Medtronic's Dividend Is Worth a Look
RJ is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As part of our process at Valuentum, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Medtronic's (MDT) case, we think the firm is undervalued. For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation and its relative valuation versus industry peers is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for a video on our methodology with President Brian Nelson), which ranks stocks on a scale from 1 to 10, with 10 being the best. If a company is undervalued both on a DCF and on a relative valuation basis, it scores high on our scale. Medtronic posts a VBI score of 6 on our scale, reflecting our 'undervalued' DCF assessment of the firm and its attractive relative valuation versus peers.
Our Report on Medtronic
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Medtronic earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 52% during the past three years.
Medtronic 's valuation is compelling at this time. The firm is trading at a nice discount to our estimate of its fair value, even after considering an appropriate margin of safety. The firm's forward earnings multiple and PEG ratio also look attractive versus peers.
Medtronic has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 25.4% in coming years. Total debt-to-EBITDA was 1.7 last year, while debt-to-book capitalization stood at 38.1%.
The firm's shares have underperformed the market benchmark during the past quarter. Although Medtronic 's valuation appears attractive, the company is currently exhibiting characteristics of a potential value trap, and we'd still be cautious at these levels.There may be a better entry point yet.
The firm sports a very nice dividend yield of 2.5%. We expect the firm to pay out about 28% of next year's earnings to shareholders as dividends. We're considering the firm for addition to the portfolio in our Dividend Growth Newsletter.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Medtronic 's 3-year historical return on invested capital (without goodwill) is 52%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Most Recent Quarterly Results
Medtronic issued strong fiscal fourth-quarter results Tuesday that showed solid earnings expansion and share gains in the US drug-eluting stent market. We think the firm’s newly-issued outlook for fiscal 2013 is easily achievable, and our fair value estimate remains unchanged.
The heart-rhythm device maker’s revenue advanced 4% on a constant currency basis versus the same period a year ago. On a non-GAAP basis, fourth-quarter net earnings and diluted earnings per share came in at $1.036 billion and $0.99, up 7% and 10%, respectively, from last year’s quarter. Consensus expectations were at $0.98 per share. Medtronic pulled in nearly $4 billion in free cash flow during fiscal year 2012. The medical-device maker noted that strength in the quarter was broad-based and pointed to strong US launches of its Resolute Integrity drug-eluting stent and RestoreSensor spinal cord stimulator. Both its Cardiac/Vascular Group and Restorative Therapies Group experienced revenue growth of 4% on a constant currency basis. We were particularly pleased with the performance of the launch of the Resolute Integrity drug-eluting stent, which has doubled Medtronic’s drug-eluting stent market share in the US.
Looking ahead, Medtronic expects fiscal 2013 revenue to be as much as 4% higher than the most-recently reported period and diluted earnings per share to approach $3.70, reflecting bottom-line growth of about 7%. Consensus expectations were at $3.66 per share. We continue to hold the firm in the portfolio of our Dividend Growth Newsletter, as management remains committed to returning cash to shareholders. Medtronic sports a Valuentum Dividend Cushion ratio of 2.8, revealing significant potential for future dividend growth.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Medtronic's free cash flow margin has averaged about 22.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Medtronic, cash flow from operations decreased about 17% from levels registered two years ago, while capital expenditures fell about 17% over the same time period.
We think Medtronic is worth $52 per share, which represents a price-to-earnings (P/E) ratio of about 18.2 times last year's earnings and an implied EV/EBITDA multiple of about 10.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 3.4% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.6%. Our model reflects a 5-year projected average operating margin of 29.6%, which is below Medtronic's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.2% for the next 15 years and 3% in perpetuity. For Medtronic, we use a 9.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $52 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Medtronic. We think the firm is attractive below $39 per share (the green line), but quite expensive above $65 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Medtronic's fair value at this point in time to be about $52 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Medtronic's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $66 per share in Year 3 represents our existing fair value per share of $52 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from
the upper and lower bounds of our fair value estimate range.
Valuentum Securities Inc. is an independent investment research provider, offering premium equity reports and dividend reports, as well as commentary across all sectors/companies, a Best Ideas Newsletter (spanning market caps, asset classes), a Dividend Growth Newsletter, business/investing book reviews pre-public release, modeling tools/products, and more. Independence and integrity remain our core, and we strive to be a champion of the investor. Valuentum is based in the Chicagoland area.