XLV Health Care Select Sector

In the wake of its dismal fiscal 2013 second quarter results, analysts covering Covidien PLC (COV), the $30 billion medical products maker, slashed earnings estimates for both this year and next by 17% each.

Not only did net income decline by 10.2% due to higher expenses, the company also warned about future investment-related expenses due to Japanese yen fluctuations that would further drag down their margins.

Plus, they are in the process of selling their Pharmaceuticals division, which is profitable and will create more uncertain expenses during the divestiture process this month.

Here's a visual of the dramatic drop in analysts estimates since the company's April 26 report, after which it slipped to a Zacks #5 Rank (Strong Sell)...

Regulation, Tax, and Cost Headwinds

The medical-technology excise tax of 2.3% has started to weigh on the bottom line from the second quarter of fiscal 2013. The tax will be a part of the SG&A expense and is expected to be approximately $25 million per quarter.

Moreover, increased investment-related expenses related to emerging markets growth is likely to keep margins under pressure going forward. The company's net income from continuing operations dropped 10.2% in the second quarter of fiscal 2013 due to higher expenses, which dampened solid sales growth.

Covidien is slated to spin-off its Pharmaceutical unit at the end of Jun 2013. The Pharma business is performing well on the back of new products and is contributing significantly to the top line. Following its divestment, Covidien will be left with only the Medical Devices and Supplies businesses.

Although the divestment will allow the company to focus on high-margin surgical products, uncertainty looms over the growth prospects of these two businesses, given the current difficult healthcare environment.

Path of Least Resistance

At $64, COV is trading about $2 below where it was when it earned a Zacks #5 Rank on May 9. After a gap lower to $62 in the aftermath of its last quarterly report, the stock climbed back above $66 but has met steady selling pressure there.

And the whole Medical Products industry group is under pressure with a Zacks Industry Rank of 171 out of 265 industries, with 72 companies including competitor Baxter (BAX).

Trading over 17 times forward estimates, COV looks poised to at least test the $61-62 support area if not lower into the high $50s. Until the earnings estimate story turns around, this one should be hands off for a while.

Kevin Cook is a Senior Stock Strategist with Zacks.com
 
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