I closely follow spinoff situations as most spinoffs are motivated by a desire to unlock value that is under-appreciated by the market. Covidien plans to spinoff the pharmaceuticals division Mallinckrodt on June 28 2013. I decided to take a closer look at COV at current valuation to see if it is a good candidate to add to my portfolio.
I) THE RECORD
Covidien (COV, Financial) has grown cashflow per share steadily from $3.56 in 2007 and is estimated to be $5.95 for 2013. EPS has increased from $2.72 in 2007 and is estimated to be $4.45 for 2013. As per ValueLine over the past 5 years sales have grown 2% per year, cashflow has grown by 8% per year, EPS has grown 7.5% per year and book value has grown 8.5% per year.
II) BUSINESS and HISTORY
Covidien was incorporated in 2000 as a fully-owned subsidiary of manufacturing conglomerate Tyco International Ltd. Covidien was spun off from Tyco in June 2007 to become a public company.
As per the company website:
“Covidien (COV, Financial) is a leading global healthcare products company that creates innovative medical solutions for better patient outcomes and delivers value through clinical leadership and excellence. Covidien manufactures, distributes and services a diverse range of industry-leading product lines in three segments: Medical Devices, Pharmaceuticals and Medical Supplies. With 2012 revenue of $11.9 billion, Covidien has 43,000 employees worldwide in 70 countries, and its products are sold in over 140 countries.
Covidien is:
- A global market leader, with more than 80% of sales derived from product categories where the Company is #1 or #2 in the market.
- 43,000 employees worldwide in 70 countries, with products sold in over 140 countries
- 51 manufacturing facilities in 18 countries.
- Dedicated to R&D, spending over $600 million in 2012, with projected increases in 2013 expected to continue the steady upward trend in this key growth-driving investment.
- Committed to creating innovative medical solutions for better patient outcomes and delivering value through clinical leadership and excellence.
Covidien's business segments:
- Medical Devices - Includes endomechanical, soft tissue repair, energy, oximetry and monitoring, airway and ventilation, vascular and other products
- Pharmaceuticals – Includes specialty pharmaceuticals, active pharmaceutical ingredients, contrast products and radiopharmaceuticals
- Medical Supplies - Includes nursing care, medical surgical, SharpSafety and OEM products
Covidien provides:
- Advanced surgical tools and supplies
- Sutures and wound care products
- Needles and syringes
- Contrast media for diagnostic imaging
- Vascular therapy products
- Respiratory care devices
- Generic and branded pharmaceuticals
- And much more
Key brands:
- Kendall
- Mallinckrodt
- Nellcor
- Puritan Bennett
- Valleylab
Products are supplied to all of the following:
- Hospitals
- Acute care facilities
- Nursing homes
- Rehab centers
- Ambulatory surgery centers
- Pharmacies
- Physician offices
- Radiopharmacies
Covidien’s investment in R&D:
- R&D spending has more than doubled in the last four years and, at more than $600 million in 2012, represents 5.3% of sales
- Globally, Covidien has more than 2,000 employees dedicated to developing products that help healthcare professionals improve patient outcomes
- Covidien has launched more than 100 new products in the last five years, and sales of new products are a key growth driver
III) OPERATIONS and COMPETITIVE ADVANTAGES
Information from the company website about operations is as follows:
Covidien operations are categorized in 3 segments:
3.1. Medical Devices
Medical Devices segment includes the following:
- Endomechanical Products – includes laparoscopic instruments and surgical staplers
- Energy Devices – includes vessel sealing, electrosurgical and ablation products
- Respiratory & Monitoring Products – includes oximetry, monitoring, airway and ventilation products
- Soft Tissue Repair Products – includes sutures, mesh, biosurgery products and hernia mechanical devices
- Vascular Therapies Products – includes neurovascular, peripheral vascular, compression, dialysis, venous insufficiency, and thrombectomy products
3.2. Medical Supplies
Medical Supplies – includes incontinence, wound care, enteral feeding, urology and suction products, operating room supplies, electrodes, thermometry products, chart paper, needles, syringes, sharps disposal products and OEM products.
3.3. Pharmaceuticals
Pharmaceuticals – includes contrast media/delivery systems, nuclear medicine products, urological imaging systems, specialty branded pharmaceuticals, specialty generic pharmaceuticals, addiction treatment and active pharmaceutical ingredients.
Competitive Advantages:COV has strong competition from Johnson & Johnson (JNJ, Financial), Becton Dickinson (BDX), C.R. Bard (BCR, Financial), 3M (MMM), Hospira (HSP), Welch-Allyn and from Private Label offerings from distributors such as Medline, Cardinal (CAH), McKesson (MCK) and PSS.
COV has the following competitive advantages:
1. COV operates in 140 countries with employees in 70 countries and 51 manufacturing facilities in 18 countries. COV had sales of $11.9B in 2012 so the company has economies of scale advantages.
2. COV products have strong brand recognition with most of its products being either #1 or #2 in their markets.
3. The medical devices business has strong barriers to entry due to the high upfront investments needed and fixed costs involved. This prevents new entrants into this business and allows existing companies to compete for the business. It is somewhat like an oligopoly. Regulatory hurdles in bringing new products to market is also a deterrent for new entrants.
4. COV has well diversified opportunities within its divisions of Medical Devices, Pharmaceuticals and Medical Supplies. This offers a range of organic growth opportunities and ability to grow with targeted acquisitions. Company's recent acquisitions include BARRX, superDimension, Newport Medical and Oridion, CNS Therapeutics, CV Ingenuity, etc.
IV) BALANCE SHEET and PROFITABILITY
Covidien (COV, Financial) has a reasonably strong balance sheet with $4.5B of long term debt and cash and equivalents of $1.9B. Free Cashflow in 2012 came in strong at $1.9B. Below is information from the company 2012 annual report, 2013 Q1 report and 2013 company presentations:
V) MANAGEMENT
I strongly believe management of Covidien is focused on value creation for the shareholders. Jose Almeida CEO since 2011 over the last 2 years has done an excellent job of focusing on the long term growth of the company. The spinoff pharmaceutical division Mallinckrodt on 28 June 2013 and separation of the company to create 2 focused businesses is a step forward. He has overseen a large number of accretive acquisitions of manageable size and initiated a share buyback authorization for $3B in 2013 (in addition to $2B buyback authorization from 2011 with $450M remaining).
COV plans to return at-least 50% of free cash flow to shareholders via dividend and buybacks. In 2012 96% of free cash flow was returned to shareholders.
As per the company website:
José E. Almeida, Chairman of the Board, President and Chief Executive Officer
“José (Joe) E. Almeida has been the President, Chief Executive Officer and a Director of Covidien PLC since July 2011. Mr. Almeida became Chairman of the Board of Directors in March 2012. Prior to being elected President and CEO, Mr. Almeida was President of the Medical Devices segment of Covidien. In this position, Mr. Almeida oversaw the Surgical Devices, Energy-based Devices, Respiratory & Monitoring Solutions and Vascular Therapies Global Business Units, as well as the Japan, Asia, Canada and Latin America regions. These businesses account for approximately two-thirds of the Company’s total annual revenues and about three-quarters of its operating profit.
Mr. Almeida joined Covidien (formerly known as Tyco Healthcare) in 1995 as Director of Manufacturing and Corporate Engineering, and then held several positions of increasing responsibility, including Vice President of European Manufacturing and Vice President of Global Manufacturing.
Before joining Covidien, Mr. Almeida was a Director of Manufacturing in American Home Products’ Acufex Microsurgical division, an Engineering Manager of Johnson & Johnson’s Professional Products division and a Management Consultant at Andersen Consulting (Accenture).
Mr. Almeida received a Bachelor’s degree from Escola de Engenharia Maua in São Paulo, Brazil. He currently serves on the Board of Directors of Advanced Medical Technology Association (AdvaMed).”
VI) VALUE and PRICE
COV is trading in $63 to $65 range as of first week of June 2013. It is fairly valued at $65 with estimated EPS of ~$4 and CashFlow/Share of ~$6. I am expecting the market may mis-price the business for a brief period after the June 28 2013 spinoff of Mallinckrodt. If this happens there may be an opportunity to start a position in post spin COV at a favorable valuation. The company has a $3.4B share repurchase authorization and possible large repurchases at lower valuation would increase per share intrinsic value.
Mritik Capital suggests a wait and watch policy on COV over the next few weeks. A purchase of post spin COV at prices below $50 has potential to offer long term returns in excess of 12% per year.
VII) CATALYSTS
1. The upcoming spinoff of the pharmaceutical division by the end of June is a positive for the remaining medical devices business. The quality and stability of earnings will be much greater moving forward. Mr. Market can afford a higher multiple for what will become a wide moat medical devices company in the coming years.
2. COV has great innovation potential and new product introductions over next few years can have strong potential for increase in the earnings. Since current CEO Joe Almeida took over in 2011 R&D spending has been on a rise towards 6% of sales, which is ideal.
3. Emerging Markets around the world have very strong growth potential due to large populations who are entering the middle class and they will be seeking quality health care as their incomes rise. COV is well positioned to benefit from this. Revenue from Asia Pacific was 16% of total revenue. Over the next 10 years this can grow at double digit rate.
4. COV has a share repurchase authorization in excess of $3.45B as of 21 March 2013. This is good for repurchasing 14% of shares outstanding at current price of $65. In 2012, Covidien returned more than $1.75 billion to its shareholders via share buybacks and dividends. This represented almost 100% of its free cash flow. Significant repurchases over next year after spinoff can meaningfully reduce shares outstanding and increase per share intrinsic value.
VIII) SPECIFIC RISK
1. COV is in a very competitive business of medical devices and products which requires continuous investment in research and development. There is the risk that new products will fail to please customers and this will affect the earnings.
2. COV has been on an acquisition spree over last 2 years. Its recent acquisitions include BARRX, superDimension, Newport Medical and Oridion, CNS Therapeutics, CV Ingenuity, etc. There is integration risks associated with its strategy.
3. There is regulatory risk. Recent US healthcare regulations and additional taxes are a drag.
4. There is foreign exchange risks since 45% of COV sales are from international markets.
5. There is risks due to product recalls and there is litigation risks.
6. Recent trend of consolidation in healthcare industry and emergence of the bargaining power of group purchasing organizations could be a headwind.
IX) WHY IS THIS CHEAP?
COV is currently fairly valued at $65 with estimated 2013 EPS of ~$4 and CashFlow/Share of ~$6. I am expecting the market may mis-price the business for a brief period after the June 28 2013 spinoff of Mallinckrodt. If this happens there may be an opportunity to start a position in post spin COV at a favorable valuation.
Disclosure
I currently don’t own shares of COV. I may initiate a position in any of the mentioned stocks at any time.
Comments and questions welcome.
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Note:
I have used information from the COV investor presentations and financial statements. I have referenced information from Yahoo Finance.
