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Growth & Income

Covidien Plc (COV - Analyst Report) operates in the relatively stable healthcare products industry which offers investors both growth and defense. That's a great thing to have in today's market.

Estimates have been rising for the company after it reported better-than-expected sales and EPS for its fiscal third quarter, sending it to a Zacks #2 Rank (Buy).

Covidien also generates substantial free cash flow and has been returning it to shareholders through stock buybacks and dividend hikes. It currently yields 1.7%.

Valuation is attractive too with shares trading at just 11.9x 12-month forward earnings, a significant discount to the industry average and its historical median.

Company Description

Covidien is a global healthcare products company. It primarily operates in three divisions: Medical Devices, Pharmaceuticals and Medical Supplies. Sales are divided as follows:

Medical Devices: 68%
Pharmaceuticals: 17%
Medical Supplies: 15%

The company derives approximately 45% of its sales from outside the United States.

Third Quarter Results

Covidien reported better-than-expected results for its fiscal third quarter on July 26. Earnings per share came in at $1.01, beating the Zacks Consensus Estimate by 6 cents. It was a stellar 19% increase over the same quarter in 2010.

Net sales rose 14% to $2.926 billion, ahead of the Zacks Consensus Estimate of $2.862 billion. The Medical Devices segment was the main growth driver as sales in the division increased 22%, led by increased demand for Vascular and Energy products.

Gross profit as a percentage of sales expanded 150 basis points to 57.1% due to in part to a positive business mix. Meanwhile, adjusted operating income was up 14% as the gross margin benefits were offset by higher research and development expenses and costs related to recent acquisitions and product launches.

Outlook

Analysts revised their estimates higher for both 2011 and 2012 following strong Q3 results. This sent the stock to a Zacks #2 Rank (Buy).

The Zacks Consensus Estimate for 2011 is now $3.93, which represents 16% EPS growth over 2010. The 2012 consensus estimate is currently $4.30, corresponding with 9% EPS growth.

Analysts believe this EPS growth will come from a mixture of acquisitions, organic revenue growth, higher margins, and stock buybacks.

Returning Value to Shareholders

Covidien generates very strong free cash flows and has been using that cash to buy back shares and raise its dividend. In the last 12 months, for instance, the company has returned over $1 billion in cash to shareholders through dividends and share buybacks.

Since it was spun off from Tyco in late 2007, Covidien has raised its dividend twice. It currently yields 1.7%.

With a payout ratio of just 21% and strong free cash flow, I'd expect another dividend hike soon.

Valuation

The valuation picture looks attractive for COV. Shares trade at just 11.9x 12-month forward earnings, a significant discount to the industry average of 16.3x, and a discount to its historical median of 13.2x.

Its price to sales ratio is in-line with the group at 2.2, despite significantly higher profit margins at Covidien.

The Bottom Line

With stable growth projections and shareholder-friendly management, Covidien looks compelling at less than 12x forward earnings.

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research.

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