One of the most enjoyable experiences for an investor is to find a stock before Wall Street catches on to the company's quality and then hold it throughout that awakening and revaluation processing. The last two years have been good ones for Covidien (UNKNOWN:COV.DL) shareholders as this underrated med-tech player got its due. Now the question is what comes next.
Covidien has an enviable hold on its key markets, with a #1 or #2 position in most of its segments, despite competing with some major rivals like Johnson & Johnson (NYSE:JNJ), Bard (NYSE:BCR), Masimo (NASDAQ: MASI), Stryker (NYSE:SYK), and Abbott (NYSE: ABT). Although I believe Covidien will continue a long run of operational success, I'm not nearly so certain that investors should expect another year of 20%-plus returns.
Leading the way in some overlooked markets
Although everybody has heard of minimally invasive surgery, it would be a mistake to assume that it is no longer a growth market. While some procedures are indeed dominated by less invasive laparoscopic approaches (cholecystectomies and bariatric surgeries are overwhelmingly done through minimally invasive approaches), adoption rates in other areas like colorectal surgery are still well below 50% and adoption rates are generally lower in Europe and much lower in emerging markets like China, India, and Brazil. If estimates of 25% global penetration are in the ballpark, that suggests years of potential growth for Covidien.
Covidien is definitely in position to benefit from this trend. By the company's estimation, it holds around 45% share of the market for endomechanical tools like staplers and energy-based cutting and sealing devices. Johnson & Johnson runs neck-and-neck in the endomechanical space, but trails a bit in the energy space, while others like Applied Medical and Olympus are not often significant threats outside of particular product areas or geographies.
If the opportunity for ongoing growth in minimally invasive surgery is overlooked, the opportunities in newer areas like lung cancer and upper GI interventions are even more so. Diagnostics and interventional tools for lung cancer could grow into a sizable market for Covidien, particularly as lung cancer is an under-screened cancer relative to others. Covidien has also established an early beachhead in Barrett's esophagus -- a precancerous condition thought to be caused by acid reflux and often a precursor to esophageal cancer (a very hard-to-treat cancer with above-average lethality).
A strong player in better-known markets
Covidien's leadership in minimally invasive, lung, and upper GI may be overlooked (both the extent of the company's market share and the potential of the markets), but Covidien is also a major player in better-known markets.
Stryker has done well with the neurovascular business it acquired from Boston Scientific and likely holds more than a third of this market, but Covidien is still a credible number two player. Likewise in peripheral stenting and intervention -- Johnson & Johnson, Bard, and Abbott are admittedly stronger in stenting, but Covidien offers a fuller suite of products. I have some concerns that the company is going to lose some share to Bard and Medtronic with their drug-coated balloons, but I believe Covidien can eventually close the gap.
Covidien also has its hat in the renal denervation ring with its OneShot system. Medtronic and St. Jude are going to compete fiercely in this market (among others), but it is likely to be a multibillion dollar annual revenue opportunity that can support more than one rival.
A long run of tuck-in deals
Larger med-tech companies are generally more active in M&A than many realize. Covidien has done nine deals itself since January 2012, but as most of these acquisitions involved private companies, it was easy to miss them unless you were a Covidien shareholder or a close watcher of the med-tech space.
Covidien has a knack for doing relatively modest deals that are centered around a particular product or market opportunity. Acquiring Maya Medical (for $230 million) brought a renal denervation platform, Newport and Oridion added to the ventilator business, and Given Imaging brings the company a GI diagnostic platform with exceptionally strong market share.
With management making it clear that M&A is an ongoing priority, I expect additional deals in 2014, though I do not expect deals that will rival Given Imaging in terms of size.
The bottom line
I think Covidien will have little trouble growing its free cash flow at a mid-to-high single digit clip for the foreseeable future. Newer markets like lung cancer and Barrett's esophagus will contribute to this growth, but so too will an ongoing focus on faster growing emerging markets where Covidien is looking to double its revenue over the next five years (currently around 15% of the total).
When I put that growth into my DCF model, I come up with a fair value of about $68 today -- more or less in line with the current price. Although Covidien is a leader in its markets, I already factor that in with a lower discount rate and I don't see great prospects for another 20%-plus year for the stock. "Fairly valued" is often taken as code to sell a stock, but I would argue that Covidien is still a stock to hold for the long term.