Sunday, September 9, 2012

Covidien Looks Good Value

For long term investors it’s always interesting to find companies that are undergoing structural changes which can unleash inherent value. These situations create opportunities for discerning investors. I think one such company is Covidien $COV and the recent results confirmed the progress that the company is making. The underlying performance of its largest medical device products remains strong and the future spinoff of its pharmaceutical division will create even more opportunity for its strong cash flow generation to be returned to shareholders. In summary, despite the superficially mundane performance, I think the underlying story is a good one.

Covidien Reports Good Results

The company beat adjusted EPS estimates by a cent but declared that the next quarter would be sequentially lower. Now given that the consensus for the next quarter is $1.06 this can be taken as Covidien guiding a bit lower. Don’t get stressed though, this is largely because of adverse currency movements and the fact that this year’s numbers will contain one week’s less trading.

In fact, all medical device product lines recorded positive growth, but currency headwinds reduced growth by 1-5% across the board. In particular the largest product line (Endomechanical) saw operational growth reduced to a reported 1% thanks to currency headwinds of 5%.  No matter, the company is doing OK and notably outperforming the medical technology market. For example Johnson & Johnson SJNJ reported nowhere near this kind of growth in its medical device division. Indeed, I think the Synthes acquisition is evidence that JNJ is focusing away from surgical procedures within its medical device division. This is good news for Covidien.

Largest Product Lines Growing the Fastest

The usual suspects of Energy and Vascular were very strong in this quarter. Endomechanical growth is definitely moderating and management talked of negative results with mechanical fixation devices due to competitors launching new products in the market place. It also has to deal with longer term competition coming from robotic technology companies like Intuitive Surgical $ISRG and Mako Surgical $MAKO. Both of whom are trying to expand the surgical procedures that their products are routinely used in.

Intuitive is seen as being very strong in one-off types of procedures, so a health center will be able to add volume by buying one of their machines. However, a general surgeon can perform all sorts of different operations and he/she will not be so inclined to outlay the expense of buying an Intuitive machine. As for Mako, the company recently cut its sales forecast for the second time in the last few months. Perhaps the march of the robots is not as inevitable as many think it is?

On the other hand, Covidien is doing fine and investors should note that the three biggest product lines within medical devices are Vascular (21.2%), Energy (16.8%) and Endomechanical (30.5%) and –on an operational basis- they grew 15%,13% and 6% respectively.

Here is the revenue breakdown for the medical device division.

In order to demonstrate how well the three largest divisions are doing, here is the separation of Endomechanical, Vascular and Energy from the rest.

It is noticeable how strong the trends in the most important product lines are.

New Product Launches

Covidien launched a number of new product launches in 2012 which lead to supra-industry growth, but is it sustainable? There are two reasons why it may well be. Firstly, medical device sales usually hit their peak a few years after their launch so what is launched in 2012 will feed into growth in future years. Secondly, investment in R&D remains healthy and Covidien can also expand its new products into new markets.

Management affirmed its confidence that Sonicision (a cordless ultrasonic dissection device which will allow surgeons more flexibility in the theatre) was receiving very positive feedback.

Geographic Opportunities Mixed

On a geographic basis, Covidien is seeing no change in the US as conditions remain repressed. This is somewhat surprising as hospital admissions appear to be trending up and its strength is in non-elective procedures. In other words, surgical revenues should be correlated with admissions.  As for Europe, conditions remain challenging with Spain noticeably deteriorating in the quarter. Asia growth remains strong. In a sense, Covidien’s geographic commentary could be scripted in common with for all the other medical device companies right now, but the company is outperforming its peers and the opportunity to expand its products into emerging markets is a good one.

Covidien’s Growth Performance and Growth Prospects

I think Covidien is outperforming thanks to its research and development profile. Ever since the Tyco spin off, management has been able to focus and invest for growth. Product innovation has been notable in Energy which has generated double digit growth for a long time now as minimally invasive surgery (MIS) increasingly demonstrates better patient outcomes and ultimately saves hospitals money.  This kind of investment produces results even in weak end markets.

In a similar way, investors can look forward to more of the same in the run up to the spinoff of the pharmaceutical division. The spinoff is on track and as a mark of confidence Covidien announced that they would be increasing the level of intended cash flow return to investors to 50% from the historical target of 25-40%.

Future growth prospects

Returning cash and spinning off divisions is one thing but the best equity investments are all about growth. The company's aim is to continue to benefit from the increase in penetration of MIS and to expand its products within emerging markets. It also has growth potential from the ramp up in sales in future years from the products launched this year and finally hospital admissions appear to be on the rise in the US and this should start to drop into the top line.

On a more negative note, Covidien does have some poorly performing product lines and it isn’t the sexiest growth story around. European exposure is an obvious worry and it operates in some fiercely competitive markets. It isn't risk free.

On balance I think the company is doing the right things in order to generate growth and returns for its shareholders. Cash generation remains excellent and the underlying performance is good. On a risk/reward basis the stock looks like a good value.


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