A Spinoff With a Healthy Future
By JOHANNA BENNETT
LONG NEGLECTED BEFORE ITS SPINOFF from industrial behemoth Tyco three months ago, the health-care giant now called Covidien has a new lease on life.
Like other spinoffs, shares of Covidien -- one of the world's largest makers of disposable medical products and a leading surgical-equipment maker -- ebbed after its July 2 debut.
After all, despite a $20 billion market value, Covidien lacks name recognition, its pipeline looks anemic, profits are falling and a product recall last year hurt sales.
But health-care spinoffs have a history of performing well, given time.
So with the stock trading at a big discount to the medical-device industry, with piles of cash and profits set to start growing again next year, Covidien is a diamond in the rough that could see its price jump 25% to 40% in the next year or two.
"It's a market-leading company focused on improving margins, cash flow and profit growth," says David Katz, chief investment officer at Matrix Asset Advisors. "There's a high likelihood of success and investors are getting the stock at a big discount."
Others agree.
The stock, after dropping in its first month as a public company, has climbed 8% since Aug. 16, when Bear Stearns initiated coverage at an Outperform.
Meanwhile, insider buying over the last month has raised a few eyebrows. Led by Chief Executive Richard Meelia's purchase of 13,000 shares for $507,000, or $39 a share, insiders paid $851,952 for a total 21,800 shares.
Covidien declined to comment for this story.
"People do not realize that this company has a lot of growth potential," says Fang Zhou, an analyst with Rochdale Investment Management.
After years operating as Tyco's health-care subsidiary, Covidien -- which takes its name from the Latin words for "together" and "life" -- emerged overnight from its scandal-plagued parent company to become a top-tier medical-equipment maker with sales totaling $10 billion.
At a Glance
Covidien
Stock Price: $41.05
52-Wk High: $49.70
52-Wk Low: $36.90
Market Cap: $20.4 billion
Est. FY'07 EPS*: $2.69 per share
Forward P/E: 15.9x
Est. Long-Term EPS Growth**: 3%
Est. (FY'08/FY'07) EPS Growth/ (Decline): (5%)
Revenue (trailing 12 months): $10.05 billion
Dividend Yield: 1.5%
CEO: Richard Meelia
Headquarters: Mansfield, Mass.
* Covidien's 2007 fiscal year ended Sept. 30, 2007.
** Based on analyst estimates looking ahead three to five years.
Sources: Yahoo! Finance, Thomson First Call, Thomson Financial/Baseline.Ventilators, laparoscopic-surgery equipment and other medical devices generate about 60% of sales. It's also the company's fastest growing and most profitable business.
But Covidien is also the world's biggest maker of acetaminophen -- the common pain reliever used in Tylenol -- which it provides to drug makers as an ingredient in over-the-counter medications. It also sells dyes used during X-rays and MRIs, and adult diapers and baby-care products.
Years of underinvestment by Tyco, however, has depleted Covidien's new product pipeline.
The company remains highly profitable. Yet despite doubling its research and development budget since 2002, Covidien underspends its peers.
Now free of Tyco, Covidien can make strategic decisions quickly and control how and where it spends capital.
There's plenty to spend. Covidien expects to generate $1.2 billion in free cash flow annually.
Management hasn't been shy about plans to buy new companies, cut costs, spend more on marketing and research-and-development, and sell underperforming businesses.
Covidien has yet to announce a divestiture. But analysts agree the likely target is its faltering $800 million retail business.
Focused on supplying stores with adult diapers and infant-care products, it's Covidien's least profitable business.
Meanwhile, Covidien plans to add up to 500 new faces to its sales staff this year.
It has also funded 22 research-and-development initiatives in its medical-device and pharmaceutical businesses, according to Bear Stearns.
The company has also cast its eyes overseas, where it already generates 39% of its revenues.
"That should be a real focus over the next few years," says Glenn Reicin, an analyst with Morgan Stanley. "Their peer group averages over 50%."
Of course, these changes will cost Covidien profits and profitability, at least this fiscal year, which ends Sept. 30, 2008.
During the next 12 months, Covidien could earn $2.56 a share, a 5% drop, according to Thomson Financial.
But the following year, profits could increase 12% to $2.92 a share and keep growing at a rate in the low double digits, according to Rick Wise, an analyst with Bear Stearns.
"Covidien has the potential to be a very solid story in the next two years," Wise says. "But this first year is all about investing."
Still, at $41.05 a share, the stock has room to move, he adds, predicting that the shares will climb to $51 a share by the end of 2008.
At 16 times projected profits over the next four quarters, Covidien trades at a 10% premium to the Standard & Poor's 500, according to Thomson Financial.
But that's a 21% discount to the basket of medical-device stocks tracked by Thomson.
"This is a great opportunity for value investors," says Alex Morozov, an analyst for Morningstar. "Once the near-term clouds part, this will be a company that will prosper."
Of course, the next year or two could be bumpy.
Its retail business continues to weigh on profits. And after last year's product recall and manufacturing problems, Covidien can't afford more setbacks.
Hospitals and nursing homes are squeezing medical-device makers' profits.
Meanwhile, a lawsuit by bondholders over Tyco's breakup remains pending.
Last week, Covidien declared its first cash dividend, a sweetener for investors willing to ride out the turnaround.
And if management can change course, then investors willing to take a little risk, could reap big rewards |
