Covidien Faces Some Near Term Risks

One of the peculiar aspects of the market move upwards in 2013 is that the defensives have led the way while the traditionally more economically sensitive areas like technology have lagged. Indeed, anyone trying to construct a balanced portfolio is going to have to deal with the contradiction inherent in only wanting to buy value as well. What happens when the value is mainly within technology and therefore guiding you towards being overweight in the sector? What happens to your diversification dream?

While the market has been somewhat vindicated in the current earnings season (a lot of tech co’s have warned), I also feel that many medical companies are at the very least fairly valued. With this in mind I thought I would look at Covidien’s (NYSE: COV) latest results. Is it time to buy in?

What the Industry Is Saying

Don’t get me wrong. I like this company and its prospects and have held and written about it before. It has many good properties, but the market seems to have factored all of this--and more--into the share price. Moreover, going into the latest set of results there were some signs that the medical device market was a bit weaker.

For example Johnson & Johnson  generally gave a positive set of results, but there was a note of caution in its medical devices division. Apparently hospitals have been reporting that the levels of surgical procedures in Q1 were tracking weaker than forecast at the end of 2012. This is problematic because, if healthcare companies are cyclical at all, it is in areas like demand from elective procedures and surgery visits.

It is not a major problem for Johnson & Johnson because it has plenty of other opportunities to grow earnings, and many of them are about internal execution (getting products back into the market, integrating Synthes etc) but for Covidien it spells danger.

Similarly, I noted that General Electric reported that its healthcare division saw its performance a bit weaker than expected as hospitals were seeing pressures on their budgets. Again a diversified industrial like GE can cover up any shortfalls elsewhere, but it’s worth noting that many of its solutions do come with relatively high ticket prices. So if you are worried about a global slowdown then GE’s healthcare revenues are likely to give you a place to hide.

Varian Medical Systems is another company I like for its emerging market growth prospects. Indeed, its latest results demonstrated strong growth from the BRICs and other emerging markets. The problem is that its equipment requires large capital outlays at a time when clinics in the US and Europe are under budgetary constraints. It was no surprise to me that its North American oncology systems net orders were weaker with a 9% decline, and it isn’t just macro. US hospitals are faced with uncertainty over reimbursement issues and health care reforms. It is all well and good lauding the claims of radiotherapy as being a cost effective treatment, but if clinics are financially constrained they will delay ordering.

Varian is definitely a stock to watch--mainly for its BRIC growth prospects--but I think buying it depends on timing the moment when the market is fearful of Western healthcare spending.

What About Covidien?

Covidien is a kind of a mix of these companies. Rather like Johnson & Johnson’s surgical division, it needs decent growth in hospital procedures in order to drive revenues at its key endo-mechanical and energy devices segments. And in common with GE it is seeing pricing pressure from hospitals. Covidien’s management made it clear that there wouldn’t be ‘upside to pricing going forward’. In other words, it’s all about volumes.

There is a silver lining in the sense that Covidien doesn’t really sell a huge amount of large ticket capital spending items. In other words many of its revenue streams can fall under the radar of cutbacks at hospitals. With that said, it was affected in the quarter (at least within Western markets) by capital spending pressures, and it's time that the market realizes this.

There was also some uneven performance among its industry segments.

Energy remains a strong point for Covidien as its solutions offer cost effective ways for surgeons to achieve better outcomes and reduce hospital costs. Meanwhile endomechanical put in another strong performance helped by stapling. However in its third key market (vascular) there were some disappointments. Covidien lost a key contract, and growth for Q3 is forecast ‘significantly below that of Q2’. Since Q2’s growth was a lowly 3.6% in vascular, I think investors should brace themselves for next quarter’s vascular results.

The Bottom Line

Covidien gave notice that Q3 would come up against some difficult yearly comparisons, and the weakness in vascular is also going to hurt performance. Moreover, the uncertainty over healthcare regulations and funding may hit capital spending in energy. In addition its plans for increased investment spending are likely to trim margins.

With that said Covidien has many good long term drivers. The pharma spinoff will allow it to focus efforts and possibly invest in some acquisitions. Longer term I think this stock will do well but growth is slowing this year and I’m not sure it’s good value just yet. One for the watch list.