The Street Has Caught Covidien

By Stephen D. Simpson, CFA | August 01, 2013 AAA

For most of 2012 and 2013, Covidien (NYSE:COV) was the not-so-little med-tech that could. In an environment were companies like Johnson & Johnson (NYSE:JNJ), Bard (NYSE:BCR), Stryker (NYSE:SYK), and Abbott (NYSE:ABT) were struggling to deliver sustained attractive growth in devices, Coviden managed to do so. Now, though, it looks like the Street has caught up with Covidien's prospects and the sequential deceleration in device growth could make it harder for these shares to outperform. Still, as one of the best companies in a still-popular sector, I wouldn't be in a hurry to sell if I owned shares.SEE: A Checklist For Successful Medical Technology Investment Overall Performance Continues To Lead, But Slow Spots Are AppearingWith 3% reported growth and 4% organic growth, Covidien basically hit its mark for the fiscal third quarter. While revenue from the supplies business declined 1%, core device growth was up 6% on a constant currency basis, making it one of the strongest large-cap device growth names. That said, it's not all roses for Covidien. Businesses like endomechanical (up 8%), energy (up 10%), and oximetry/monitoring (up 15%) are maintaining very healthy growth rates and gaining share, but Covidien's soft tissue and vascular businesses are looking quite a bit more ordinary (flat and up 1%, respectively, this quarter).  Margins were okay, and I wouldn't read a lot into this quarter, given the split with Malliinckrodt (NYSE:MNK). Gross margin declined a point, but this was in line with expectations and due primarily due to forex. Likewise, while the 5% decline in operating income was not exactly good news, the company's performance was as expected. Opportunity Versus TimingOne of the big long-term drivers for Covidien is that the global minimally invasive surgery (MIS) market is still less than one-quarter penetrated, with likely only about one-third penetration in the U.S. Given the improvements in outcomes and total costs, I expect MIS adoption to continue to grow, with Covidien well-placed to benefit with its strong share in endomechanical and energy devices. Of course, it's never quite that simple. While MIS penetration is already above 90% in gall bladder procedures and above 85% in bariatric surgeries, Intuitive Surgical (Nasdaq:ISRG) has identified both of these as potential growth markets for its robotic surgery approach. On the other hand, markets like colorectal and hernia surgery are dramatically under-penetrated (15% to 30%), so I think Covidien will, on balance, gain more than it may lose to Intuitive. SEE: Which Is Better: Dominance Or Innovation?The one “yeah, but” to this scenario is that penetration rates change slowly. Doctors/surgeons can be surprisingly stubborn, and though the introduction of better tools from Covidien and JNJ will help, I believe this is a market where it's much more likely that there will be many years of mid-to-high single-digit growth as opposed to blockbuster years of double-digit growth. Doing Well In Oximetry/Monitoring, But Is Vascular A Cause For Concern?Covidien continues to post strong double-digit growth in its oximetry and monitoring business, and based upon the most recent reports, it looks like Covidien is gaining share from Masimo (Nasdaq:MASI) (or, alternatively, out-gaining Masimo in taking share from others). On the other hand, the vascular business has not been looking so strong. Although some of this can certainly be explained by tough comps, I do wonder if the company is losing some share to Stryker in neurovascular (embolic coils) and the likes of Abbott, JNJ, and maybe even Spectranetics (Nasdaq:SPNC) in the peripheral vascular space. The Bottom LineI have liked Covidien for some time now, and I'm not really concerned all that much by the slowing pace of device growth, nor do I think the tax deficiency notice to Tyco (NYSE:TYC) is any near-term threat to the company (though Covidien would have roughly 42% of the total liability). Rather, my concern is more that the Street has latched on to the idea that Covidien is a great med-tech story and the analysts are whipping this horse for all it's worth. I'm still looking for revenue growth around 5% over the next decade, which is more than a point higher than I see for the underlying market(s). With corresponding 7% growth in FCF, I think fair value on these shares is in the low-to-mid $60s. Relative to today's price, then, there's not all that much free money on the table (though I still think the year-to-year performance will be worthwhile). Although Covidien may not be the most attractively-priced med-tech stock today, I wouldn't be in any hurry to sell and I'd keep an eye out for a pullback as a chance to build a position. At the time of writing, the author did not own shares of any company mentioned in this article.

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