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

With the spin-off of the no-moat pharmaceutical segment,  Covidien's 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.

Covidien invested heavily in the past five years to re-establish itself as a top-tier competitor, which we believe has given its device business a wide moat. Intangible assets, cost advantage, and switching costs are the biggest moat components of Covidien's story, particularly when it pertains to the company's (and its key competitors') ability to keep new entrants out. Covidien ranks at or near the top in all product categories where it competes within devices, challenged mainly by Johnson & Johnson (JNJ); the rest of the field typically is highly fragmented, with most companies occupying product niches rather than competing broadly with the big two. Covidien's impressive efforts on the new product front have garnered a few points of market share gains at the expense of J&J, but the market is still largely a duopoly, with no new entrants making significant inroads. There are a few new competitors that pop up on the margins, ranging from less sophisticated (discounted prices) to high end (technological advancements), but they rarely result in monumental market shifts. The existing players' positions are very defensible, with most practitioners rarely switching to competitors' products because of inertia as well as up-front training costs. While arguably the surgeons' influence on procurement decisions is waning, the established players also have administrators' ears. Covidien and J&J dominate a number of surgical specialties with the breadth of their portfolios, rendering competitors' efforts to displace them on the cost of individual products less meaningful.

Another component of switching costs is that evolutionary advancements achieved by smaller competitors are replicated fairly quickly, and more revolutionary breakthroughs rarely result in sustainable gains. Larger players have the technological know-how to effectively fend off new competitors, assuming they continue to reinvest in their product portfolios. Through their continuous contact with surgical specialists, larger established players have intimate knowledge of the marketplace, allowing them to react quickly to emerging competition by allocating a greater portion of their massive R&D budgets into emerging areas (renal denervation, for example) or outright acquisitions (ev3).

Covidien's cost advantages stem from its massive distribution infrastructure, with 4,000-plus sales representatives across 50 countries, and also from its sizable database that supports the clinical and economical value of its products. Covidien's products are less susceptible to pricing pressure than those of many of its peers because the company embraced the entire health-care system's focus on overall value ahead of most other device players. For example, Covidien has been at the forefront of minimally invasive and advanced energy surgery, which led to better patient outcomes. These procedures are also affordable for hospitals, allowing them to function more effectively in cost/benefit-sensitive environments. Further, most of Covidien's products make up only a small portion of the overall procedure cost, unlike products such as orthopedic implants. As a result, extracting pricing concessions from Covidien isn't the highest on a provider's priority list.

​

The firm's financial results support our wide-moat recommendation. Covidien's device business carries operating margins and returns on par or exceeding most of its wide-moat med tech peers. The company also carries gross margins of 60%, indicative of the noncommodity nature of its products, as well as resilience to pricing pressure. J&J's device segment, which we believe also has a wide economic moat, has margins and returns on assets in line with Covidien (30% and 17%, respectively), further supporting our assessment.

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. Covidien's device business grew in the midsingle digits throughout the recession, in part because of the essential nature of many of the firm's products (also buoyed by new product introductions). The company's capital equipment sales account for a low-single-digit percentage of total revenue, further immunizing it from cyclical pressures. The company's resistance to cycles also underscores its stickiness. While hospitals are encouraged to cut back on excessive spending and extract pricing discounts, Covidien by and large stood its ground, with only more commodified product lines (safety, trocars) experiencing price erosion.

We anticipate potential changes to the regulatory approval process will hurt med tech firms, and while Covidien won't be immune to new regulations, we believe the impact will not be as pronounced on the firm. The majority of Covidien's products fall into the instrument category and thus aren't likely to face the same level of scrutiny as implanted devices. This means that the company will not be forced to ratchet up its spending on clinical trials and the approval process (in part because of its proactive efforts), minimizing the negative pressure on its long-term returns on invested capital.

Covidien's geographic footprint improved slightly with the spin-off of pharmaceuticals, and the company now had 11% of sales from emerging markets. It is noteworthy that Covidien's margins in emerging markets are actually north of the corporate average, mainly because of its focus on high-end instrumentation and not basic supplies, unlike many other med tech firms that see margins hurt as the geographic mix shifts toward emerging markets. As a result, we are not expecting pressure on margins and returns on invested capital because of this shift.

Advancements Shift Covidien Further Away From Commodified Products
Over the past five years, Covidien made the greatest strides in high-growing device areas, such as energy and vascular. These businesses account for close to 30% of total sales and are growing in the high single to low double digits in relation to the mid-single-digit growth of the firm's other medical device products.

In addition to being faster-growing segments, vascular and energy are significantly less commodified than, for example, basic surgical instruments like trocars. Vascular is attractive for Covidien, given the firm's presence in every major product line, allowing it to entrench itself with vascular surgeons who tend to be fairly sticky. This marketplace is concentrated, as are most areas where Covidien competes, with 80% of the share divvied up among J&J, Covidien, and Stryker (SYK). The concentration and the corresponding barriers to entry are increasing, with smaller competitors steadily being gobbled up. The company is building a very strong franchise that could support double-digit growth over the next five years and lead the firm to the top position in this market. Covidien's vascular business currently accounts for 12% of total sales, but we expect this to reach 19% by 2017. Energy is an area where Covidien has long maintained leadership positions, and with Sonicision, the company now has a complete suite of products to effectively compete (in a rational fashion) with J&J.

​

The neuro segment of vascular (which is also very moaty and high-growth) has been growing in double digits ever since the acquisition of ev3. Growth has been even more remarkable over the past year, mainly as the company capitalized on Boston Scientific's (BSX) missteps and Stryker's integration issues, propelling Covidien to a strong number-two position. We envision the growth will continue with the launch of Covidien's Pipeline Embolization Device and Solitaire FR.

PED (launched in calendar 2011) represents the firm's key new product in neurovascular, with potential to reach $200 million in sales by 2013-14. While a novel technology, flow diverters have the potential to revolutionize large aneurysm treatment. The market opportunity is sizable, but adoption rates are conditional on long-term device effectiveness data as well as cost/benefit analysis. Nevertheless, these devices, particularly for market pioneer Covidien, represent a lucrative revenue stream, and we forecast the market will grow to $400 million in sales by 2016 (from zero currently). PED is the first and only flow diversion device both cleared in Europe (since July 2009) and approved by the U.S. Food and Drug Administration (premarket approval received in April 2011). Covidien is set to dominate this market, but we anticipate J&J and Stryker will enter by 2014-15, either through internal efforts or acquisitions.

Solitaire FR, Covidien's clot retrieval device for patients with ischemic stroke, has the potential to revolutionize the embolectomy market, as the company showed an overwhelming patient benefit for Solitaire compared with Merci Retrieval Device (manufactured by Concentric Medical, now part of Stryker), which is the current standard of care. We estimate that Solitaire will supplant Merci in stroke centers where embolectomy procedures are performed; given a higher price than Merci, we expect this product to reach $50 million-$100 million in sales (Merci has less than $30 million). However, this product will soon face competition from J&J's Revive and Stryker's Trevo devices, although Covidien's early entrance into the U.S. market gives it an advantage.

In energy, Sonicision represents Covidien's challenge to one of the most successful products in vessel sealing, J&J's Harmonic portable blade. Harmonic, ever since its release, has been virtually unchallenged in the handheld energy product market and generates approximately $750 million in annual sales, making it one of the best performers in J&J's surgical business. Unlike Harmonic, Sonicision is completely wireless, expanding its applications to nontraditional areas for energy devices. Covidien rolled out Sonicision in the second half of 2012 and is challenging Harmonic's monopoly position as well as broadening the size of the overall market. We expect the portable energy device marketplace to grow to more than $1 billion in annual sales within the next few years, with Sonicision capturing a sizable share of the new market and supporting our 9%-10% five-year compound annual growth forecast in energy.

The endomechanical portfolio doesn't have the pizzazz of the vascular or energy business, but Covidien has established a leading and sturdy franchise in this area mainly on the strength of its Tri Staple platform. Covidien and J&J, once again, dominate this market, with Covidien gaining share because of the success of Tri Staple. Share gains, in general, are tough to obtain because of switching costs arising from surgeon preferences. This area does have a few commodified products, where Covidien is more susceptible to pricing pressure, but the overall endomechanical franchise should still grow ahead of the overall market because of the increasing emphasis on minimally invasive surgery.