Financial Engineering Helps Covidien's Earnings

Apr.26.14 | About: Medtronic plc (MDT)

Summary

Earnings per share were only lifted thanks to a reduction in the share count.

Revenues were excellent having increased 3% from last year.

The company returned over $2.0 billion to shareholders over the last twelve months through share repurchases and dividends.

The last time I wrote about Covidien plc (COV), I stated:

"I'm going to avoid pulling the trigger here and wait to see how they report. The next earnings report is scheduled for 24Jan14."

Since that article was published the stock is up 1.75% while the S&P 500 (NYSEARCA:SPY) is up 1.06%. Covidien is engaged in the development, manufacture and sale of healthcare products for use in clinical and home settings.

The company reported earnings before the market opened on 25Apr14 and on the surface the results were mixed with the company reporting earnings of $0.96 per share (beating estimates by $0.01) on revenue of $2.59 billion (missing estimates by $20 million). What I'd like to do at this time is delve into the weeds and pick out some highlights from different portions of the report to see if the stock is worth buying at the present time.

Segment Revenue

Product Line Sales (millions)

2FQ14

1FQ14

2FQ13

Q/Q

Y/Y

Surgical Solutions

$ 1,213

$ 1,261

$ 1,166

-4%

4%

Advanced Surgical

$ 835

$ 853

$ 774

-2%

8%

General Surgical

$ 378

$ 408

$ 392

-7%

-4%

Vascular Therapies

$ 409

$ 425

$ 406

-4%

1%

Peripheral Vascular

$ 298

$ 315

$ 295

-5%

1%

Neurovascular

$ 111

$ 110

$ 111

1%

0%

Respiratory and Patient Care

$ 976

$ 953

$ 958

2%

2%

Patient Monitoring

$ 258

$ 250

$ 250

3%

3%

Airway & Ventilation

$ 190

$ 182

$ 191

4%

-1%

Nursing Care

$ 258

$ 259

$ 254

0%

2%

Patient Care

$ 270

$ 262

$ 263

3%

3%

Total Sales

$ 2,598

$ 2,639

$ 2,530

-2%

3%

Click to enlarge

On the segment revenue side of the earnings report, there was nothing really too spectacular to report. Surgical Solutions, which accounts for 46% of total revenues, increased 4% from the prior year. This was due in large part to another double digit quarterly sales gain for vessel sealing and solid growth for stapling. Vascular Therapies, which accounts for 15% of sales, had an annual revenue increase of 1%. This increase was due to increased sales of compression products as neurovascular sales were unchanged from last year. Respiratory and Patient Care which accounts for the remainder of revenue increased 2% from the prior year. All in all the company pulled in some pretty good revenue having increased total revenue by 3% from the prior year.

Income Statement

Income Statement

2FQ14

1FQ14

2FQ13

Q/Q

Y/Y

Net Sales

$ 2,598

$ 2,639

$ 2,530

-2%

3%

Cost of goods sold

$ 1,080

$ 1,076

$ 1,002

0%

8%

Gross Profit

$ 1,518

$ 1,563

$ 1,528

-3%

-1%

Selling, general and administrative expenses

$ 896

$ 850

$ 830

5%

8%

R&D expenses

$ 135

$ 125

$ 122

8%

11%

Restructuring charges, net

$ 16

$ 57

$ 54

-72%

-70%

Gain on divestiture, net

$ (111)

$ -

$ -

N/A

N/A

Operating Income

$ 582

$ 531

$ 522

10%

11%

Interest expense

$ (54)

$ (53)

$ (51)

2%

6%

Interest income

$ 6

$ 2

$ 2

200%

200%

Other income

$ 67

$ 33

$ 17

103%

294%

Income from continuing operations before taxes

$ 601

$ 513

$ 490

17%

23%

Income tax expense

$ 160

$ 115

$ 110

39%

45%

Income from continuing operations

$ 441

$ 398

$ 380

11%

16%

Income from discontinued operations, net of income taxes

$ -

$ -

$ 59

N/A

-100%

Net Income

$ 441

$ 398

$ 439

11%

0%

Non-GAAP restructuring charges

$ 13

$ 22

$ 38

-41%

-66%

Non-GAAP transaction costs

$ 5

N/A

N/A

Non-GAAP acquisition related adjustments

$ (13)

N/A

N/A

Non-GAAP Impact of tax share charges

$ (57)

$ 49

-216%

N/A

Non-GAAP environmental charge

$ 40

N/A

N/A

Non-GAAP gain on divestiture

$ (111)

N/A

N/A

Non-GAAP Agreement

$ (28)

-100%

N/A

Non-GAAP tax matters

$ 104

$ 15

$ 40

593%

160%

Avg. diluted shares outstanding

454

456

476

0%

-5%

Non-GAAP Diluted Earnings per share

$ 0.96

$ 1.00

$ 0.93

-4%

2%

Click to enlarge

With top line growth, we should hope for bottom line growth and we see just a 2% increase in earnings when compared to last year. We see that gross profit decreased by 1% due in large part to an 8% increase in cost of goods sold. For a medical device company I always like to see increased spending in R&D and the company did just that, increasing R&D expenses by 11% on a year over year basis. Restructuring charges decreased by 70% which allowed operating income to increase 11% more from last year. The company's interest income increased 200% while other income increased 294% helping income from continuing operations before taxes increase 23%. When you make more money you have to pay more taxes, and that's what happened with income tax expenses increasing 45% from last year. Income after taxes increased 16%. Covidien reports non-GAAP earnings, and after adjustments the company had earnings which increased 2%. What I don't like about the quality of these earnings is that outstanding shares were reduced by 5% from last year, and if you take away that affect we should have gotten a decrease of 2% in earnings.

Conclusion

The company reported non-GAAP earnings which were 2% higher than a year ago on 3% higher revenue, while the share price was up 2.03% since the last earnings call excluding dividends. All segments of the company reported increases in revenue when compared with last year, but gross margins dropped 3.3%. Operating income increased 11.5% and management left 2014 guidance unchanged. The share count has decreased 5% from the prior year, but I don't like the quality of these earnings as we only got positive earnings due to financial engineering. The results weren't that great to me, and investors seem to think they weren't either as the stock dropped 2.23% after reporting while the S&P 500 was down 0.81%. That being said, I think the stock is fairly valued. With these results the stock is on the cusp of getting cut off my team just due to financial engineering propping up earnings.

Disclaimer: This article is meant to serve as a journal for myself as to the rationale of why I bought/sold this stock when I look back on it in the future. These are only my personal opinions and you should do your own homework. Only you are responsible for what you trade and happy investing!

Disclosure: I am long COV, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.