Why Covidien Is Heading To $80

Apr.25.14 | About: Medtronic plc (MDT)

Summary

Going forward, I expect these results to only improve, especially given that the company will no longer be burdened by the impact of the annualized medical device tax.

While I can't say that the stock is cheap trading at a P/E of 20, this is only 1 point above Johnson & Johnson, while trading 10 points below Stryker.

At $67 per share, Covidien should command a fair-market value of $90 in 12 to 18 months on the basis of improved margins and accretive benefits from the Given deal.

It wasn't too long ago that analysts did nothing but complain about Covidien's (COV) potential downfall following the spin-off of its pharmaceuticals business to Mallinckrodt (NYSE:MNK). With shares of Covidien stock now resting near their 52-week high, these prior concerns have been forgotten.

Management's decisions have begun to pay off, including posting one solid quarter after another. This is while larger med-tech rivals like Abbott Labs (NYSE:ABT) and Johnson & Johnson (NYSE:JNJ) have begun to show signs of slowing growth. But how long can Covidien outperform? On Friday, management answered this very important question with a strong fiscal second-quarter report.

Covidien posted revenue of $2.6 billion, which increased 3% year over year, topping last year's mark of $2.53 billion. What makes this quarter impressive is that, according to Forbes, analysts were projecting revenue to fall 16% year-over-year. The company posted operational sales growth of 4%, which was adversely impacted by 1% due to foreign exchange rates.

In terms of profitability, Covidien reported an operating income of $582 million, which was up more than 11% year over year. Last year's profit was $522 million. This still shows how analysts have underestimated the company. Ahead of the report, analysts had revised their earnings-per-share estimates down to 95 cents. Covidien delivered diluted GAAP earnings per share of 97 cents. On an adjusted basis, the 96 cents still amounted to a 1-cent beat. Last year, the company posted an adjusted earnings of 93 cents per share.

That adjusted operating income, excluding the specified items, now represented 21.6% of sales (versus 22.6% last year), this demonstrates how well management is executing on its global strategy -- this is even with the slight decline in gross margin, which was largely due to unfavorable foreign exchange rates. From my vantage point, management has turned this company into a much leaner operation, which was the goal of the Mallinckrodt spin-off. So despite the 2% dip in gross margin this quarter, investors should continue to expect long-term margin expansion.

Recall, in December, Covidien spent $860 million to acquire Given Imaging (GIVN), a company with close to 90% global share in the growing endoscopy market. It was a worthwhile deal with the gastrointestinal market worth an estimated $3 billion. But with organic growth advancing near 4%, management is demonstrating that it still has a strong grip on the core operation. And with another strong showing this quarter in Surgical Solutions, the company is performing as good as (in some cases, better than) Johnson & Johnson and Stryker (NYSE:SYK).

Going forward, I expect these results to only improve, especially given that the company will no longer be burdened by the impact of the annualized medical device tax. And when you consider that the lion's share of the negative currency impact will be gone, investors can also expect that in the third quarter Covidien will produce double-digit earnings growth.

Now, I'm not suggesting Covidien is flawless. There is still execution risk regarding the deal for Given Imaging. Not to mention it was an expensive deal at a 27% premium. But Covidien has shown that it can post growth where others have not. And assuming that Covidien can capitalize on Given's global reach, it shouldn't be too long for that sort of leverage to impact Covidien's bottom line, particularly in the overseas market.

As it stands, this is one of the best companies among a long list of standout performers in medtech. While I can't say that the stock is cheap trading at a P/E of 20, this is only 1 point above Johnson & Johnson, while trading 10 points below Stryker. This tells me that the Street, which expected a decline in profits, will have to revise upward. At $67 per share, Covidien should command a fair-market value of $90 in 12 to 18 months on the basis of improved margins and accretive benefits from the Given deal. But for now, we can agree $80 is a sure bet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's healthcare sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.