Covidien Offers 50% Upside, Safer Than Baxter

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Includes: BAX, MDT
by: Takeover Analyst

With concerns about volatile capital markets looming, investors should consider shifting to healthcare companies where inelastic demand supports stability and innovation fuels growth. Covidien plc (COV) and Baxter International (NYSE:BAX) are two suppliers of medical equipment with strong support on the Street. I find that M&A and other planned strategic activity will drive value creation above what the market has recognized.

From a multiples perspective, Covidien is the cheaper of the two. It trades at a respective 11.5x and 9.3x past and forward earnings while Baxter trades at a respective 12.7x and 10.3x past and forward earnings. Baxter has shown a greater commitment to returning free cash flow to shareholders, as demonstrated by its 2.8% dividend yield. With that said, this could very well be due to slower growth prospects and less opportunities to magnify upside. My belief is that the aggressive capital allocation policy is due both to slower growth rates and a way of further de-risking the business to attract investor entry. While strategic activity will restructure operations in both firms, Covidien's gross margins for last year were 1,040 bps higher than that of its competitor at 56.8%.

At the fourth quarter earnings call, Covidien's CEO, Joe Almeida, noted solid performance:

"We had a strong finish to fiscal 2011, as sales came in slightly above our expectations. We again improved our growth and operating margins, and we delivered an exceptional 29% increase in adjusted EPS in the quarter. This is the fifth quarter in a row that we have exceeded our internal expectations on the bottom line.

In the Medical Devices segment, we had another solid quarter, with broad-based growth led by Vascular, Energy and stapling products.

Quarterly sales improved in our Pharmaceuticals business for the first time since the first quarter of 2010, paced by outstanding growth for specialty products. In supplies, all four product lines advanced, led by incontinence, eenteral feeding and electrodes."

Particularly noteworthy was the firm's performance in emerging markets. The top-line in Europe, Asia and Latin America all grew at double-digit rates. In addition, management was able to expand EPS by $0.05 by unlocking revenue and cost synergies from the ev3 acquisition. Medical Devices performed strong and endomechanical/vascular continues to show promise.

Recently, Covidien announced that it will be spinning off its ~$2B pharmaceuticals unit. The franchise, although challenged by quotas, has demonstrated meaningful growth and will be more properly valued by the market on a standalone basis due to its increasing complexity. This strategic decision will have minimal tax implications and help to close the discount to intrinsic value.

Consensus estimates for Covidien's EPS are that it will grow by 8.1% to $4.29 in 2012 and then by 8.4% and 9.9% more in the following two years. Assuming a multiple of 14.5x - admittedly, on the high-side - and a conservative 2012 EPS of $4.58, the rough intrinsic value of the stock is $66.41, implying 53.2% upside. Even if the multiple were to decline to 9.5x and 2012 EPS turns out to be 7.5% below the consensus, the stock would only fall by 5.7%. Accordingly, I am in agreement with the "strong buy" rating on the Street.

Promise, although less favorable risk/reward, exists in a Baxter investment. The company recently announced a $260M buyout of Synovis LifeTechnologies (NASDAQ:SYNO), which is a maker of products that repair soft tissue. This acquisition will be approximately $0.04 dilutive to 2012 EPS, but start to be accretive and generate synergies following 2014. Baxter earlier acquired Baxa, which caused dilution due to its macro vulnerabilities.

Pension costs are likely to rise above previous expectations, although will be offset by product innovation. Baxter's pipeline is strong with biosciences targeting a $2B market and HyQ likely to be approved sometime in mid-2012. It is also anticipated that Octopharma will be entering the U.S. market and that Phase III IVIG data will expand upside.

Consensus estimates for Baxter's EPS are that it will grow by 8.3% to $4.31 in 2011 and then by 8.1% and 10.1% more in the following two years. Assuming a multiple of 14.5x and a conservative 2012 EPS of $4.61, the stock has 39% upside. If the multiple were to fall to 9.5x and 2012 EPS turns out to be 7.1% below the consensus, the stock would fall by 14.4%. The Street currently rates Baxter around a "buy."

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