Abbott, Baxter, Covidien All Undervalued, Downside Already Factored In
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is a $20B tax included in the Affordable Care Act that has failed to receive much media attention but will nevertheless have a large and negative impact on the healthcare sector. Starting in 2013, device makers will face a 2.3% excise tax on revenues regardless if they generate a profit. Jobs have already been cut in anticipation of the tax implementation. In such a climate, it is necessary to review how undervalued device makers are right now. I find Abbott Labs (NYSE: ABT), which will retain the medical device segment, Baxter (NYSE: BAX), and Covidien (NYSE: COV) have factored in much of the downside and are undervalued right now.
Several months ago, Abbott decided to split into two companies. One company, newly christened "AbbVie", will be in charge of the pharmaceutical device company. This has brought in the majority of business with Humira being the largest cash cow as the leading profitable drug. Tricor, Trilipix, and Kaletra are other large drivers that are worthy of watching. The $14.5B financing package behind the split is the largest transaction of its kind ever in healthcare. Abbott will retain the medical device business.
Investors have responded favorably to the shift. By retaining the medical device business, Abbott will be able to report faster growth where the segment is growing 20% each year. My main concern with the device business is that there needs to be more cross-selling developing beyond the drug-coated stent line. Peers, like Medtronic (NYSE: MDT), have substantial inroads in this market, and the takeover market should be ripe with potential candidates weary of the 2.3% excise tax.
Abbott is reasonably priced at 12.4x forward earnings and a projection for 8.3% annual EPS growth over the next 5 years. More significantly, Abbott is defensive investment given its generous 3.1% dividend yield and low beta of 0.31.
Baxter is similarly attractive at a 3.1% dividend yield and 12.1x multiple. Analysts expect around 60 bps-greater annual growth over the next 5 years, but Baxter has less of a patient population to cross-sell products to. Accordingly, Abbott merits a higher premium despite the lower growth expectations.
But if investors are looking for diversification in the device business, they should consider names beyond Abbott. Baxter is a pure play on the industry and offers products for renal diseases, hemophilia, and infections, among others.
During the second quarter, management released results that were in-line with guidance. Diluted EPS grew 5% to $1.12, which was at the high-end of guidance range previously provided. Global sales hit $3.6B as synergies were yielded from the Synovis and Baxa acquisitions. Domestic growth was in the double-digits where benefits are being realized from ADVATE's new expanded label. Regenerative medicine sales grew 18% to $174M as momentum at FLOSEAL took off.
Going forward, there are several headwinds to value creation. Baxter has underperformed the market over the last year, but that has begun to change in the last month. The FDA recently informed Baxter that more data was needed on the long-term use of Gammagard HyQ, which will allow weekly injections to be replaced by self-administered monthly injections. Gammagard targets the antibody therapy business; but, as a result of the delay, will face greater competition as peers make advances.
In my view, Covidien is the most attractive device maker right now. It trades at a respective 14x and 12.4x past and forward earnings with a low 1.6% dividend yield. Annual EPS growth is forecasted at 10.8% - the highest of the three companies highlighted herein. Double-digit ROE and ROI are compelling reasons to buy shares now. According to FINVIZ.com, analysts rate the stock a 1.7 out of 5.
Assuming Covidien is able to meet growth expectations, 2016 EPS will come out to $6.22. At a 15x multiple, the future value of the stock is $93.30. Discounting backwards by 10% yields a present value of $57.93 - roughly in-line with the current market assessment.
Free cash flow has grown substantially over the last four years. In 2008, the company generated $250M in free cash flow. In 2011, the company generated $1.7M in free cash flow. Better yet, capital expenditure has stayed relatively constant while net income has been on a dramatic rise. Even though operating cash flow growth is decelerating, invested cash flow margins are still growing due to the excellent handling of CAPEX. For an attractive growth stock, Covidien is truly worth an investment.
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Abbott Laboratories and Medtronic. Motley Fool newsletter services recommend Covidien Ltd.. 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.If you have questions about this post or the Fool’s blog network, click here for information.