- The US corporate tax policy is uncompetitive on a global scale.
- The benefits of incorporating in the US - a strong legal system and law enforcement - are no longer differentiating factors.
- Emerging market growth potential would indicate that a base in the US is not necessary.
Considering Walgreen (NYSE:WAG) and its plans to move to Switzerland, Pfizer's (NYSE:PFE) failed bid for UK-based AstraZeneca (NYSE:AZN), and now Medtronic's (NYSE:MDT) acquisition of Ireland-based Covidien (NYSE:COV), it's very clear to us that many US-based companies want to escape the tax burden of the US. We also think such moves implicitly reveal their company's views (or perhaps the executive suite's views) on the direction of future fiscal deficits in the US, and by extension, the belief that the financial burden will only increase on future generations. Are the firms that stay in the US just rearranging the chairs on the Titanic? Time will tell.
We have no interest in generating a political stance for or against tax inversion (i.e. re-incorporating overseas to reduce taxes), but Dividend Growth portfolio holding Medtronic is the latest to pursue such a strategy. The medical technology firm announced June 15 that it will acquire Covidien in a cash-and-stock transaction valued at ~$93 per share. According to the terms of the transaction, each outstanding ordinary share of Covidien will be converted into the right to receive $35.19 in cash and 0.956 of an ordinary share of Medtronic. The ~$43 billion deal is based on Medtronic's June 13 closing price of $60.70 per share.
Medtronic is paying above Covidien's standalone value, but after factoring in the substantial cost synergies related to the transaction, estimated at ~$850 million on an annual pre-tax basis, the price is near Covidien's adjusted valuation range. Using Medtronic's ~10% discount/hurdle rate (weighted average cost of capital), we value the cost synergies on a go-forward basis at approximately $8.5 billion ($850 million divided by 0.099).
Importantly, this estimate does not consider any potential revenue synergies resulting from the combined entity's enhanced product portfolio and broader geographic reach - nor does it consider the substantial tax savings from the combined entity re-incorporating in Ireland (where Covidien's current headquarters resides). The main corporate tax rate in Ireland is 12.5% compared to 35% in the US. On a cash earnings basis, the transaction is expected to be accretive in fiscal year 2016 (the first full fiscal year) and significantly accretive thereafter. We like the deal for shareholders of both parties.
Below, we've reproduced Medtronic's strategic rationale from the press release:
• Therapy Innovation: With its expanded portfolio of innovative products and services, Medtronic will be a preeminent leader in delivering therapy and procedural innovations to address the major disease states impacting patients and healthcare costs around the world. Covidien has an impressive portfolio of industry-leading products that enhance Medtronic's existing portfolio, offer greater breadth across clinical areas, and create exciting entry points into new therapies.
• Globalization: With a presence in more than 150 countries, the combined entity will be better able to serve global market needs. Medtronic and Covidien have combined revenues of $13 billion from outside the U.S., of which $3.7 billion comes from emerging markets. Covidien's extensive capabilities in emerging market R&D and manufacturing, joined with Medtronic's demonstrated clinical expertise across a much broader product offering, significantly increases the number of attractive solutions the new company will be able to offer to governments and major providers globally.
• Economic Value: Medtronic has adopted an intense focus on aligning with its customers to create more value in healthcare systems around the world - in various delivery and payment systems - by combining products, services and insights into solutions aimed at expanding access and reducing healthcare costs. With Covidien, Medtronic will be able to provide a broader array of complementary therapies and solutions that can be packaged to drive more value and efficiency in healthcare systems. Both companies' deep relationships with healthcare system stakeholders will provide enormous ability to identify and create further value-based solutions.
As Medtronic is included in the portfolio of the Dividend Growth Newsletter, we would have liked to see a better price paid for Covidien, but we still expect the deal to be value-creative for Medtronic shareholders. Covidien shareholders are getting a price greater than the fair value of Covidien's assets on a standalone basis, and while no one was ever hurt taking profits, we expect continued value creation from the combined entity through the latter part of this decade and beyond.
The day after the merger announcement Medtronic renewed its commitment to dividend growth shareholders, increasing its quarterly dividend to $0.305 per share (or $1.22 per share annualized). The increase marks the 37th consecutive year of increased dividend payments at Medtronic. We don't expect to make any changes to the firm's weighting in the Dividend Growth portfolio at this time. Investors should pay attention to any tax implications as a result of the relocation of the headquarters to Ireland, however.
As for the US' uncompetitive tax policy, well, that's a question for the comments section. Clearly, the US is not what it once was as companies are speaking with actions and taking significant steps to locate outside the country. In the Pfizer-AstraZeneca saga, we were flat-out surprised at the exorbitant price Pfizer was willing to pay with non-US domiciled cash in part to reduce the tax burden with such a transaction.
The tax-inversion trend is worth watching very closely, and the answer for politicians may rest in a more competitive tax policy (and reduced fiscal spending) than enacting laws that prevent firms from leaving the US (thereby inhibiting free markets). Are firms that stick around in the US just rearranging deck chairs on the Titanic?
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: MDT is included in the Dividend Growth portfolio.