Inside Wall Street: Covidien's upswing far from over

The long-term positive impact of the company’s spinoff plan is still unappreciated.

By Gene Marcial Mar 30, 2012 9:39AM

Last December, Covidien (COV) announced its plan to spin off its pharmaceutical division. Since then, shares have advanced 25% to $54 a share as investors have supported the move. But now, some say the hefty gain suggests the spinoff's potential impact is fully reflected in the stock price and would inhibit any further upside move.

 

Don't bet on it.

 

Although details of the proposed spinoff have yet to be announced, some investment pros who focus on spinoffs believe the stock, which has now climbed close to its 52-week high of $57.65 hit back in May 2011, has a lot more upside potential.

 

"Our immediate price target for the stock is $60, but if the spinoff goes as planned, the stock could go as high as $70 by next year," says Joseph Cornell, president of the Spin-Off Research. That's because even at its current rally price, the stock is still undervalued, he says, and the spinoff "will unlock the value of Covidien's assets."

 

Covidien itself is a product of a spinoff. Formerly owned by Tyco International, Covidien was spun out and subsequently became an independent entity. It is a global maker of medical devices, diagnostic imaging agents, pharmaceuticals and other healthcare products.   

 

The non-core pharmaceutical operations have been a volatile business and a drag on Covidien's earnings. By spinning it off, the company can focus more on its faster growing medical devices and supplies operations, which generate high operating margins of about 30%. As a result, investors would be able to better appreciate Covidien's potential growth and value, says Cornell.

 

As an independent company, the pharmaceutical unit would be worth $2.7 billion, figures Cornelll, and could be sold in the future for what it is worth. Management has yet to disclose its plans for the unit. It's possible that it might attract a suitor when its goes on its own. In the meantime, investors would receive a special dividend from the pharma unit's spin-off.

 

Cornell notes that the pharma business of late has been turning around, with sales and margins improving.

 

The spinoff will result in a revitalized Covidien, with concentrated operations in medical devices and supplies, which analysts expect will fetch a premium valuation with its better profile.

 

"We expect the medical devices unit to continue to post strong growth supported by tailwinds from increasing presence in the emerging markets, better mix, and rationale capital deployment," says Cornell. Emerging markets accounted for double-digit sales growth in past years and management sees sales growing by more than 10% yearly over the next five years. Covidien is seeing considerable growth in Brazil, China, Middle East, and Africa. Europe is also seeing improved sales growth.

 

Covidien generated some 66% of its revenue last year outside of the U.S., and management expects the new Covidien without the pharma unit to generate higher revenue from the emerging markets in the years ahead.

 

With focused operations on medical devices and supplies, Coviden's stock should get higher valuation from Wall Street analysts, says Cornell, because companies in that sector of healthcare command price-to-earnings multiples of about 15.4, vs. Covidien's price-to-earnings ratio of about 12.4.

 

With its rising cash flow and improving revenue and earnings, the new Covidien's stock could shoot up to as high as $70 a share in 2013, says Cornell.

 

Analyst Phillip Seligman of S&P Capital IQ says the planned spinoff "makes good strategic sense, as it should provide greater flexibility and focus for each business." The new Covidien will show "faster sales growth and wider margins," benefiting from the global aging population and its penetration into the rapidly growing emerging markets. He rates the stock as a "strong buy," with a 12-month target of $64 a share, based mainly on the company's "improved top-line growth and margin expansion prospects."

 

Spinoffs have always been a favored strategic option for many U.S. corporations to unlock hidden value in their assets and further enhance their valuation in the market. Covidien is one stock that will realize the full value of a spinoff -- at the right time and the right market environment.





Gene Marcial wrote the column “Inside Wall Street” for Business Week for 28 years and now writes for MSN Money’s Top Stocks. He also wrote the book "Seven Commandments of Stock Investing," published by FT Press.

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