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It may be tempting to revise the idea that investing in the medical device sector is a defensive strategy. However, don't be too quick to fall out of love with Covidien (NYSE: COV ) . The company represents one of the more compelling long-term growth prospects within its sector, and has several ways to generate long-term growth.
Covidien, an emerging market play
Prospects for emerging markets to increase medical spending look strong. Not only are they growing their GDP at a faster rate, but countries like China are under increasing pressure to spend their foreign currency reserves on stimulating domestic demand via infrastructural investment.
Moreover, at its latest investor day, Covidien argued that emerging markets had only 6% of their GDP in health care, compared to 18% for the U.S. and 10% in the European Union. The potential for growth is significant, and Covidien hasn't been slow in investing in technology and innovation centers in places like Istanbul, Shanghai, Mumbai, and Sao Paulo.
Although the company currently generates less than 20% of its sales from emerging markets, its growth rates from these regions is little short of spectacular. For example, the BRIC (Brazil, Russia, India and China) countries make up 40% of its emerging market sales, and they are currently growing at around 25%. Meanwhile, the non-BRIC countries are growing at a very respectable 10%. Covidien's growth looks set to focus on the BRIC countries as it forecasts that 60% of its emerging market revenues will come from them by 2018.
Covidien's four sweet spots
First, unlike rivals like Johnson & Johnson (NYSE: JNJ ) or General Electric's (NYSE: GE ) health care division, Covidien doesn't have many large-ticket capital machinery type items. Instead, its solutions tend to come at more accessible price points -- a key plus point when trying to expand EM sales. Moreover, Covidien claims that its emerging market margins are higher than the company average, so there is a margin expansion opportunity as well. Furthermore, with no product (or class of product) contributing more that 5% of total sales, it isn't reliant on any one item for its sales growth.
Second, its solutions tend to be relatively non-cyclical, because its strength is in non-elective surgical procedures. Johnson & Johnson is struggling to generate growth in its surgical device markets, and has talked about a hospital capital spending market in a recession. In fact, in its latest results Johnson & Johnson's surgical care results declined 1.1% on an operational basis. Meanwhile, Covidien's endomechanical and energy growth remains strong.
Third, its endomechanical and energy products -- particularly those relating to minimally invasive surgery, or MIS, solutions -- tend to reduce hospital costs because they produce better patient outcomes. Going forward, Covidien has a growth opportunity by convincing hospitals (particularly in emerging markets) to use MIS procedures to reduce hospital costs. Moreover, if authorities are convinced of the efficiency benefits of MIS, they may start reimbursing this type of procedure in future.
Covidien's fourth sweet spot is that its strengths (endomechanical and energy products) are relatively under-penetrated areas in emerging markets. And there is more opportunity to come, because at its recent investor day the company argued that "10 of 12 pipeline products that we have in the pipeline are going to come from classes of trade where we expect 70% of our growth, Endomechanical, Energy and Vascular."
Where next for Covidien?
Its defensive characteristics and emerging markets prospects will help to offset sluggish spending in its core developed markets, but its forecast for overall revenue growth in 2014 is only between 2% and 5%. Analysts have revenue growth at 3.6% for 2014, and EPS growing just 7.2% to $3.98. While this may seem paltry, consider that GE's medical division revenues were flat in the last quarter despite recording 10% growth from its emergin markets operations.
Moreover, Covidien's forecasts assume a 4% headwind due to foreign exchange and the medical device tax. In other words, Covidien's underlying forecast for 2014 is in-line with its long-term aim of mid-single digit revenue growth and double-digit EPS growth. On a forward P/E ratio of 15.3 times earnings, and with upside from increasing adoption of MIS in emerging markets, the stock is attractive.
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