Dividend investors rarely argue with a healthy payout increase -- as long as the company can afford that increase. Nobody wants to face the potential of a painful cut further down the line.
Recently, medical devices company Medtronic (MDT 0.68%) authorized an increase in its quarterly dividend from $0.58 per share to $0.63. An 8.6% increase to a forward yield of 2% is nothing to sneeze at, especially compared with the S&P 500's 1.3% average yield, and it may signal that the company is fundamentally well and management is looking to return more capital to shareholders to drive returns.
That said, the new dividend obligation could be an unsupportable amount, especially if the fundamentals are weakening. Let's take a look at whether Medtronic's dividend remains safe.
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Earnings appear to support the dividend
When looking at the viability of a dividend payout, we can consider the company's earnings capacity as well as its dividend liability.
To evaluate Medtronic's earnings power, let's discuss earnings per share (EPS), which come in both GAAP and non-GAAP (Generally Accepted Accounting Principles) types.
The key advantage of using GAAP EPS is that it mandates consistency from companies when reporting financial results. Conversely, the uniformity of GAAP doesn't allow for the communication of significant items, such as the amortization of intangible assets (e.g., the writing down of a patent's book value based on its remaining estimated useful life).
This is a particularly important factor in the case of Medtronic, which is the holder of countless patents that are periodically written down. In its FY 2021 alone (which ran through April 30), Medtronic amortized nearly $1.8 billion, or $1.11 per share, primarily as a result of the value of its patents being adjusted.
Medtronic produced $4.63 in currency-neutral non-GAAP EPS in FY 2021 against $2.32 in dividends per share, which works out to a non-GAAP EPS payout ratio of 50.1%.
For context, this payout is in line with arguably the safest dividend in healthcare, Johnson & Johnson's 49.6% non-GAAP EPS payout ratio.
Where is the ratio likely to go from here? Citing new product launches and a recovery in many products post-COVID, Medtronic is forecasting non-GAAP EPS of about $5.68 in FY 2022 (its current fiscal year), and plans to pay dividends per share of $2.52 for a non-GAAP EPS payout ratio of 44.4%.
The balance sheet isn't perfect, but it is improving
Medtronic maintained $10.8 billion in cash and investments at the end of FY 2022, which is enough to repay almost half of its $26.4 billion in long-term debt, assuming management believed that to be the best use of capital.
A helpful metric to consider here is the interest coverage ratio, which is a measure of a company's ability to cover its interest costs with earnings before income taxes (also known as EBIT). The interest coverage ratio is a valuable indicator of whether a company's long-term debt and accompanying interest expense is too excessive to be covered during a downturn.
While Medtronic's interest coverage ratio of 4.2 in FY 2021 ($3.9 billion in EBIT/$900 million in interest expense) is far from world-beater status, it is an improvement over FY 2020's interest coverage ratio of 3.7 ($4.1 billion in EBIT/$1.1 billion in interest costs).
Simply put, Medtronic's earnings would need to fall quite precipitously for there to be any possibility of it not covering its interest expense. Medtronic faced significant COVID headwinds over the past year, with many elective procedures across the world put on hold as a means of curbing COVID transmission, and even that only resulted in a 4% decline in EBIT from FY 2020 to FY 2021. It seems reasonable to conclude that the likelihood of such an event occurring is about even with a zombie apocalypse.
A diversified business mix
There's one key reason that Medtronic never experienced a significant drop in its EBIT, despite the COVID headwinds: its diversification.
The company's predominant three segments -- cardiovascular, medical surgical, and neuroscience -- provided well-balanced contributions to FY 2021 sales at 35.8%, 29%, and 27.2%, respectively. Add in Medtronic's smaller diabetes segment, which contributed the remaining 8% of FY 2021 revenues, and the company's business mix is diverse enough that it won't be harmed by unfavorable developments in a single area.
Despite last year's challenges, each of Medtronic's segments generated sales growth, with neuroscience leading the way at 6.1% year-over-year, followed by medical surgical at 4.6%, cardiovascular at 2.9%, and diabetes at 1.9%.
The past was superb; the future appears promising
Medtronic's 44 consecutive annual dividend increases mark it as a Dividend Aristocrat, an accomplishment that all dividend-paying companies should pursue, but what's arguably more important is that the company appears well positioned going forward.
This is supported by the anticipated improvement in its payout ratio this fiscal year, thanks to new product launches and a reversion to pre-COVID sales patterns; a fair and improving interest coverage ratio; cash and investments that can cover half of the company's long-term debt; and a multifaceted business mix.
Taking all of this into consideration, I believe that Medtronic's 9% dividend increase was squarely in the Goldilocks territory of rewarding shareholders in the present while also looking ahead to the future. Investors seeking a dividend that is sustainable and positioned to grow in the future would do well to consider Medtronic below $125 per share.
