Should You Buy This Dividend Aristocrat?

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As the market becomes more volatile and high-grade dividend stocks begin to fall in price an opportunity opens up to buy those stocks at a more reasonable price than the last few months have offered. I recently introduced my Dividend Growth Watchlist, a list of dividend stocks with suggested buy targets, to make it simpler to track the prices of high-quality dividend stocks and determine when they become undervalued. Today I'll look at the recently minted dividend aristocrat Medtronic (NYSE: MDT).

A cash machine

Medtronic was recently added to the S&P 500 Dividend Aristocrat Index after reaching 35 years of consecutive dividend increases. Medtronic is in the medical technology business, creating products and therapies which today treat nearly 40 different medical conditions. The company is large, with a $50 billion market capitalization and about $16 billion in annual revenue.

One thing which makes Medtronic stand out is its exceptional cash generation. In fiscal 2013, which ended in April, the company generated $4.4 billion in free cash flow, or nearly 27% of the revenue. Medtronic's return on equity, or ROE, is an impressive 23.7%.

The company is committed to returning at least 50% of the free cash flow to shareholders through both dividends and buybacks, and in fiscal 2013 the company spent over $1.2 billion on share buybacks and over $1 billion on dividend payments. Combined these eat up about half of the free cash flow. The payout ratio with respect to the free cash flow is roughly 25%.

Medtronic could raise the dividend significantly, but the company seems to favor increased buybacks instead. The current dividend yield is 2%, but the company could easily support a 3% dividend or higher by simply favoring dividends over buybacks. This doesn't seem likely to happen, though.

Over the past decade Medtronic has raised its dividend fairly rapidly, at an annualized rate of 16%. The most recent increase, occurring at the beginning of last year, was a measly 7.2% in comparison. Medtronic is due to increase its dividend again within the next few weeks, if history is any indication, so we'll have to wait and see by how much the company increases the payment.

One serious area of growth for Medtronic is in emerging markets. Revenue from emerging markets has been growing at a 19% CAGR since fiscal 2008, and over the next five years the company expects emerging markets to make up about 20% of the company's total revenue.

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Source: Medtronic presentation

Success in emerging markets should allow Medtronic to continue growing its revenue, earnings, and dividend well into the future.

Because Medtronic's yield is so low the required dividend growth rate is fairly high, well beyond 7.2%. It's hard to predict how fast the dividend will increase in this case because it could be doubled tomorrow and still be completely sustainable. But the company favors buybacks over a higher dividend. For this reason Medtronic isn't a great dividend stock, and the price would have to be pretty low to justify its purchase as such. How low? Well, let's split the difference and say that the dividend growth rate over the next decade will be 12%, roughly half-way between the historical rate and last year's increase. I'll do a simple dividend discount model calculation to estimate the fair value of the stock under this assumption.

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The stock is worth about $44 per share to a dividend investor, around 15% below the current market price. Now, that's not to say that Medtronic is overvalued in general, but to a dividend growth investor it is. If the company boosted its dividend by 50%, putting the yield at 3% and the the payout ratio still below 40%, the stock would be significantly undervalued. But as it stands right now, Medtronic isn't a great dividend stock. I'll add it to the watchlist with a buy target of $44 per share.

The alternatives aren't much better

Trying to find an alternative medical technology stock with a more attractive dividend than Medtronic appears to be a fool's errand. The larger Abbott Laboratories (NYSE: ABT), which recently completed the spin-off of the drug maker AbbVie, pays a lower dividend than Medtronic. Pre-spinoff the quarterly dividend sat at $0.244 per share, but that was cut to $0.14 per share after the spin-off. Abbott seems to have lost one of its big cash cows with the AbbVie spin-off, and dividend growth going forward is fuzzy at best. But with a yield of just 1.53% the required dividend growth for the stock to be attractive is likely higher than we'll see. Incidentally AbbVie pays a 3.5% dividend, but it's not in the same business as Medtronic so I won't consider it here.

A smaller medical technology company is Stryker (NYSE: SYK), but the story is much the same. Stryker pays a 1.59% dividend, and much like Medtronic the company has an extremely low payout ratio and has ramping up its share buyback program. Stryker's most recent dividend increase was a solid 24.7%, so it seems that Stryker may give you higher dividend growth going forward compared to Medtronic. But the yield is quite a bit lower, and the preference for buybacks should be concerning to the dividend investor.

The bottom line

Medtronic is a cash machine, but it just doesn't fit the bill as a dividend stock. In most cases buybacks are good for dividend stocks since they lower the payout ratio, but when dividend growth is sacrificed in favor of increased buybacks it becomes clear that the company has no intention of making the dividend truly attractive. It also clouds the future dividend growth rate, since the company is capable of raising the dividend significantly but likely won't. Without a true focus on the dividend Medtronic is a tough sell as a dividend stock.

Timothy Green has no position in any stocks mentioned. The Motley Fool owns shares of Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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