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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.

Covidien's 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.

Covidien also trades at a slight discount to most medical device firms we cover, despite its better-than-average earnings growth profile. The growth profile difference becomes even more pronounced once we remove a slower-growing, lower-margin pharmaceutical business. On a free cash flow basis, Covidien stock currently yields 8.5% (with our forecast calling for double-digit free-cash-flow growth) and pays a 1.7% dividend yield.

Since the spin-off from Tyco, Covidien has focused on its device business, increasing R&D and sales and marketing. As a result of these investments, the device unit has been growing at above-industry rates, and unlike most of its peers, its growth has been largely internal. Siemens (SI), Philips (PHG), Abbott (ABT), and Danaher (DHR) have become dominant players in the med tech mainly through sizable acquisitions over the past three years.

Covidien's investments in R&D have gone disproportionately into devices, while the supplies segment has been put into "harvest" mode. While the blended growth rate has averaged 7.5%, the device segment (adjusted for the ev3 acquisition and sharp safety and radiopharma reclassification) has grown approximately 9% internally. This growth is against the backdrop of tough macroeconomic conditions, which suppressed overall health-care utilization and constrained hospital spending. With the former head of the device business, Jose Almeida, stepping into the CEO role in 2011, the emphasis on devices has only accelerated, highlighted by the spin-off of the pharma unit announced in December.

Pharma Struggles Have Pressured the Stock
While Covidien is markedly different now than it was upon the spin-off from Tyco, the market is valuing it at roughly the same level. A number of factors both macro and company-specific have kept this company out of favor with the investment community, but we consider the volatile and unpredictable nature of its pharmaceutical business to be a chief culprit. Pharma struggles have overshadowed strides the company made in top-line growth (particularly in devices), as well as the overall margin and earnings improvement. Covidien has historically traded at a discount to its device peers (on an earnings multiple basis) as a result of the hybrid nature of its business model, despite posting above-industry-average earnings expansion and having a better growth model. We've long advocated for the pharma spin-off or an outright sale, and the December announcement to separate this entity from the device company was not surprising. We speculate the company was contemplating a sale rather than a spin-off, but the unattractive nature of certain product lines (contrast agents, for example) made the sale challenging.

Device Business Has a Strong Moat
Covidien's device business possesses numerous competitive advantages. Barriers to entry in the industry are typically fairly high, given the requirement for a sizable initial investment in infrastructure as well as R&D and IP platforms. Having a sizable scale advantage gives larger entrenched players the ability to maintain pricing power and share in more commodified product lines. Switching costs also tend to be a deterrent, although this factor may be getting weaker as procurement decision-making gradually switches from the hands of practitioners to administrators. Most device subsegments operate in an oligopolistic fashion; absence of the irrational price competition and an evolutionary rather than revolutionary nature of innovation tend to lead to only marginal share shifts within the industry and strong excess returns.

Even before Covidien's independence from Tyco, we believed its device business had strong economic moat characteristics, offsetting the no-moat pharmaceutical, imaging, and retail businesses. However, the device industry has its share of companies whose moats have declined over time because of chronic underinvestment in technology or overinvestment in areas where moats are more challenging to obtain. When we initiated coverage of Covidien in 2008, we noted that the company had to invest to protect its moat, and it has delivered.

Covidien currently ranks at or near the top in all device categories where it competes, challenged mainly by Johnson & Johnson (JNJ). The company has made the greatest strides in high-growth areas such as energy and vascular. These businesses account for almost one fourth of total sales and are growing in the high single or low double digits. We expect these two product lines to maintain their strong growth profile, offsetting more mature growth from the endomechanical business as well as some near-term pressures in airway and ventilation and soft tissue repair.

After the pharma spin-off, the revenue shift toward high growth will be even more pronounced. By 2016, we expect the energy and vascular segments to account for roughly a third of the total sales and medical supplies to continue shrinking. Aside from the revenue growth contribution, the shift and spin-off will help the mix and margins.

R&D Investment Has Boosted Growth
Covidien was able to bolster its growth profile mainly thanks to its investment in R&D, which has replenished a rather barren product pipeline. Since 2008, the company has brought product introductions to more than 40 a year from only a few. Covidien also launched several devices that should support its above-market growth rate and have the potential to significantly expand their target markets and applications.

The company has had a few pockets of weakness in devices as of late, particularly in soft tissue and airway and ventilation. The soft tissue repair business was hurt by J&J's launch of its new mesh and fixation products midway through 2011, while the A&V business was hurt by weak capital spending and the firm's underinvestment in its ventilator platform. We expect soft tissue growth will remain suppressed over the near term, although J&J's market entrance should be lapped by the fourth quarter. Covidien hasn't made any sizable investments in soft tissue and is likely to grow at below-market rates here, barring a large acquisition. While the company has stated its desire to jump-start this product line, the bulk of its soft tissue sales is in slow-growing sutures, while it lacks presence in a more rapidly growing biologic mesh. Growing a business from the ground up isn't necessarily in the company's DNA, so if Covidien moves into biologic mesh, it will be via acquisitions. However, there aren't many pure-play mesh makers available, particularly after Synovis Surgical was acquired by Baxter (BAX). J&J (via its Ethicon unit), C.R. Bard , and privately held KCI (via its LifeCell unit) are the top players in the market and don't represent logical targets for Covidien. The firm plans to launch six new soft tissue products in 2012 and three more in 2013, but our forecast calls for a subpar 4% compound annual growth rate for this line.

Ventilator growth has been lackluster for several years, as the firm largely ignored this product line, focusing R&D elsewhere. In addition, ventilators are also more susceptible to macro pressures, particularly in mature markets, as they don't usually involve rapidly evolving technology and thus tend to have extended life cycles during budget-constrained periods. While U.S. hospital spending is gradually recovering, Europe is weighing on capital spending growth. Covidien's A&V business isn't likely to grow at more than the inflationary rate, and it now represents less than 10% of total device sales.

As Covidien has jettisoned low-margin product lines and decelerated cost increases, its margins have shown signs of improvement. The medical device segment's margin on earnings before interest and taxes is roughly double that of the pharmaceutical and supplies segments, and as the mix has shifted toward devices, overall profitability has improved. This happened against the backdrop of a sizable margin contraction in the pharmaceutical segment over the past few years because of competitive pressures, generic competition, and other factors. The company's gross margin, the best indicator of a product mix shift, has grown nearly 500 basis points since fiscal 2007. We expect these trends to continue, particularly as the pharma margin stabilizes. Moreover, we anticipate that the company's profitability will continue to improve despite several unavoidable headwinds to the margin, like additional investments in R&D and the medical excise tax, which we expect will result in an incremental 100 basis points of margin pressure.

Both Businesses Should Benefit From Separation
After the spin-off, the pharma unit will have flexibility to deploy its capital as it sees fit, as it is clear that this business hasn't been a capital investment priority under Covidien. The unit could also prune its business even further, potentially spinning out radiopharmaceuticals and contrast agents to focus solely on the pain franchise, which we view to be the strength of this business.

We believe the pharma business could be worth north of $4 billion based on an average 2 times sales multiple we observe in the marketplace for companies with similar profiles. We note, however, that Covidien's pharma unit isn't facing major business disruptions like some of its peers, such as Lidoderm's patent loss for Endo (ENDP), Cardiolite's patent loss for the former Bristol (BMY) imaging business, loss of Provigil for Cephalon (now part of Teva (TEVA)), and reactor concerns with Nordion .

While Covidien's pharma business carries margins similar to most of its peers, these margins are also more stable because of the lack of major patent losses. Thus, we could foresee its valuation closer to $5 billion, particularly if we gain more visibility on the pipeline, which, according to the company's 2010 investor day, has drugs with a combined peak sales potential of $1.5 billion-plus (which we are very skeptical about, given the nature of the pain therapeutic area that is dominated by generic drugs). The pain market hasn't seen many revolutionary changes over the past decade, with the exception of drug delivery, and we believe Covidien's older pain drugs will still have a place in the market. The company's favorable position should be amplified by the lack of interest in pain from the majority of Big Pharma firms (Pfizer's acquisition of King is a rare exception), so the next generation of pain drugs could be several years away.

Most of the value, however, should accrue to the device business. After the spin-off, Covidien's device unit will enjoy a better growth profile, less volatility, and improved margins and returns on invested capital, which in turn should reward it with a valuation more indicative of its growth trajectory. Unlike many of its med tech peers, Covidien faces only limited near-term operational, regulatory, and macroeconomic concerns, which should also reward it with a higher multiple.

Covidien is less sensitive to economic cycles than its peers. Unlike orthopedic manufacturers and elective surgery firms, Covidien has escaped the economic slowdown relatively unscathed, as demand for its products tends to be less cyclical. While we are seeing signs of the demand improvement for companies like Zimmer (ZMH) and Stryker (SYK), another pullback in spending won't be as devastating for Covidien as it would be for other firms.

Also, Covidien doesn't face the same degree of regulatory scrutiny as other med tech firms. While the firm won't be immune to new regulations, we believe the impact will not be as pronounced, given that the majority of its products fall into the instrument category and thus aren't likely to face the same level of scrutiny as devices implanted inside patients' bodies.

Covidien's geographic footprint will improve slightly with the disposition of pharmaceuticals, and the company will have 11% of sales from emerging markets going forward (up from 10% currently). Covidien's margins in emerging markets are actually north of the corporate average, unlike many other med tech firms that see margins decline as the geographic mix shifts toward emerging markets.

The firm will maintain its Ireland domicile and as a result will maintain its advantageous tax status relative to its med tech peers. In addition, its balance sheet is solid. Covidien isn't overburdened with leverage or reliant on capital markets to fund its level of reinvestment. It can maintain its dividend and fund its $2.5 billion buyback program without stressing the balance sheet.

Investor sentiment should improve after the spin-off, thanks to better growth prospects and less volatility. Removing pharma from the total equation increases our forecast for the five-year top-line compound annual growth rate by 60 basis points on average, boosts pro forma margins by 200 basis points, and improves returns on invested capital as well as reduces uncertainty. As a more pure-play device firm, Covidien should see its valuation expand.

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