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Spin-Off Covidien Already a Healthcare Hit


Covidien is the ninth largest drug company in the United States, the world's biggest maker of controlled substances and the largest manufacturer of acetaminophen.


In politics, "spin" has a bad connotation. But it can be a very exciting word for investors when applied to companies that are tossed out of larger companies for reasons that may be dubious, misguided, or even downright dumb.

Spin-outs, also called spin-offs, are the market's least loved, most misunderstood and often most ignored foundlings They typically occur when a conglomerate that was once busy buying up every small and mid-sized company in sight finally realizes that it's really hard to get them all to work together. The conglomerate, typically suffering a stagnant stock price, complains bitterly that investors don't appreciate all the sacrifices that it has endured to get big and accelerate revenue growth. But the market fails to listen. At some point, executives decide that it's time to hire a consulting firm or an investment bank to break off those underappreciated little pieces and see if the parent can achieve a higher price as a slimmer, more easily understood entity.

Paradoxically, the spins usually do nothing for the parent company, but the spins often do great. One of the all-time greats was Coach (COH), which was spun out of Sara Lee (SLE) years ago. More recent winners were Ameriprise (AMP), spun out of American Express (AXP), and Genworth Financial (GNW), spun out of General Electric (GE). All three met with a lot of skepticism, but ultimately kicked sand on their doomsayers by advancing smartly.

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My favorite right now in this vain is Covidien (COV), which was spun out of Tyco (TYC) a couple of months ago. It was formerly known as Tyco Healthcare, and it's no tiny little shop. Covidien currently pulls down $9.6 bln in annual sales (35% internationally), which puts it in the top tier of medical technology companies in the vicinity of Johnson & Johnson (JNJ), Abbott Laboratories (ABT), Medtronic (MDT) and Baxter International (BAX). It sells a diverse group of medical products, including 59% devices, 13% drugs, 10% supplies, 9% imaging solutions and 9% retail products. Among the well-known brand names in the group are U.S. Surgical and Puritan Bennett. It's a big company, in other words, that few people outside the business have really heard of.

Spin-outs usually spend a few weeks to a few months underwater as shareholders of the parent dump them out of their portfolios indiscriminately. But eventually the good ones find support and start trading higher on good volume, and that's where Covidien is today. The last few years have seen a number of successful healthcare spin-offs, including Warner Chilcott (WCRX) in October 2006 and Hospira (HSP) in April 2004. For the most part, after an initial period of choppiness newly independent management teams are able to unlock value in previously neglected assets.

With the corporate bureaucracy of Tyco cleared away, strategic decisions can now be made more nimbly at Covidien. After years of underinvestment, the company appears ready to pursue opportunities in its profitable imaging, pharmaceuticals and medical devices segments with boosts to its research and marketing budgets. Look for double-digit revenue growth in these areas moving forward, which collectively generate 81% of Covidien's revenues annually.

The management team, led by CEO Richard Meelia, will likely consider exiting non-core, low-margin businesses to dedicate resources to more lucrative acquisition targets and internal projects. The most likely candidate is the company's retail segment, which focuses on supplying store-brand hygiene and infant care products to big-box stores. These aren't exactly high-growth areas.

One area in the Medical Devices segment that I find especially exciting involves bio-synthetic materials, which are surgical adhesives and anti-adhesives that can be applied within the body. An example of this would be the application of fibrin glues and synthetic sealants to actively stop unwanted bleeding. Compare this with the more traditional approach of applying a patch and waiting for blood platelets to coagulate. The bio-synthetic materials market is a relatively young $1 bln industry, but it is expected to grow 15% annually moving forward.

Another interesting segment is Pharmaceutical Products, which generated revenues of $1.2 bln last year. This business creates and manufactures the active pharmaceutical compounds that power both brand name and generic drugs. It also provides specialty chemicals to laboratories. According to estimates from management, Covidien is actually the ninth largest drug company in the United States. Claims to fame in this division include its position as the world's biggest maker of controlled substances, including morphine and codeine. It also sells a number of drugs used to treat Attention Deficit Hyperactivity Disorder. On the other end of the spectrum, it is also the largest manufacturer of acetaminophen-the common pain reliever inside your Tylenol caplets.

Also promising is the company's Imaging Solutions division, which makes the contrast and contrast delivery systems used in X-rays, MRIs and CT scans. Last year, this segment generated some $870 mln in sales. But besides these well-known imaging tests, this business also markets radiopharmaceuticals, which are radioactive isotopes used in nuclear medicine. Basically, this is the branch of medicine that uses radioactivity to detect abnormalities in the body or its functions. It can also be used to treat diseases or provide pain relief to the chronically ill.

If executives play their cards right-divesting non-core assets, acquiring fill-in products and picking the right innovations to pursue-the company will be transformed into an industry powerhouse with the ability to earn as much as $3 in 2009. If you put a 20X price/earnings multiple on that, which is typical for the industry, you get a $60 target. Not too long ago, adding some oomph to valuation validation, Meelia bought 13,000 shares of common stock at $39 apiece, which it is trading slightly above now.

Of course, it won't be an easy road for the company -- not by a long shot. There will be quarters where year-over-year comparisons are difficult and calculations of cash flow will make your head spin, as newly public spin-offs have all kinds of accounting minefields to tiptoe through. But if Covidien is able to demonstrate an ability to grow revenue, improve the sales force, step up research and development, dump non-core assets and pay off debt -- all at a rapid, steady pace -- then it's going to be a big winner.
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Position in COV.

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