Why Medtronic-Covidien Deal Will Lead To Strong 2015 Performance

| About: Medtronic plc (MDT)
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Summary

Medtronic will buy Covidien for $43 billion in debt and stock, the largest transaction in medical device history.

Changing the headquarters to Ireland will result in 1-2% tax savings due to new tax laws.

The combined company will have a diversified pipeline, increased globalization, and stronger cash flows.

By Eric Li

On Sunday, June 16th, medical device maker Medtronic (NYSE:MDT) announced its plans to buy Covidien (COV) for $43 billion in debt and stock, the largest transaction in medical device history. Each Covidien share was valued at $93.22, paid by $35.19 in cash and .956 Medtronic shares, representing a 29% premium to Covidien's closing stock price on June 14th. This will leave Covidien shareholders with 30% of the combined company, resulting in $850 million pre-tax cost synergies by the end of 2018. The successful merger on January 27, 2015 marks Medtronic as the world's largest medical technology producer, surpassing the incumbent Johnson & Johnson (NYSE:JNJ). The closing price was $75.59 and shares are being traded on the NYSE under ticker "MDT".

Headquartered in Minnesota, Medtronic purchased Covidien, legally headquartered in Ireland, not just for product expansion, but for the opportunity to pay lower taxes as well. While the United States holds a 35% corporate tax rate, Ireland's is only 12.5%, which leads to significant tax savings. As long as profits come from overseas and stay there, Medtronic will not have to pay US taxes. Since it has agreed to distribute a sizable portion of its $14 billion cash holdings to its shareholders, Medtronic has amassed billions in debt from buying back shares and paying dividends. Because of the United States' low interest rate, it is cheaper for Medtronic to borrow money rather than pay the 35% tax rate. If Medtronic fully converted to an Ireland-based firm, however, it could pay dividends without paying the US corporate tax.

In late September, however, new tax rules were announced by the Treasury Department, which specifically target the numerous inversions in the healthcare industry. Despite the pessimism, especially because of the size of the deal with Covidien, Medtronic continued the process. Because it can no longer use its overseas cash reserves, Medtronic had to withdraw $13.5 billion in debt to fund the cash component of the merger. Its dedication to the deal demonstrates that Medtronic sees other benefits from the deal.

Since both companies reached a deal, Medtronic and Covidien will both benefit in the long run, creating new opportunities for growth and cost savings. Since its announcement in June, Medtronic's stock has risen 15.26%, beating the Dow and S&P 500 by 10%. Currently valued at $76.48, it will have room to grow, as the purchase of Covidien will provide an array of new products in vascular and lung cancer care.

Shareholders can also benefit from synergies, which are predicted to be $850 million pre-tax by the end of 2018's fiscal year. There are risks that delay the benefits of the merger such as difficulty in integrating the process. This may disrupt business practices leading to inconsistencies in cash flow and a loss of benefits such as synergies and growth prospects. The causes of the delay in benefits may be due to negative economic and market conditions, which are usually uncontrollable. As mentioned above, the Treasury tightened tax laws with the intent to discourage inversion deals. However, the tax rate for new Medtronic will still be reduced by 1-2 percent, compared with the company's blended rate.

Overall, I think the merger between the two companies was a solid idea because of the diversified pipeline, cost savings, and globalization. From Medtronic's side, merging with Covidien establishes a larger R&D base, leading to better and diversified products that can improve patient care. Currently, the combined revenue is $27 billion, with $13 billion coming from outside the United States, of which $3.7 billion is coming from emerging markets. Medtronic's expertise in global outreach, combined with Covidien's talent in R&D, will lead to quality and innovative products that can be distributed globally. This will lead to a stronger cash flow due to the increased size of the business and its ability to reach new capital markets. I think new Medtronic should especially focus on the musculoskeletal industry because there is an aging global demographic trend, with the percent of people 65 and older growing around 2% every 10 years. Developing products such as joint replacements can prove to be lucrative. Investors should look to long Medtronic stock. With Covidien's Solitaire thrombectomy device recently approved by the FDA, Medtronic is pushing the device towards hospitals, which can reduce care costs. This is only one of the many upcoming products being produced by the combined power of the two medical technology companies. Medtronic-Covidien's growing pipeline will be able to expand their market share and advance the international healthcare system.

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. The author has no business relationship with any company whose stock is mentioned in this article.