(By Alex Morozov, CFA) Covidien's (COV) valuation has remained suppressed even as our thesis has been playing out. Key culprits behind the company's uneven performance are the broad health-care utilization trends for medical technology firms in general and, more important, struggles in Covidien's pharmaceutical segment. We've long advocated for the sale of this business, as it has obscured stellar results from the firm's device operations. Covidien's December 2011 announcement of a spin-off of its pharma segment is welcome news for the firm's investors; the market should reward the remaining business with a higher valuation, given its better growth profile, less challenging competitive dynamics, and robust returns on capital. In our opinion, Covidien's current valuation doesn't fully incorporate attractive growth prospects for the device business.
Covidien is trading at just a 15% premium to its post-2007 spin-off value, despite the significant overhaul of its operations since separating from Tyco International--focusing on opportunities with high returns on investment and high growth, mainly in medical devices. Since the spin-off, Covidien has increased revenue more than 20%, to $11.57 billion in fiscal 2011, while jettisoning close to $1.5 billion in sales from noncore, no-moat businesses such as retail, specialty chemicals, and radiopharmacies. Some of the top-line growth has come through acquisitions, most notably the 2010 purchase of ev3, which contributed about $500 million to the top line and bolstered Covidien's position in the vascular market. The company also increased its adjusted earnings per share from $2.17 to $4.00 over the same period, despite increasing research and development spending twofold in absolute dollars (from 2.9% to 4.8% of sales) and significantly investing in its sales and marketing staff as well as infrastructure, mainly in emerging markets.
Covidien also trades at a slight discount to most medical device firms we cover, despite its better-than-average earnings growth profile. The growth profile difference becomes even more pronounced once we remove a slower-growing, lower-margin pharmaceutical business. On a free cash flow basis, Covidien stock currently yields 8.5% (with our forecast calling for double-digit free-cash-flow growth) and pays a 1.7% dividend yield.
Since the spin-off from Tyco, Covidien has focused on its device business, increasing R&D and sales and marketing. As a result of these investments, the device unit has been growing at above-industry rates, and unlike most of its peers, its growth has been largely internal. Siemens (SI), Philips (PHG), Abbott (ABT), and Danaher (DHR) have become dominant players in the med tech mainly through sizable acquisitions over the past three years.
Covidien's investments in R&D have gone disproportionately into devices, while the supplies segment has been put into "harvest" mode. While the blended growth rate has averaged 7.5%, the device segment (adjusted for the ev3 acquisition and sharp safety and radiopharma reclassification) has grown approximately 9% internally. This growth is against the backdrop of tough macroeconomic conditions, which suppressed overall health-care utilization and constrained hospital spending. With the former head of the device business, Jose Almeida, stepping into the CEO role in 2011, the emphasis on devices has only accelerated, highlighted by the spin-off of the pharma unit announced in December.
Pharma Struggles Have Pressured the Stock
While Covidien is markedly different now than it was upon the spin-off from Tyco, the market is valuing it at roughly the same level. A number of factors both macro and company-specific have kept this company out of favor with the investment community, but we consider the volatile and unpredictable nature of its pharmaceutical business to be a chief culprit. Pharma struggles have overshadowed strides the company made in top-line growth (particularly in devices), as well as the overall margin and earnings improvement. Covidien has historically traded at a discount to its device peers (on an earnings multiple basis) as a result of the hybrid nature of its business model, despite posting above-industry-average earnings expansion and having a better growth model. We've long advocated for the pharma spin-off or an outright sale, and the December announcement to separate this entity from the device company was not surprising. We speculate the company was contemplating a sale rather than a spin-off, but the unattractive nature of certain product lines (contrast agents, for example) made the sale challenging.
Device Business Has a Strong Moat
Covidien's device business possesses numerous competitive advantages. Barriers to entry in the industry are typically fairly high, given the requirement for a sizable initial investment in infrastructure as well as R&D and IP platforms.