3 Reasons Why Medtronic's Purchase of Covidien Makes Sense

Medtronic (NYSE: MDT  ) investors are probably wondering what they could be getting with the acquisition of medical device company Covidien (NYSE: COV  ) for $42.9 biillion. Simply put, Covidien's attraction is that its surgical equipment is helping it to outperform Johnson & Johnson  (NYSE: JNJ  ) within the category, and fears of encroaching competition from Intuitive Surgical are probably overdone. Superficially, the company's forecast EPS growth rate of 7% for 2014 doesn't make it look like a high growth proposition, but for a host of reasons its growth is better than the headline numbers suggest. Let's take a quick look at three major reasons why Covidien is attractive to Medtronic.

Emerging markets
First, emerging market spending on health care is an exciting growth opportunity for the stock. For example, Johnson & Johnson's U.S. sales only increased 2.2% in its last quarter, while international sales grew 5.3% on an operational basis.

Although emerging markets only contributed 14.7% of Covidien's sales in the recent second quarter, they contributed 46% of the growth in the quarter. Moreover, as part of its growth plans for emerging markets, Covidien made an acquisition of a surgical equipment business in Brazil, and entered into a joint venture in China with a medical stapler company. Growth looks set to continue in 2014, with its emerging market sales growing 14% operationally in the second quarter and BRIC growth coming in at the "high teens".

Financials
Third, the strength of the company's financial numbers has been masked by various factors which are likely to recede going forward.

  • Adjusted gross margin came in 180 basis points lower than last year at 58.6%, but this was primarily due to negative foreign exchange effects. There is no guarantee that these negative effects will remain in future, because currencies move around.
  • SG & A expenses came in 1.7 percentage points higher than last year at 34.5%, but adjusting for an environmental charge in the quarter means they would have decreased 1.1 percentage points from last year thanks to productivity improvements
  • Research and Development costs increased .4 percentage points to 5.2% of sales, but this is in order to create future growth, particularly with new MIS products that CEO, Joe Almeida, said could be launched "in the next 12 to 36 months." Of course, how much the Medtronic acquisition would shift this is difficult to know for sure. 

Simply put, the issues discussed above have held back Covidien's reported growth rate, but its underlying prospects are a lot better.

Valuation
In terms of valuation, the deal makes sense for Medtronic. Aside from the tax advantages of the deal, and potential for synergies between two medical device makers. Covidien's cash flow generation means that Medtronic is getting the company at an attractive price.  Despite the headwinds discussed above, Covidien generated over $2 billion in operating cash flow over the last four quarters—a figure representing about 5% of the estimated value of the deal of $42.9 billion. That's not a bad price to pay for Covidien's combination of earnings and revenue growth in future years. Throw in the other benefits, and Medtronic investors should warm to the deal.

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