Significant Upside Of About 25% For Baxter, Covidien

Includes: BAX, HSP, MDT
by: Takeover Analyst

Over the last three months, Baxter (NYSE:BAX), Covidien (COV), and Hospira (NYSE:HSP) have gained by 13.0%, 14.7%, and 20.2%, respectively. Despite outperforming Baxter and Covidien, Hospira is the least preferred on the Street, according to T1 Banker. This is mainly due to the company's shocking troubles (see here). Based on my review of the fundamentals, DCF model, and multiples analysis, I find strong upside for Covidien and Baxter.

From a multiples perspective, Covidien is the cheapest of the three. It trades at a respective 13.3x and 11.4x past and forward earnings, with a dividend yield of 1.7%. Baxter and Hospira, on the other hand, trade at a respective 11.5x and 13.3x forward earnings.

At its fourth-quarter earnings call, Baxter's management noted a strong close to the year:

"I'm very pleased with the progress our company continues to make financially, operationally and scientifically. In fact, despite the global macro environment, competitive landscape and ongoing uncertainty, Baxter continues to report strong financial results. This includes record sales and earnings for 2011, as you saw this morning, while accelerating investments in innovation, advancing our new product pipeline and pursuing other initiatives to enhance long-term growth while returning significant value to our shareholders...

[A]djusted EPS in the fourth quarter increased 5% to $1.17 per diluted share. For the full year, adjusted EPS was $4.31, which exceeded our original guidance range provided last January of $4.15 to $4.25 per diluted share. On a reported basis, worldwide sales in the fourth quarter increased 3%, and after adjusting for the U.S. multisource generic injectable divestitures, sales growth was 4%".

Fourth-quarter earnings and revenues were in line with consensus, but the 2012 outlook was mostly disappointing, given a worse-than-anticipated FX forecast. Free cash flow is expected to grow by $533M over the next three years to around $2.4B in 2014. Over the same time, ROE will expand by around 260 bps. Several catalysts will drive this progress. First, Grammagard SubQ is making significant gains, as evidenced by IV conversions.

Second, MMN expansion labeling was only recently filed in the United States, having been successfully approved in Europe. This is beneficial for Baxter, since it enables the company to market to neurologists. Third, demand remains strong for Octapharma, as margins are meaningful high, given the lack of supply.

Consensus estimates for Baxter's EPS forecast that it will grow by 5.3% to $4.54 in 2012, and then by 8.8% and 10.3% in the following two years. Of the 15 revisions to estimates, all have gone down for a net change of -1.3%. Assuming a multiple of 14.5x and a conservative 2013 EPS of $4.88, the rough intrinsic value of the stock is $70.76, implying 24.2% upside.

Covidien is, in my view, slightly more attractive. The company delivered stellar results in the fourth quarter, with adjusted EBITDA skyrocketing 29% and operating margins meaningfully expanding. Double-digit top-line momentum in Latin America, Asia, and even Europe highlight the value of the company's brand, as it works on integrating for $0.05 EPS accretion. With the effort to spin-off its complex ~$2B pharmaceuticals business, investor entry is likely to follow, as earnings trends become clearer.

Consensus estimates for Covidien's EPS forecast that it will grow by 7.8% to $4.28 in 2012 and then by 7.5% and 8.7% in the following two years. Assuming a multiple of 14.5x and a conservative 2013 EPS of $4.54, the rough intrinsic value of the stock is $65.83, implying 25.9% upside.

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