Why Covidien Stock Is Still Undervalued Despite the Medtronic Deal

NEW YORK (TheStreet) – You don't need me to tell you there's value in Covidien (COV). Just ask the management at Medtronic (MDT), which recently agreed to buy Covidien for $42.9 billion.

At a 29% premium to Covidien's prior closing price, the company's investors became wealthier overnight. The stock closed Wednesday at $89.29. Shares are up 32% on the year to date, outperforming the health care sector's 13% gain. But it's not time to get complacent.

Instead of thanking Medtronic, try to understand the nature of its proposed offer. You will find that Covidien is still undervalued by 8%. From my calculations, the stock is worth at least $97 per share. The company reports fiscal third-quarter results Friday.

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Prior to the announced deal, Covidien shares traded at around $72, as of the June 13 closing price. Medtronic made its move on June 15. On June 16, Covidien shares soared to an intraday high to $92.68 and closed at $86.75.

Over the past month, the stock has traded in a tight range between $88 and $91. This is because investors have not factored the implied value of Covidien based on Medtronic's offer.

First, the deal, which will be financed with $35.19 billion in cash and stock, values Covidien at $93.22 per share. This means Covidien is already discounted 4.4% based on Wednesday's closing price. That's money left on the table.

Second, the stock swap calls for Covidien investors to receive 0.956 shares of Medtronic for each Covidien shares they own. So, with Medtronic shares closing Wednesday at $63.37, this means an additional 4% discount has been added to the overall purchase price of Covidien.

The way I see it, there is a combined 8.4% premium that belongs to Covidien shares. Assuming that the deal closes by early 2015, investors who are willing to capitalize on the market's mistake will begin 2015 with potentially 10% to 12% annualized gains based on $4.45 earnings estimates.

My bullishness is not just about the potential deal, however.

While larger med-tech rivals Abbott Labs (ABT) and Johnson & Johnson (JNJ) are showing signs of slowing growth, Covidien appears revived. Management has executed with pinpoint accuracy and have delivered one solid quarter after another.

To that end, the company deserves an apology from Wall Street. There were operational concerns following the spinoff of the pharmaceuticals business to Mallinckrodt (MNK). But Covidien has tuned into a leaner operation -- one with the potential for long-term margin expansion.

Last but not least, on its own there is still a long-term growth story here in various end-markets like Surgical Solutions. This is an area where Covidien is outperforming both Johnson & Johnson and Stryker (SYK). In areas like endoscopy, Covidien should gain close 90% global share by virtue of its acquisition of Given Imaging in 2013.

All told, Covidien will remain a standout in medtech for many years to come, whether on its own or as part of Medtronic. In that regard, I don't anticipate any regulatory issues that would prevent this deal from closing. But as long as Covidien stock remains under $97 per share, it's a buy.

At the time of publication, the author held no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

TheStreet Ratings team rates COVIDIEN PLC as a Buy with a ratings score of A-. TheStreet Ratings Team has this to say about their recommendation:

"We rate COVIDIEN PLC (COV) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its solid stock price performance, growth in earnings per share, increase in net income, revenue growth and notable return on equity. Although no company is perfect, currently we do not see any significant weaknesses which are likely to detract from the generally positive outlook."

Highlights from the analysis by TheStreet Ratings Team goes as follows:

  • Investors have apparently begun to recognize positive factors similar to those we have mentioned in this report, including earnings growth. This has helped drive up the company's shares by a sharp 43.97% over the past year, a rise that has exceeded that of the S&P 500 Index. Regarding the stock's future course, although almost any stock can fall in a broad market decline, COV should continue to move higher despite the fact that it has already enjoyed a very nice gain in the past year.
  • COVIDIEN PLC has improved earnings per share by 21.3% in the most recent quarter compared to the same quarter a year ago. The company has demonstrated a pattern of positive earnings per share growth over the past year. We feel that this trend should continue. During the past fiscal year, COVIDIEN PLC increased its bottom line by earning $3.40 versus $3.37 in the prior year. This year, the market expects an improvement in earnings ($3.99 versus $3.40).
  • The net income growth from the same quarter one year ago has exceeded that of the S&P 500 and greatly outperformed compared to the Health Care Equipment & Supplies industry average. The net income increased by 0.5% when compared to the same quarter one year prior, going from $439.00 million to $441.00 million.
  • Despite its growing revenue, the company underperformed as compared with the industry average of 6.0%. Since the same quarter one year prior, revenues slightly increased by 2.7%. Growth in the company's revenue appears to have helped boost the earnings per share.
  • The return on equity has improved slightly when compared to the same quarter one year prior. This can be construed as a modest strength in the organization. Compared to other companies in the Health Care Equipment & Supplies industry and the overall market, COVIDIEN PLC's return on equity exceeds that of both the industry average and the S&P 500.

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