Medtronic (MDT, Financial) was founded in 1949. The company has grown into the largest publicly traded medical technology company with a market cap of $71 billion. The company has paid increasing dividends for 35 years making it a Dividend Aristocrat and the focus of part 44 of the Dividend Aristocrats In Focus series. When I last analyzed Medtronic, the company had just released favorable second quarter results which sent shares higher. The company’s operations are analyzed below.
Business Overview
Medtronic manufactures and markets medical devices and technology. The company operates in 3 distinct segments: Cardiac & Vascular, Restorative Therapies, and Diabetes. Each of the three segment’s percentage of total revenue for the company’s most recent quarter is shown below to give an idea of the relative importance of each segment to Medtronic:
- Cardiac & Vascular: 52% of total revenue
- Restorative Therapies: 38% of total revenue
- Diabetes: 10% of total revenue
Covidien Acquisition & Growth Prospects
Medtronic is going through a transition at this time. In June of 2014 the company announced it would acquire Irish medical device company Covidien for $42.9 billion. The deal is expected to close in the first quarter of 2015. The Covidien deal will propel Medtronic forward in three key areas: portfolio diversification, globalization, and tax efficiency.
Covidien is a large company approximately 2/3 the size of Medtronic. The acquisition will significantly expand Medtronic’s portfolio of products and intellectual property. Covidien specializes in surgical products, patient care products, and nursing care products while Medtronic specializes in cardiac, vascular, and orthopedic products. The image below shows how the combined business will be significantly more diversified within the medical technologies industry than either company was on its own.
Source: Medtronic Investor’s Presentation
Medtronic will gain better access to global markets with the Covidien acquisition. Covidien generates over 50% of its revenue outside the US. The company also has realized $1.6 billion in emerging market revenue over the past year. Covidien is based on Ireland, and has a strong presence Europe.
Covidien’s Irish domicile is not beneficial simply for global diversification. Ireland has a low corporate tax rate of 15%, less than half that of the US’s 35% corporate tax rate. Medtronic has plans to do a tax inversion when it acquires Covidien and relocate the company’s headquarters to Ireland. The move will allow Covidien to repatriate international earnings to Ireland at a 15% corporate tax rate instead of the US’s comparatively onerous 35% corporate tax rate.
Over the next several years, Medtronic’s growth will be driven by the integration of Covidien’s operations. Medtronic is still experiencing solid growth on its own. The company has grown revenue per share at 6.4% over the last decade. EPS have increased at a slightly faster 7.1% rate per year over the same time period. Medtronic’s EPS growth appears to be accelerating. The company has an EPS growth guidance of 7% to 10% for full fiscal 2015.
Competitive Advantage
Medtronic’s historical growth and competitive advantage rest on its strong research and development operations and its robust intellectual property portfolio. The company has grown to be worth over $70 billion through innovation within the medical technology industry. Medtronic has spent an average of 9.1% of sales on research and development over the last 3 years. In fiscal 2014, Medtronic spent $1.48 billion on research and development; a sizeable sum for the company. Strong research and development spending has given the company a robust product pipeline. The image below shows the company’s expected new products over the next two years.
Source: Medtronic Investment Conference Presentation
In addition to the company’s research and development specialization, Medtronic has a competitive advantage resulting from its large size, global reach, and long history in the health care industry. The company’s supply chain and contacts would be very difficult for competitors to replicate. As the company grows organically and through the Covidien acquisition, it will only broaden its reach and deepen its expertise in the medical industry.
Dividend Analysis, Shareholder Return & Valuation
Medtronic has a dividend yield of 1.7%. For comparison, the S&P 500 has a dividend yield of about 1.9%. Medtronic has a low payout ratio of just 35% of expected fiscal 2015 EPS. The company’s solid growth potential and low payout ratio give it substantial room to grow its dividend for years to come.
Shareholders of Medtronic can expect a return of between 8.5% and 12% per year going forward. Dividend payments will contribute 1.7% of this. Acquisitions, organic growth, and share repurchases should fuel EPS growth of somewhere around 7% to 10% going forward.
Medtronic is trading at a P/E ratio of about 18 times expected fiscal 2015 EPS. The S&P 500 currently has a P/E ratio of about 20 and a forward P/E ratio of about 17. Medtronic ‘s fiscal 2015 is half way over; an average of the S&P 500’s current and forward P/E ratio is 18.5, slightly higher than Medtronic’s fiscal 2015 EPS P/E ratio. Over the last 6 years, Medtronic has traded at a discount to the S&P 500’s P/E ratio. The 6 years prior to that, Medtronic traded at a premium to the S&P 500. I believe the company should trade at a premium of about 1.1x to the S&P 500’s P/E ratio due to its strong growth prospects and stability. At current prices, Medtronic is somewhat undervalued.
Recession Performance
Medtronic performed exceptionally well through the Great Recession of 2007 to 2009. The company saw EPS increase each year of the Great Recession. Medtronic saw strong growth despite a weakening economy because health care spending is difficult to cut back on, even during times of economic weakness. The company’s EPS through the Great Recession are shown below to give an idea of how well the company performed over this time period:
- 2007 EPS of $2.61
- 2008 EPS of $2.92 (12% increase)
- 2009 EPS of $3.22 (10% increase)
- 2010 EPS of $3.37 (5% increase)
Final Thoughts
Medtronic is a Top 20 stock based on The 8 Rules of Dividend Investing due to its solid growth, low payout ratio, and stability. The company makes a solid investment for long-term investors seeking exposure to the health industry. Medtronic has significant growth opportunities ahead and will likely see solid growth in the short-term as it acquires Covidien.
