Independent and in tune

Since our last review, Covidien (COV) has continued making moves that we expect will transform the company into a leaner, more focused business following its de-merger from Tyco. Encouragingly, the company is developing a strategy that should result in much improved operational performance as a standalone entity.

"We believe that the company's independence now allows it to make more in-tuned capital allocation and operating decisions, unhindered from the bureaucracies of an enlarged group."

This strategy is centered on growing the business, bringing innovation into its objectives and ramping up globalization efforts. Along these lines, Covidien's management has already commenced increasing sales headcount, invested in other marketing initiatives and increased research and development expenditure.

These measures should bring with them much needed operational benefits which we believe will lead to better returns. However, we acknowledge that this will take some time and hence have not yet been reflected in the recently reported fourth quarter results.

For the fourth quarter, the company reported 5 percent sales growth to $2.6 billion, but more importantly, recorded a profit at the operating line of $156 million, compared with a loss of $730 million in the third quarter. In order to gain a more meaningful analysis, we look at the margin stripping out restructuring costs and impairment charges and find an operating margin of 18.2 percent, compared with 20 percent in the corresponding previous quarter.

The company's operating margin decline was due mainly to an increase in selling and research and development costs, which, although impacting on current profitability, we believe it is money well spent and should translate into further earnings growth going forward.

Considering each division's performance in turn, Medical Devices, which account for 61 percent of sales, reported a solid 9 percent rise in the quarter, driven by new products, higher volumes and acquisitions. It is clear that the group's core business is still showing very robust top line growth and we expect this trend to continue.

Strong sales in the US and Europe led to a solid 4 percent increase in the Pharmaceutical Products segment, while in the Imaging Solutions division, sales rose an impressive 11 percent due to higher sales of cardiology and oncology products.

The rest of Covidien's businesses fared less well. The Medical Supplies business sales fell slightly due to lower sales of Original Equipment Manufacturer products. Meanwhile, the struggling Retail Products business continues to falter, reporting a 23 percent decline in sales. In light of the group's new status as an independent entity, we are encouraged that the company has recently signed an agreement to divest this division.

Looking ahead, Covidien expects a similar sales growth for the 2008 fiscal year but with a slight improvement in operating margin to a 19 to 20 percent range. This is not entirely surprising but we would expect a further ramp up in years to come reflecting the benefits of the group's restructuring efforts.

Although the group's recent results have hardly been outstanding, we are still positive on the company's long term prospects.

We believe that the company's independence now allows it to make more in-tuned capital allocation and operating decisions, unhindered from the bureaucracies of an enlarged group.

And certainly from a macro perspective, the prospects for Covidien's products look promising as the ageing population, especially in the emerging markets, underpin demand for health care and medical products. Moreover, the huge baby boomer demographic, looking for improved lifestyles should also generate increasing demand for medical products and equipment.

Looking at the valuation parameters, Covidien is fairly fully priced at 16.9 times 2008 Bloomberg consensus earnings and solid return on equity of 16.8 percent. Given these ratios, the company hardly looks expensive.

And from a charting perspective, growing investor support has seen Covidien achieve substantial gains in recent months. From a low of $37.73 in November, the stock rallied more than 22 percent to reach a high of $46.11 during January.

As shown on the daily chart, the recent bout of global volatility has seen a correction in prices. However, support has emerged in the $40 region, signaling the early stages of the development of a rising trend channel. While we cannot rule out further volatility in the near-term, we believe that underlying investor support will see Covidien move gradually higher in the months ahead.

Accordingly, Covidien will remain firmly held in the Fat Prophets Portfolio.