By most standards, Covidien (COV.DL) has been a superior performer in the med-tech sector. That hasn't always shown up in the company's stock performance, however, as rebound stories like St. Jude Medical, Boston Scientific, and Bard have raced ahead. With Covidien announcing a noisy quarter with some apparent seasonal pressures on Friday, it looks as though Fools have an opportunity to add shares in a high-quality name at a pretty interesting valuation.
Fiscal second quarter results come in a little light
If these results from the fiscal second quarter are what it looks like when Covidien misses, long-term shareholders will be fine. It wasn't a great quarter and there was a noticeable slowdown in the growth rate, but management remains confident in the full-year outlook and even this somewhat repressed result is OK.
Revenue rose a little less than 3% on a reported basis, coming in just shy of the average sell-side estimate. Organic growth for the quarter was about 4%, a slowdown from last quarter's 5% growth but not far out of line with the recent trend. Surgical Solutions led the way with 6% growth, helped in part by double-digit growth in vessel sealing and strong growth in stapling.
Margins were a little more mediocre. Gross margin declined almost two points and missed the sell-side target by about a point as FX had a bigger impact than expected and weaker results in Vascular led to a lower-margin mix. Covidien clawed a lot of that back through lower SG&A spending, though, and operating income fell 2%, coming in about 2% below expectations.
More than holding its own in surgery
Surgical Solutions accounts for almost half of Covidien's revenue, and the company continues to perform well here. The "Advanced" business, which includes advanced sealing ("energy"), stapling tools, and fixation saw 7% growth.
By way of comparison, Johnson & Johnson (NYSE: JNJ) saw just 2% growth in its surgical business, with a pronounced slowdown in urological and gynecological procedures. Bard also had a relatively weaker performance, as surgical sales were up 3% organically with a double-digit decline in hernia fixation.
Endomechanical and electrosurgery was weaker, as sales were up a little less than 2%. Stryker certainly saw a better result in its MedSurg instrumentation business (up double-digits), but this isn't the most fair or accurate head-to-head comparison. Overall, Covidien's 6% growth in Surgical Solutions compares well with virtually all of its rivals and comps. Even Intuitive Surgical saw a decline in instrument/accessory sales.
Vascular not nearly so strong
In contrast to the surgical business, Covidien's Vascular business delivered just 2% growth this quarter. Neurovascular sales were flat at a time when Stryker saw double-digit growth in both the U.S. and OUS markets. Even granting that this was a very challenging comp (last year's neurovascular sales were up 17%) and that the Pipeline recall hurt results, Stryker seems to be stretching its lead.
I am less certain what to make of the 3% growth in peripheral sales. Cardiovascular Systems and Spectranetics are both showing double-digit revenue growth in their peripheral businesses, so it would seem that ev3 has lost some momentum in the peripheral market (though this business goes behind atherectomy.)
A diverse business, but one with growth opporunities
As large as Covidien is, with something on the order of 15,000 products, individual opportunities tend to be relatively limited in their scope for moving the needle. Even so, Covidien continues to develop some attractive new products. The Endo GIA Reinforced Reload looks like a strong successor to the Duet, a stapler that generated close to $100 million before the company pulled it from the market. Likewise, the new LigaSure Maryland Jaw is a good sealer device.
Investors should also keep an eye on Barrx, the company's ablation platform for Barrett's Esophagus. Multiple clinical trials have confirmed compelling efficacy in treating dysplasia and reducing the risk of progression for cancer. While it would seem that Johnson & Johnson should be able to enter this market at some point given its platform technology in ablation (albeit cardiac), for the time being Covidien can move to take share in a seriously under-treated market worth possibly $1 billion in annual revenue.
The bottom line
Covidien is unlikely to generate the sort of top-line growth that will make it a top performer in any given year, but it's a quality business that should generate good returns over the long term. I look for long-term revenue growth of around 4% a year, with improved free cash flow generation leading to nearly double that rate of FCF growth. At today's level, that all suggests that Covidien is priced to deliver total returns in excess of 9%. Likewise, the company's shares trade at around 3.25 times its 2014 revenue estimates, a pretty modest multiple for a high-quality med-tech stock.
