Covidien's Growth is Stronger Than you Think

Foolish investors would do well to take a close look at medical device company Covidien  . The company is often ignored by investors in the medical device sector. It doesn't have the glamour appeal of a peer like say, Intuitive Surgical and its surgical robotic systems.  It doesn't offer the familiarity and solidity of having a medical device division within a major company like Johnson & Johnson . Moreover, its forecast EPS growth rate of 7.5% in 2013 is hardly the stuff of legend. So what is there to like about the stock?

Why Covidien's offers more than its peers
Covidien's key attraction is its mix of relatively low-ticket medical device solutions with which it can penetrate emerging markets. This is a major benefit as hospitals and clinics in the developed world are being challenged by austerity measures. A lot of Covidien's products simply fall below the radar of targeted cutbacks. Meanwhile, austerity is hitting the industry hard. For example, Johnson & Johnson only managed to report revenue growth of 0.3% in its medical devices and diagnostics segment, in its last quarter. Its international revenue grew 4.2% with the segment, but US revenue declined by a similar amount.

Meanwhile, Intuitive Surgical's challenge is to convince hospitals and clinics of the merits of its high-ticket robotics solutions. This not an easy task at the best of times, and it's a lot harder when a study like this one from the Journal of the American Medical Association comes out, which claims "Total costs associated with robotically assisted hysterectomy were $2189 (95% CI, $2030-$2349) more per case than for laparoscopic hysterectomy."  Note that Covidien is one of the leading players in laparoscopic instrumentation.

Intuitive has had a difficult year, and it only managed to sell 101 systems in its last quarter, compared to 155 last year. Only 36 systems were sold internationally, of which only six went outside Europe or Japan. It's not looking like an emerging market play!

Covidien's confusing quarter
While Covidien is thematically attractive, its recent fourth-quarter results were not superficially impressive. Adjusted diluted EPS growth was just 5.8% on the quarter, and non-GAAP adjusted operating margins fell 110 basis points. However, you should look beyond these numbers, because the underlying performance is much better. On its conference call, the management outlined:

We delivered adjusted EPS of $0.91 for the quarter, a 6% increase over the prior year, despite the impact of unfavorable FX and the medical device tax. Combined, these 2 items reduced EPS by about $0.10 per share or 11 percentage points

Adding the $0.10 back in EPS gives a far more impressive growth rate of over 17% on the quarter. And on the issue of operating margins:

we declined 110 basis points year-over-year on operating margin. 170 basis points was due to FX and device tax. So we actually would have improved operating margin 60 basis points

The results were a lot better than they appeared.

Emerging markets and supply issues
All told, there were some positive and negative points in the quarter. Its emerging market revenues continue to grow strongly with revenue from the BRIC countries increasing 25%. According to Covidien, emerging markets now make up around 16%-17% of total revenues, and at these kinds of growth rates they are likely to hit 20% of sales by the end of 2014.

On a less positive note, its medical supplies business (around 17% of full-year sales) had a disappointing quarter with US sales down 2%, amid suffering some cost increases due to issues with a supplier. According to the company, the latter issue has been fixed, and it also expects medical supplies volumes to get back into a normal range in upcoming quarters. Its something to look out for going forward.

Where next for Covidien?
Analysts have Covidien on 7.5% EPS growth for 2014, and this is despite facing a headwind from the medical device tax in the first, and ongoing difficult foreign exchange comparisons in the first half. The underlying business is solid, and on a P/E ratio of around 16 times forward earnings the stock is good value for its emerging market growth prospects.

Johnson & Johnson Looks Fairly Valued

Investors in health-care giant Johnson & Johnson (NYSE: JNJ) have been rewarded with a 30% share price rise in the last year. The health-care giant remains a go-to choice for investors seeking a relatively recession-proof stock with a decent dividend. However, investors need to ask themselves a few questions about its recent results: Can this share price run continue?  Does Johnson & Johnson still provide compelling value?  And what are the key takeaways for the healthcare industry from these results?

Johnson & Johnson delivers

The argument for buying Johnson & Johnson is based on the fact that its three big near-term factors depend on how its management performs, rather than purely on the economy. This means that the stock can appreciate even in a weak economy.

First, Johnson & Johnson has been trying reintroduce a number of over-the-counter (OTC) products that were taken off the U.S. market due to production issues. Second, its pharmaceutical division has several new drugs with which it can develop sales. Finally, the successful integration of orthopedic company Synthes in its medical devices and diagnostics division will create earnings growth in a weak medical spending environment.

A checklist of these three factors would conclude that the company is well on track.

The company's plan to reintroduce 75% of those lost consumer brands by the end of 2013 was confirmed in its recent second-quarter results.  U.S. OTC sales were up 17.4% in the quarter, and although they only currently compose 7.9% of total consumer sales, the marginal increases in sales and profits will make an impact in future quarters.

Furthermore, its pharmaceutical division has delivered strong performance, with a 12.9% rise in constant-currency sales in the quarter. The standout performers within pharmaceuticals included newer drugs like Stelara (psoriasis), Incivo (hepatitis C), Xarelto (anti-coagulant), Invega Sustenna (anti-psychotic) and Zytiga (castration-resistant prostate cancer), all of which recorded sales growth at around 50% or more in the quarter.  In addition, its biggest drug, Remicade (rheumatoid arthritis), which contributes nearly 24% of its pharmaceutical sales, saw sales rise an impressive 10.3% in the quarter.

Lastly, the Synthes acquisition is working well. Indeed, J&J's overall growth in the medical devices and diagnostics sector was 12% in constant currency, largely thanks to Synthes.  Excluding the acquisition, the division would have reported sales growth of just 0.5%. It’s clear that the acquisition is helping Johnson & Johnson generate growth within a difficult part of the health-care industry.

It’s all in the price

The problem for investors wanting to buy in is that the market now seems to have priced these three factors into the share price. Compare Johnson & Johnson's price-to-cash flow multiple with its price chart:

JNJ Price to Cash Flow TTM data by YCharts

The stock hasn’t traded on a price-to-cash flow multiple of around 20 since 2005-2007. A cursory glance at the chart would reveal that the share price struggled to appreciate in that period. On the basis that it currently trades on that valuation, I would argue that much of the good news is already priced into the stock. Furthermore, analysts have earnings growing in only the mid-single digits for the next two years, and I’m not sure I’m keen to pay 24.5 times earnings for that kind of growth profile.

Winners and losers from Johnson & Johnson’s results

It’s always fascinating to read between the lines of Johnson & Johnson’s results and pick out indicators for other companies’ prospects. On the positive side, investors in eye-care specialist Cooper (NYSE: COO) will be interested to hear that Johnson & Johnson recorded 5.4% operational growth in its worldwide vision care business, and specifically cited daily lenses as an area of growth.

This indicates strength within the eye-care market, and should be good news for Cooper Companies, since one of its key aims in 2013 is to increase its one-day modality sales. Cooper’s one-day lenses generate three to five times more profit than its monthly lenses. Moreover, it is more of a pure-play on the increasing popularity in one-day lenses, because it doesn't sell lens-care solutions.

On the other hand, two losers from this report could be medical device company Covidien (NYSE: COV) and radiation oncology specialist Varian Medical Systems (NYSE: VAR).

Covidien has generated much of its growth in recent years from surgical device appliances within its energy and endo-mechanical divisions. Indeed, it’s a leader in the minimally invasive surgery market. Covidien’s supporters (and I’m one of them) will always point out that its solutions are relatively low-ticket, and they demonstrate a tangible way for hospitals to reduce costs via achieving better patient outcomes.

On the other hand, Covidien is still exposed to the volume of surgical procedures in medical centers, and in its conference call, Johnson & Johnson outlined that hospital and surgical procedures are flat to negative.

Turning to Varian Medical Systems, this company definitely is a high-ticket solution provider, and could suffer disproportionately if there is a buyer’s strike in the hospital and medical center market. There is a SWOT analysis of the company in an article linked here which outlines its prospects for 2013. Johnson & Johnson talked of the negative impact of macroeconomic conditions on its medical device sales, and robotic surgery appliance manufacturer Intuitive Surgical (another high-ticket solution provider) has already disappointed in this earnings season.

Moreover, in its conference call, Johnson & Johnson described the hospital capital expenditures market as being in recession for 10 to 12 consecutive quarters. All of these events are signs that Varian may find its customers more reluctant to spend in 2013.

The bottom line

Johnson & Johnson has pretty much priced in most of the good news, and it’s hard to see how the stock can appreciate much from here. The stock has had a great run, but now it’s time to wait for a pullback.

What to Expect From Covidien in 2013

The JP Morgan Healthcare conference is the most important event in the industry's calendar and helps set the tone for the rest of the investing year. Typically the pharma/biotech companies outline the key pipeline events of the year or how they plan to expand existing product sales while the medical technology and services companies discuss their prospects for the coming year. I thought I’d help investors compress their research of the event and the sector by providing a brief overview of some of the presentations. In this article I will focus on Covidien (NYSE: COV). 

Covidien Wants to Do Deals

There are always a few key takeaways from these presentations, and for Covidien it is that the company is looking to use its excellent cash flow in order to make acquisitions. In addition, it remains on track with its pharmaceutical spin-off. With a target of returning more than 50% of free cash flow to investors, Covidien is a very shareholder friendly company and a well managed ‘value play’ in the sector.

The spin-off should be complete by the end of the summer and it looks like it could be a busy time for Covidien if the M&A rhetoric turns into any kind of action. With that said Covidien has a history of successfully integrating companies and buying R&D capability by doing so. Indeed, despite a string of acquisitions, headcount has been reduced by 1,300 (nearly 5%) in the last four years. Furthermore four facilities and three distribution centers were cut too. This company is clearly focused on generating operational efficiencies where it can and it may as well need to do so because many of its end markets in medical devices will experience slowing growth this year.

Covidien’s Growth Drivers

I’ve discussed the company previously in an article linked here. Although Q4 top line growth appeared a little weak, there was a host of extenuating circumstances that masked a decent enough performance. Top line growth has been difficult to come by due to pricing (hospital budgets are under increasing pressure), but it has managed to increase revenues via volumes and product mix. When a healthcare bellwether like Johnson & Johnson continually reports anemic growth in its surgical revenues it is a clear sign that the number of elective procedures is not increasing much nor are hospitals spending like they used to.

The investment case for Covidien is that of a company being able to focus on investing in its growth areas (as well as M&A) following the pharma spin-off. The idea being that this can release the value in its product portfolio and particularly within emerging markets. The plan with the latter is to increase sales until they make up around 15% of revenues by 2016.

Essentially, Covidien is seeing growth in its Energy and Vascular business and has invested accordingly. Its minimally invasive surgical (MIS) equipment is very attractive because it reduces hospital bills by creating better patient outcomes and lessens outpatient days. Moreover, a number of procedures were outlined that currently have less than 20% MIS penetration. Furthermore, since many governments (particularly in the higher growth emerging markets) do not currently reimburse MIS procedures, there is a real opportunity for growth here. There was also some discussion of growth opportunities in Energy with frequent procedures like Hysterectomy and Colorectal being mentioned as under-penetrated.

Investors are always going to compare Covidien’s surgical solutions with Intuitive Surgical (NASDAQ: ISRG) and Mako Surgical (NASDAQ: MAKO) but I think this is somewhat unfair. Those two companies have equipment that works very well (so far) in a limited scope of procedures. They help surgeries perform a lot more of these operations but they are not currently used as all-purpose machines by, say, a general surgeon who can perform a wide range of operations. Intuitive and Mako are fine and worthy companies in their own right but I doubt they are impinging on Covidien’s MIS market just yet. Incidentally, it is a sad but telling state of affairs when you realize that Bariatrics (weight loss procedures) is probably the biggest single driver of demand for Covidien’s surgical products.

Where Next for Covidien?

On a trailing PE of 15.2 and a current EV/EBITDA multiple of 9.6 Covidien is hardly the most expensive medical stock out there. Throw in a decent and growing 1.8% yield, a management committed to returning more than 50% of its free cash flow to shareholders (and recall that its current free cash flow yield is around 6.6%) and you have a stock that can appreciate from here provided it executes well.

The long term idea is to increase growth in emerging markets, focus on its growth products, generate operational efficiencies and probably make some more acquisitions. There is much to do for Covidien this year but it looks capable of hitting its target of mid single digit revenue growth and double digit earnings growth. I think it is close to fair value now so I will wait for a dip before thinking about buying in. The stock does have execution risk