Exploring 3 Medical And Safety Device Manufacturers

Includes: MDT, MSA, ZBH
by: Valuentum

The medical devices industry is heavily regulated and characterized by rapid technological change.

Medical device firms can gain advantages by developing products with differentiated clinical outcomes or by creating patent-protected technology.

In this article, we dig into three very different companies that all share one goal: creating the best devices to solve the world's greatest health and safety issues.

Image Source: Medtronic investor presentation

By Valuentum Analysts


The medical devices industry is heavily regulated and characterized by rapid technological change. Firms have been forced to compete on price due to economically-motivated buyers, consolidation among healthcare providers, and declining reimbursement rates. Healthcare reform measures have put additional pressure on procedure rates and market sizes. Still, firms can gain advantages by developing products with differentiated clinical outcomes or by creating patent-protected technology. Since most constituents hold important patents or trade secrets, we tend to like the group.

In this article, we will dig into three very different companies that all share one goal: creating the best devices to solve the world's greatest health and safety issues. The ideas in this article may not provide the highest available dividend yields, but dividend growth potential exists among some ideas. Solid dividend track records speak to the commitment of management to shareholder-friendly policies, and multiple ideas in this article boast this trait. However, we find forward-looking, cash-flow based analysis to be the most effective means of identifying dividend growth ideas that are poised to continue growing the payout well into the future. With that in mind, let's take a look at three ideas in the space.

Medtronic (MDT) - Dividend Yield: ~2.2%

Image Source: Medtronic investor presentation

Medtronic is a global leader in medical technology. The company currently functions in four operating segments: Cardiac & Vascular, Minimally Invasive Therapies, Restorative Therapies, and Diabetes. Medtronic bought Covidien in a tax-inversion deal in 2015 and recently sold its Patient Care, Deep Vein Thrombosis, and Nutritional Insufficiency businesses.

Medtronic's baseline, organic expectations are achievable. Over the long haul, the company expects consistent mid-single-digit currency-neutral revenue growth, ~8% adjusted EPS growth on a constant currency basis, and to return 50% of free cash flow to shareholders. Medtronic identifies three diversified growth vectors it expects to help it achieve its mid-single-digit revenue growth target: a full pipeline of new therapies (expected annual growth of 2-3.5%), penetration of existing therapies into emerging markets (1.5-2%), and driving annuity revenue in services and solutions (0.4-0.6%).

Medtronic expects fiscal 2019 organic revenue growth to be 5.25-5.5%, up from initial guidance of 4-4.5%. Earnings per share leverage is expected as a result of ongoing operating margin improvement, and free cash flow is expected to be in a range of $5-5.2 billion. Its 'Diabetes' segment has turned in double-digit growth of late, thanks in part to robust demand for its MiniMed 670G insulin pump system.

Medtronic is a Dividend Aristocrat, and it has grown its per share dividend at an 18% CAGR over its 40-year history. Management remains committed to returning at least 50% of free cash flow per year to shareholders via dividends and share repurchases, which have been relatively balanced of late.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside for shares based on our fair value estimate (see image that follows):

Key Strengths

We've been big fans of Medtronic's recent acquisition of Covidien, partially due to the tremendous free cash flow generating capacity the combined entity retains. CEO Omar Ishrak has noted that his team plans to return at least 50% of adjusted free cash flow to shareholders via dividends and share repurchases in coming years, but the company's target of $40 billion in adjusted free cash flow generation over the 5 fiscal years following the deal's closing, has come into question more recently. It expects an 80% free cash flow conversion ratio in the coming years, and it is targeting a payout ratio of ~40%. Share repurchases and dividend payments are projected to come in at ~$10 billion in the five-year period ending in fiscal 2019.

Potential Weaknesses

While our free cash flow generation forecasts were increased following management commentary surrounding the Covidien acquisition, so too was the firm's debt load, which keeps its Dividend Cushion ratio below historic highs. Deleveraging initiatives are sure to eat up significant amounts of capital in coming years, but if management is able to deliver on its free cash flow generation targets, there will be plenty of cash available for income-minded investors. Share repurchases will make up a large portion of the cash to be returned to shareholders, but the sheer magnitude of the company's free cash flow targets and it achieving targeted synergies from the Covidien deal allow us to keep our optimistic opinion of its dividend growth profile.

Image shown: Medtronic is currently trading at $93 per share, which is firmly in the lower half of our fair value range. We think shares have notable upside potential.

MSA Safety (MSA) - Dividend Yield: ~1.5%

Image Source: MSA Safety Annual Report

MSA Safety makes products that protect people's health and safety, and due to the preventative nature of its products, we view a large part of MSA's business as being related to the healthcare, or medical devices more specifically, field. Its safety products typically integrate any combination of electronics, mechanical systems, and advanced materials to protect users against hazardous or life-threatening situations. Investors should know that the safety products market is highly competitive, with participants ranging in size from small companies focusing on a single type of personal protection equipment to a few large multinational corporations.

The global safety market is estimated at $40-45 billion, and MSA Safety estimates its addressable market at ~$7 billion. We like that the products MSA Safety sells are generally considered non-discretionary since they protect workers in hazardous and life-threatening work environments, and it focuses on sophisticated products that require technology differentiation and have high barriers to entry.

Both the oil and gas and industrial end markets have been improving, but confidence remains understandably tempered as clients in these areas work to right-size spending. The company generates ~26% of total revenue from emerging markets, where new and increasingly enforced safety regulations are driving growth opportunities. MSA Safety's long-term financial goals include mid-single-digit constant currency revenue growth, cost structure and margin expansion, EBITDA growth at 1.5-3x revenue growth, and 100%+ free cash flow conversion. Acquisitions, product development, and a growing dividend are among capital priorities.

Here's what we say about its dividend, and as for its valuation, we're not seeing much upside based on our fair value estimate (see image that follows):

Key Strengths

The fact that MSA Safety's products are generally non-discretionary provides a degree of resiliency to its business, and its focus on markets with high barriers to entry helps keep competition limited. The company holds a leading market position in nearly all of its core products, which account for ~85% of total revenue. Management's focus on continual EBIT margin expansion is admirable, and we love its target to convert 100% of net income into free cash flow. Free cash flow generation averaged ~$182 million over the past three years (2016-2018), which is more than three times its annual run-rate cash dividend obligations of $57 million. MSA Safety has more than 50 consecutive years of consecutive dividend increases.

Potential Weaknesses

We're big fans of MSA Safety's free cash flow coverage of its dividend payments, and its tremendous dividend track record speaks for itself, which makes it increasingly difficult to find holes in its dividend profile. The company has also done a nice job in reducing its debt load recently, as it held $166 million in net debt at the end of 2018, which marks a significant decrease from $340 million a year earlier. We're expecting ongoing growth in the payout on the basis of its reasonable balance sheet and strong free cash flow coverage of dividends, but competing uses of capital have the potential to impact the pace of dividend growth moving forward, including M&A activity and share repurchases.

Image shown: MSA Safety is currently trading at $100 per share, which is near the upper bound of our fair value range. We don't see too much upside potential in shares at current levels.

Zimmer Biomet (ZBH) - Dividend Yield: ~0.8%

Image Source: Zimmer Biomet quarterly presentation

Zimmer Biomet, which was formed as a result of the merger of Zimmer and Biomet in 2015, produces orthopedic reconstructive devices, spinal and trauma devices, biologics, dental implants, and related surgical products in the Americas, Europe, and Asia Pacific. Zimmer Biomet has remained acquisitive since the big merger, though the acquisitions have been of the smaller, tuck-in variety. Recent examples include the purchase of a Dutch developer of 3D range of motion technology and a musculoskeletal diagnostics testing firm. The firm has spent $1.5 billion on 8 M&A transactions since the Biomet merger.

Knees, hips, and S.E.T. (surgical, sports medicine, foot & ankle, extremities, and trauma) are Zimmer Biomet's three largest markets in terms of revenue generated at 35%, 24%, and 22%, respectively. The company is a market leader in the hip and knees musculoskeletal solutions space with 37% share in knees and 32% share in hips. It also holds 11% share of the S.E.T. market.

There are multiple drivers of sustainable growth present for Zimmer Biomet such as favorable global demographics (65+ age group growing), penetration opportunity in developed markets, expanding access to healthcare in emerging markets, and accelerating innovation. Zimmer Biomet is expecting top-line growth to remain muted in the near term, and adjusted operating profit margin is expected to be roughly 27-28% in 2019 compared to 27.9% in 2018. Its $1.1-1.3 billion free cash flow generation target for the year leaves a bit to be desired as well.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside for shares based on our fair value estimate (see image that follows):

Key Strengths

Zimmer Biomet's value creation framework consists of a three-pronged capital allocation strategy focused on long-term returns. We like the firm's strong free cash flow generation, but its paltry dividend yield leaves a great deal to be desired. The company has ambitious financial goals through 2020, as it is targeting revenue growth of 4%+, an adjusted operating margin of more than 35%, adjusted EPS growth of 10%+, and annual free cash flow generation of more than $2 billion. We like what such targets mean for future dividend growth potential, but investors must be aware of the increased financial leverage that came as a result of the Zimmer-Biomet tie-up. We think there are far better dividend growth opportunities available.

Potential Weaknesses

Zimmer Biomet's Dividend Cushion ratio has taken a substantial hit due to the significant increase in its debt load following the Zimmer-Biomet merger. As of the end of 2018, the firm's long-term debt was ~$8.4 billion, compared to just over $1.4 billion at Zimmer at the end of 2014 (but down from ~$10.7 billion at the end of 2016). If management is able to deliver on its financial targets, we see no cause for concern as it relates to the long-term health of the company, but it will more than likely impact the pace of dividend expansion in the near term. Though management has indicated share repurchases will be a core portion of its capital allocation program, we think this capital may be more prudently used in shoring up its balance sheet.

Image shown: Zimmer Biomet is currently trading at ~$124 per share, which is in the upper half of our fair value range. We don't think shares offer an attractive valuation opportunity at current levels.


We see little valuation opportunity in MSA Safety and Zimmer Biomet at current levels, leaving us rather less than excited about shares at this juncture. MSA Safety's long-term dividend track record is certainly an impressive feat, and its ongoing free cash flow coverage of dividend payments suggests there is ample room for dividend growth to continue. The non-discretionary nature of the majority of its products provides support to long-term dividend health as well. Zimmer's financial leverage leaves us uninterested in its dividend growth potential, and its low dividend yield is not likely to attract income-oriented investors. The company does hold solid share in some attractive markets, but shares appear fairly valued at current levels.

Medtronic is our favorite idea of this group of three due to its strong free cash flow generating potential and relatively attractive valuation opportunity. The company's debt load was notably increased by the Covidien deal, but so too was its free cash flow-generating capacity, which drives our expectations for future dividend growth. As a result of this free cash flow-generating capacity, it retains a solid Dividend Cushion ratio despite the increased financial leverage. We think its long-term targets are reasonable, and investors should expect management to continue its shareholder-friendly ways. As with any company operating in such a rapidly developing and highly regulated field, however, future success can depend on its ability to successfully realize the potential that lies within its pipeline of future products.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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.