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Defensive stock pick for volatile markets

Fat Prophets
0 Comments| October 15, 2008

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Given the extremely high levels of uncertainty and volatility buffeting the stock market, we believe that owning stock in defensive, non-discretionary companies should be on the to-do list of all investors. In this regard, we have in the past recommended the global healthcare product manufacturer, Covidien (NYSE: COV, Stock Forum).

From a fundamental point of view, we believe that Covidien is currently in a strong position with prospects that offer significant upside potential. All the while providing a relatively stable stream of revenues and earnings given the industry they operate within.

In addition to operating in a sector we believe is well insulated from the vagaries of the business cycle, the company also has a large percentage of international sales exposure. With sales in over 130 countries, international revenues represent around 45% of group totals.

In keeping with our view of a weakening dollar, we believe this dynamic will not only help make Covidien cost competitive, but also benefits the group’s bottom line when translating foreign denominated earnings back to America at advantageous exchange rates.

Demographic trends are also a great advantage for medical device companies like Covidien. In the West, the population is aging. It’s no secret that as we age health care spending begins to creep up. Clearly with such a large segment of the population such as the baby boomer generation beginning to show their years, spending on the products made by Covidien will find a welcome market.

As a brief reminder, the company’s business units cover the following four segments: Medical Devices, Imaging Solutions, Pharmaceutical Products and Medical Supplies. So if the West is getting older, in developing markets society is getting richer. Not comparable to the standards we enjoy in America or Europe but affluence is on the rise. With this increase in wealth, the demand for health care also rises. Once again, with broad geographical diversification, Covidien is in an ideal position to benefit.

We saw the benefits of all these factors in the last set of results we covered in FAT127. Quarterly turnover in the U.S. was up 9% (to $1.4 billion), while international sales were up a solid 22% (to $1.2 billion). All regions exhibited positive growth. And while operational growth internationally matched the 9% achieved in America, the remaining 13% (to get to 22%) was the result of favorable exchange rates.

We believe this fairly succinctly reinforces our investment case for Covidien. The positive impact of spinning of from Tyco International last year is also becoming more apparent. Last month, management took the opportunity of an Investor Meeting to reappraise the market of what some of these were. Among the list were several impressive accomplishments, such as accelerated sales growth, improved gross margins, and the launch of a whole host of new products. All done whilst also making a concerted effort to improve the marketing function through investments in selling, marketing and research and development.

This robust operational performance meant the group was also able to reduce net debt by more than $1.6 billion and return over $300 million to shareholders via dividends. Corporate activity also retained a more focused approach as bolt-on strategic acquisitions were balanced with disposals of low-growth, non-core business units.

In our view, these outcomes and actions all benefited from a focus management team intent on growing the health care business rather than competing with other divisions as would have been the case in the old Tyco conglomerate business model.

Looking ahead, Covidien is not stopping there. Additional initiatives to boost performance are already in the works. One such innovative approach is the decision to set up Covidien Ventures in August. This unit will act as a vehicle for the group to gain exposure to cutting edge technology at an early stage. We believe that given the speed of change in the medical device sector, the establishment of such a first mover’s unit will help the group stay at the forefront of the industry.

And from a more nut and bolts perspective, management are initiating a restructuring program with the aim of generating $50 to $75 million in annualized cost savings. Although the cost to implement the program will be around $200 million, we believe the medium and long-term benefits will be worth the expense.

So from a fundamental point of view, we believe that Covidien is currently in a strong position with prospects that offer significant upside potential. All the while providing a relatively stable stream of revenues and earnings given the industry they operate within.

From a charting perspective, the most dominate feature is the robust upward trend that has developed over the past 12 months. As shown on the daily chart, prices have recently achieved a new all time high of $57 in mid September.

Given the recent increase in volatility, and a slight softening of prices in recent weeks, we anticipate a pause for consolidation in the near term. However, any potential downside is likely to be limited, with the May high of $50.50 offering initial support, underpinned by additional support at $45.73.

From a broader perspective, we believe that any near-term dip should be viewed as corrective. With a strong upward trend in place, we believe that the stock retains the potential to extend the upward trend to new highs above $57 in the coming months.

There is little doubt that economic growth in America is beginning to slow. In this environment, we believe having investments in relatively defensive sectors makes more sense than ever. In this regard, Covidien appears to check all the right boxes. In light of our upbeat outlook for the group, we believe the company’s prospective price earnings ratio of 17 times is undemanding.

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



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