Baxter (NYSE:BAX) is one of our favorite dividend growth ideas, but it's not included in the Dividend Growth portfolio. This isn't anything against this fantastic firm (we like it a lot), it's just that we can't include every great dividend growth idea in the portfolio.
For one, recent studies/theories indicate that ~90% of the maximum benefit of diversification is derived from a portfolio of about 12 to 18 stocks. Though the precise number to achieve optimum diversification will vary (and is probably a number greater than this range), if you own 40 or 50 dividend growth stocks, you're likely just paying too much in commissions. And secondly, diversification is often dubbed "diworsification", as in doing so, one is inevitably diluting the returns of his/her favorite, high-conviction ideas. With this background and an understanding that we like the company very much, let's run shares of Baxter through the Valuentum process.
Baxter Investment Considerations
- Baxter's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders, with relatively stable operating results for the past few years, a combination we view very positively.
- Baxter makes products that help people with hemophilia, immune disorders, infectious diseases, kidney disease, trauma and other medical conditions. The firm's diversified healthcare portfolio generates 70%+ of revenue from products in market-leading positions.
- Baxter 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 16.5% in coming years. Total debt-to-EBITDA was 2.6 last year, while debt-to-book capitalization stood at 52%. It has returned ~$4 billion to shareholders via dividends and buybacks since 2008.
- Baxter's strong image and brand is augmented by an extensive global footprint and channel strength. The company continues to enhance its position in hemophilia and advance its pipeline to late-stage development. There are ~20 phase III pipeline programs, compared to just 2 in 2005.
- The firm sports a very nice dividend yield of 2.8%. We expect the firm to pay out about 40% of next year's earnings to shareholders as dividends, and the company continues to target paying out 40% of earnings as dividends in the future. Its Dividend Cushion ratio is 1.4. You can access Baxter's landing page on our website here.
About the Dividend Cushion ratio: The Dividend Cushion score is based on the firm's future fundamental cash-flow generation and the health of its balance sheet, helping investors avoid the two major factors that cause dividend cuts. The score is a ratio, and is forward-looking and meaningful. For example, in the case where one of your dividend growth holdings has a score of 1.4 (in the case of Baxter), you can confidently say the following:
Baxter can cover its future cash dividends and embedded growth rate in them (as shown in the dividend report on Valuentum's website) with traditional free cash flow (cash flow from operations less capital expenditures) and after considering the obligations of its balance sheet by 1.4 times during the next 5 years.
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. Baxter Intl.'s 3-year historical return on invested capital (without goodwill) is 31.4%, which is above the estimate of its cost of capital of 9.8%. 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.
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. Baxter Intl.'s free cash flow margin has averaged about 12.7% 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 Baxter, cash flow from operations increased about 14% from levels registered two years ago, while capital expenditures expanded about 59% over the same time period.
Our discounted cash flow model indicates that Baxter Intl.'s shares are worth between $58-$86 each. The company is trading at ~$77 per share at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
Our estimate of Baxter's fair value is $72 per share (the mid-point of the fair value range), which represents a price-to-earnings (P/E) ratio of about 19.6 times last year's earnings and an implied EV/EBITDA multiple of about 13.1 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.5% during the next five years. Our fair value estimate reflects a 5-year projected average operating margin of 22.9%, which is above Baxter's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years, and 3% in perpetuity. For Baxter, we use a 9.8% weighted average cost of capital to discount future free cash flows.
For more information on how we think about our forecasts, please click here.
We 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-earnings-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. For relative valuation purposes, we compare Baxter to peers Becton, Dickinson (NYSE:BDX) and Boston Scientific (NYSE:BSX).
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 $72 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 Baxter Intl. We think the firm is attractive below $58 per share (the green line), but quite expensive above $86 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 Baxter's fair value at this point in time to be about $72 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 Baxter Intl.'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 $91 per share in Year 3 represents our existing fair value per share of $72 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: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.