Sunday, December 16, 2012

A Mixed Outlook For Covidien

Covidien (NYSE: COV) remains as Covidien was, an undervalued health care stock with a product mix that is experiencing differing growth rates.  The future spin off is likely to release value and increase focus and the company remains share holder friendly as it continues to retain free cash flow to investors via dividends and buybacks. It’s not the sexiest story out there but if you looking for a solid value play in healthcare than this is worth a look.

Covidien’s Earnings Overview

Before I get into the color I want to break out the segmental importance. For the full year revenue split was as follows.

First, it should be noted that the final quarter’s results were affected by an unfavorable comparison to last year due to an extra week in last year’s quarter. It may seem innocuous but management argued that it reduced Q4 sales growth by 7-8% and had a ‘leveraged’ effect on the bottom line.

Second, negative currency effects helped to reduce reported revenue growth in the quarter and Covidien predicts a similar affect in Q1. I’ve adjusted for currency effects here.

There are some pretty dramatic effects here which make the reported results much worse and FX also helped to reduce gross margins.

Third, the product recall with Duet reduced revenues by about $20m or by just above 3.3% within the endo-mechanical segment.

Fourthly, Covidien doesn’t break out earnings by emerging markets but the commentary on the conference call suggested that  ‘momentum has actually increased’ despite the slowing of GDP growth in emerging markets like Brazil and China. Meanwhile conditions remain tough in Europe and the US.

Medical Devices Focus

With the excuses/explanations out of the way it’s time to look in more detail at the medical device division.

Growth is slowing and is expected to moderate overall next year. The strength of Covidien is in that it offers solutions that are not so expensive that they filter themselves out of medical capital expenditure plans and they are not so commoditized that they are subject to heavy pricing pressure from competitors.

In particular Energy and Vascular look sources of good growth in future. Covidien’s Energy solutions are still relatively lowly penetrated in the market place and offer significant cost savings to hospitals through minimally invasive surgical (MIS) procedures. Patient outcomes are better and hospital stays are less.

I think Energy will continue to do well. Granted there is competition for surgery spending budgets coming from robotics companies like Intuitive Surgical (NASDAQ: ISRG) and Mako Surgical (NASDAQ: MAKO) as these two companies are very keen to expand the treatment procedures that their solutions are typically used for.  The difference is that the initial take up of Intuitive and Mako’s solutions has been in focused areas where surgeries can increase the amount of procedures done within a narrow field whilst a general surgeon will use Covidien’s Energy solutions for a much wider range of procedures.

They are also a lot cheaper than the huge capital outlay that it takes to buy, say, Intuitive’s Da Vinci system. For these reasons Covidien can also still expect strong growth in emerging markets but overal the surgery market looks tough. If Johnson & Johnson’s (NYSE: JNJ) recent numbers in General Surgery are anything to go by (a paltry .1% rise in worldwide revenues on a constant currency) then the market is actually getting tougher. Indeed Covidien’s numbers in Soft Tissue Repair have been weak for some time and even the new product initiatives were not forecast to take its growth to anything above the market.

Endo-mechanical has had issues with a product recall but stapling is reported to be doing well and Vascular continues to be as bright spot as further investment is put into clinical trials. Stryker (NYSE: SYK) is moving into the market after its acquisition of Boston Scientifics Neurovascular business in 2011. Stryker’s entry could encourage more hospital investment within this treatment area as it should help raise awareness. In the end the key for any medical device company in this environment is to demonstrate efficacy without and tangible return on capital without being too cost intrusive and Covidien is well placed.

The Bottom Line

Covidien isn’t expensive and if you can ignore the currency effects here the underlying growth is okay. The company is shareholder friendly and if Abbott’s performance this year is anything to go by then the market should like the upcoming split.  The growth areas are in things like Energy, Vascular and certain Endo-mechanical products. Elsewhere Covidien remains challenged by a weak spending environment and pressure on hospital budgets.

In conclusion, it’s a decently valued stock but without tremendous upside. On 12.5x forward earnings it's attractive for those who want a solid medical play with the upside of an improving economy

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