By The Valuentum Team
Medtronic's Investment Considerations
• Medtronic (NYSE:MDT) 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 recently bought Covidien in a tax-inversion deal. It is a Dividend Aristocrat and traces its roots back to the late 1940s.
• The integration of Covidien may steal the headlines in coming quarters, but all three of Medtronic's legacy businesses are performing well. Its innovation capabilities have made it a partner of choice for hospitals. The firm has remained active in M&A through smaller, tuck-in acquisitions.
• Medtronic's baseline, organic expectations are achievable. Over the long haul, the company expects to deliver consistent mid-single-digit revenue growth, consistently grow earnings per share 200-400 basis points faster than revenue, and return 50% of free cash flow to shareholders. The deal with Covidien will generate significant synergies and may change these targets, however.
• The company's emerging market business should be a strong source of growth. On a pre-Covidien basis, Medtronic is targeting a 20% CAGR in emerging markets, and expects emerging markets to represent 20% of its legacy revenue mix by mid-decade (it had currently been ~12%).
• Medtronic is one of the most exciting companies in the medical devices industry. It is targeting 4%-6% operational revenue growth for fiscal 2016 and diluted cash earnings per share in the range of $4.36-$4.40, which includes a hefty currency headwind.
• We're watching the company's financial leverage, as it recorded short-term borrowings and long-term debt of nearly $36 billion versus a cash and investments balance of $17.3 billion at the end of January 2016; it has taken on a significant amount of debt to facilitate the Covidien transaction. At the end of fiscal 2013 (ending in April), by comparison, Medtronic had short-term borrowings and long-term debt just north of $10 billion, less than a third of its current balance.
• Medtronic plans to return at least 50% of its adjusted free cash flow to shareholders through dividends and share repurchases. If the company makes good on its target to generate $40 billion in adjusted free cash flow over the next 5 years, the sheer magnitude of free cash flow generation offers significant promise for the payout. For one, on an annual run-rate basis, following the massive ~25% dividend hike in June, the company's dividend obligations are barely north of $2 billion.
Economic Profit Analysis
In our opinion, 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 42.2%, 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.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Medtronic's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.5 (anything above 1 is considered strong).
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 25% 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 increased about 0% from levels registered two years ago, while capital expenditures expanded about 25% over the same time period.
Through the first three quarters of fiscal 2016, Medtronic reported cash from operations of nearly $3.9 billion and capital expenditures of ~$700 million, resulting in free cash flow of $3.2 billion. This represents an increase of nearly 20%.
This is the most important portion of our analysis. Below we operate on our valuation assumptions and derive a healthy fair value estimate for shares.
Our discounted cash flow model indicates that Medtronic's shares are worth between $54-$80 each. Shares are currently trading at ~$74, in the upper half of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from the historical volatility of key valuation drivers. The estimated fair value of $67 per share represents a price-to-earnings (P/E) ratio of about 27.8 times last year's earnings and an implied EV/EBITDA multiple of about 15.1 times last year's EBITDA.
Our model reflects a compound annual revenue growth rate of 10% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 7.8%. Our model reflects a 5-year projected average operating margin of 23.8%, 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.
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 $67 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 above, we show this probable range of fair values for Medtronic. We think the firm is attractive below $54 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 $67 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above 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 $86 per share in Year 3 represents our existing fair value per share of $67 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.
Wrapping Things Up
We've been huge fans of the Medtronic-Covidien tie up, and part of the reason has to do with the tremendous free cash flow generation capacity the combined entity retains. Our biggest concern with Medtronic, however, has little to do with its business strength or its free-cash-flow generating prowess. Instead, we're watching the company's financial leverage, as it recorded short-term borrowings and long-term debt of nearly $36 billion versus a cash and investments balance of $17.3 billion at the end of January 2016; it has taken on a significant amount of debt to facilitate the Covidien transaction. At the end of fiscal 2013 (ending in April), by comparison, Medtronic had short-term borrowings and long-term debt just north of $10 billion, less than a third of its current balance.
That said, CEO Omar Ishrak was quick to note that his team plans to return at least 50% of its adjusted free cash flow to shareholders through dividends and share repurchases. If the company makes good on its target to generate $40 billion in adjusted free cash flow over the next 5 years, the sheer magnitude of free cash flow generation offers significant promise for the payout. For one, on an annual run-rate basis, following the massive ~25% dividend hike in June, the company's dividend obligations are barely north of $2 billion.
The extra debt on Medtronic's books certainly has our attention, but we like the company's willingness to increase the payout on the basis of its future targets of free cash flow. Look for more dividend increases, as Medtronic accelerates its dividend payments to reflect a 40% payout ratio (it is ~34% currently). We continue to like the company as a holding in the Dividend Growth Newsletter portfolio, but it's also fair to say that we may trim our weighting should shares continue to run far ahead.
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Disclosure: I/we 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.