%, Spine 10%, Neuromodulation 7%, Surgical Technologies 6%, Neurovascular 2%, and Diabetes Group 6%.
Essentially, the company's medical device portfolio is extremely broad and diversified.
By geography, about 55% of Medtronic's revenue is generated in the U.S., 33% comes from other developed markets, and 12% is derived from emerging markets. Altogether, the company's products are used in more than 140 countries.
Business analysis
Medtronic's strength comes from its scale ($28 billion in sales), strong market positions in its key segments (#1 in diabetes, restorative therapies, minimally invasive therapies, and cardiac and vascular), and a highly diversified product portfolio.
Medtronic is typically first to the market with new products, a result of 50 years of innovation and a strong commitment to R&D (the company has committed to investing an incremental $10 billion in R&D over the next decade). Given the price-sensitive nature of the healthcare industry, developing successful new technologies and medical devices is essential to maintaining market share and healthy profitability.
While price seems to be an increasingly important consideration for customers going forward as a result of the Affordable Care Act (more focus on reducing healthcare costs), the mission-critical nature of many of these products can help insulate them from price pressure.
A lot of Medtronic's medical devices significantly impact patients' quality of life and must be of extremely high quality. The company's specialized products can offer superior performance in many instances, allowing it to maintain strong market share and profitability. As seen below, Medtronic has maintained a double-digit return on invested capital every year (FY 15 was due to immaterial accounting distortions), suggesting it has a moat:
Source: Simply Safe Dividends
Beyond innovative products, Medtronic's scale will likely serve as an increasingly important advantage as the healthcare system becomes more cost-focused and efficient. The company's acquisition of Covidien doubled its revenue base and significantly expanded its product portfolio. Medtronic expects the merger to result in cost savings of $850 million annually within the next few years. Smaller medical device players could struggle to maintain their market share as Medtronic becomes more a low-cost, one-stop shop.
Altogether, Medtronic's primary advantages come from its ability to continuously develop specialized medical devices in high profit areas of the healthcare market. Its diversified product portfolio and the recession-resistant nature of its products provide reliable free cash flow which can be reinvested into the business to drive future growth. As the healthcare industry focuses more on taking out costs, larger vendors such as Medtronic should benefit because of their economies of scale, product breadth, unique technologies, and existing customer relationships.
Key risks
Whenever a company doubles its revenue via an acquisition, we approach the company with an extra level of caution. A study by global accounting firm KPMG found that 83% of mergers hadn't boosted shareholder returns, and a separate analysis by A.T. Kearney concluded that total returns on M&A were negative.
What are the risks of Medtronic's $50 billion acquisition of Covidien?
First, this deal allowed Medtronic to move its headquarters from Minneapolis to Ireland (known as a "tax inversion"), meaningfully lowering the company's overall tax burden because the corporate tax rate there is about a third of the U.S. rate.
Not surprisingly, the U.S. government isn't too keen on losing tax revenue from major corporations, and calls to change the nation's tax code to prevent tax inversions continue to gain steam. For now, Medtronic's management team has argued that the Covidien deal makes fundamental sense regardless of future tax code changes, but it's a possible headline risk to be aware of. It probably doesn't impact the long-term earnings power of the combined company, but who really knows what a material change in the tax code could do to the stock's near-term price.
More importantly, bringing together two huge businesses of equal size poses numerous integration risks. While Medtronic has executed on its cost synergies so far, there is still much work to be done - both companies need to get on the same enterprise software platform, the majority of expected cost savings are spread over the next few years, integrating two cultures is a sensitive issue, going to market with a substantially broader product portfolio takes time, and much more.
Overall, the Covidien deal is a move that does seem to make sense on paper. As the medical device market becomes increasingly price-sensitive to save costs in the healthcare system, market consolidation is to be expected. In recent years we have seen Johnson & Johnson (JNJ) acquire Synthes for $21 billion, and Zimmer Holdings bought Biomet for $13 billion.
Smaller players who have higher costs of production and lower R&D budgets will increasingly struggle to compete with the big players. With that said, we typically steer clear of "mega" deals until they have had plenty of time to be digested by the acquirer. There are too many potential surprises that we simply cannot forecast but have shown to destroy shareholder value historically.
The Covidien deal aside, the medical devices market is extremely competitive and sensitive to government regulation.
Most medical device markets are fairly ruthless despite some of their high-tech innovations. Products generally have short life cycles, are notoriously price-sensitive, and require constant R&D to maintain their market share. In other words, investors wouldn't want to be involved with companies that are dependent upon a small portfolio of products for their earnings!
Fortunately, Medtronic has meaningful scale ($28 billion in sales), strong market positions in its key segments, and a highly diversified product portfolio. Even still, the company had to reduce prices meaningfully during 2010 to 2011 as the economy was slow to recover from the recession.
Government regulations such as the Affordable Care Act will continue to impact the U.S. medical device industry as well (Medtronic generates over half of its sales in the U.S.). Medical device manufactures have been assessed a 2.3% excise tax on revenue since 2013, reducing profit growth and limiting future returns. It also seems likely that the government will continue tightening standards for medical device reimbursements in an effort to contain healthcare costs.
The good news is that U.S. healthcare reform has significantly expanded coverage to a broad range of patients over the last two years. Around 17 million Americans have gained health insurance since September 2013, resulting in a meaningful increase in procedure volumes and strong domestic demand for many of Medtronic's products.
However, trees don't grow to the sky. According to a report by Fitch, hospitals are seeing the tailwind from the Affordable Care Act start to dissipate. Even Medtronic's management team acknowledged that growth is likely to level out over the coming quarters, mentioning that growth in the U.S. "has been stronger than I can remember for a long time" and that "some of the hospitals have reported slightly sort of loewr growth rates, so we are watching this carefully."
If volume growth does slow over coming quarters, it could surprise some investors and potentially raise questions about the Covidien deal impacting the combined company's top line momentum. While there probably isn't an impact on Medtronic's long-term earnings potential, it might create some near-term stock price volatility.
Overall, it's challenging to predict what other government regulations, favorable or unfavorable for Medtronic, could emerge over the next five to 10 years as our healthcare system continues evolving.
Dividend analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Medtronic has one of the safest dividends investors can find, recording an excellent dividend Safety Score of 83. The dividend's safety appears to be very high because of the company's low payout ratios, consistent free cash flow generation, reasonable balance sheet, recession-resistant products, and strong commitment to the dividend.
Over the last 12 months, Medtronic's dividend has consumed 33% of the company's free cash flow, leaving plenty of room for the company to continue paying and growing the dividend regardless of near-term business trends.
Looking at longer-term trends in payout ratios can also be helpful to see if growth in earnings per share has kept up with dividend growth. As seen below, Medtronic has consistently paid out about 20% to 30% of its free cash flow, which is a sign that the company is a reliable cash flow generator with plenty of sustainable dividend growth ahead.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
For dividend companies with enough operating history, it's always a prudent exercise to observe how their businesses performed during the financial crisis. During the recession, Medtronic's sales and free cash flow grew each year, a remarkable performance. Many of the company's medical devices are needed regardless of how the economy is performing, although pricing pressure can intensify.
Source: Simply Safe Dividends
High quality companies are able to generate free cash flow year in and year out. Rising cash flow is important because it supports continued dividend growth without expanding the payout ratio. As seen below, Medtronic's high quality business model has enabled it to generate and grow free cash flow per share over the last decade.
Source: Simply Safe Dividends
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us a better sense of a dividend's safety, the balance sheet is an extremely important indicator as well.
Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.
In Medtronic's case, we were interested to see what impact the company's $50 billion acquisition of Covidien had on the balance sheet. As seen below, the company's balance sheet is in reasonable shape with $35.6 billion in debt compared to $18 billion in cash on hand.
Medtronic has around $13 in cash on hand for every $1 it paid out as a dividend last year, and the combined company with Covidien is expected to generate about $7 billion in annual free cash flow. This means Medtronic could pay off its entire debt balance in less than three years with free cash flow generation and its cash on hand.
Source: Simply Safe Dividends
Overall, Medtronic appears to be an extremely safe source of income and is certainly a blue chip dividend stock.
Dividend Growth Score
Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Medtronic's Growth Score is 79, meaning its dividend's growth potential ranks much higher than most other dividend stocks. ITW's relatively low payout ratios, consistent cash flow generation, and diversified growth opportunities support the rating. The company has also increased its dividend for 38 consecutive years, easily securing its spot on the dividend aristocrats list.
Medtronic's dividend has compounded by 13% per year over the last decade, and the company most recently raised its dividend by 25% earlier this year.
If management hits their earnings growth objective, the dividend should continue growing at about a double-digit pace (management expects to grow the dividend rate faster than earnings).
Ultimately, Medtronic has stated that it intends to reach a 40% payout ratio on a non-GAAP basis within the next few years, still leaving plenty of room for healthy dividend growth regardless of near-term results. As a dividend aristocrat, Medtronic's long-term dividend growth should be about as dependable as it gets.
Valuation
Medtronic trades at about 17.5x forward earnings guidance and has a dividend yield of 2%. Management targets reliable, consistent revenue growth in the mid-single digits and expects earnings to grow 2% to 4% faster than its sales growth rate.
If the company achieves its goals and delivers high-single digit earnings growth, the stock would appear to offer total return potential of 9% to 11% per year. Medtronic appears to be about fairly valued today.
Conclusion
For investors looking for long-term dividend growth in the healthcare sector, Medtronic looks like an interesting business to consider. Its dividend appears to have double-digit growth potential, cash flow is diversified across numerous product lines, its large scale should make it an even more compelling supplier for hospitals, and changing population demographics should drive greater demand for medical devices.
With that said, Medtronic appears to face more regulatory risk than most companies. The medical device industry is extremely competitive, and governments are constantly looking to reduce healthcare costs (e.g. lower reimbursement rates for hospitals could further pinch medical device pricing). In the U.S., the Affordable Care Act has resulted in a nice volume boost in medical procedures over the last two years as more people have been insured, but we see signs of this tailwind beginning to slow over the next year.
We also prefer to avoid companies that have recently made a substantial acquisition. While Medtronic's purchase of Covidien could prove to be a home-run over the next decade, broader statistics have shown that the far majority of large acquisitions do not create shareholder value.
For these reasons, we have chosen to remain on the sidelines at this time and will consider other stocks for our Top 20 Dividend Stocks portfolio. Otherwise, investors who are bullish on the U.S. healthcare system and Medtronic's acquisition of Covidien can take comfort in the stock's safe 2% yield and double-digit dividend growth potential.
Disclosure: The author has no position in MDT.
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