Image Source: Medtronic, JP Morgan Healthcare Conference Presentation, January 11
On March 1, top holding in the Dividend Growth Newsletter portfolio Medtronic (MDT) reported solid fiscal third-quarter results, now a full year after it completed the deal with Covidien. In the period, Medtronic’s comparable, constant-currency revenue advanced 6% while it recorded non-GAAP diluted earnings per share of $1.06. Management complained of currency headwinds, not unlike that of other multinationals, but reiterated its 2016 diluted non-GAAP earnings per share in the range of $4.36-$4.40, which includes a forex headwind of $0.45-$0.50 in the year. Non-GAAP earnings in Medtronic’s case “relate to charges or gains that management believes may or may not recur with similar materiality or impact on results in future periods.” We’re comfortable with the non-GAAP representation in this case given the magnitude of the Covidien deal.
We’ve been huge fans of the Medtronic-Covidien tie up, “Medtronic on Track with Covidien Integration (June 2015),” and part of the reason has to do with the tremendous free cash flow generation capacity the combined entity retains. In the nine months ended January 29, 2016, for example, net cash provided by operating activities totaled ~$3.9 billion while additions to property, plant and equipment came in at ~$690 million, good for roughly $3.2 billion in free cash flow. Adjusting for restructuring items and certain litigation and tax items, adjusted free cash flow for the period came in at ~$4.1 billion, good for more than 19% of revenue. Said differently, for every dollar that Medtronic generates, nearly 20 cents is raw free cash flow that can be used for share buybacks or dividend growth. Dividends to shareholders during the nine-month period totaled $1.6 billion, meaning Medtronic currently covers dividend payments more than 2.5 times with adjusted free cash flow.
Our biggest concern with Medtronic, however, has little to do with its business strength or its free-cash-flow generating prowess. Instead, we’re watching the company’s financial leverage, as it recorded short-term borrowings and long-term debt of nearly $36 billion versus a cash and investments balance of $17.3 billion at the end of January 2016; it has taken on a significant amount of debt to facilitate the Covidien transaction. At the end of fiscal 2013 (ending in April), by comparison, Medtronic had short-term borrowings and long-term debt just north of $10 billion, less than a third of its current balance. Once we roll our valuation model forward following fiscal 2016 results, we would expect a significant reduction in the company’s Dividend Cushion ratio as a result of the increased net debt load. We’re not saying the debt load is not manageable, but it does complicate income-related matters as deleveraging becomes an increasingly more important use of free cash flow.
That said, CEO Omar Ishrak was quick to note that his team plans to return at least 50% of its adjusted free cash flow to shareholders through dividends and share repurchases. If the company makes good on its target to generate $40 billion in adjusted free cash flow over the next 5 years, the sheer magnitude of free cash flow generation offers significant promise for the payout. For one, on an annual run-rate basis, following the massive ~25% dividend hike in June, the company’s dividend obligations are barely north of $2 billion. The Covidien integration continues to progress nicely, and management noted that it “is delivering robust operating leverage” as synergies are captured. The executive team also said on the conference call that its “confidence around the sustainability and consistency of revenue growth within mid-single-digit range continues to build with each passing quarter.” Through fiscal 2018, it expects to be “at the high-end of or exceed (its) EPS leverage goal of 200 to 400 basis points.” It’s hard not to like the fundamental news.
The extra debt on Medtronic’s books certainly has our attention, but we like the company’s willingness to increase the payout on the basis of its future targets of free cash flow. And how can we not like the executive suite’s following words: “As an S&P Dividend Aristocrat, we expect to deliver dependable long-term dividend growth.” Look for more dividend increases, as Medtronic accelerates its dividend payments to reflect a 40% payout ratio (it is ~34% currently). We continue to like the company as a holding in the Dividend Growth Newsletter portfolio, but it’s also fair to say that we may trim our weighting should shares continue to run far ahead. Medtronic is currently a weighting north of 7% in the portfolio, which surpasses a “full” position defined as ~5% of total portfolio assets.