Undervalued Medtronic Sports Strong Dividend Growth Prospects

JHVEditorial photo/iStock via Getty Images

By the Valuentum team

There’s not much not to like about Medtronic plc (NYSE:MDT), although recently its business has faced headwinds in the form of supply chain impediments, poor operational execution and inflationary pressures. Medtronic remains a star free cash flow generator with a strong dividend cushion ratio, although the company’s prospects for margin expansion opportunities have been somewhat reduced. Share buybacks compete for capital with Medtronic’s dividend obligations, and potential M&A activity should be monitored (add-on acquisitions are a central part of Medtronic’s business model). Medtronic has a large total debt load, although the company generally maintains sufficient cash. The shares are trading at the lower end of our fair value estimate range and are posting a healthy dividend yield of 2.7% supported by a dividend cushion ratio of 1.8. We are fans of the company.

Dividend Cushion Cash Flow Bridge

Dividend Cushion Cash Flow Bridge (Image source: Valuentum)

The Dividend Cushion Cash Flow Bridge, shown in the image above, illustrates the components of the Dividend Cushion ratio and highlights in detail the many factors behind it. Medtronic’s Dividend Cushion Cash Flow Bridge reveals that the sum of the company’s expected cumulative free cash flow generation over 5 years, as measured by operating cash flow less all capital expenditures, plus its position of net cash/debt on the balance sheet, as of the last financial year, is greater than the sum of the next 5 years of expected cash dividends paid. Since the Dividend Cushion ratio is forward-looking and reflects the trajectory of the company’s free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or deficit at the end of the year. the 5-year period, taking into account the leverage effect on the balance sheet, the main source of risk.

On a fundamental basis, we believe that companies that have a strong net cash position on the balance sheet and generate a significant amount of free cash flow are better able to pay and grow their dividend over time. Companies that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all other things being equal, our opinion. Generally speaking, the more positive the “blue bar” to the right, the more sustainable a company’s dividend, and the more negative the “blue bar” to the right, the less sustainable a company’s dividend. In the case of Medtronic, we consider its dividend to be quite healthy.

Key Medtronic Investment Considerations

Investment Considerations

Image source: Valuentum

Medtronic is a world leader in medical technology. The Company operates in four operating segments: Cardiac and Vascular, Minimally Invasive Therapies, Restorative Therapies and Diabetes. Medtronic bought Covidien under a tax inversion deal in 2015 through a cash and stock deal worth about $42.9 billion. Medtronic traces its roots to the late 1940s.

Medtronic aims to grow organic revenue by more than 5% per year and adjusted EPS by more than 8% per year. Complementary acquisitions are an integral part of its business model. Medtronic has more than 49,000 patents in its portfolio and the company continues to innovate.

Medtronic’s long-term free cash flow conversion goal is 80%+ and historically the company has been an exceptional free cash flow generator in nearly every operating environment. The company’s product portfolio remains robust, with an eye on its “deep brain stimulation system”, pacemaker, atrial fibrillation and pelvic health offerings.

Medtronic sees emerging markets underpinning its long-term growth trajectory, which represented a relatively small but growing share of its fiscal year 2022 revenue. The company has identified three areas to work on to improve its performance in these markets : channel optimization, functional capabilities and localization.

Recently, Medtronic has faced headwinds in the form of supply chain hurdles, poor operational execution and inflationary pressures. These factors, among others, weigh negatively on its ability to significantly increase its margins in the future.

While we appreciate Medtronic’s business model and competitive advantages, its latest quarterly release in May left much to be desired as “global supply chain and COVID-19 controls in China” weighed on performance. Looking forward, the company expects FY23 organic revenue in the 4% to 5% range and non-GAAP EPS in the range of $5.53 to $5.65 per share, the latter being weighed down by negative currency translation.

Analysis of the economic benefits of Medtronic

The best measure of a company’s ability to create value for its shareholders is expressed by comparing its return on invested capital to its weighted average cost of capital. The gap or difference between ROIC and WACC is called the economic profit gap of the firm. Medtronic’s 3-year historical return on invested capital (excluding goodwill) is 22%, which is higher than its cost of capital estimate of 9.4%.

As such, we give the company an EXCELLENT value creation rating. In the chart below, we show the likely trajectory of ROIC in the coming years based on the estimated volatility of the main drivers of the metric. The solid gray line reflects the most likely outcome, in our view, and represents the scenario that results in our estimate of fair value. Medtronic is a powerful generator of economic value.

Adjusted return on invested capital

Image source: Valuentum

Medtronic Cash Flow Valuation Analysis

Cash flow generation

Image source: Valuentum

We believe Medtronic is worth $103 per share with a fair value range of $82.00 to $124.00. The margin of safety around our estimate of fair value is determined by the company’s LOW ValueRisk rating, which is derived from an assessment of the historical volatility of key valuation factors and a future assessment of these.

Our near-term operating forecasts, including revenue and earnings, do not differ materially from consensus estimates or management guidance. Our model reflects a revenue compound annual growth rate of 4.2% over the next five years, faster than the company’s historical 3-year compound annual growth rate of 1.2%.

Our valuation model reflects a projected 5-year average operating margin of 32.2%, which is above Medtronic’s 3-year average. Beyond year 5, we assume that free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. For Medtronic, we use a weighted average cost of capital of 9.4% to discount future free cash flow.

Valuation assumptions

Image source: Valuentum

Rating Breakdown

Image source: Valuentum

Medtronic Safety Margin Analysis

Range of potential results

Image source: Valuentum

Our discounted cash flow process evaluates each company based on the present value of all future free cash flows. Although we estimate Medtronic’s fair value at approximately $103 per share, each company has a range of likely fair values ​​that is created by the uncertainty of key valuation factors (such as future revenue or earnings, for example). . After all, if the future were known with certainty, we wouldn’t see much volatility in the markets, as stocks would trade precisely at their known fair values.

This is an important way to view markets as an iterative function of future expectations. As future expectations change, the value of the company and its stock price should also change. Stock prices are not a function of fixed historical data, but rather act to capture future expectations as part of constructing company valuation. It’s a key part of our book Value Trap: Universal Valuation Theory.

Our ValueRisk Rating defines the margin of safety or range of fair value we assign to each stock. In the chart above, we show this likely range of fair values ​​for Medtronic. We think the company is attractive below $82 per share (the green line), but quite expensive above $124 per share (the red line). Prices that fall along the yellow line, which includes our estimate of fair value, represent a reasonable valuation for the business, in our view.

Final Thoughts

Medtronic aims to generate a long-term free cash flow conversion rate of 80% (or more). In fiscal 2022, the company met its long-term free cash flow conversion target. Medtronic is a dividend aristocrat that has increased its payout for the past 40 consecutive years, and we expect it to continue to increase its payout at a rapid pace in the future.

Medtronic aims to grow organic revenue by more than 5% per year and adjusted EPS by more than 8% per year over the long term, supported by the launch of new offers and by strengthening its presence in emerging markets. Medtronic’s Dividend Cushion ratio is rock solid and it aims to grow its dividend along with its earnings. We think stocks look cheap and investors are getting a good dividend yield to wait for the price to converge to the estimated fair value.

This article or report and any links it contains are for informational purposes only and should not be considered a solicitation to buy or sell securities. Valuentum is not responsible for any errors or omissions or results obtained from the use of this article and assumes no responsibility for how readers may choose to use the content. Assumptions, opinions and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Comments are closed.