Friday morning Covidien plc (COV) announced second quarter results for fiscal 2013 (January 2013 through March 2013). Covidien shares plunged out of the gate to end the day down 6.58% to $62.00 (Covidien shares haven't traded that low since February of this year). Given the fact that Covidien shares were trading at a fresh 52-week high of 68.83 just a dozen trading days earlier, is this dramatic decline in share price warranted? I don't think it is, as I explain below.
Spin-off of Covidien's Pharmaceutical Business
First, Covidien plans to spin-off its pharmaceutical business at the end of its fiscal third quarter (approximately June). This move is aimed at unlocking value for shareholders, as it will create two different companies that will appeal to investors with different goals and will allow the non-pharmaceutical business to compete more aggressively with other Medical Device and Medical Supply companies. In early January this year, Abbott Laboratories (ABT) completed the spin-off of its pharmaceutical business, AbbVie (ABBV), with the similar goals in mind. On the first day of trading as separate companies, Abbott rose 2.3% to $32.05 while AbbVie rose 2.8% to $35.12. Now (as of the close of trading today, April 30th), a mere 4 months later, shares of Abbott are trading 15% higher ($36.92 per share) and shares of AbbVie are trading a whopping 30% higher ($46.05 per share). (Click here for an article discussing the AbbVie spin-off). According to a company press release, Covidien is expected to provide the public with more information about the spin-off as well as guidance for each new business this Friday (May 3rd).
But, besides the value that will likely be unlocked through the spin-off, I think Covidien's current fundamentals support a higher share price for the existing company. After crunching the numbers and running them through my discounted cash flow model (DCF model), I believe fair value to be in the range of $72 to $77 dollars per share. This article will discuss the variables and assumptions that went into my DCF model as well as the resulting estimate of fair value. You can view a copy of my DCF spreadsheet here and follow along as I explain some of the components of my model.
Discounted Cash Flow Model
In Finance 101 we learn that the value of a firm can be understood as the present value of the future free cash flows generated by the firm. Thus, we can derive a firm value for Covidien by estimating its future free cash flows and discounting them back to present value at an applicable discount rate. Once we have calculated the value of Covidien as a firm (meaning the value of cash flows to both debt and equity stakeholders), we can calculate the value of Covidien's equity (and ultimately shares) by subtracting debt and adding cash to firm value (and dividing by the number of shares outstanding).
There are two important parts to any DCF model: (1) the estimate of future free cash flows and (2) the rate used to discount these cash flows back to present value. I will discuss each of these important components in further detail below. If you are viewing my DCF spreadsheet, you will notice that I use "adjusted" income and "adjusted" margin numbers in my DCF model. As I explain in more detail below, I made an adjustment to these numbers to reflect the need to capitalize R&D expenditures since Covidien's primary mode of reinvestment and therefore growth is through R&D.
Estimated Future Free Cash Flows
To give you some context, in fiscal year 2012, Covidien generated $2.425 billion in operating cash flow off $11.852 billion in sales. During that same year, Covidien spent $578 million on capital expenditures and $1.134 billion on acquisitions, resulting in $713 million of free cash flow ($1.847 billion if we exclude acquisitions). The year prior, in fiscal year 2011, Covidien generated $2.182 billion in cash flow off $11.574 billion in sales. That year Covidien's free cash flow ($1.696 billion) was markedly higher than in 2012 because Covidien spent much less on acquisitions ($13 million) and slightly less on capital expenditures ($473 million). (Source of Data: Morningstar.com).
If you're looking at my spreadsheet here, you can see that my DCF model starts with Revenues and derives an estimate for operating income for each year in the forecast period based on my estimate of operating margins. According to Yahoo Finance, analysts estimate that Covidien's revenues will grow 6% this year and 4.7% next year. I used these analyst estimates to calculate my revenue numbers for year 1 and 2 of my model. From there, I estimated that revenues will grow at 5.61% in years 3 through 5 (2015 through 2017) based on historical growth rates and historical returns on capital. From year 6 on, I estimated that revenue growth will decline until it reaches the rate of long-term stable growth in the economy, or 1.7%, in year 10 (the year 2022). I estimated adjusted operating margins to be 24.34% (21.03% unadjusted) for years 1 through 5 based on historical margins and from there trended that number to 24.5% (21.19% unadjusted), which is the average operating margin of firms in the same primary industry (i.e., firms in the medical devices business).
I estimated Covidien's effective tax rate for years 1 through 5 to be 15.40%, which is Covidien's 5-year median effective tax rate. Starting in year 6, I trended this tax rate to a marginal tax rate of 38% in year 10. Using these estimates for taxes, I arrived at my estimate for after-tax operating income each year.
As stated above, I made some adjustments to operating income (EBIT) and after-tax operating income (EBIT(1-T)) to better account for R&D expenditures, which according to NYU finance professor Aswath Domodaran, should be treated as capital expenditures rather than operating expenses. I won't go into detail here on how I made the adjustments-you can read Professor Damodaran's paper on its importance and how to do this here (specifically, starting on page 9). Professor Damodaran says it is important to make this type of adjustment for firms that primarily reinvest and generate growth through R&D. Damodaran explains that capitalization of R&D expenses (and resulting adjustments) is necessary to get an accurate picture of a firm's profitability (e.g., ROE and ROC) and reinvestment needs (e.g., reinvestment rates).
In my model, I capitalized Covidien's R&D expenses to create an R&D asset and then amortized this asset over a 5 year period (5 years because I am assuming it takes Covidien's research and development takes 5 years, on average, to develop into commercial products). The capitalization and correspondent amortization of R&D expenses resulted in an upward adjustment to Covidien's operating income. However, this upward adjustment to operating income was partially offset by an upward adjustment to Covidien's reinvestment needs. The net effect of capitalizing Covidien's R&D expenses was a slightly higher ROC (Return on Capital) and, consequently, a slightly higher estimated free cash flow each year.
I used my adjusted estimate of ROC and sales-to-capital ratio (sales/invested capital), as well as historical net reinvestment rates, to estimate the amount of net reinvestment required for Covidien to achieve the estimated growth in revenues and operating income. Historical net reinvestment rates were computed as: ((Capital Expenditures + R&D Expenses + Changes to Non-Cash Working Captial + Acquisition costs) - Depreciation Expense + R&D Amortization Expense)). Taking net reinvestment needs into account, I estimated peak Free Cash Flow to the Firm (FCFF) of approximately $2.5 billion in year 5 (2017), tapering off to about $2 billion in year 10 (2022) when the firm is in stable growth.
Discount Rate (or Cost of Capital)
I computed Covidien's weighted average cost of capital to be 7.09% based on a cost of equity of 8.01% and a tax-adjusted cost of debt of 1.77%. In this article, I won't go into detail on how I estimated Covidien's cost of debt, but instead will focus how I estimated Covidien's cost of equity. You can see how I computed the cost of equity, debt, and capital by clicking the second tab of my DCF spreadsheet.
I developed Covidien's initial cost of equity (8.01%) by use of the CAPM (Capital Asset Pricing Model) where Cost of Equity = Risk-free Rate + Beta*Equity Risk Premium. The data I used to derive the Cost of Equity is from Professor Damodaran's website. For the risk-free rate, I used the 10-year Treasury Bond rate of 1.7%.
To develop the overall equity risk premium (ERP) for Covidien, I had to weight ERPs for several different regions because Covidien operates and sells products in different regions of the world. The ERP is the premium investors demand over and above the risk-free rate to compensate them for putting their money at risk in equity investments. I obtained ERP estimates for various regions of the world from Professor Damodaran's website and as well as his monthly tweet (Professor Damodaran tweets the implied ERP for U.S. equity markets at the beginning of each month). Since most of Covidien's sales come from North America ($6.572 billion, or 56%), I weighted North America's ERP of 5.8% most heavily in computing my overall ERP. Covidien's remaining sales are spread among Western Europe ($2.637 billion, or 22%), Asia ($1.918 billion, or 16%), and Central and South America ($725 million, or 6%). Thus, I weighted each region's ERP accordingly and ultimately derived an overall ERP of 6.51%.
To develop a beta for Covidien, I also used data from Professor Damodaran's website. Each year, Professor Damodaran provides an average unlevered beta for each industry on his website (click on "Updated Data" link). Because Covidien operates in three different industries (Medical Devices, Medical Supplies, and Drugs/Pharmaceuticals), I weighted the industry betas based on the portion of revenues each business contributes to the whole to derive an overall unlevered beta for the firm. In 2012, the bulk of Covidien's revenue came from its Medical Devices business ($8.111 billion, or 68%), while the remainder came from its Pharmaceutical ($2.001 billion, or 17%) and Medical Supplies businesses ($1.740 billion, or 15%). This weighting resulted in an overall unlevered beta of 0.88. From here, I derived a levered beta for Covidien of 0.97 based on its debt levels and marginal tax rate.
Plugging my risk-free rate of 1.7%, ERP of 6.5%, and levered beta of 0.97 into the CAPM formula resulted in a cost of equity of 8.01% (1.7% + (0.97*6.5%)). Since I estimated Covidien's capital structure to be about 85% equity and 15% debt, I weighted Covidien's cost of equity and debt accordingly to arrive at an overall cost of capital of 7.09% ((8.01%*.85)+(1.77%*.15)). I used this cost of capital to discount free cash flow for years 1 through 5. Starting from year 6, I trended this cost of capital number down to 6.40%, which is the average cost of capital for each of the three industries Covidien does business in (again, weighted according to revenue).
Based on my DCF model, I computed a fair-value range for Covidien's equity of $34.5 to $36.9 billion, or $72 to $77 per share. As of the close of trading on Tuesday (April 30, 2013), Covidien shares were priced at $63.84. Given the fact that healthcare needs are expected to increase rapidly as baby boomers enter old age, I don't think my fair-value estimate is far off-especially when you consider that I have assumed long term growth of only 1.7% after year 10 (after 2022). Covidien appears to be in a prime position to reap the benefits of a large aging population since its primary customers include hospitals, surgical centers, and long-term care facilities. At current prices, I think Covidien shares still have room to run.
Additional disclosure: I do not warrant the accuracy of any data provided in this article or in the referenced DCF spreadsheet. My fair value conclusion in this article is solely my opinion. You should not treat any opinion expressed in this article as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the author's opinion.