Covidien: A Conviction Buy

By Ashish Sharma - August 24, 2012 | Tickers: BSX, BCR, COV, STJ | 0 Comments

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Covidien (NYSE: COV) is a worldwide leader in Medical Devices & Diagnostics products. The company operates through three segments: Medical Devices, Pharmaceutical/Imaging Products, and Medical Supplies. Late last month, Covidien reported fiscal 3Q results with sales of $3 billion (up 3% YoY) and EPS of $1.07 vs. the consensus estimates of $1.06. Adjusted gross margin rose 90 basis points YoY to 58.0%, while R&D spending increased a healthy 15% YoY. Importantly, operational growth of 22.5% remains impressive in light of the challenging macro-economic environment with an 8% YoY increase in the medical devices business (69% of total sales). When the companies like St. Jude (NYSE: STJ), Boston Scientific (NYSE: BSX) and CR Bard (NYSE: BCR) are struggling to show growth in surgery and vascular, Covidien continues its strong growth as evident from a 6% organic revenue growth. I believe Covidien is driving superior results through a combination of investments in emerging market infrastructure that is now bearing fruit; smart acquisitions that have accelerated the growth profile; and improving operating structure into the execution of the Pharma spin-off.

M&A to Drive Growth

Covidien has traditionally been active on the M&A front. Following deals have been made, which I believe will be additive to the company’s growth rate over time:

• On 2^nd July’12, Covidien acquired MindFrame (devices to optimize rapid perfusion and clot removal in the treatment of ischemic stroke) for approximately $75 million. In my view, this technology acquisition will complement Covidien’s rapidly growing Neuro franchise in ischemic stroke.

• On 26^th June’12, Covidien completed its acquisition of Oridion (patient monitoring/ capnography) for $327 million. I believe this acquisition complements their existing product portfolio of pulse oximeters and monitoring products.

• On 15^thMay’12, completed the Super-D deal (minimally invasive interventional pulmonology devices) for $286 million. In my view this acquisition will allow it to deliver more comprehensive solutions in the evaluation and treatment of lung disease.

Each of these acquisitions is in the integration process with Covidien. On a combined basis the markets these companies compete in, represent more than ~$7 billion globally, growing at a double-digit rate.  These well diversified acquisitions offers entry into several promising clinical areas including gastrointestinal disease, oncology and hypertension. I believe that each one of these acquisitions provides entry into a fast growing market on top of access to products or technology that will accelerate Covidien’s growth. Additionally, it will strengthen Covidien’s core business and provide opportunities to leverage geographic footprint and functional capabilities.

Ample cash flow and balance sheet capacity to continue acquisitions while also returning impressive cash to shareholders

Covidien's capital allocation strategy has been to return 25% - 40% of its FCF to shareholders each year through dividends and share repurchases. However, Covidien has returned cash at a much higher rate (over 80% of FCF over the last four quarters while investing greater than $1 billion in acquisitions).  Covidien is now targeting to return a minimum of 50% of FCF to shareholders through dividends and buybacks in the long term.

Over the next four years, I expect Covidien to generate ~ $9 billion in free cash flow which is equivalent of 35% of its current market cap.  As growth reaccelerates, I believe that management will continue to its strategy for capital allocation and further enhance shareholder returns.  I am optimistic that higher returns to shareholder will further gain traction among investors.

Growth in emerging markets

In emerging markets, comprising Eastern Europe, Middle East and Africa, Asia and Latin America, sales grew at a double-digit pace with broad-based gains led by Endomechanical, Soft Tissue Repair and Energy products. Also, Company has registered exceptional growth in the BRIC countries led by China and Brazil. In the near term, Company has plans to make incremental investments in emerging markets to accelerate growth and expand product offerings. I believe that the demographic trends are favorable in emerging markets and incremental investment will result in long term EPS growth.

3Q results put Covidien among the top-tier topline & bottom line growers across large-cap Med-Tech. However valuation has only marginally improved. Looking into FY13, I believe Covidien has one of the most promising growth outlook among large cap MedTech companies. Moreover, company’s plan to spin its pharmaceuticals business into a separate publicly traded company as a positive structural move, which should lift Covidien’s topline organic growth. According to me, recent acquisitions and pharma spin arbitrage are not fully factored into company’s valuation. Thus, I expect that valuation will steadily improve towards premium territory relative to its peers. Hence, I recommend it as a conviction buy.

Note: The article was originally published on TheAnalystHub.com. For more in-depth research articles please visit our site today.

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