Thursday, August 30, 2012

An Undervalued Health Care Stock

Investors have been keen to bid up defensive sectors recently but one stock seems to have been left behind in the rush. Tyco spinoff Covidien (NYSE: COV) appears to be unloved by the market, yet its mix of stable single digit revenue growth plus double digit earnings growth and high cash flow generation is quite compelling.

Moreover, the future spinoff of its low growth pharmaceuticals division will allow the management to fully focus on medical devices. Reductions in headcount and facilities over the last few years have generated operational efficiencies that have led to margin improvement. This company is well run, it trades at a discount to its peers and I think it's well worth a look for risk adverse investors.

Covidien Offers a Mixed Growth Opportunity

In this article I am going to focus on medical devices. A graphic depiction of Covidien’s offerings by product line reveals the mixed performance over the last few years.

Whilst Soft Tissue Repair and Airway & Ventilation growth has been hard to come by, Vascular and in particular Energy growth has been strong.  Oximetry & Monitoring and Endomechanical growth has slowed this year.  The company is currently tracking ahead of its internal 2-5% overall growth for medical devices but it has been clear in articulating that headwinds would get stronger in the second half. In addition there is one less trading week this year.

Endomechanical and Energy Products are Driving Growth

Together these product lines make up 46.8% of medical device sales, and Energy has consistently generated double digit revenue returns in recent years. Endomechanical and Energy devices in surgical procedures are increasingly being used in a drive to shift surgical procedures from open toward minimally invasive surgery (MIS). The big advantage of MIS is that it tends to lead to better patient outcomes, which in turn creates shorter hospital stays and less post-surgery complications. Both of which reduce hospital costs.

Growth has been impressive over the last few years.

Growth in endomechanical can be seen as tracking a combination of hospital admissions and elective surgical procedures. Both of which are seen as slowly improving in line with the economy. Provided the economy keeps growing, Covidien can expect similar growth in the second half.

As noted earlier, Energy revenues will increase as a function of increasing penetration rates of MIS –especially in regions such as emerging markets- and new product launches. For example, Covidien i particularly excited about the new launch of Sonicision (a cordless ultrasonic dissection device) which will allow surgeons more flexibility in the theatre.

However what about the threat from robotic based surgery?

Intuitive Surgical?

Perhaps one reason that Covidien doesn’t have a higher rating is that investors are looking at the spectacular growth rates at Intuitive Surgical (NASDAQ: ISRG) and concluding that robotics will encroach on its market share or at least moderate Covidien’s growth potential.

It is a powerful case and Intuitive is a strong company in its own right, however its systems require a significant capital outlay and they are seen as being of more immediate benefit to ‘one-off’ type of procedures where the surgeon may not have been trained in MIS procedures, for example things like prostatectomy.

Surgeries adding Intuitive’s robotics can see their revenues jump as a consequence of being able to offer more procedures; however, a MIS trained general surgeon can and will do a whole host of operations in his work. He doesn’t necessarily need to buy a robotics solution in order perform new procedures.

In other words, both markets can grow without Intuitive being able to cannibalize Covidien’s growth prospects.  Although cautious investors will want to keep an eye on Intuitive and in particular its success at expanding the procedures that surgeons use its machinery for, particularly as Johnson & Johnson (NYSE: JNJ) is believed to be seeing slowing growth in endomechanical due to the encroachment of Intuitive Surgical.

Other Divisions Mixed

Covidien also competes with Johnson & Johnson in soft tissue repair and this sector has seen significant competition. Its aim here is to protect market share rather than invest in biologics. It will be hard pushed to achieve this without investment so I would expect further pressure ahead.  It’s a different story with Vascular where Covidien has actively been investing in order to drive growth. Vascular now makes up more than 20% of revenues so if we combine the divisions that are doing well (Endomechanical, Energy and Vascular) it makes up 67.2% of revenues. Covidien is in good shape.

Fundamentals and Future?

The market warmly welcomed Abbott Labs (NYSE: ABT) proposed split and its puzzling to see why it has not accorded Covidien the same kind love. Abbott’s deal makes perfect sense-at least I hope so because I hold a long position- and so does Covidien’s. Indeed, the preparation for the split has seen an increased focus on medical devices being applied.

Hospital admissions and elective surgeries can be expected to provide a favorable market environment in the future and Covidien is growing its largest medical device offerings. The weakness is in the smaller product lines. Turning to valuation matters, it trades on 13.5x its earnings and on an EV/Ebitda ratio of 8.6, both of which are attractive for a company forecasting double digit earnings growth in future. Covidien is forecasting $1.9bn in free cash flow (equivalent to 6.7% of its EV) which will give it the leeway to make acquisitions, invest in R&D or pay off debt.

The next set of results will be in a couple of weeks and it is a stock well worth monitoring for investors looking for exposure to the healthcare sector.

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