Medtronic (NYSE:MDT) is simply a fantastic company. The firm has #1 share positions in almost every product category it operates in and has a leading pipeline with some of the most compelling medical technology programs and innovative therapies. The firm's solutions span the care continuum, and the company is a leader in some of the largest chronic disease areas, including cardiology, neuro/ortho, and diabetes. We're huge fans of its dividend growth potential, which we'll address in this article, and the company scores fairly well under the Valuentum method. Let's dig in.
But first, a little background to help with the understanding of some of the terminology in this piece. At our research firm, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. We think stocks that are cheap (undervalued) and just starting to go up (momentum) are some of the best ones to evaluate for addition to the portfolios. These stocks have both strong valuation and pricing support. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best.
Most stocks that are cheap and just starting to go up are also adored by value, growth, GARP, and momentum investors, all the same and across the board. Though we are purely fundamentally-based investors, we find that the stocks we like (underpriced stocks with strong momentum) are the ones that are soon to be liked by a large variety of money managers. We think this characteristic is partly responsible for the outperformance of our ideas -- as they are soon to experience heavy buying interest. Regardless of a money-manager's focus, the Valuentum process covers the bases.
We liken stock-selection to a modern-day beauty contest. In order to pick the winner of a beauty contest, one must know the preferences of the judges of a beauty contest. The contestant that is liked by the most judges will win, and in a similar respect, the stock that is liked by the most money-managers will win. We may have our own views on which companies we like or which contestant we like, but it doesn't matter much if the money managers or judges disagree. That's why we focus on the DCF -- that's why we focus on relative value -- and that's why we use technical and momentum indicators. We think a comprehensive and systematic analysis applied across a coverage universe is the key to outperformance. We are tuned into what drives stocks higher and lower. Some investors know no other way to invest than the Valuentum process. They call this way of thinking "common sense."
Medtronic's Investment Considerations
• 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 58.5% during the past three years.
• Medtronic is a global leader in medical technology. The company currently functions in two operating segments that manufacture and sell device-based medical therapies: Cardiac/Vascular and Restorative Therapies.
• 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 26.3% in coming years. Total debt-to-EBITDA was 1.8 last year, while debt-to-book capitalization stood at 36.3%.
• We think Medtronic's baseline expectations are achievable. The company expects to deliver consistent mid-single-digit revenue growth, consistently grow EPS 200-400 basis points faster than revenue, and return 50% of free cash flow to shareholders.
• The company's emerging market business should be a strong source of growth. Medtronic is targeting a 20% CAGR in emerging markets and expects emerging markets to represent 20% of its revenue mix by mid-decade (it's currently 10%).
• If a company is undervalued both on a discounted cash-flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Medtronic posts a Valuentum Buying Index score of 6, reflecting our 'fairly valued' discounted cash-flow valuation assessment of the firm, its neutral relative valuation versus peers, and bullish technical. Medtronic is included in the Dividend Growth portfolio.
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 with its weighted average cost of capital. 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 58.5%, which is above the estimate of its cost of capital of 9.9%. 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.
Medtronic is poised to capture a nice piece of the massive opportunity for existing therapies in emerging markets, an incremental $5 billion by our estimate. Emerging-market exposure is only about 12%-13% of the company's revenue mix, and performance in developing regions should grow at a nice mid-teens annual pace in coming years (see image below). Coupled with therapy innovation and growth in services and solutions, investors should expect a mid-single-digit pace of overall top-line expansion at the company.
Image Source: Medtronic
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 30.8% 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. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Medtronic, cash flow from operations increased about 31% from levels registered two years ago, while capital expenditures fell about 17% over the same time period.
We estimate Medtronic's fair value is $64 per share, which represents a price-to-earnings (P/E) ratio of about 19 times last year's earnings and an implied EV/EBITDA multiple of about 11.3 times last year's EBITDA. Shares are trading at just under $60 per share at the time of this writing. Our model reflects a compound annual revenue growth rate of 3.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.6%. Our model reflects a 5-year projected average operating margin of 31.4%, which is above Medtronic's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For Medtronic, we use a 9.9% weighted average cost of capital to discount future free cash flows.
Our discounted cash-flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis, versus both their industry and peers. Many institutional money-managers--those that drive stock prices--pay attention to a company's price-to-earnings ratio and price-earning-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash-flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We compare Medtronic to peers Intuitive Surgical (NASDAQ:ISRG), Waters (NYSE:WAT), and Zimmer (ZMH).
Medtronic's free cash flow generating capacity is undeniable and represents the primary reason why the company has such a high score on the Valuentum Dividend Cushion methodology. The Valuentum Dividend Cushion adds the firm's net cash position on the balance sheet (cash less debt) to its future expected free cash flow (cash from operations less capital spending) over the next five years. The measure then takes that sum and divides it by expected future cash dividend payments in the next five years to arrive at a free-cash-flow based dividend coverage measure that also considers the strength of the balance sheet. The methodology has performed very well. Medtronic's score on the Valuentum Dividend Cushion is 2.5 at the time of this writing. Future dividend increases should be expected.
In fact, we think Medtronic will be one of the great dividend growth stories of the next few decades. The company is already a Dividend Aristocrat, posting 35 years of consecutive dividend increases. With a payout ratio of 30% and one of the best Valuentum Dividend Cushion scores (given the size of its annual yield: ~2%), the company could double its dividend again and still have excess capacity. Shares are not terribly cheap at this juncture, but we won't be looking to trim our position in Medtronic in the Dividend Growth portfolio until it registers a 1 or a 2 on the Valuentum Buying Index.
Image Source: Medtronic
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 $64 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 $48 per share (the green line), but quite expensive above $80 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 $64 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 $83 per share in Year 3 represents our existing fair value per share of $64 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.
Pro Forma Financial Statements
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: MDT and ISRG are currently included in the newsletter portfolios.