Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.
In MDT’s case, we were interested to see what impact the company’s $50 billion acquisition of Covidien had on the balance sheet. As seen below, the company’s balance sheet is in reasonable shape with $35.6 billion in debt compared to $18 billion in cash on hand.
MDT has around $13 in cash on hand for every $1 it paid out as a dividend last year, and the combined company with Covidien is expected to generate about $7 billion in annual free cash flow. This means MDT could pay off its entire debt balance in less than three years with free cash flow generation and its cash on hand.
Source: Simply Safe Dividends
Overall, MDT appears to be an extremely safe source of income and is certainly a blue chip dividend stock.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
MDT’s Growth Score is 79, meaning its dividend’s growth potential ranks much higher than most other dividend stocks. MDT’s relatively low payout ratios, consistent cash flow generation, and diversified product portfolio support the rating. The company has also increased its dividend for 38 consecutive years, easily securing its spot on the dividend aristocrats list.
MDT’s dividend has compounded by 13% per year over the last decade, and the company most recently raised its dividend by 25% earlier this year.
If management hits their earnings growth objective, the dividend should continue growing at about a double-digit pace (management expects to grow the dividend rate faster than earnings).
Ultimately, MDT has stated that it intends to reach a 40% payout ratio on a non-GAAP basis within the next few years, still leaving plenty of room for healthy dividend growth regardless of near-term results. As a dividend aristocrat, MDT’s long-term dividend growth should be about as dependable as it gets.
Valuation
MDT trades at about 17.5x forward earnings guidance and has a dividend yield of 2.0%. Management targets reliable, consistent revenue growth in the mid-single digits and expects earnings to grow 2-4% faster than its sales growth rate.
If the company achieves its goals and delivers high-single digit earnings growth, the stock would appear to offer total return potential of 9-11% per year. MDT appears to be about fairly valued today.
Conclusion
For investors looking for long-term dividend growth in the healthcare sector, MDT looks like an interesting business to consider. Its dividend appears to have double-digit growth potential, cash flow is diversified across numerous product lines, its large scale should make it an even more compelling supplier for hospitals, and changing population demographics should drive greater demand for medical devices.
With that said, MDT appears to face more regulatory risk than most companies. The medical device industry is extremely competitive, and governments are constantly looking to reduce healthcare costs (e.g. lower reimbursement rates for hospitals could further pinch medical device pricing). In the U.S., the Affordable Care Act has resulted in a nice volume boost in medical procedures over the last two years as more people have been insured, but we see signs of this tailwind beginning to slow over the next year.
We also prefer to avoid companies that have recently made a substantial acquisition. While MDT’s purchase of Covidien could prove to be a homerun over the next decade, broader statistics have shown that the far majority of large acquisitions do not create shareholder value.
For these reasons, we have chosen to remain on the sidelines at this time and will consider other stocks for our Top 20 Dividend Stocks portfolio. Otherwise, investors who are bullish on the U.S. healthcare system and MDT’s acquisition of Covidien can take comfort in the stock’s safe 2% yield and double-digit dividend growth potential.
Disclosure: None
