A Busy Year Ahead for This Medical Device Company

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

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.

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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.


SaintGermain has a position in Johnson & Johnson. The Motley Fool recommends Covidien Ltd., Intuitive Surgical, Johnson & Johnson, and MAKO Surgical . The Motley Fool owns shares of Intuitive Surgical, Johnson & Johnson, and MAKO Surgical . Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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