Healthcare is one of the sectors that I see a long growth runway playing out over the next few decades. The combination of an aging population in most developed markets as well as the rising number of middle class families in developing/emerging markets should continue to keep the sector moving forward.
Becton, Dickinson and Company (NYSE:BDX) is poised to capitalize on those population trends. Becton, Dickinson is the world's largest manufacturer and distributor of medical products such as syringes and needles, the class razor blade business model. They also make a variety of diagnostic instruments as well as infusion pumps and ventilators. After being in a hospital with our son for 8.5 months it was amazing to see just how many Becton, Dickinson products were used on a daily basis.
Becton, Dickinson's share price is only up ~5% since I last examined the business so I wanted to see how things have changed and update my valuation on what I consider to be a high-quality business.
The investment strategy that I gravitated towards when I started my investment journey was dividend growth investing. That means that I want to focus on what I deem to be quality businesses that have a history of and a likelihood of continuing to pay and grow dividends.
Image by author; data source Becton, Dickinson & Company Investor Relations
*An interactive version of this chart is available here.
Becton, Dickinson and Company is a Dividend Champion with 48 consecutive years of dividend growth. That dividend growth streak has survived numerous recessions and market pullbacks as well as just about every economic environment you can think of.
Of the 48 1-year periods during Becton, Dickinson's streak annual dividend growth has ranged from 2.2% to 40.0%. The average annual growth has worked out to 11.4% with a median of 10.6%.
There's been 43 rolling 5-year periods during BDX's streak and annualized dividend growth over those periods has ranged from 5.5% to 21.4% with an average of 11.4% and a median of 10.9%.
Of the 39 rolling 10-year periods, annualized dividend growth has ranged from 8.3% to 16.7% with an average of 11.6% and a median of 10.8%.
That's remarkable consistency in dividend growth over nearly half a century. That sustained dividend growth has led to the dividend being up nearly 17,000% for investors that purchased in 1972.
The 1-, 3-, 5- and 10-year rolling dividend growth rates since 1962 can be found in the following table. Dividends are based on calendar year payouts.
Table and calculations by author; data source Becton, Dickinson & Company Investor Relations
*An interactive chart of the information presented in the table can be found here.
Businesses have many ways to grow their dividend the most important being growth in the underlying business. However, companies can also expand their payout ratio to support the dividend during times of struggle for the business or to increase the pace of dividend growth. The payout ratio allows investors to get a quick gauge on the safety of the dividend and its sustainability.
Prior to the C.R. Bard acquisition in FY 2015, the payout ratio based on net income and free cash flow typically tracked each other and ranged between ~25%-40%. The average free cash flow payout ratio over the last decade works out to 37.5% with the 5-year average at 40.1%.
The two main goals for my investment strategy are to invest in businesses that have a history of paying and growing their dividends and that I believe have a moat around their business to keep returns high. One of the ways I do that is to look at various financial metrics to determine the quality and the strength of the business.
The first thing I want to see is how revenues have done over the last decade. Becton, Dickinson has done a great job growing the top line from $7.37 B in FY 2010 to $17.29 B in FY 2019 although a good portion of that growth has come via acquisitions rather than true organic growth. In total sales have grown 135% over the last decade or ~9.9% per year. The 2 largest acquisitions were C.R. Bard in 2017 and Carefusion in 2014.
Despite the impressive growth in revenues, operating income only grew from $1.68 B in FY 2010 to $2.24 B in FY 2019. That's just 33% total growth or 3.3% annualized.
Operating cash flow has fared better than operating income growing from $1.74 B to $3.33 B over the same period. That represents 90.8% total growth or 7.4% annualized.
Meanwhile, free cash flow grew from $1.11 B to $2.37 B which is 113% growth or ~8.8% per year.
I consider a free cash flow margin >10% to be a sign of a business that generates ample free cash flow. Becton, Dickinson is doing well on that front hitting >10% every year for the last decade. The 10-year average free cash flow margin is 13.6% with the 5-year average at 13.3%.
My preferred profitability metric is the free cash flow return on invested capital, "FCF ROIC." The FCF ROIC represents the annual cash return that a business generates on the capital invested in the business. My goal is to find businesses that earn and can reinvest at high returns on capital. I consider a business that generates >10% FCF ROIC to be a strong business.
Prior to the CareFusion purchase in FY 2014, FCF ROICs were well above the 10% threshold. The ~$12.2 B acquisition was financed primarily with debt which led to FCF ROIC's declining from ~14-15% area to the ~5%. Over the last decade Becton, Dickinson's FCF ROIC has averaged 10.2%, although the most average for the last 5 years is just 6.3%.
I want the businesses that I invest in to use their cash flows in ways that align with shareholders. That means the number one priority is to protect the business via capital expenditures. If there's free cash flow then I would expect some to be funneled to owners via dividends. Any excess cash flow would then be used for debt reduction, acquisitions, building cash reserves or share repurchases.
To understand how Becton, Dickinson & Company uses its free cash flow, I calculate three variations of the metric, defined below:
Ideally, a prospective investment would show positive FCFaDB more often than not. I'm not concerned with a negative value in any given year; rather, it's the trend over the longer term that I pay closer attention too. A consistently negative FCFaDB means that the excess spending is being funded via asset sales, cash on the balance sheet or taking on additional debt; none of which are good for shareholders.
For starters, Becton, Dickinson has had positive FCF every year which is what has allowed management to move to dividends as a way to return cash to shareholders.
In total, BDX has generated $14.54 B in FCF and paid out a total of $5.52 B in dividends over the last decade. That puts the cumulative FCFaD at $9.02 B and Becton, Dickinson has also managed a positive FCFaD every year.
The strong FCFaD has allowed management to pursue buybacks to return additional excess cash flow to shareholders. Over the last decade, Becton, Dickinson has spent $4.82 B on buybacks with 10-year total FCFaDB of $4.20 B.
Image source: Author; data source: Becton, Dickinson & Company SEC filings
Becton, Dickinson's share count rose from 230.0 M in FY 2010 to 270.5 M in Fy 2019 due to the various acquisitions starting in FY 2015. In total, the share count has increased by 17.6% although all of the increase has come since the C.R. Bard and CareFusion acquisitions. Prior FY 2015 the share count had declined every year for a total decrease of 16.5% or ~4.4% annually.
As I mentioned above, my preference is to see a management team that prioritizes their cash flow first towards the business, then to dividends and only if there's excess left over move to share buybacks.
For some perspective on Becton, Dickinson's use of cash flow, the following chart shows the breakdown of cash used for shareholders.
In FY 2011 and 2012, management was quite aggressive with their share repurchases spending nearly as much on buybacks through free cash flow as well as through non-FCF supported. Considering management was able to reduce the share count by 6.6% and 8.3%, respectively, in those years it's reasonable to assume that management saw significant undervaluation in their shares at that time.
Starting in FY 2015, share repurchases have ground to a halt while management follows through on their plan to de-lever the balance sheet after the two large acquisitions.
Debt is a double-edged sword and while I prefer for the companies I own to carry little to no debt that would also severely limit the investment possibilities. Therefore, I want to see reasonable and stable debt levels from the businesses that I won. Over the last decade, Becton, Dickinson's debt-to-capitalization ratio has seen large fluctuations due to the acquisitions and has ranged from 23.8% to 64.2%. The average over the last decade has come to 46.5%.
The debt that Becton, Dickinson & Company does carry on its balance sheet is very affordable. At the end of FY 2019, the free cash flow interest coverage ratio stood at 3.7x. Based on FY 2019's balance sheet and free cash flows, BDX could pay off all of their current debt load with 8.2 years of FCF and 14.0 years of FCFaD.
I have no concern regarding the leveraged balance sheet at this time. The debt service is manageable and management appears committed to the de-leveraging process.
One method that I use to value a prospective investment is the minimum acceptable rate of return ("MARR") analysis. A MARR analysis requires you to estimate the future earnings and dividends that a company will produce, apply a reasonable expected multiple to those future earnings and then determine whether the expected return exceeds your threshold for investment.
Analysts expect Becton, Dickinson to report FY 2020 EPS of $12.57 and FY 2021 EPS of $14.00. Over the next 5 years, analysts expect Becton, Dickinson to grow earnings 9.6% per year. I then assumed that BDX would manage 5.0% per year earnings growth for the following 5 years. Dividends are assumed to target ~25% payout ratio.
Historically, market participants have valued Becton, Dickinson's TTM EPS between ~10x - 30x and I will use those multiples for the MARR analysis.
The following table shows the potential internal rates of return than an investment in Becton, Dickinson & Company could provide if the assumptions laid out above come to pass. Returns include dividends taken in cash and are calculated assuming a purchase price of $261. Returns are run through the end of calendar year 2024, "5-Year," and calendar year 2029, "10-Year."
|P/E Level||5 Year||10 Year|
Alternatively, I want to know what price to purchase shares in order to generate the returns that I'm after. The target returns that I will use are 10%, my typical minimum threshold, 9% and 12%. The 9% is derived from the estimated 10-year earnings growth rate of 7.7% plus the starting dividend yield of 1.2% while the 12% includes a 25% margin of safety normalizing over 10 years of ~2.25% annualized.
|Purchase Price Targets|
|10% Return Target||9% Return Target||12% Return Target|
|P/E Level||5 Year||10 Year||5 Year||10 Year||5 Year||10 Year|
Dividend yield theory is another valuation method to get a quick gauge of the current valuation. Dividend yield theory assumes that the 5-year average dividend yield is a good proxy for the fair value of established businesses with a history of paying dividends.
Image by author; data source: Becton, Dickinson & Company Investor Relations and Yahoo Finance
*An interactive version of this chart is available here.
Becton, Dickinson shares currently yield 1.21% compared to the 5-year average dividend yield of 1.48%. Dividend yield theory suggests a fair price of $214.
Becton, Dickinson & Company is a high quality business that I believe is poised to take advantage of the aging population trends across the developed world as well as the rising middle class across the developing/emerging economies.
The recent dividend increase of 2.6% announced in late November left a lot to be desired as it strayed far from the norm that Becton, Dickinson has provided its owners. However, that was due to the two large acquisitions, CareFusion and C.R. Bard, that Becton, Dickinson has made since FY 2015 and subsequent increase in leverage.
Management has committed to de-levering the balance sheet and thus far has delivered on that promise. As such, I expect lower than normal dividend growth over the next 1-2 years as the company continues the de-levering process before returning to high single to low double-digit annual increases.
The fact that management is following through with the plan to reach investment grade ratings again strengthens the case that management is looking at the long term.
Dividend yield theory suggests a fair value range for Becton, Dickinson & Company between $194 to $238. My fair value range based on the MARR analysis is $210 to $262. At a current price around $261 shares appear to be on the upper end of fair value.
I've owned shares of Becton, Dickinson since April 2015 and have been more than happy with the returns those shares have offered. It's hard to complain about 15%+ IRRs.
I've been nibbling by adding more shares over the last few months on dips into the $240s now that commissions are largely $0 for most U.S. based investors and plan to continue doing so. I would feel more comfortable adding large size purchases on pullbacks into the $230s or lower.
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Disclosure: I am/we are long BDX. 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: I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.