Much as we had noted during an
early run-through of the holdings of several of our
Ultimate Stock-Pickers
last month, health care continues to be an area of focus for our top
managers. Given that the sector is one of the few areas where our
analysts are still finding value, with 19 out of the 49 stocks we
currently have rated 5 stars coming from the health-care sector, it
didn't come as too much of a surprise. As you may recall from
our recent overview of
Vanguard PRIMECAP's
(
VPMCX)
holdings, health-care stocks have been under pressure for much of this
year over concerns about the impact that a government-sponsored
health-care plan could have on the industry's profitability. The
question for investors, though, has been whether or not these near-term
issues will derail the long-term positive impact that the aging of the
baby boomers is expected to have on the industry. Judging from the
recent purchases by our Ultimate Stock-Pickers, the answer appears to
be no.
While it would be easy to focus on only the top 10 health-care
holdings of our top managers, which currently include 5-star names like
Johnson & Johnson
(
JNJ),
Pfizer
(PFE), and
Merck
(
MRK),
we thought we'd look a little bit deeper into the most recent
high-conviction purchases made by our Ultimate Stock-Pickers in the
sector. Despite already being the largest health-care holding of our
top managers coming into the most recent period, Johnson & Johnson
continues to be purchased with conviction, with at least one manager
making a new money purchase in the stock. Merck and
Novartis
(
NVS)
are two other top health-care holdings that continue to draw the
attention of our Ultimate Stock-Pickers, albeit with slightly less
conviction than other purchases in the sector. This leaves us then with
seven names that aren't in the top 10 health-care holdings, with almost
all of them trading at levels below our Consider Buying price.
Each of these seven stocks stands out not only because it was
a high-conviction buy during the most recent period, but because each
had new money committed to it by at least one of our top managers.
Abbott Laboratories
(
ABT)
had the most activity, being purchased by four managers and having
seven of them hold positions in the name at the end of the second
quarter.
Genzyme
(
GENZ)
was also purchased by multiple managers during the period, although we
did note that one manager completely eliminated his stake in the
biotech firm.
Bristol-Myers Squib
(
BMY),
Medtronic
(
MDT), and
Zimmer
(
ZMH)
all benefited from high-conviction new money purchases during the
quarter, but all of these names still paled in comparison to the
activity seen in both
Becton, Dickinson
(
BDX)
and
Covidien
(
COV).
Covidien's a Company Warren Buffett Would Love
As you may recall, we sat down
back in June
with Alex Morozov, the associate director of stock analysis for the
Morningstar health-care team, to talk about Becton, Dickinson after it
turned up on our list of new money purchases during the first quarter
of 2009. As it turned out Alex wasn't the only person who liked Becton,
Dickinson, as Warren Buffett's
Berkshire Hathaway (
BRK.A)
(
BRK.B)
stepped up during the second quarter and made a big new money commitment to the name. While Alex
continues to believe
there's upside in Becton, Dickinson, we wanted to get his thoughts on
Covidien, another medical device firm he covers, which had three
significant purchases during the quarter, two of which were new money
investments. Having just returned from Covidien's Investor Day, Alex
had plenty of fresh insight to offer us.
Alex, can you please give us a quick overview of Covidien's business?
Covidien was formerly the health-care unit of Tyco International
(TYC).
The company develops, manufactures, and distributes medical and imaging
devices, pharmaceuticals, and other health-care products to medical
professionals worldwide. Through its predecessors, Covidien has an
operating history that spans 140 years and boasts a direct sales
presence in more than 50 countries worldwide.
What's the basis for the company's narrow economic moat? Does it have the potential to expand its moat?
Covidien's moatiest businesses can be found in its medical devices
segment, where it enjoys the advantages of brand recognition,
technological innovation, and substantial scale. Of particular note is
its high-end medical device/surgical instruments business, where it
essentially shares the market with Johnson & Johnson's Ethicon
business. The areas of the surgical instruments field where Covidien
competes are relatively sticky--especially in sophisticated surgical
tools, where surgeons require constant training and switching costs are
high.
The company also has a presence in lower-end basic surgical
products, like sutures and syringes, where its scale and tight cost
control offset a lack of differentiation, allowing Covidien to maintain
its returns on capital. Covidien's recent market share advancements in
the surgical devices area came at the expense of both its smaller
competitors and Ethicon. As the company commands a greater presence in
the operating room, its position is becoming defensible, given the
significant technological and administrative hurdles its competitors
would have to overcome in order to replace Covidien.
With its legacy pharmaceutical business, Covidien boasts a leading
position in the production of controlled substances. As the
manufacturing process for these products is tightly regulated by both
the FDA and the DEA, the company's long history of dealing with both
agencies represents a sizable barrier to entry.
While the company still has its share of businesses that lack
substantial competitive advantage (contrast agents in imaging, medical
supplies), their presence as a percentage of revenue has been gradually
dwindling. The firm has also been actively pruning what we consider to
be no-moat businesses and product lines, such as retail (divested),
specialty chemical (for sale), and sleep diagnostics (sold), further
enhancing its returns on invested capital. While we feel that
Covidien's moat might be widening as a result of the improvements in
its operations overall, regulatory uncertainty regarding competitive
bidding and the impact of health-care reform on future hospital
spending have precluded us from assigning it a wider moat.
Covidien seems to have been investing heavily in research
and development, an area where you think that the company's efforts are
finally bearing fruit. Where do you see the company getting the most
bang for its research buck these days?
Covidien's investment in medical devices is yielding a number of
promising product launches and technological advancements. The
company's R&D prowess that had wilted under Tyco is starting to
flourish again, with Covidien re-establishing itself as a powerhouse in
surgical tools. The particular focus has been on providing products for
procedures where favorable secular trends--such as the expansion of
minimally invasive surgical applications based on their economic
attractiveness, the adoption of new technologies that simplify and
improve the quality of procedures, and the rapidly growing market for
metabolic surgery--should fuel strong growth in the future.
What makes you believe Covidien is a good value at the current stock price?
Covidien's earnings should receive a significant boost longer term
from its sales momentum and margin expansion, driven by favorable
product mix and operational and financial leverage. The firm should see
some improvement on its P&L as it benefits from a shift to
higher-margin devices, leverages its general and administrative
expenses, and lowers its tax rate. The boost to earnings will not,
however, come at the expense of R&D, while improvements in gross
margin due to product mix are likely to be offset somewhat by
unfavorable foreign exchange given the firm's largely domestic
manufacturing base. There are also some near-term earnings head winds
as segments outside of devices, particularly pharmaceutical and
imaging, face challenges, but at this point Covidien's EPS forecast for
2010 is in line with our projections. The firm's ongoing commitment to
invest in the areas where it enjoys competitive advantage (as well as
its willingness to de-emphasize product lines that don't generate
sufficient returns on capital) solidifies our take on Covidien's
ability to strengthen its competitive position in the long run.
How's the financial health of the company?
Covidien sports a healthy balance sheet and has commenced paying
both a dividend and buying back shares. Further, given its strong cash
flow from operations, Covidien should be able to maintain its current
cash position without dialing down its acquisition strategy. To
reiterate this point, management stated during the Investor Day that it
plans to maintain its cash balance at its current level, which means
that more than $1.5 billion in annual free cash flow will be dispersed
for acquisitions, dividend payments, share buybacks, and debt
reduction. Our average projected debt/capital ratio over the next five
years is approximately 20%.
While Covidien might not be as clear-cut a story as Becton,
Dickinson, Alex continues to believe that the stock represents an
appealing long-term investment opportunity. He feels that Covidien's
strong product pipeline, management team dedicated to maximizing
returns on investment, and favorable secular trends bode well for its
future prospects. With several of our top managers making new money
purchases in the name during the most recent period (and six of them
now holding positions in the stock), we feel he might be on to
something here.
Disclosure: Bradley Meeks does not own shares in any of the companies mentioned above.
About the Author
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