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Summary

  • Medtronic nears Covidien deal, which should help improve on its effective tax rate.
  • The company will realize at least $740 million in tax savings, but this is not the only benefit.
  • The real benefit is long term, and includes expansion of product offering and widening of the addressable market.

Reports indicate that Medtronic (NYSE:MDT) is in advanced talks to acquire Irish medical devices and pharma company Covidien PLC (NYSE:COV), in a deal valued at $42.9 billion.

The move is widely seen as a tax-inversion strategy by which Medtronic would become domiciled in Ireland and thus lower its corporate tax rate to about 12.5% (Irish headline corporate tax rate), compared to the 35% federal tax regime in the United States.

This sounds like a way of avoiding tax burden, which makes it "evil". However, the primary goal of the company is deliver value for money to shareholders, and based on recent developments in the U.S healthcare industry, this evil might prove necessary in the end.

Medtronic's effective tax rate of about 17% is relatively low, compared to the 35% U.S corporate tax rate. This shows that the company could even improve on this rate if domiciled in a country with a corporate tax rate of 12.5%. The improvement (percentage wise) might be small, but in the long term, could be significant on EPS.

Medtronic is the world's fourth-largest medical devices company, with a market cap of ~$60 billion, while Covidien is the eighth-largest medical devices manufacturer, with a market cap of ~$32 billion. This deal would be one of the largest mergers in the healthcare industry, after Pfizer (NYSE:PFE) failed in its attempt to acquire AstraZeneca (NYSE:AZN) recently.

Medtronic's cash and cash equivalents stood at $14.2 billion as on April 25, 2014. Most of the cash is parked outside the US to limit the tax burden. Medtronic will pay $35.19 billion in cash and 0.956 of its own share for each Covidien share, which translates to a premium of 29% to Covidien's current share price. Medtronic and Covidien closed at $60.7 (the stock was up 9% pre-market on June 15) and $72.02 (the stock was up 33% pre-market on June 15), respectively on June 13, 2014.

Statistics from Bloomberg indicate that there have been 44 tax-inversion deals completed in the US so far. Since the introduction of the Affordable Healthcare regime by the Obama administration, US medical companies have been under severe pressures to reduce their costs, due to lower pricing accepted by hospitals. High corporate tax, in addition to lowering gross margins threaten to make a severe dent in the earnings, forcing strategic tax-related deals.

Apart from tax benefits, the acquisition of Covidien is also expected to expand Medtronic's product portfolio, as the two companies have little overlapping product domains. Medtronic's product portfolio is focused on cardiovascular devices (defibrillators, pacemakers), diabetes treatment (insulin pumps) and spinal surgery (minimal invasive systems), while Covidien is strong in respiratory treatment (airway ventilation, oximetry monitoring), tissue repair and endomechanical instruments. This is the ideal benefit, and is expected to give the company the ability to diversify its product offering.

The medical device industry has exhibited slow penetration, forcing several consolidations to take place, as witnessed over the last few years. For instance, Stryker (NYSE:SYK), on March 7, completed the acquisition of Pivot Medical, and in 2012, Johnson & Johnson spent $19.7B in medical devices-related acquisitions after acquiring Synthes (a medical device company) in cash and stock.

Combined product offering provides long-term benefits

Covidien PLC reported 2013 revenue of $10 billion and a free cash flow of $1.6 billion. Access to this cash reserve will further enable Medtronic in increasing capital expenditure in 2014 ($10B capex for 2014 in US was announced). Furthermore, Covidien's product offerings are bringing in $10 in annual revenues, which means the deal currently values the stock at about 4.29x in P/S. This is slightly above Medtronic's own P/S of 3.57x and Covidien's 3.14x. However, considering the long-term benefits associated with combining the two companies' product verticals, Medtronic appears well set to dominate the industry.

The combined product portfolio will help make inroads into new geographies where either Medtronic or Covidien had less presence earlier and compete strongly against market leaders Johnson & Johnson (NYSE:JNJ) and Siemens (OTCPK:SIEGY).

Medtronic reported a 3% revenue growth to $17 billion for the year ended April 2014, while Covidien's grew by a paltry 2.7%. Therefore, both companies are experiencing low revenue growth rates, and combining the two might just provide the needed impetus to augment each other in various markets.

Medtronic's outlook for 2015 is positive, with 3-5% revenue growth and ~$4 full-year EPS. The stock price of Medtronic has been in a long-term uptrend since 2013, with the price rising 50% since then.

Based on 2014 earnings before tax, about $740 million tax saving can be achieved per year if the deal goes through. With product diversification and other benefits, the deal is expected to increase the long-term price target further.

Conclusion

In summary, Medtronic's acquisition of Covidien will bring several benefits to the company. The immediate benefits would be in the form of reduced tax burden, which would help channel more income to shareholders, while the long-term benefits include expansion of product offering and a widened addressable market.

While some would argue that the company is running away from a tax burden that has seen so many companies stash their cash outside of the US, the bottom line is that this move is necessary in bid to deliver value for money to shareholders as the market becomes more hostile.

Source: Medtronic's Move To Acquire Covidien Is A Necessary Evil