Every long-term investor should have at least some healthcare stocks in their portfolio. People will always need care, and the industry constantly looks for new and better ways to provide it. Medtronic (MDT 0.62%) is a longtime staple in healthcare, as evidenced by its long history and 46 years of consecutive dividend growth.
The stock has outperformed the broader market over its lifetime but is nearly 40% off its highs today. Is this a dip worth buying, or is Medtronic's business losing its luster? This Fool investigated to find out. Here is what I found.
Headwinds are eating at profit growth
Medtronic provides medical devices, equipment, and supplies worldwide. The United States, the world's largest healthcare market, contributes roughly half of Medtronic's sales. The rest comes from both developed and emerging international markets. The pitfall of global markets is that Medtronic, which reports its financials in U.S. dollars, must translate its international revenue to dollars. An unfavorable exchange rate can understate Medtronic's reported profits.
The company recently reported its second-quarter earnings for the 2024 fiscal year; earnings per share (EPS) were $1.25, a 3.8% year-over-year decline. Taking out the effect of currency rates, EPS grew 2.3% over the prior year.
Additionally, gross profit margins have declined a few percentage points in recent quarters due to inflation, something management spoke about in its most recent earnings call. The downside of doing business in emerging markets is that they generally can't afford to spend nearly as much as developed countries, so Medtronic doesn't have the room to raise prices and offset its rising costs as it might with U.S. customers.
These headwinds have cratered growth estimates, and it looks like that's the culprit for Medtronic's share price woes. And to be frank, that's fair. Medtronic is feeling these headwinds on its bottom line. The question for investors is whether the business is broken or this is just a passing storm.
Fundamentals are intact but weakened
Medtronic can't do much to control how currency exchange impacts its business. It can work through inflation by cutting expenses and working on price increases. So these headwinds seem more temporary than anything, especially with Medtronic delivering mid-single-digit revenue growth.
But the headwinds have weakened Medtronic's financials, which investors should watch moving forward. Most notable is the drop in free cash flow. The drop has increased the company's dividend payout ratio to roughly 90%, leaving little room for management to do things like pay down debt on a balance sheet holding nearly three times as much debt as Medtronic's earnings before interest, taxes, depreciation, and amortization (EBITDA).
MDT Free Cash Flow data by YCharts.
Don't get me wrong. Investors shouldn't panic. Medtronic is still a financially stable company. The corporate ratings agencies give Medtronic's credit an A rating with a stable outlook, which is comfortably investment-grade. The biggest concern is Medtronic's current lack of financial flexibility. It's not a crisis, but you'd like a lower payout ratio and a cleaner balance sheet.
Is Medtronic a buy now?
Are you looking for a quick rebound and profit on Medtronic? Pump the brakes. The company's lower growth and weakened financials justify the stock's decline. These headwinds will probably need to pass before the stock comes alive again.
The good news is that shares trade at a forward price-to-earnings ratio of 16, down from 24 years ago. If Medtronic can accelerate its earnings growth to somewhere near 10%, today's valuation could be a bargain. Medtronic doesn't look like a broken business, but it faces financial headaches from things it can't do much about right now.
A long-term investor willing to buy and wait for a turnaround might buy Medtronic today. But since it's hard to tell when things might get better, it doesn't look like a can't-miss opportunity.
