Updated on February 1st, 2019 by Bob Ciura
Every year, we review each of the Dividend Aristocrats, a group of 57 companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.
The next Dividend Aristocrat in the series, is healthcare giant Medtronic (MDT).
Medtronic has an impressive history of dividend growth. The company has increased its dividend for 41 years in a row.
At 2.3%, Medtronic is not exactly a high-yield stock. However, its current yield still beats the average dividend yield in the S&P 500 Index.
Plus, Medtronic typically raises its dividend at a high rate each year, thanks to its strong earnings growth and durable competitive advantages.
These qualities make Medtronic an attractive dividend growth stock for long-term investors.
Medtronic was founded in 1949 as a medical equipment repair shop by Earl Bakken and his brother-in-law, Palmer Hermundslie. Today, Medtronic is one of the largest healthcare companies in the world. It has a market capitalization of $118 billion.
Medtronic PLC is the largest manufacturer of biomedical devices and implantable technologies in the world. The company serves physicians, hospitals and patients in more than 150 countries and has over 86,000 employees.
Source: Investor Presentation
Medtronic currently has four operating segments: Cardiac and Vascular Group, Minimally Invasive Therapies Group (MITG), Diabetes Group and Restorative Therapies Group. It’s on pace to generate ~$30 billion in revenues and ~$7 billion in profits this year.
On November 20th, Medtronic reported financial results for the fiscal 2019 second quarter. The top line came in at $7.48 billion for the quarter, a 6.1% increase, with GAAP earnings-per-share of $0.82 and non-GAAP earnings (mostly related to an amortization charge) of $1.22, a 14% year-over-year increase.
The Cardiac and Vascular Group grew sales 3.1% to $2.58 billion, the MITG segment increased sales by 4.9% to $2.05 billion, Restorative Therapies grew sales 7% to $1.99 billion and the Diabetes Group increased sales 26.2% to $583 million.
Medtronic also updated its fiscal year 2019 guidance. The company increased its organic revenue growth guidance from a range of 4.5% to 5.0%, to a range of 5.0% to 5.5%. Full year EPS guidance is unchanged at $5.10 to $5.15.
The current fiscal year is likely to be another year of steady growth for Medtronic. And, thanks to the favorable economics of the U.S. healthcare industry, Medtronic should enjoy many years of growth up ahead.
Medtronic is investing in growth, both organically and through acquisitions. The first catalyst for Medtronic is the aging population. There are over 70 million Baby Boomers in the U.S., those aged 51-69 years. Thousands of people are entering retirement every day. Combined with longer life expectancy and rising healthcare spending, the operating environment is very attractive for Medtronic.
Medtronic also has a major growth opportunity in new geographic markets. Specifically, Medtronic has a presence in several emerging markets, such as China, India, Africa, and more. These countries have large populations and high economic growth rates.
Source: Investor Presentation
Medtronic’s emerging-market revenue has consistently grown at a double-digit rate over the past seven years. Revenue from the emerging markets increased 13.5% last quarter, more than five percentage points higher than Medtronic’s growth rate in the United States.
While the U.S. currently accounts for over half of Medtronic’s revenue, the emerging markets represent just 15% of total company sales. This leaves plenty of growth potential left for Medtronic in the developing world.
Another growth catalyst for Medtronic is acquisitions. The largest single acquisition for Medtronic was its $50 billion acquisition of Covidien in 2015. The acquisition presented significant growth potential for Medtronic.
Covidien is also a medical device maker, with a focus on hospital supplies. The deal lets Medtronic broaden and diversify its product portfolio.
Medtronic has a long history of successful acquisitions. In fiscal 2017, Medtronic completed 5 bolt-on acquisitions, for a total of $1.5 billion. Acquisitions are an important part of Medtronic’s growth strategy.
Competitive Advantages & Recession Performance
The main competitive advantage for Medtronic is its research and development capabilities. The company spends heavily on R&D each year, which provides it with product innovation.
Medtronic’s R&D investments over the past few years are as follows:
- FY 2016 R&D expense of $2.2 billion
- FY 2017 R&D expense of $2.2 billion
- FY 2018 R&D expense of $2.3 billion
The result of all this spending is that the company has a huge intellectual property portfolio with over 46,000 awarded patents. This has allowed Medtronic to build a strong product pipeline across each of its business segments.
In addition, Medtronic benefits tremendously from global scale. The company operates in over 150 countries around the world. It has the operational flexibility to generate industry-leading profit margins, which helps fuel its growth.
Another competitive advantage for Medtronic is that it operates in a defensive industry. Consumers often cannot choose to forego medical treatments, even when the economy goes into recession.
Medtronic’s earnings-per-share during the Great Recession are as follows:
- 2007 earnings-per-share of $2.61
- 2008 earnings-per-share of $2.92 (12% increase)
- 2009 earnings-per-share of $3.22 (10% increase)
- 2010 earnings-per-share of $3.37 (5% increase)
Medtronic had the rare achievement of earnings growth each year during the recession. This demonstrates its recession-resistant business model. Medtronic should be able to continue growing its dividend each year, in both economic recessions and expansions.
Valuation & Expected Returns
Based on expected earnings-per-share of $5.12 in fiscal 2019, Medtronic stock trades for a price-to-earnings ratio of 17.2. The current valuation of the stock is significantly below that of the broader S&P 500 Index, but Medtronic’s valuation is above its own long-term average.
A breakdown of Medtronic’s historical price-to-earnings ratio can be seen in the table below:
In the past 10 years, Medtronic stock held an average price-to-earnings ratio of 14.2. However, we feel Medtronic deserves a slightly higher valuation than the 10-year average. Our fair value estimate is a price-to-earnings ratio of 15, which represents a reasonable valuation for a blue-chip industry leader.
Still, Medtronic shares appear to be overvalued today. If the stock valuation retraces to our fair value estimate, the corresponding multiple contraction would reduce annual shareholder returns by approximately 2.7% per year.
Fortunately, Medtronic stock will offset its overvaluation with earnings growth and dividends. Medtronic grew its earnings-per-share by 5.3% annually in the past 10 years. We expect 6% annual earnings growth for Medtronic through 2024.
Medtronic’s cash returns will also contribute to future returns. Medtronic routinely buys back its own stock, and it has increased its dividend for 41 consecutive years. With a dividend payout ratio near 40%, and a positive earnings growth outlook, there is plenty of room for Medtronic to continue increasing its dividend each year.
The combination of valuation changes, 6% annual earnings growth, and Medtronic’s 2.3% dividend yield result in total expected returns of 5.6% per year through 2024. This is a solid rate of return, but not enticing enough to warrant a buy recommendation today.
Medtronic has virtually all of the qualities dividend growth investors should look for. It possesses a highly profitable business, a leadership position in its core markets, and durable competitive advantages. It also has multiple catalysts for future growth, and the ability to keep growing its dividend even during recessions.
Medtronic has increased its dividend for 41 consecutive years, including a strong 9% increase in 2018.
The only negative aspect of investing in Medtronic stock today is the valuation. We believe Medtronic is a slightly overvalued stock today. As a result, value investors should wait for a pullback before buying the stock. That said, Medtronic remains a high-quality holding for long-term dividend growth investors.