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Medical device stocks might not be the first thing that comes to mind for investors who are searching for dividend income. After all, high R&D expenses and acquisition-oriented management teams are hallmarks of the industry. However, some mature industry players have large product portfolios that generate cash flow beyond what is needed to support available organic and acquisition-driven growth opportunities. These companies offer reasonable dividends and can be excellent defensive plays for investors.

Luxury goods consumers might be able change their buying habits in bear markets, but it is significantly harder for people – and governments – to do to the same when it comes to healthcare. As baby boomers age, they have increasing need of medical devices. Potential 510(k) regulatory changes are an ever-present risk, but patent shields protect cash flow for medical device companies with established product portfolios.

When evaluating medical device companies that offer dividends, I believe it is important to look for companies that exhibit the following characteristics:

  • Established product portfolio that generates consistent cash flow
  • Strong balance sheet
  • Proven management
  • Track record of bringing new products successfully to market
  • Not prone to reckless acquisitions or devoting R&D to a single high-risk product
  • Experienced internal sales channel
  • No potentially devastating lawsuits pending
  • Diverse pipeline of new products
  • Attractive current valuation

This article will focus on five medical device dividend-paying stocks that have these characteristics and offer valuable opportunities for the long-term investor.

Medtronic (NYSE:MDT) – Dividend Yield 2.75%

MDT is the largest medical device company in the world, and has been in existence for over 60 years. It has a diversified product portfolio consists of two divisions: the Cardiac and Vascular Group and the Restorative Therapies Group. The Cardiac and Vascular Group includes cardiac rhythm disease management, cardiovascular products, and physio-control products. The Restorative Therapies Group includes neuromodulation therapies, spinal and biologics products, diabetes solutions, and surgical technologies.

The company offered a quarterly dividend of $0.04 per share in 2000 and now offers a quarterly dividend of $0.2425, an annualized increase of nearly 18%. The EPS payout ratio is a conservative 31%. In fiscal year 2011, the company produced $2.3 billion in free cash flow even after paying $969 million in dividends and $501 million in capital expenditures. Its debt-to-equity ratio is 62% and its interest coverage ratio is a healthy 10x.

According to CNBC data, consensus estimates of MDT’s 3-5 year EPS growth rate is 8%, well below the medical device industry’s 15% expected growth rate. However, the low growth is priced into the valuation; MDT trades at a trailing twelve month P/E of 10.4x, a low multiple in comparison to the industry’s 17.3x average.

St. Jude Medical (NYSE:STJ) – Dividend Yield 2.55%

STJ has a 35-year history and a product portfolio of atrial fibrillation, cardiac rhythm management, cardiovascular, and neuromodulation products that is sold is 100 countries. The company invests a 12.5% of annual sales in R&D. With a 21.5% five-year EPS CAGR, a payout ratio of only 23%, and interest coverage of 19.8x, STJ’s $0.21 quarterly dividend is secure.

CNBC reports that consensus estimates have pegged STJ’s 3-5 year EPS growth rate at 16.5% compared to 15% for the medical device industry as a whole. Despite this, STJ has a trailing P/E of 10.4x versus the industry average of 17.3x. I believe this is due to several short-term risk factors. However, STJ offers a secure dividend – with room for dividend raises – and excellent long-term EPS growth potential.

Baxter International (NYSE:BAX) – Dividend Yield 2.79%

BAX is a company with a $27 billion market cap and an 80-year history. The company deals in a wide range of bioscience products ($5.7 billion 2010 sales), medication delivery solutions ($4.8 billion 2010 sales), and renal therapies ($2.4 billion 2010 sales). BAX has an interest coverage ratio of 11x and a payout ratio of 33%. A 3-5 year consensus EPS growth rate of 12.5% is more than enough to secure the quarterly dividend, which was just raised to $0.335 from $0.31 in the previous quarter.

BAX also appears attractive at its current valuation. An excellent Seeking Alpha article by Bret Jensen that was just released offers 7 reasons why Baxter is undervalued at $48 a share.

STERIS Corp. (NYSE:STE) – Dividend Yield 2.42%

STE is a $1.63 billion market cap company comprised of three segments: healthcare, life sciences, and Steris Isomedix services. The healthcare segment offers a range of sterilizers and capital equipment to healthcare providers while the life sciences segment offers similar types of products to pharmaceutical companies. The Isomedix segment sells processing services that use gamma irradiation and ethylene oxide technologies. The company was founded in 1985 but has roots back to a sterilization company founded in 1894.

STE has an interest coverage multiple of 15.7x and a total debt-to-equity ratio of just 24.5%. STE’s payout ratio is 64.82%, which may suggest that the company is not giving itself the cash it needs to grow EPS. However, with a consensus 3-5 year EPS growth rate at 15.4%, a strong balance sheet, a stable product portfolio, and a trailing P/E of 13.2x – well below the industry average of 17.3x – STE is worth a look.

Mine Safety Appliances Co. (NYSE:MSA) – Dividend Yield 3.14%

MSA has a market cap of $1.2 billion and purports to be the only publicly-traded safety company in the United States. Originally founded in 1914 as a manufacturer of safety equipment for coal mining, MSA now operates 13 factories in 8 countries. Its products include air purifying respirators; eye, face, and hearing protection; fall protection; gas detection instruments; head protection; supplied-air respirators; and thermal imaging cameras. Customers groups include companies involved in the following activities: oil and gas products, construction, mining, fire service, law enforcement, military, and homeland security.

Though MSA is not a traditional medical device company, I have included it in this list because it operates much the same way in terms of R&D spend and sales motion. It is also an alternative for the investor concerned about 510(k) risk. The company has a diversified portfolio of products that are essential in a number of recession-resistant industries.

MSA is significantly riskier than other stocks on this list. Its dividend payout ratio is 58%. As a general rule of thumb, payout ratios above 50% may be an early warning sign that the company is paying out too much of its earnings in dividends. In this case, the 58% figure is due to declines in EPS that occurred in 2009 and 2010. Poor economic conditions meant less development activity and therefore less need for safety devices. EPS has picked up again in 2011, but consensus estimates have 3-5 year EPS declining.

Still, the current $0.26 dividend is supported by a reasonably strong balance sheet. The company’s debt-to-equity ratio is 84% and its interest coverage ratio is 8.5x. MSA is positioning itself in Asia, Eastern Europe, and Latin America to take advantage of future growth in those developing markets. The company has increased global R&D spend 50% over the past five years.

For investors who see growth in developing markets, MSA could be a defensive means of getting exposure. For such investors, the current MSA stock price offers value. It currently trades at a P/E of 19x compared to 30x one year ago when the company had lower EPS. MSA could be a good pick for the long-term investor willing to wait for improvement in the global economy while collecting a 3.14% dividend.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 5 Medical Device Dividend Buys