Medtronic Changes the Game

In one dramatic swoop, Medtronic (NYSE: MDT  ) answered a lot of the questions that investors had about its plans for its overseas cash balance, it's long-term growth plans, and whether it wanted to enter additional "power alley" med-tech markets. Medtronic has announced that it will be acquiring Covidien (NYSE: COV  ) in a cash-and-stock transaction that is not only a tremendously large med-tech deal, but one that makes an exceptional amount of sense.

Medtronic has changed the med-tech game on multiple levels. Not only will the new Medtronic be the most diversified company in med-tech, with leadership in over a half-dozen major therapeutic markets, but the size of this deal may well spur actions to close the tax inversion loopholes that companies have been using to reduce their tax bills. Most importantly of all, it's a good deal for Medtronic and Covidien shareholders, though some will see the tax ramifications as less than ideal.

A big deal in every sense
When rumors started spreading that Medtronic was taking a look at Smith & Nephew, a lot of analysts dismissed them saying that Medtronic wouldn't be interested in a deal of that size. What nobody seemed to think, though, was that Medtronic would consider Smith & Nephew as too small for its ambitions. Instead of buying Smith & Nephew, Medtronic announced a nearly $43 billion deal for Covidien, one of the world leaders in surgery, energy tools, respiratory, and patient monitoring.

Medtronic will be paying $35.19 in cash for each Covidien share and 0.956 shares of the new Medtronic. All told, Covidien shareholders will own 30% of the company and are receiving a 29% premium to Friday's close (though that number will move with Medtronic's stock price). Based upon trailing numbers, the new company will have $27 billion in revenue ($17 billion from Medtronic, $10 billion from Covidien) and $8.7 billion in pre-synergy EBITDA ($5.9 billion from Medtronic).

While there are some overlaps in the two companies' peripheral/endovascular, neurovascular, and energy businesses, most of what Covidien brings to Medtronic is new to the company. Together, this will be the largest player in cardiac rhythm management (pacemakers and ICDs), spinal care, diabetes devices, energy tools, patient monitoring, respiratory care, peripheral vascular, and nursing products, as well as a virtual co-#1 with Johnson & Johnson (NYSE: JNJ  ) in endomechanical surgical tools.

Can Medtronic reach synergy targets?
When med-techs with large overlapping businesses get together (like in the case of Zimmer and Biomet), there are often revenue dysynergies and sales disruptions. That's much less likely here, given the limited overlap. Over time, Medtronic believes it can see significant cross-selling potential in areas like patient monitoring and adding Covidien's businesses certainly fits with Medtronic's new ideas about integrated health solutions.

A cost synergy goal of $850 million sounds reasonable, with Medtronic looking to drive cost savings from a more efficient manufacturing footprint, more scale in global sourcing, and the elimination of redundant back-office costs. Given the lack of overlap, I would be surprised if Medtronic looked for large headcount reductions in sales and marketing and given Medtronic's strong commitment to R&D, I wouldn't think it would look to slash personnel, projects, or spending here either.

Factoring in a slightly lower tax rate (and access to its overseas cash pile), I expect Medtronic to earn a long-term rate of return in the 6% to 10% from this deal. That is below the company's trailing return on assets, equity, and invested capital, but that also reflects the realities of how difficult it is for Medtronic to find large-scale reinvestment opportunities that offer attractive expected returns.

What does this mean for others?
Johnson & Johnson cannot be thrilled to see its primary rival in surgical and energy tools acquired by a company that will maintain (if not accelerate) its commitment to R&D. Likewise, more competition in areas like peripheral care won't be welcomed by Johnson & Johnson, Boston Scientific, Bard, or Abbott. This deal may likewise prove to be disappointing to a host of small/mid-cap med-techs that could have made worthwhile additions for either Medtronic or Covidien.

All told, this may not be a good deal for the small/mid-cap space. If other companies adopt Medtronic's view that scale and scope is increasingly vital in the evolving med-tech world, larger companies may look more toward mergers of equals (or near-equals) instead of the more historically typical acquisitions of product/market-specific small companies.

This may also be a big enough tax inversion deal that it really spurs the U.S. government to tie up that loophole. If the window is closing, I could see other companies like Essilor, Coloplast, Smith & Nephew, Getinge, and bioMerieux coming into play. Japanese companies like Terumo and Olympus could also get a look, but it is relatively rare for U.S. companies to acquire Japanese companies.

The bottom line
Medtronic has done a good job of answering questions about how it would augment its growth potential and address its growing OUS cash pile. Adding Covidien brings a great business that addresses numerous large markets with growth potential from both new product introductions in developed markets and volume growth in emerging markets. Covidien also offers the potential to reduce the tax rate and achieve some significant cost reductions. 

The one downside here is on taxes. While I believe Covidien does add value to Medtronic, shareholders of both companies will incur a taxable event in this combination. Apart from that short-term pain, this is a deal with the potential to provide meaningful long-term gain to both groups of shareholders.

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