January 13, 2015 Covidien plc Current Recommendation Prior Recommendation NEUTRAL Underperform Date of Last Change 08/14/2013 Current Price (01/12/15) $105.29 Target Price $111.00 SUMMARY (COV-NYSE) Covidien reported strong fourth-quarter fiscal 2014 results wherein both earnings and revenues improved year over year and also exceeded our expectations. Earnings surged 26.4% year over year on stringent cost control as well as higher sales across all segments. We believe that Covidien is poised to grow on the back of new product launches, strategic acquisitions along with expansion in emerging markets. Moreover, its recent takeover by Medtronic is expected to generate significant synergies going forward. However, the company faces stiff competition and remains exposed to pricing and utilization headwinds in certain end-markets. As a result, we reiterate our Neutral recommendation and set a price target of $111.00. SUMMARY DATA 52-Week High $105.68 52-Week Low $66.35 One-Year Return (%) 54.47 Beta 0.97 Average Daily Volume (sh) 3,400,471 Shares Outstanding (mil) 453 Market Capitalization ($mil) $47,674 Short Interest Ratio (days) 1.18 Institutional Ownership (%) 86 Insider Ownership (%) 1 Annual Cash Dividend $1.44 Dividend Yield (%) 1.37 5-Yr. Historical Growth Rates Sales (%) 0.6 Earnings Per Share (%) 5.4 Dividend (%) 15.1 using TTM EPS 25.4 using 2015 Estimate 24.4 using 2016 Estimate 22.6 Zacks Rank *: Short Term 1 3 months outlook * Definition / Disclosure on last page 4 - Sell Risk Level * Type of Stock Below Avg., Large-Growth Industry Med Products Zacks Industry Rank * 154 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Dec) (Mar) (Jun) (Sep) (Sep) 2013 3,056 A 3,103 A 2,578 A 2,560 A 11,297 A 2014 2,639 A 2,598 A 2,688 A 2,734 A 10,659 A 2015 2,721 E 2,678 E 2,752 E 2,848 E 10,999 E 2016 2,678 E 11,447 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Dec) (Mar) (Jun) (Sep) (Sep) 2013 $1.10 A $0.93 A $0.91 A $0.91 A $3.72 A 2014 $1.00 A $0.96 A $1.04 A $1.15 A $4.15 A 2015 $1.03 E $1.01 E $1.07 E $1.21 E $4.32 E 2016 $1.12 E $4.66 E Projected EPS Growth - Next 5 Years % 9.9 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606
OVERVIEW Covidien Plc, based in Dublin, Ireland, is a global leader in the development, manufacture, and distribution of medical devices and supplies, diagnostic imaging agents, and other health care products through its subsidiaries for use in clinical and home settings across the U.S. and international markets. The company was incorporated in 2000 as a fully-owned subsidiary of manufacturing conglomerate Tyco International Ltd. Covidien spun off from Tyco International in Jun 2007 to become a public company. After the spin-off of its Pharmaceutical Division (Mallinckrodt) on Jun 30, 2013, the company started operating through two segments: Medical Devices and Medical Supplies, effective Oct 1, 2013. According to the new reporting structure, the results of the Medical Supplies segment in Western Europe have been reflected in the Medical Devices segment. Product line sales under Medical Devices segment have been reported in three categories: (i) Surgical Solutions (ii) Vascular Therapies and (iii) Respiratory & Patient Care. Also, sales are primarily based on customer location, i.e., (i) U.S. (ii) Non-U.S. Developed Markets and (iii) Emerging Markets, rather than location of the selling entity. Surgical Solutions comprises Advanced Surgical and General Surgical product groups; Vascular Therapies comprises Peripheral Vascular and Neurovascular product groups; and Respiratory and Patient Care comprises Patient Monitoring, Airway & Ventilation, Nursing Care and Patient Care. The Medical Devices segment (85.3% of total revenues in FY14) includes the development, manufacture and sale of a broad spectrum of endomechanical instruments, energy devices, soft tissue repair products, vascular products, oximetry and monitoring products, airway and ventilation products, and other medical products. The company offers its products to physicians, nurses, materials managers, group purchasing organizations and governmental health care authorities. The Medical Supplies segment (14.7%) offers nursing care products, including those for wound care and surgery such as operating room supply products and related accessories. Supplies include electrodes, chart paper product lines, SharpSafety products, and original equipment manufacturer products including medical supplies such as needles and syringes, and incontinence products. Covidien is currently in the process of being acquired by Medtronic for a total cash and stock value of $42.9 billion. The acquisition, announced on Jun 15, 2014, is in its final leg as the deal has obtained all necessary regulatory go-aheads including shareholders approval of both companies. As of now, the deal is expected to close in the last week of January or early Feb 2015, subject to the approval of the Ireland High Court. Note: The company s fiscal year ends on Sep 29; fiscal references do not coincide with the calendar year. Equity Research COV Page 2
REASONS TO BUY Covidien is a leading global health care products 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. Despite a difficult Med-tech environment, Covidien continues to post healthy revenue growth, backed by the right business mix, new products, and growth in emerging markets. We also believe that the company s focus on minimally invasive surgical (MIS) procedures should drive longterm growth for the company. Covidien s MIS devices from the Energy and Endomechanical franchises are expected to drive meaningful growth for the company. Covidien has been following an acquisition-driven strategy to boost its growth profile. Over the last two years, the company has cut several targeted deals (11 companies) that have largely expanded its product portfolio across both the business segments. We note that most of these acquisitions provided products that are complementary to Covidien s existing product line, thus improving top-line growth. Most importantly, the acquisition of Given Imaging in Feb 2014 contributed roughly 1.1% or $121 million to total net sales in fiscal 2014. Apart from acquisitions, Covidien successfully completed the divestiture of its biosurgery sealant product line within the Medical Devices segment during fiscal 2014 and the spin-off of its Pharmaceutical division in the third quarter of fiscal 2013. We believe that the strategic acquisitions and divestitures carried out by Covidien will help the company improve operations, financial returns and flexibility to execute growth plans including expansion in international markets. Covidien is expanding its footprint in the emerging markets, notably in Eastern Europe, Middle East and Africa, 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 are growing at a healthy pace, particularly in Russia. The company has acquired a number of entities in the past and plans to make further investments in emerging markets as it continues to see excellent opportunities in the aforementioned countries. Moreover, the company is hiring sales personnel in the emerging markets, which will result in better focus on its high-growth businesses. During fiscal 2014 fourthquarter, the company expanded its training and research capabilities in emerging markets by opening an innovation and training center in Brazil, which represents the first center in Latin America and the fifth in emerging markets. Covidien remains committed to roll out new products and technologies, focusing on faster-growing products and markets, and widening its product range through investments in innovative products. We are encouraged by the recent U.S. Food and Drug Administration (FDA) and CE Mark approvals for the company s products. Covidien s Stellarex DCB received CE Mark in Jan 2015, while the Fortrex PTA balloon catheter attained FDA clearance in Nov 2014. These two platforms along with Covidien s latest offerings like the Pipeline embolization device and EverFlex stent should boost the underlying Vascular business. We expect the company s Oximetry and Monitoring Products unit under the Medical Devices business to greatly benefit from its Nellcor technology, which includes a number of recently FDA-approved and CE-marked devices. We believe that Covidien s robust product pipeline will make significant contributions to its long-term growth trajectory. Covidien is currently restructuring its business segments to improve its cost structure. The restructuring program, launched in fiscal 2013, aims at reducing corporate expenses, expanding the use of shared services in low-cost locations, streamlining the organization structure, consolidating manufacturing locations and distribution centers and expanding low-cost country sourcing. The company expects $200 $225 million in annual savings from this restructuring move. We believe that savings from the restructuring effort coupled with the current cost reduction program will help the company neutralize raw material price hikes and also boost margins and profits. Equity Research COV Page 3
REASONS TO SELL Covidien derives half of its revenues from the ex-u.s. markets (50.4% in fiscal 2014). The economic downturn along with austerity programs in Europe is affecting the entire Medtech space. Moreover, fluctuating foreign currency rates may hurt the company s revenues from these markets and subsequently its bottom line. Covidien continues to acquire a large number of companies. While this improves revenue opportunities, it adds to integration risks. We are concerned over the company s increasing expenses associated with acquisitions, expansion in emerging markets and restructuring programs. Covidien is subject to various legal proceedings and claims, including patent infringement claims, product liability matters, environmental matters and other commercial disputes. Since it is difficult to predict the outcome of these proceedings, we feel that one or more of the proceedings could have a material adverse effect on Covidien s cash flow or operations in the future. Covidien is exposed to a potentially tougher reimbursement landscape. In a bid to curb the nation s bloated budget deficit, the Obama administration has passed a bill, which includes plans to cut health care expenditure. This has elevated reimbursement risk for Covidien, which may adversely impact the demand for its products. Covidien's core Medical Device business overlaps with the business of its competitors like Johnson & Johnson (JNJ), Becton Dickinson (BDX), and C.R. Bard (BCR). Covidien s hernia repair franchise faces increased challenges as rival C.R. Bard continues to strengthen its foothold in this market with new products (including the laparoscopic ventral hernia repair product Echo PS Mesh Positioning System). Moreover, the company envisions greater competition in the energy business moving ahead given the emergence of new entrants. Market share gains by competitors, especially in the oximetry market, remain an overhang. RECENT NEWS Fourth Quarter Highlights Covidien reported fourth-quarter fiscal 2014 earnings of $1.15 per share, which beat the Zacks Consensus Estimate by $0.14. Earnings per share (EPS) also surged 26.4% from the year-ago quarter on the back of higher sales growth and stringent cost control. Quarter Details Sales increased 6.8% year over year (y/y) to $2.73 billion, outperforming the Zacks Consensus Estimate of $2.68 billion. The year-over-year growth was driven by robust performance across all segments. Surgical solutions sales increased almost 11% to $1.33 billion. Meanwhile, Stapling also posted considerable growth in the quarter. Vessel sealing, interventional lung, synthetic mesh and Covidien s BARRX gastrointestinal business achieved double-digit sales growth. The takeover of Given Imaging also drove advanced surgical sales. Equity Research COV Page 4
Vascular Therapies sales climbed 3% to $426 million on the back of higher neurovascular sales. The upside was driven by double-digit sales growth in both stents and access delivery products and higher revenues from coils and flow diversion products. Peripheral Vascular sales posted modest growth, with higher sales of chronic venous insufficiency and procedural support products, partially offset by decreased compression and dialysis product sales in the U.S. Respiratory and Patient Care sales inched up 3% to $974 million. Patient Monitoring sales increased 6% year over year, primarily resulting from increased sales of capnography products, which continued to grow well above 20%. Airway & Ventilation sales grew modestly in the quarter owing to increased sales of ventilators. Nursing Care sales increased slightly on a year-over-year basis, led by increased sales of wound care, enteral feeding and incontinence products. Patient Care sales grew slightly primarily due to higher sales of electrodes and OEM products. Gross margin expanded 260 basis points (bps) from the year-ago quarter to 60.8%. Adjusted selling, general & administrative (SG&A) expenses, as percentage of revenues, declined 130 bps on a year-over-year basis. The decline can be primarily attributed to productivity improvements partially offset by higher costs associated with acquisitions and transactions related to the company s pending acquisition by Medtronic. Adjusted research & development (R&D) expenses increased 40 bps to 5.4% in the quarter driven by continuing investments in strategic initiatives. Operating margin expanded 360 bps from the year-ago quarter to 24.3%, primarily owing to lower SG&A expenses and a higher gross margin base. Equity Research COV Page 5
VALUATION Covidien shares are trading at 25.4x TTM earnings, a discount to the peer group average of 47.8x but a premium to the S&P 500 average of 18.8x. The TTM multiple is higher than the historical range of 10.7x to 24.6x TTM earnings, indicating downside potential. The stock is trading at 24.4x our forward earnings estimates for 2015, a 60.8% discount to the peer group average of 16.3x, which is higher than the 49.6% average discount for the historical period, indicating limited downside risk. Given the mixed signals, we maintain our Neutral recommendation and set a price target of $111.00 (25.7x 2015 earnings). Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF (TTM) (TTM) 5-Yr High (TTM) 5-Yr Low (TTM) Covidien plc (COV) 24.4 22.6 9.9 19.2 25.4 24.6 10.7 Industry Average 62.3 48.3 15.2 38.8 47.8 114.6 13.5 S&P 500 16.3 15.3 10.7 15.9 18.8 19.4 12.0 Baxter International Inc. (BAX) 15.6 14.9 8.2 11.6 14.4 15.9 10.5 Medtronic, Inc. (MDT) 18.4 17.1 6.8 15.8 19.0 18.8 9.7 Stryker Corporation (SYK) 18.3 16.9 8.7 20.1 20.9 20.9 12.9 Owens & Minor Inc. (OMI) 18.2 16.8 6.1 13.1 19.8 21.4 13.6 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B P/B P/B ROE D/E Div Yield EV/EBITDA Last 5-Yr High 5-Yr Low (TTM) Last Qtr. Last Qtr. (TTM) Qtr. Covidien plc (COV) 4.6 4.6 2.0 19.4 0.4 1.4 19.2 Industry Average 17.3 17.3 17.3-216.4 0.0 0.4 17.2 S&P 500 5.1 9.8 3.2 24.8 N/A 2.0 N/A Equity Research COV Page 6
Earnings Surprise and Estimate Revision History Equity Research COV Page 7
DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of COV. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1105 companies covered: Outperform - 15.2%, Neutral - 78.7%, Underperform 5.8%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Equity Research COV Page 8