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Pharma Spin-Off Should Unlock Value of Covidien's Well-Positioned Device Business

The market's not accounting for attractive growth prospects.

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Covidien's (COV) valuation has remained suppressed even as our thesis has been playing out. Key culprits behind the company's uneven performance are the broad health-care utilization trends for medical technology firms in general and, more important, struggles in Covidien's pharmaceutical segment. We've long advocated for the sale of this business, as it has obscured stellar results from the firm's device operations. Covidien's December 2011 announcement of a spin-off of its pharma segment is welcome news for the firm's investors; the market should reward the remaining business with a higher valuation, given its better growth profile, less challenging competitive dynamics, and robust returns on capital. In our opinion, Covidien's current valuation doesn't fully incorporate attractive growth prospects for the device business.

Covidien is trading at just a 15% premium to its post-2007 spin-off value, despite the significant overhaul of its operations since separating from Tyco International--focusing on opportunities with high returns on investment and high growth, mainly in medical devices. Since the spin-off, Covidien has increased revenue more than 20%, to $11.57 billion in fiscal 2011, while jettisoning close to $1.5 billion in sales from noncore, no-moat businesses such as retail, specialty chemicals, and radiopharmacies. Some of the top-line growth has come through acquisitions, most notably the 2010 purchase of ev3, which contributed about $500 million to the top line and bolstered Covidien's position in the vascular market. The company also increased its adjusted earnings per share from $2.17 to $4.00 over the same period, despite increasing research and development spending twofold in absolute dollars (from 2.9% to 4.8% of sales) and significantly investing in its sales and marketing staff as well as infrastructure, mainly in emerging markets.

Alex Morozov does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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