Medtronic Stock: An Undervalued Dividend Aristocrat (NYSE: MDT)
Medtronic (NYSE:MDT) is one of the largest manufacturers of medical devices in the world. It offers a wide range of products covering various clinical conditions. Unlike some smaller competitors, it’s not tied too much to a specific product, device, or type of treatment.
Like most of its peers, Medtronic’s stock has been sick since the novel coronavirus pandemic began. At first, this was because hospitals chose to delay elective surgeries in order to reserve beds for Covid-19 patients. On top of that, many patients understandably chose to avoid hospitals in order to avoid potential exposure to the virus.
While mainstream media attention to the pandemic has waned since the rise of widespread vaccination, many strains and variants of the coronavirus have continued to spread in 2022 in various parts of the world. Granted, much of the elective surgery landscape has returned to normal, but there’s still a significant drag on results.
All of this resulted in MDT stock remaining at the lower end of its five-year trading range:
Stocks traded around $80 in 2018 and briefly hit that level at the start of the Covid-19 pandemic. MDT stock almost fell that far this summer and is still stuck below $100 now, even with the recent rally in the overall stock market.
Why is Medtronic stock so low?
If the underlying business is doing well, why aren’t Medtronic shares gaining much ground?
There are several factors apparently at work. On the one hand, the whole sector has been under great pressure:
As the chart above shows, Medtronic has actually been the top performer of these top six industry players so far this year. A 10% drop isn’t huge – and Medtronic also fell significantly in 2021 – but other medical device makers are also having a tough 2022. Much of the apathy toward Medtronic stock is part of a broader aversion to its industry. In fact, the median inventory of medical devices is down more than 20% since the start of the year.
The company encountered its own problems in a wider difficult landscape. CEO Geoff Martha explained at a recent industry conference:
“From probably the middle of the fourth quarter, these [supply chain issues] began to present themselves in a much more acute way. I mean, at the start of the fourth quarter, a lot of our safety stock was depleted due to the ongoing chip and resin issue. But in the fourth quarter, like the mid-term, things got much more acute, especially for our Surgical Innovations business. Due to this packaging issue that we had in our supply chain, there was an explosion at one of our suppliers that shut them down for a few months and that really impacted our SI business . And then you shut down China in April and May.”
Martha explained that these issues will continue at a high level for some time to come. More generally, the company has acquired many other businesses in recent years and has thus acquired many factories and facilities as part of these transactions. Martha said the company previously centralized supply chains and logistics through these new acquisitions to gain operational scale, but is now decentralizing some operations to avoid the kind of headaches we’ve seen over the past 12 month.
Given this broader business realignment, investors should view Medtronic as a story of recovery in 2023 rather than something that will turn around in the next quarter. This is perhaps part of what weighs the stock down so significantly.
Zooming in further, there is some perception that Medtronic may not be a top player in the industry. In recent years, for example, Medtronic’s organic growth has lagged significantly behind better-performing rivals such as Stryker (SYK).
There has been much debate as to whether this is an inherent flaw in Medtronic’s process in particular, or simply a combination of pipeline, new products, competition, etc. And, some will argue, perhaps rivals like Stryker have outperformed due to aggressive management tactics that may backfire sooner or later. That is outside the scope of this article though, and I would note that I also own some Stryker stock.
Leaving that aside, you can safely say that Medtronic’s product lineup is generally less appealing than some other rivals. The pacemaker business, for example, is likely to be quite commoditized and therefore have a lower margin compared to some of the more cutting-edge products from peer companies.
Competition could also affect the fastest growing areas of the business. Medtronic’s diabetes business, for example, has posted double-digit annualized growth in the past, but could be at significant risk now, as various new innovative treatment products and techniques are currently being developed, which could disrupt existing players.
Valuation is attractive
Medical device companies have strong moats due to patents, doctors’ familiarity and training with individual devices, and significant R&D efficiencies, among others. Profit margins tend to be high and demand continues to increase over the long term. It’s a good industry that deserves to trade at a premium to the S&P 500 as a whole.
Medtronic, however, is selling at just 17 times current and future earnings:
I get all the worries about supply chains and Covid hangovers and so on but 17x earnings is not the right price for a company of this caliber without the whole market being at a low multiple. As it stands, the S&P 500 is at 23x earnings. MDT shares simply selling at that same multiple as the market would put the stock at $128/share versus the current $93.
Longer term, Medtronic management aims to deliver 8% earnings growth and 5% revenue growth compounded annually. The company has also been very successful in generating free cash flow from earnings, which means that the current starting earnings yield of 6% can be widely used for dividend increases and share buybacks. Delivering the company’s long-term average growth rates relative to the current starting valuation should lead to total returns that significantly exceed the S&P 500.
I am not alone in seeing considerable value in MDT shares at current prices. Morningstar analyst Debbie Wang values the stock at $129, which puts MDT stock at a 30% discount to its fair value today. In May, Wang wrote:
We maintain our fair value estimate of $129 per share, which includes our expectations for the resumption of pre-pandemic response volume in fiscal 2023, hospital workforce constraints that will prevent meaningful expansion of mid-term capability and planned denervation launch by early 2024. We continue to have fairly optimistic expectations for innovation in the heart, diabetes and neurovascular structural units, as well as a incremental margin expansion to accommodate efficiency programs and new higher margin products.
Finally, Medtronic is a dividend aristocrat. Stocks are currently near their highest dividend yield, with the 2.8% yield well above its historical median of around 2.0%:
For a dividend aristocrat with high-single-digit growth in an above-average industry, a starting dividend yield of 2.8% is a pretty solid offer.
Additionally, Medtronic has increased said dividend at a compound rate of 8%, 8%, and 10% over the past three, five, and ten years, respectively. This, combined with an attractive starting valuation, makes Medtronic a suitable growth and revenue company in the healthcare industry today.