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.