Medtronic, Inc. (MDT): Should You Buy This Dividend Aristocrat?

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As the market becomes more volatile and high-grade dividend stocks begin to fall in price an opportunity opens up to buy those stocks at a more reasonable price than the last few months have offered. I recently introduced my Dividend Growth Watchlist, a list of dividend stocks with suggested buy targets, to make it simpler to track the prices of high-quality dividend stocks and determine when they become undervalued. Today I’ll look at the recently minted dividend aristocrat Medtronic, Inc. (NYSE:MDT).

Medtronic, Inc. (NYSE:MDT)

A cash machine

Medtronic, Inc. (NYSE:MDT) was recently added to the S&P 500 Dividend Aristocrat Index after reaching 35 years of consecutive dividend increases. Medtronic is in the medical technology business, creating products and therapies which today treat nearly 40 different medical conditions. The company is large, with a $50 billion market capitalization and about $16 billion in annual revenue.

One thing which makes Medtronic stand out is its exceptional cash generation. In fiscal 2013, which ended in April, the company generated $4.4 billion in free cash flow, or nearly 27% of the revenue. Medtronic, Inc. (NYSE:MDT)’s return on equity, or ROE, is an impressive 23.7%.

The company is committed to returning at least 50% of the free cash flow to shareholders through both dividends and buybacks, and in fiscal 2013 the company spent over $1.2 billion on share buybacks and over $1 billion on dividend payments. Combined these eat up about half of the free cash flow. The payout ratio with respect to the free cash flow is roughly 25%.

Medtronic, Inc. (NYSE:MDT) could raise the dividend significantly, but the company seems to favor increased buybacks instead. The current dividend yield is 2%, but the company could easily support a 3% dividend or higher by simply favoring dividends over buybacks. This doesn’t seem likely to happen, though.

Over the past decade Medtronic has raised its dividend fairly rapidly, at an annualized rate of 16%. The most recent increase, occurring at the beginning of last year, was a measly 7.2% in comparison. Medtronic, Inc. (NYSE:MDT) is due to increase its dividend again within the next few weeks, if history is any indication, so we’ll have to wait and see by how much the company increases the payment.

One serious area of growth for Medtronic is in emerging markets. Revenue from emerging markets has been growing at a 19% CAGR since fiscal 2008, and over the next five years the company expects emerging markets to make up about 20% of the company’s total revenue.

Source: Medtronic presentation

Success in emerging markets should allow Medtronic to continue growing its revenue, earnings, and dividend well into the future.

Because Medtronic’s yield is so low the required dividend growth rate is fairly high, well beyond 7.2%. It’s hard to predict how fast the dividend will increase in this case because it could be doubled tomorrow and still be completely sustainable. But the company favors buybacks over a higher dividend. For this reason Medtronic, Inc. (NYSE:MDT) isn’t a great dividend stock, and the price would have to be pretty low to justify its purchase as such. How low? Well, let’s split the difference and say that the dividend growth rate over the next decade will be 12%, roughly half-way between the historical rate and last year’s increase. I’ll do a simple dividend discount model calculation to estimate the fair value of the stock under this assumption.

The stock is worth about $44 per share to a dividend investor, around 15% below the current market price. Now, that’s not to say that Medtronic is overvalued in general, but to a dividend growth investor it is. If the company boosted its dividend by 50%, putting the yield at 3% and the the payout ratio still below 40%, the stock would be significantly undervalued. But as it stands right now, Medtronic isn’t a great dividend stock. I’ll add it to the watchlist with a buy target of $44 per share.

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