Strong 1Q for Covidien, but Bolstered by Several Nonrecurring Benefits

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Covidien’s fiscal first-quarter results slightly exceeded our forecast, but we’re cognizant of several unexpected benefits that helped top-line growth in the quarter and will linger through the rest of the year. Covidien increased its revenue outlook, although its margins are unlikely to change as it will reinvest incremental revenue in its emergingmarkets infrastructure.

The firm’s key strategic units delivered solid growth, although results in energy and vascular were both affected by extremely tough comparisons. Nevertheless, the highsingle- digit organic revenue expansion in both of these units was well ahead of the markets. New product launches continue to move the needle on growth with Sonicision and Solitaire both capitalizing on the tremendous market opportunity.

Other device units also exceeded our expectations, and we note that the flu had a slight positive impact on the ventilation and oximetry businesses. Emerging markets are starting to factor in overall growth as the firm’s steady investment in infrastructure in this area continues to pay off. This marketplace represents an enormous opportunity, but it isn’t crucial to the firm’s nearterm strategy as developed markets still offer plenty of room for expansion; any additional revenue growth picked up as a result of emerging-market penetration is a bonus to Covidien. Overall, the firm’s increased projection for medical device growth to 5%-8% from 4%-7% squarely positions it in the middle of our previously rather optimistic forecast of 6.5%.

Better-than-expected results in pharmaceuticals were due to strong Exalgo performance but also buoyed by the generic Concerta launch, which is now expected to contribute north of $100 million in incremental sales. The firm boosted its outlook for this segment, and we’re planning to adjust our forecast as our low-single-digit growth didn’t fully account for the positive Concerta impact. This, however, doesn’t have a material impact on our valuation of the firm. The spin-off remains targeted for mid-2013, with the Form 10 to be filed in the next few weeks.

Covidien’s adjusted operating margin was down slightly year over year, with currency weighing on profitability, but remained in line with the previously communicated range. The firm continues to make investments in its emergingmarkets infrastructure and research and development, but the growth rate should start slowing next year. That said, the adjusted operating margin for next year will be affected by the $75 million in extra selling, general, and administrative expenses as a result of the new medical device tax. This does decelerate our earnings growth for next year, but once this is annualized, we believe Covidien should return to solid a high-single-/low-double-digit rate over the next five years.

 

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