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Covidien's Wide-Moat Device Business Positioned Well for Long-Term Growth

R&D investments and a narrowed focus have widened the firm's competitive advantages.

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With the spin-off of the no-moat pharmaceutical segment,  Covidien's (COV) business is largely composed of products that garner strong competitive positioning in the marketplace. The company's device business has wide-moat attributes because of its strong intellectual property and significant switching costs, which imply high barriers to entry. Given Covidien's focus on products that deliver value to patients, providers, and payers, it is well positioned to prosper as more provisions of the U.S. Affordable Care Act take effect, while many of its peers will face significant regulatory and reimbursement pressures. The company's growth prospects are healthy, buoyed by a particularly productive pipeline. As a result, we continue to believe the firm deserves a valuation premium compared with some of its medical technology peers.

The device industry, in general, affords participants a number of moat attributes. Barriers to entry are typically fairly high, given the requirement for a sizable initial investment in infrastructure (manufacturing and distribution) as well as the research and development and intellectual property 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 may be getting weaker in an environment where procurement decisions are gradually switching from the hands of practitioners to administrators. Most device subsegments operate in an oligopolistic fashion; the absence of irrational price competition and an evolutionary rather than revolutionary nature of innovation tend to lead to only marginal share shifts in the industry and strong excess returns. The device industry still has its share of companies whose moats have declined, however, because of chronic underinvestment in technology or overinvestment in areas where moats are more challenging to obtain.

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

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