Johnson & Johnson Latest Earnings Analysis

The investment case for Johnson & Johnson (NYSE: JNJ  ) in the past few years has focused on a combination of two things: its ability to generate growth through internal execution, and a "growth kicker" from a potential improvement in the more cyclical parts of its heath-care portfolio. By the look of its recent second-quarter results, the company continues to do well with the former but is finding the latter harder to come by. Is Johnson & Johnson still a buy?








Johnson & Johnson's consumer segment (19.2% of sales)
The company's management has certainly executed on most of the things it has set out to do in the past few years. In consumer products, after some well-documented product recalls and production difficulties, Johnson & Johnson has been steadily bringing the affected over-the-counter, or OTC, brands back into the marketplace. In fact, its U.S. OTC sales increased 9% in the quarter. Moreover, excluding the women's health category in the U.S., where a divestiture was made, would see U.S. consumer product sales rising 5%, instead of the reported 0.5% decline.


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Johnson & Johnson in 2014

The recent earnings results from Johnson & Johnson  $JNJ were met with a near 2% sell-off on the day. As ever, a lot of journalists and commentators immediately searched for a negative in the results or guidance in order to justify the drop. There was nothing significantly wrong with the results. However, the company's stock looks fairly valued and it probably needs to surprise the investment community on the upside in order to move significantly higher in 2014.

The running story with its divisions in 2013 was one of strong pharmaceutical sales, weakening medical device & diagnostics, and moderately growing consumer products. The fourth quarter results stuck to the script, and it's hard to see how things will change much in 2014.

Pharmaceuticals (39.4% of 2013 sales)
Johnson & Johnson's pharmaceutical performance stood out because it had a number of new drugs in early marketing stages, while continuing to generate strong growth with its Remicade (rheumatoid arthritis) treatment.

Remicade sales grew by nearly 14% in the fourth quarter, and generated more than 23% of pharmaceutical sales and over 9% of total company sales in the quarter. Meanwhile, some of its newer drugs achieved very strong growth:

Drug	Treatment	Fourth Quarter Sales ($m)	Fourth Quarter Growth
Stelara	psoriais	417	55%
Simponi	rheumatoid arthritis	254	40%
Invega Sustenna	anti-psychotic	350	54%
Xarelto	anti-coagulant	271	n/a
Zytiga	castration-resistant prostate cancer	495	87.5%

Source: Company Presentations

Together, these fast-growing drugs generated 24.4% of total pharmaceutical sales in the fourth quarter. Growth should continue at a strong pace in 2014 as the company's sales reach is expanded.

However, one potential problem could be Hospira's (NYSE: HSP  )  biosimilar for Remicade, called Inflectra. Hospira's drug was approved by the European Commission in late 2013, and has proved to be comparable to Remicade in a large-scale trial.   Johnson & Johnson's patent protection for Remicade will run out in most countries in Europe in February 2015, and in February 2018 in the United States. Given the importance of Remicade, Hospira's Inflectra could turn out to be a challenge to Johnson & Johnson in future.

Medical Device & Diagnostics (40% of 2013 sales)
Pharmaceuticals did well, but the medical device & diagnostics division is facing another difficult year. The whole indusrtry has found it tough. Medical device sales are not often seen as economically sensitive, but when the economy is slow patients tend to make fewer visits to the physician. Ultimately, this results in fewer surgical procedures. Throw in a climate of austerity in hospital spending, and the outlook for medical devices looks moderate in mature markets. Indeed, Johnson & Johnson's management outlined on the conference call that surgical lab procedures were "flat over the last 12 months" in the United States.

Consumer Products (20.6% of 2013 sales)The 2.8% increase in consumer products sales for the fourth quarter was disappointing to some, but Foolish investors should note four things about the division.

First, the consumer products division is probably the most visible of its operations, though it's actually the least important in terms of sales. Second, it's also the division with the largest reliance on international markets, and currency effects reduced sales by a significant amount. In fact, on a constant currency basis, consumer products sales were up 4.4% in the fourth quarter.  Third, the company achieved its aim of getting 75% of its over-the-counter brands (previously affected by production problems) back onto the shelves. Indeed, its U.S. OTC sales rose 21.6% in the fourth quarter. Finally, if you exclude the effects of the sales of the manual toothbrush (oral care) and women's sanitary protection (women's health) businesses then U.S. sales were actually up 10%, with global operational sales growth up 6%. 

Johnson & Johnson in 2014
Looking into 2014, investors should focus on three things:

• Acceleration in the economic recovery so medical device sales can pick up inline with an increase in surgical procedures.

• Ongoing development of pharmaceutical sales, and activity to protect future market share for Remicade in Europe.

• An improvement in its international consumer products sales, as they only grew 3.1% operationally in 2013.

Achieving two of the three things should provide for some upside surprise, and Johnson & Johnson needs it. On current analyst estimates, it trades on a valuation of 16 times forward earnings. The company also has only 6% and 7.4% earnings-per-share growth estimated in the next two years. This makes it look like a fairly valued stock.

Cooper Companies Offers Great Long Term Prospects

In a world where investors make knee-jerk reactions to the latest quarterly earnings reports, it's sometimes difficult to focus on the long term. In the case of the soft contact lens industry, Foolish investors are faced with an industry with pretty secure long-term growth prospects. The only significant players are Johnson & Johnson and Novartis'  Ciba unit, with Cooper Companies  coming in third. Meanwhile, Valeant's  2013 acquisition of Bausch & Lomb puts it in fourth place. Cooper is the closest to a pure eye-care play among them, and it presents an interesting proposition for long-term buy-and-hold investors.

Cooper Companies' long-term growth
According to independent analysis, the soft contact lens industry is intended to grow at a rate of nearly 6% from 2012-2016. Indeed, Cooper companies reported that worldwide industry growth was at 5% this year. However, its CooperVision unit (around 80% of revenue, with CooperSurgical making up the rest) reported soft contact lens sales up at a more impressive 10% this year.

Essentially, CooperVision has the opportunity to grow faster than the market for four key reasons.

First, Cooper's silicone hydrogel (more comfortable, longer-lasting) lens sales grew at 19% (constant currency) in the fourth quarter, and are set to grow faster than the market. Moreover, since silicone hydrogel lenses make up 45% of its CooperVision's total revenue, Cooper can grow ahead of the market. In particular, its Biofinity (monthly, silicone hydrogel) lens has a growth opportunity in the US from customers trading up.

Second, industry wide single-use lens sales grew at 10% over the last 12 months, and CooperVision's single-use lens sales increased by 18% (constant currency) over the last year. They made up 21% of CooperVision sales in the fourth quarter. Going forward, Cooper is gearing up for an aggressive expansion of its MyDay (daily, silicone hydrogel) lens in Europe. Customers trading up to its single-day lens generate four to six times more revenue and three to five times more profit. In other words, Cooper has a revenue and margin expansion opportunity with MyDay, but it will take a few years to come to fruition.

Third, Cooper's specialty lenses (toric and multifocal) grew at 8% and 19% respectively in the fourth quarter, and now contribute nearly 40% of CooperVision revenue.

Finally, CooperVision's Asia sales grew at 11% (constant currency), and Cooper's management claims to have good growth opportunities with its Biofinity lens.

All told, it's not hard to see why analysts have the company growing revenue at more than 7% for the next few years.

Johnson & Johnson, Novartis and Valeant report
With a 43% share of the market, Johnson & Johnson is the No. 1 player, but its growth in the third quarter was a far more pedestrian 3.9% (constant currency). Moreover, its U.S. sales only grew 1.9%. Johnson & Johnson has a dominant market position in the two-week modality in the US and this may prove difficult to defend in future, as single-usage lenses gains popularity. 

Novartis operates Ciba Vision (25% of total market) out of its Alcon division, and its contact lens revenue was up 6% (constant currency) in the third quarter with growth driven, unsurprisingly, by its daily lenses and silicone hydrogel lens called AirOptix. Meanwhile, Valeant's Bausch & Lomb (9% market share) launched a one-day lens this year, but the parent company's main focus is on integrating the eye-care company and cutting costs. Indeed, Valeant is expected to reduce Bausch & Lomb's workforce by up to 15% going forward, while it seeks to expand internationally.

In a sense, Cooper's growth prospects (single-use, silicone hydrogel and international expansion) are nicely mirrored in what its rivals are saying too.

Cooper's bumpy growth
While Cooper's prospects look assured, the growth ahead won't be in a straight line. For example, management was very clear on the conference call that it was willing to invest in building out capacity for the growth of MyDay. According to CEO Robert Weiss:

 it is unlikely we will be making profits on MyDay in the next several years with the intent of continuing to develop that franchise, continuing to drive down cost of goods... ...capacity increases behind the product once we come to the U.S. and then... ...other markets around the world

Ultimately, it's not clear how this will affect profitability over the next few years. Moreover, international expansion comes at a cost, and Cooper predicts capital expenditures at a historical high of $200 million (nearly 12% of projected revenue) for next year.

A look at its historical performance demonstrates that Cooper can grow revenue in a recession (note its 2008-2010 performance) and its adjusted free-cash flow (calculated by assuming capital expenditure is equivalent to depreciation) is quite strong.

Sources: Company presentations, author's estimates.

Time to buy Cooper Companies?
Cooper's aim is to hit 25% operating margins by 2018. Assuming it does so, and revenue grows at 7%, then operating income is likely to be $560 million or 71% higher than it is now. In other words, operating income looks set to grow in excess of 11% a year compounded.

That's not astonishingly cheap for a company generating around 4.4% of its enterprise value in adjusted free-cash flow. However, Cooper is a relatively recession-resistant company, and Foolish investors should be willing to pay a premium for this quality. It's a good stock for long-term investors, but don't expect the ride to be plain sailing all the way.

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 Now Relying on Pharma

Health care giant Johnson & Johnson (NYSE: JNJ  ) recently delivered a mixed set of quarterly results that produced more questions than answers. It's hard to be too critical of a company that beats estimates and raises full-year guidance, but there are a few considerations to ponder.

Yet again, the stand-out performer in the quarter was its pharmaceutical division. However, the underlying performance in its consumer and medical devices and diagnostics divisions contained some warning signs. Moreover, whenever pharmaceutical stocks are analyzed the usual approach is to estimate the future value of its pipeline, rather than focus on current earnings. The market should do the same here.

Pharma (40.1% of sales) stands out

While it's pleasing to see an increase in revenues of $523 million (3.1%), the pharma division contributed $634 million of that figure. Ultimately, pharma offset a reduction of $141 million in medical devices and diagnostics revenues and a paltry $30 million gain from consumer products. In other words, the non-pharma divisions (60.5% of revenues) saw their revenues fall by $111 million on a combined basis.

The pharma division is rapidly expanding sales of some of its newer drugs like Stelara (psoriasis), Xarelto (anti-coagulant), Zytiga (castration-resistant prostate cancer), and Invega Sustenna (anti-psychotic). In fact, these drugs contributed $572 million of the $634 million in increased sales in the pharma segment.

Going forward, Johnson & Johnson has high hopes of developing sales of Invokana (type 2 diabetes) although it may face competition in future for its leading treatment Remicade (rheumatoid arthritis). Naturally, it will vigorously defend its Remicade patents, especially given that the therapy represents 24% of its pharma sales.

Consumer products (20.5% of sales)

Operational sales actually rose 2% (and 4% excluding divestitures), but currency effects reduced reported growth to just 0.8%. In addition, this is the year that Johnson & Johnson planned to reintroduce 75% of the consumer brands that were affected by product quality issues. Indeed, two of the affected brands, Tylenol and Motrin (painkillers), were cited as "positive contributors" in the quarter. While their contribution is an obvious plus, it suggests that the underlying performance within consumer products is weak.

There was even some discussion of consumers trading down to store brands. Frankly, this wouldn't be a surprise because the likes of CVS and Walgreen (NYSE: CVS  ) have been aggressively expanding their in-store brand sales. Moreover, the drug stores are likely to keep pushing generic versions of pharma companies' over-the-counter (OTC) and prescription drugs.

Ultimately, growth in the consumer segment will rely on emerging markets, as the U.S. mass market consumer remains challenged by a weak economy.

Medical devices & diagnostics (39.4% of sales)

Orthopedics make up a third of the division's revenues, and unfortunately they only grew 1.1% operationally in the quarter. Despite the long-term growth prospects coming from aging population, there is a note of caution going forward. On the conference call, the management cited pricing competition primarily in the trauma segment in the U.S. In addition, pricing in U.S. orthopedics remains an issue as pricing declines of 3%, 1.5% and 4% were declared for hips, knees and spine solutions, respectively.

Incidentally, this is pretty much in line with what Zimmer (NYSE: ZMH  ) said in its last results. Zimmer saw pricing down 1.3% in the second quarter. Knee pricing declined 1.4% with hip pricing down 2.1%. In a foretaste of what Johnson & Johnson would say, Zimmer had outlined on its conference call: "Competitive pressures, most notably in the United States, slowed our Trauma growth for the quarter, but were mitigated by the company's consistently strong performance in overseas markets."

The worry is that more intensive price competition will extend beyond the trauma market and increase pricing headwinds in the U.S. orthopedics market for all the leading players.

Elsewhere, its eye-care numbers were somewhat disappointing with US growth of only 1.9%, and international operational growth at 4.9%. Contact lens specialist Cooper Companies (NYSE: COO  ) sees the global lens market growing at 4%-6% this year, but for the second quarter running it recorded only 4% growth. Given that Johnson & Johnson' s overall operational growth was only 3.9%, it's reasonable to worry that Cooper's growth might continue at the low end of its targeted range.

The bottom line

The pharma division is firing on all cylinders, and looks set to continue in future quarters. However, there are some warning signs in the other divisions. It's unreasonable to expect all its divisions to be performing well at the same time, but the trend of pharma outperforming has been here for nearly a year now.Much depends on the future pipeline.

All told, the stock looks close to fair value. A forward P/E of around 16.6 times earnings isn't especially cheap for a stock forecast to grow earnings at 6%-7% rate over the next few years. The current dividend yield of 2.9% will attract income seekers, but otherwise the stock looks pretty fairly valued at $91.

Covidien is the Pick of the Medical Device Sector

It may be tempting to revise the idea that investing in the medical device sector is a defensive strategy. However, don't be too quick to fall out of love with Covidien (NYSE: COV  ) . The company represents one of the more compelling long-term growth prospects within its sector, and has several ways to generate long-term growth.

Covidien, an emerging market play
Prospects for emerging markets to increase medical spending look strong. Not only are they growing their GDP at a faster rate, but countries like China are under increasing pressure to spend their foreign currency reserves on stimulating domestic demand via infrastructural investment.

Moreover, at its latest investor day, Covidien argued that emerging markets had only 6% of their GDP in health care, compared to 18% for the U.S. and 10% in the European Union. The potential for growth is significant, and Covidien hasn't been slow in investing in technology and innovation centers in places like Istanbul, Shanghai, Mumbai, and Sao Paulo.

Although the company currently generates less than 20% of its sales from emerging markets, its growth rates from these regions is little short of spectacular. For example, the BRIC (Brazil, Russia, India and China) countries make up 40% of its emerging market sales, and they are currently growing at around 25%. Meanwhile, the non-BRIC countries are growing at a very respectable 10%. Covidien's growth looks set to focus on the BRIC countries as it forecasts that 60% of its emerging market revenues will come from them by 2018.

Covidien's four sweet spots
First, unlike rivals like Johnson & Johnson (NYSE: JNJ  ) or General Electric's (NYSE: GE  ) health care division, Covidien doesn't have many large-ticket capital machinery type items. Instead, its solutions tend to come at more accessible price points -- a key plus point when trying to expand EM sales. Moreover, Covidien claims that its emerging market margins are higher than the company average, so there is a margin expansion opportunity as well. Furthermore, with no product (or class of product) contributing more that 5% of total sales, it isn't reliant on any one item for its sales growth.

Second, its solutions tend to be relatively non-cyclical, because its strength is in non-elective surgical procedures.  Johnson & Johnson is struggling to generate growth in its surgical device markets, and has talked about a hospital capital spending market in a recession. In fact, in its latest results Johnson & Johnson's surgical care results declined 1.1% on an operational basis. Meanwhile, Covidien's endomechanical and energy growth remains strong.

Source: Company filings.

Third, its endomechanical and energy products -- particularly those relating to minimally invasive surgery, or MIS, solutions -- tend to reduce hospital costs because they produce better patient outcomes. Going forward, Covidien has a growth opportunity by convincing hospitals (particularly in emerging markets) to use MIS procedures to reduce hospital costs. Moreover, if authorities are convinced of the efficiency benefits of MIS, they may start reimbursing this type of procedure in future.

Covidien's fourth sweet spot is that its strengths (endomechanical and energy products) are relatively under-penetrated areas in emerging markets. And there is more opportunity to come, because at its recent investor day the company argued that "10 of 12 pipeline products that we have in the pipeline are going to come from classes of trade where we expect 70% of our growth, Endomechanical, Energy and Vascular."

Where next for Covidien?
Its defensive characteristics and emerging markets prospects will help to offset sluggish spending in its core developed markets, but its forecast for overall revenue growth in 2014 is only between 2% and 5%. Analysts have revenue growth at 3.6% for 2014, and EPS growing just 7.2% to $3.98. While this may seem paltry, consider that GE's medical division revenues were flat in the last quarter despite recording 10% growth from its emergin markets operations.

Moreover, Covidien's forecasts assume a 4% headwind due to foreign exchange and the medical device tax. In other words, Covidien's underlying forecast for 2014 is in-line with its long-term aim of mid-single digit revenue growth and double-digit EPS growth. On a forward P/E ratio of 15.3 times earnings, and with upside from increasing adoption of MIS in emerging markets, the stock is attractive.

Cooper Companies, Great Prospects, Expensive Stock

When it comes to investing, sometimes it's best to start with the obvious and look for companies that have the potential to slowly grow. Contact lens specialist Cooper Companies  (NYSE: COO  ) is one such stock, and it's definitely worth taking a closer look at it.

Cooper Companies growth prospectsCooper reports numbers in two separate segments. CooperVision is a soft contact lens manufacturer generating 80% of revenues. CooperSurgical generates 20% of revenues, with two-thirds coming from surgical devices, and one-third from its fast growing fertility treatment products.  I'm going to focus on CooperVision.

Cooper's management is on record as expecting the soft contact lens market to grow at a 4%-6% clip this year. The bad news is that, for a second quarter running, the worldwide market only grew at 4%. This suggests that market demand is not as strong as it could be.

The good news is that CooperVision managed to grow its sales by 11% over the last 12 months, and there are a number of reasons why it can continue to grow.

First, its silicone hydrogel lenses (more comfortable, last longer) revenues now make up 43% of CooperVisions total. They grew at 22% (constant currency) in the last quarter, and Cooper can expect to generate more growth in the future from customers "trading up" to these lenses.

Second, Cooper's management never tires of pointing out that a customer trading up to its single-use (or one-day) lenses generates four to six times more revenue and three to five times more profit. In other words, there is ample room for growth in earnings and margin growth from expanding one-day sales. For reference, its single-use sphere revenues only make up 21% of CooperVision revenues (17% of total company), and they grew at 9% in constant currency in the last quarter.

Third, Cooper plans to move in on Johnson & Johnson's (NYSE: JNJ  ) dominant position in the two-week modality in the U.S. by marketing its own two-week lenses.

Fourth, Cooper has just launched its new branded one-day silicone hydrogel based lens called MyDay in Europe. According to the management, MyDay is "not going to be a major influence" next year because sales are building from a small base. It will take Cooper time to build up production capacity, but longer-term Cooper should have good prospects with MyDay. 

And finally, Cooper has plans to geographically expand sales of its leading Biofinity (monthly silicone hydrogel lenses). Moreover, it can cut costs thanks to not paying royalties, because sillicone hydrogel patents will expire in the U.S. in 2014 and globally in 2016.

Threats to growth?While Cooper has been growing, there is no guarantee that it will continue to do so. Indeed, Valeant Pharmaceutical's (NYSE: VRX  ) purchase of Bausch & Lomb suggests that competition will get tougher. For example, Bausch & Lomb recently launched a one-day lens. Moreover, Valeant has worldwide plans to generate synergies between its existing dermatology and eye-care products, and Bausch & Lomb's eye-care solutions. Valeant will surely invest in trying to expand Bausch & Lomb's international sales.

Similarly, Johnson & Johnson managed to accelerate growth in its vision-care segment to 5.4% operationally in the last quarter, and it cited its one-day lenses as one of "the primary contributors to operational growth." Cooper is not alone in recognizing the margin potential of one-day lenses, and Johnson & Johnson has a formidable distribution network in the kinds of emerging markets that Cooper wants to expand into.

A look at the numbersCooper has strong prospects, but it also has a strong valuation. Cooper's own EPS guidance has increased throughout the year.

Source: Company presentations.

However, its valuation has more than kept pace, and it now sits on a forward P/E of over 20 times the mid-point of its full-year EPS guidance. This looks expensive, but recall that Cooper has long-term margin expansion opportunities. Furthermore, a better gauge of its value is to look at its free cash flow potential. I've chosen to adjusted for the increased capital expenditure program it's undertaking right now. Cooper is investing in order to develop production capacity and to accelerate sales of its silicone hydrogel based sales. 

In the following table, I have assumed that capital expenditures equate to depreciation in order to give a better picture of underlying cash flow generation.

Sources: Company releases, author's estimates for 2013 and 2014.

My underlying free cash-flow estimates of $264 million and $290 million for the next two years indicate that Cooper continues to generate plenty of cash. However, these figures represent only around 4% and 4.3% of its current $6.65 billion enterprise value.

Cooper is an attractive company, but its valuation gives little room for error, and it operates in a very competitive market against giants like Johnson & Johnson and Novartis (Alcon). It's a great company, but one to keep on your watchlist for now.

Covidien Has Upside Potential

It’s been a tricky market for medical device companies in 2013, but you wouldn’t know it from Covidien’s (NYSE: COV) share price performance.

The stock is up nearly 23% this year, even while companies like Johnson & Johnson(NYSE: JNJ) have disclosed lower-than-expected growth in surgical procedures. Moreover, the spinoff of Covidien's pharmaceuticals business (to be called Mallinckrodt) turns it into a pure-play medical device company. Why is Covidien outperforming its sector, and what can investors expect in future from the company?

Covidien offers inexpensive, cost-effective solutions

Firstly, while the overall medical device market is bedeviled with weak spending patterns, Covidien’s solutions tend to come at much lower ticket prices than many of its competitors. This means that a lot of its solutions fall under the radar of items earmarked for cutbacks.

However, other companies in the sector have not fared so well.  For example, on its last conference call Johnson & Johnson described the hospital capital spending market as being in a recession for the last 10 to 12 quarters. Indeed, Johnson & Johnson only recorded 0.5% growth (excluding acquisitions) in its medical device & diagnostics division.

Meanwhile, Covidien managed to grow constant currency revenues by 5% in the last quarter, despite coming up against some difficult comparables in its vascular product sales.

A breakout of its product revenue growth reveals pretty solid growth, and on its conference call, management affirmed its belief that growth would continue “to be slightly above market.”

Source: Company SEC filings.

Second, many of Covidien’s solutions actually enable hospitals to reduce costs. For example, its energy devices division has some of the world’s leading minimally invasive surgical (MIS) equipment.

Covidien’s MIS solutions allow hospitals to create better patient outcomes, and save costs by reducing outpatient days. Such properties mean that hospitals keen on restraining spending will still consider making purchases. Moreover, in previous conference calls, Covidien argued that it could generate growth by increasing MIS use in procedures such as hysterectomies and colorectal surgery.

Emerging markets, obesity, and cost savings

Third, emerging markets present a strong growth opportunity. According to company presentations, Covidien plans to reach $2 billion in emerging market sales within the next couple of years. The current percentage of overall sales from emerging markets is around 15%, and a move to $2 billion would probably take it nearer to 20%. This looks achievable, because in this quarter alone, Covidien recorded “operational sales growth in the mid-teens and double-digit increases in most product lines” within emerging markets.

This compares favorably with what General Electric (NYSE: GE) reported in its health-care division recently. GE outlined that its emerging-market growth was up 10%, while developed-market revenues declined 4%. In the end, GE’s health-care revenues were flat on the last quarter.

The first two reasons discussed above are a big part of Covidien’s appeal to hospitals in emerging markets. Its products are not the kind of high-ticket capital machinery solutions that will make poorer countries balk at up-front purchases. In addition, areas like endomechanical and energy devices (MIS) enjoy significant growth potential because they haven't yet expanded much into those emerging markets.

The fourth reason why Covidien can generate growth relates to the kind of procedures that its equipment serves. Previously, management has outlined that bariatric (weight-loss) procedures are one of its most important profit drivers. Frankly, with more than one-third of U.S. adults obese, the demand for bariatric surgery isn’t going away anytime soon.

Finally, spinning off Mallinckrodt will allow Covidien to focus on investing as a pure medical device company. This is likely to mean more acquisitions, and a heavy focus on emerging markets.  It should also enable the company to cut some corporate costs. Indeed, management outlined programs designed to trim around $400 million from its budget.

Investors should look out for more disclosure in the upcoming investor day event in September. Covidien’s management is very good at this sort of thing. For example, despite a string of acquisitions, it managed to reduce headcount by around 5% over the last four years.

Where next for Covidien?

In conclusion, this was a pretty strong quarter for Covidien. Unlike Johnson & Johnson and GE, it managed to generate some good growth from medical device sales, despite a sluggish hospital spending environment. In the long-term its growth prospects look assured, and the stock is one of the most attractive in its sector. In the near term, it has managed to get over a tricky quarter in its vascular business, and there is likely to be some upside to come from its cost-cutting initiatives.

Analyst estimates call for $4.04 in EPS for 2014, which puts the stock on a forward valuation of around 15.8 times earnings. If you are happy to pay this valuation for a company with solid 4% to 6% revenue growth prospects, and earnings growth forecast in the high-single-digits, go ahead and buy the stock.

In my view, it looks fairly valued for now, but I wouldn’t bet against management’s ability to generate future cost savings and margin expansion. With this in mind, it’s well worth closely following what the management says in its investor day presentation in September.

Why General Electric is Outperforming

If you think that investing is simple, then just take a look at industrial giant General Electric’s (NYSE: GE) latest results. The industrial sector has been weaker this year, but GE reported a surprisingly good set of results. Furthermore, rivals such as Switzerland’s ABB and Germany’s Siemens, have subsequently given disappointing results and guidance. So what's going on with GE? How has it managed to achieve such good results?

The three reasons why the results were good

GE actually reported a 4% decline in revenues, and its earnings from continuing operations before taxes were down 11%. It may seem peculiar to describe such results as being "good," but here are three reasons why the description fits.

First, the industrial side actually increased segment profits by 2%. The negative contribution came from the financial services side, where GE Capital’s segmental profits declined 9%. The decline at GE Capital was in line with the company's strategy to reduce its portfolio size and focus instead on its core GE business. The days are long gone from when GE was regarded as a financial services company with an industrial division attached to it. In fact, the industrial division now generates double the income of the GE Capital.

Here is a chart (sourced from company accounts) of GE’s segmental income in the quarter:

Five of the six industrial segments increased profits, so the underlying performance is better than it appears at first.

Orders are up

The second reason is that its industrial orders were better in the quarter. Overall orders were up 4%, with U.S. orders up a whopping 20%, and its European orders were up 2%, having been down 17% in the previous quarter. Indeed, industrial bellwether Alcoa (NYSE: AA) highlighted similar dynamics in its latest conference call.  Alcoa implied that North America was strengthening, Europe was weak-but-stabilizing, and its outlook for China remained the same. Meanwhile, GE claimed on the conference call that its emerging-market performance “remained resilient.”

A breakdown of GE’s order growth in the quarter, with all data sourced from company accounts:

Power & water has been the problematic segment this year, particularly within Europe. Indeed, European power & water orders were down 40% in the quarter. Excluding Europe, power & water orders were actually up 6%.

Furthermore, GE claimed that 70% of the segment's shipments would occur in the second half of the year, which should lead to strong margin expansion in the second half. This is good news, because the segment is GE’s biggest industrial profit center.

Relative strength in GE’s key markets

Finally, GE is relatively well-exposed to the growth areas in the industrial sector in 2013. The relative strength in the aerospace and automotive sectors has been a recurring theme of investing in the industrial sector this year.

Indeed, Alcoa noted a similar trend in its recent results. Alcoa investors should note that, on its conference call, GE discussed its gas turbine orders, and said that “the overall market is not going to be quite as strong as we had initially expected.”  In contrast, Alcoa left its forecast for industrial gas turbines unchanged.

GE also has heavy profit exposure to other sectors that are outperforming, such as oil & gas, and transportation. The most surprising result probably came from its health-care segment.

Healthcare giant Johnson & Johnson (NYSE: JNJ) has a large medical device and diagnostics division (40% of sales) that achieved tepid growth of only 0.5% (excluding acquisitions) in the last quarter. Moreover, Johnson & Johnson described the U.S. hospital capital expenditure market as being in a recession for the last 10 to 12 quarters.

GE’s healthcare sales told a similar story. Its strong expansion in growth markets (revenues up 10%) managed to offset weakness in developed markets (where revenue declined 4%), resulting in flat revenue for the quarter.

Where next for General Electric?

In conclusion, revenue growth will be hard to generate in 2013 due to a weak global economy, but GE has enough exposure to the end markets that are doing relatively better. Conditions could hardly get much worse for its European power & water operations, and going forward, GE will start to lap some easier comparables.

The underlying performance on the industrial side is relatively good for the sector, and GE represents one of the better ways to play the industrial sector this year. It's well worth looking at.

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.

Cooper Companies Has Good Long Term Prospects

Everyone loves a defensive growth story, and there aren’t many better companies in the category than Cooper Companies (NYSE: COO). In general, ophthalmology is an industry that can grow irrespective of the economy. Within this, Cooper has its own mix of earnings drivers with which it can generate superior industry growth.

It is a compelling mix. In fact, so much so that the stock has gotten away from this investor’s hopes for a buying opportunity. In summary, the recent results were pretty good in a relatively weak environment, and the full year EPS guidance hike is seeing the stock higher as I write. Is there more to come?

Super Cooper

Before going into the details, here is a summary of the updated full year guidance versus the previous company estimates.

The key changes are the raising of EPS guidance (I have bracketed) and a $10 million lowering of revenue guidance for Coopervision and Coopersurgical respectively. The former is largely due to currency effects and the latter is due to the kind of softness with medical surgery that others like Johnson & Johnson (NYSE: JNJ) have reported in the quarter.  In fact, Johnson & Johnson explicitly stated that hospitals had reported that surgical procedures were currently running at levels below the rate that they had predicted for 2013. As for the full year currency effects on Coopervision, we got an idea of how pervasive they are in the current quarter whereby 11% growth at constant currency turned into only 7% reported growth.

So while the reduction to revenue expectations was slightly disappointing, the increase in the EPS guidance was well received. There was no change to free cash flow (FCF) guidance.

Essentially Cooper is succeeding in its aims of trading up customers to its (higher margin) silicone hydrogel lenses (which now make up 43% of Coopervision revenues) and towards its one-day modality. The latter generates 4-6x the revenue of ordinary lenses and 3-5x the profit. All of which is good news because if we go back to the previous set of results Cooper outlined its intention to increase capital expenditures by $90 million in order to accelerate the sales expansion of its silicone hydrogel based lenses. The recent results suggest that it was a good move.

Long term growth looks assured

Going forward the long term opportunity for Cooper is obvious. The company is catching up with its rivals in terms of its silicone hydrogel lens penetration, and the benefits of a one day modality to the consumer are obvious. Moreover, unlike some of its rivals, Cooper is not encumbered with the strategic difficulty of missing out on lens care sales (one day lenses don’t require care) because it is expanding its one day sales. Furthermore it can expand its private label sales, and the growth potential in the emerging world is obvious.

However, the story isn’t just about Coopervision. Its surgical division is a strong FCF generator, and the strategy is to make further acquisitions in the space in order to leverage its sales infrastructure. Putting all these elements together should ensure long term growth and, more importantly, at a rate in excess of industry growth.

What the industry is saying

Cooper reported that the market only grew 4% (at the bottom of the expected 4-6% range) and that it expected it to grow at 4-6% for the rest of the year. The good news is that Cooper is able to grow in excess of these numbers. A quick look around the industry shows some sluggish conditions. Its biggest rival is probably Johnson and Johnson, and it reported only 1.6% constant currency growth for its vision care range; thanks to currency effects its international vision care was down 4.4%.

It was a similar story with Novartis’ (NYSE: NVO) Alcon unit. Ophthalmic pharmaceuticals sales were up 5%, but vision care was only up 3% and, in line with what Johnson & Johnson and Cooper said, its surgical revenues were soft with only 2% growth being recorded. Alcon is not a huge part of Novartis' revenues, but it is of strategic important to the company and complements its generic and OTC pharmaceuticals activities.

However, the big news in the industry in the quarter was Valeant Pharmaceuticals' (NYSE: VRX) agreement to purchase Bausch & Lomb for $8.7 billion. It is certainly a busy time for Valeant as it attempts to integrate Medicis as well as prepare for Bausch & Lomb. Interestingly Valeant disclosed that Bausch & Lomb grew revenues at 9% last year (although this includes its surgical segment). Valeant talked about generating $800 million in cost synergies by the end of 2014, but this does not mean it won’t be investing in eye-care. In fact Bausch & Lomb’s strength in emerging markets is complimentary to Valeant’s North American focus, and eye-care, dermatology and aesthetics are good bed-fellows in terms of strategic development. We can expect increased competition as a result of this deal.

I would summarize the industry background as being stable but slightly weaker than might have been expected.

Where next for Cooper Companies?

In conclusion Cooper Companies is a very attractive company that can achieve good revenue and margin growth even if the economy slows. In my opinion its evaluation should command a premium over the market but, as ever, the question is how much do you want to price in?  The ‘defensive’ sector has certainly led the market this year, and many stocks within it (particularly food stocks) are starting to look toppy to me.

As I write this, Cooper Companies trades on $120 and an enterprise value (EV) of $5.85 billion. Interpolating from my table above, this puts it on a forward PE ratio of 19.3x and a forward FCF/EV yield of only 3.1%. As much as I like the stock I am still going to truculently go away, sit in a corner and mumble that it’s too expensive right now while patiently waiting for a dip.

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.

General Electric Reports Mixed Results

Anyone who has watched the classic sales movie Glengarry Glen Ross or worked in sales will know that the acronym ‘ABC’ stands for ‘always be closing.’ However anyone who hasn’t and instead has solely listened to US blue chip conference calls over the last few years will probably conclude that it actually stands for ‘always be cost-cutting.’ In other words, investing for growth is still on the back-burner in favor of pruning and consolidating measures made in light of uncertain end demand. Such considerations came to mind when considering General Electric’s $GE latest results.

A mixed Industrial Environment

The earliest indication of how the industrial sector was faring was outlined by Alcoa $AA recently, and it was pretty positive in my view. Other than a slight weakening of its European automotive outlook, Alcoa kept its end markets prognosis constant. However, on closer inspection it is clear that Alcoa’s growth prospects in 2013 are highly reliant upon China. In addition it is exposed to a few industries that are doing relatively better.

As this article demonstrates, global aerospace is doing well with airlines surprising on the upside and passenger growth numbers growing at a decent clip. This is obviously good news for General Electric and its aviation segment. In addition, Alcoa’s North American outlooks for its automotive and commercial building & construction segments respectively were for 0-4% and 1-2% with China growing up to 10% in both. Europe is expected to decline in both of these segments. So while China is doing well and some global industrial sectors are doing okay, it is far from a universal situation.

More evidence of this divergence in the industrial sector can be gleaned from looking at what the industrial suppliers like Fastenal and MSC Industrial are saying. Aerospace and auto are fine but elsewhere there was weakness in Q1.

What GE Said

Fast forward to GE’s latest results and the company reported that its industrial segment profits were $200 million lighter than had been expected largely due to Europe being weaker than forecast. The power & water segment was particularly affected while elsewhere GE reported some reluctance to close orders in a few of its shorter cycle industries. Again, the latter statement correlates with what the industrial suppliers (who are as about as short cycle as you can get) indicated.

In order to see the relevance of the power & water segment here is a breakdown of GE’s segmental profitability in the quarter.

As the chart indicates the industrial segments that increased profitability were aviation, healthcare and transportation. GE capital profits improved in line with its rationalization strategy. Overall segment profits were down 4%, but net earnings rose 16% thanks to lower charges and eliminations.

See what I mean about ABC? Indeed, the immediate response to the weakness in the quarter was to announce more cost cutting measures. Plus ca change and all that.

What the Results Mean to The Market

Another area of interest was US healthcare, which GE said was a bit weaker than expected. Investors got an early read on this when Johnson & Johnson gave results and noted (within its medical devices and diagnostics segment) that US hospital procedures were weaker than the hospitals had forecast going into 2013. In addition hospital spending wasn’t as strong. It’s nothing dramatic for Johnson & Johnson because it has plenty of other profit drivers within pharma and consumer products, but for a company like Varian Medical Systems $VAR it is a cause for concern.

I like Varian, and based on a SWOT analysis think it has some very impressive long term growth prospects with its proton therapy solutions. In the near term it can expand its radiation therapy into indications like lung cancer, particularly within emerging markets. In addition its new deal (GE was its former partner) with Siemens (which is pulling out of radiation oncology) gives it a large installed base on which to target. On the other hand its systems require significant outlays, and with Johnson & Johnson and GE reporting some weaker conditions, can we really expect immediate upside from Varian?

On a more positive note GE forecast that its oil & gas and home & business segments are going to be ‘pretty solid’ for the year. Within the latter segment one of its key rivals is Whirlpool $WHR I think Whirlpool has good growth prospects in 2013. The US housing market is recovering, and Whirlpool is starting to anniversary the housing boom of 10 years ago. In other words, the white goods purchased back then should have depreciated by now and a replacement cycle should kick in. Furthermore, GE reported good results in emerging markets so we have reason to believe that Whirlpool will do okay in its key Brazilian market.

Where Next for GE?

Cost cutting isn’t sexy, but it does represent a key bottom line opportunity for GE this year. Europe was weaker than expected but China’s strength was a welcome positive note. As noted above GE’s end markets will be variable this year with areas like aviation, transportation and health care (especially in emerging markets) likely to remain strong and counteract areas more exposed to austerity measures like US military spending and European infrastructural spending.

Investors looking for a more focused exposure to their favorite end markets will not buy GE because of its diversification, but those looking for a 3.5% yielding global GDP type play will view this mini sell-off as a buying opportunity.

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