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Covidien Remains Neutral Post-Earnings

Zacks Equity Research

We reiterate our Neutral recommendation on Covidien plc. (COV). The company’s adjusted earnings per share (from continuing operations) of $1.07 for the third quarter of fiscal 2012 were a penny above the Zacks Consensus Estimate and 6 cents higher than the year-ago quarter earnings.

Revenues increased 3% year over year to $3,007 million, led by higher sales from the Medical Devices segment. However, sales were lower than the Zacks Consensus Estimate of $3,012 million. Profits from continuing operations decreased 15% to $453 million (or 93 cents a share) due to higher income tax-related expenses and currency fluctuations.

Covidien is a leading global health care product manufacturing company that develops and markets medical solutions for better patient outcomes. It has a history of developing and manufacturing high-quality products in a cost-effective manner.

The company boasts a well-diversified product and technology portfolio. Covidien continues to post healthy revenue growth, despite a difficult Med-tech environment, backed by the right business mix, new products, share gains and acquisitions.

The company remains committed to rolling out new products and technologies, focusing on faster-growing products and markets, and broadening its product range through acquisitions and strategic collaborations.

New offerings such as the LigaSure Small Jaw and the Sonicision ultrasonic dissection device are already contributing to revenues of the Energy business. The Neurovascular business is also benefiting from the Solitaire blood flow restoration device to treat patients with acute ischemic stroke.

Covidien remains committed to delivering incremental returns to its investors. Recently, the company raised its commitment to return more than 50% of its free cash flow (earlier 25% - 40%) to its shareholders via dividends and share repurchases. In the last one year, the company has returned almost 80% of its free cash flow to its shareholders (approximately $1.4 billion in cash).

In addition, Covidien is expanding its footprint in emerging markets, notably in Asia and Latin America, and boosting market share in core segments through investments in sales and marketing infrastructure. The company’s sales in the BRIC nations especially China and Brazil are growing at a healthy pace. In August 2012, the company opened a new research and development (R&D) center in China to develop innovative medical devices to cater to the Chinese as well as other emerging economies.

However, Covidien derives roughly 45% of its revenues from international markets. The economic downturn along with austerity programs in Europe is affecting the entire Medtech space. Moreover, the strengthening U.S. dollar versus other currencies (including the euro) may hurt the company’s revenues from these markets and subsequently its bottom line. Covidien’s revised guidance for fiscal 2012 indicates a more unfavorable foreign exchange environment.

Recently, Covidien was on an acquisition-spree and scooped up several new companies for diversification and development of new products/technologies. We believe that the company’s acquisitions will pay off in the long term.

However, we remain cautious about the near-term dilution associated with the company’s acquisitions of BARRX, superDimension, PolyTouch, Newport Medical and Oridion, among others. The company needs to successfully integrate these acquisitions so that they do not turn out to be wastage of resources.

Moreover, we are concerned about intense competition, reimbursement uncertainty and the sustained pricing and procedure volume pressure, which may have an unfavorable impact on the company’s core Medical Devices business. Covidien competes with Johnson & Johnson (JNJ), Becton Dickinson (BDX) and C.R. Bard (BCR) among others. Rising raw material costs can also act as a headwind.

Our long-term Neutral recommendation on Covidien carries a short-term Zacks #4 Rank (Sell) rating.

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