There's no reason that Covidien (COV) "shouldn't" be one of the top-performers in large med-tech, nor enjoy some of the best multiples. If there's a more consistent performer (to the good side), I can't immediately think of it, and management has built this company to deliver strong performance on a lasting basis. Not buying these shares a year or two ago goes down as a sizable regret in my personal investing history, but I would caution investors to resist the temptation to chase this name.
A Good Start To What Will Be A Busy Year
Covidien got its fiscal year off to a good start with a modest beat on the top and bottom lines. Reported revenue increased more than 5%, with organic revenue growth likely close to 5% as well. Devices led the charge, with better than 6% organic growth, while pharma was flat and revenue from the supplies business rose about 3%.
Covidien did fine on margins too. Gross margin fell from last year (130bp), but improved a point sequentially and came in just a bit better than forecast. Operating income was down 3% from last year (on an adjusted basis) and operating margin followed a similar trajectory to gross margin, but again came in a little better than expected.
Plenty Of Good News In Devices
Covidien posted broadly strong results in its device businesses, and continues to be one of the top performers in terms of revenue and volume/share growth.
Endomechanical sales were strong (up 8% in constant currency), as were energy (up 9%). Johnson & Johnson (JNJ) and Stryker (SYK) also saw solid results in surgery-related businesses, but Covidien continues to stay at least a step or two ahead with products like Sonicision. While Intuitive Surgical (ISRG) also reported very strong procedure growth this quarter, Intuitive's strongest areas really don't challenge Covidien's core markets at this point.
Soft tissue sales were soft (no pun intended) at 4% growth, but it doesn't look as though the company is really ceding share to JNJ, Bard (BCR), or Boston Scientific (BSX). Airway was solid (up 9%) and 18% growth in oximetry suggests to me that Covidien is gaining share back from Masimo (MASI) even after considering the impact of acquisitions.
If there was a disappointment or area of concern, it would be vascular. Sales were up 8% here, which is not bad, and management highlighted "exceptional gains for neurovascular products." With Stryker showing 13% growth this quarter, it looks like the neuro market is quite strong and that Covidien is holding its own. On the other hand, I'm assuming that the company's peripheral business is not doing as well - investors will need to stay tuned for reports from companies like Bard and Cardiovascular Systems (CSII) to see how much is a market slowdown and/or whether share shifts are at play.
The Last Days For Mallinckrodt Pharmaceuticals
While Covidien's drug business had a so-so quarter, posting no real revenue growth and missing estimates slightly, it's not really a long-term concern. Covidien should complete the spin-off of Mallinckrodt Pharmaceuticals around mid-year, making Covidien a pure device/supplies company. That's not to say that MP is chopped liver - the company's recent approval for generic Concerta was a solid win and this is a decent (albeit not spectacular) business.
Build To Last
While Covidien has had a good run, I don't think shareholders need to be in any hurry to sell. Simply put, I think management has put together a very good business here and is running it quite well.
Covidien has not been at all shy about doing deals - bulking up its oximetry and airway/ventilation businesses last year with a series of deals. Likewise, about a month ago the company announced the acquisition of CV Ingenuity - a company developing a drug-coated balloon with a tunable rapid-release system. This still puts Covidien about two years behind Bard and a year and a half behind Medtronic (MDT) in drug-coated balloons for peripheral intervention, but it fills a gap and opens up what could be a sizable opportunity.
And that's part of what I like about Covidien's philosophy. While the company doesn't try to be all things to all people, it does look to build out robust offerings in those areas where it has decided to compete. In peripheral, for instance, the company has double-digit share in stents, strong share in atherectomy, and growing share in balloons - meaning that it's not shut out of any significant market segment.
I also appreciate that the company has targeted markets where it cannot only hold sizable share, but continue to drive modest organic growth. Laparoscopic/minimally invasive surgery has been around for a while now, but colorectal and thoracic procedures are only about 20% penetrated by these methods, leaving Covidien ample opportunity to leverage its 45%-plus market share with new tools, new procedures, and so on. Moreover, while there is arguably plenty of room to share with the likes of Intuitive Surgical, the robot-maker is really not pushing Covidien aside yet in core procedure markets.
Continuing that theme, I believe that endomechanical, energy and vascular can all be solid high single-digit growth markets for at least the next five years, if not longer. Moreover, while markets like oximetry and ventilation don't hold the same growth potential (in North America and Europe, at any rate), they're consistent markets and may have some upside if changes in the U.S. healthcare system do in fact lead to higher utilization rates (more procedures/admissions, in other words).
That's not to say that Covidien doesn't have some high-potential opportunities. I continue to believe that peripheral vascular intervention is a seriously under-penetrated market, ripe for good growth with better mousetraps. Likewise, while the renal denervation market is going to be quite crowded with Medtronic, St. Jude Medical (STJ), Boston Scientific and likely others, Covidien has its play here as well and should enjoy what could be one of the next big things in med-tech.
Above-Average, But Not Breakaway, Growth Prospects
I believe that Covidien's addressed markets are likely to grow at around 5% over the next five years, and I project that the company will slightly outgrow that. With sales growth slowing after that point, I still expect just over 4% in long-term revenue growth at Covidien - better than St. Jude and Johnson & Johnson, and only slightly below Stryker.
Along the way, I also see opportunity for additional margin leverage from improving mix (endomechanical, energy, and vascular should be higher-margin growth opportunities) sufficient to move free cash flow margin from the mid teens to around 20%. Blended with the revenue growth, that points to 7% free cash flow growth on a long-term basis.
The Bottom Line
While 7% free cash flow growth is good, a lot of that is already in the stock. Fair value on these shares seems to be around $70 or so, which leaves only modest potential from here.
I find it a little odd that Johnson & Johnson, Stryker and St. Jude all trade at very similar discounts to fair value, but that's how it is today. Within that group, I'd give the best growth prospects to Stryker and Covidien, while St. Jude and Johnson & Johnson have arguably more potential to outperform expectations and/or improve themselves from within.
A pullback below $60 would make Covidien a lot more interesting to me, and the quality of the company makes it a tempting pick even today. That said, things have been going very well for Covidien and the company may find it increasingly difficult to keep raising the bar and keep the attention of the growth-addled segment of the institutional crowd. As such, approach with caution or a long-term horizon.