Seeking Alpha: Medtronic – Ultimate Success Of Covidien Acquisition Relies On Still Unknown Revenue Synergies

From Seeking Alpha, June 16, 2014


On Sunday Medtronic (MDT) announced that it will acquire Covidien PLC in an attempt to create a huge global medical device supplier.

Medtronic is paying a relatively steep premium to acquire Covidien which cannot be entirely rationalized by cost savings, as tax synergies will be limited despite the “inversion” move to Ireland.

The ultimate success of the deal depends on the size of revenue synergies, something which the company has not yet elaborated on.

The Deal Highlights

Medtronic announced that it has reached a definitive agreement to acquire Covidien PLC (COV) in a $42.9 billion deal.

Shareholders in Covidien will receive $35.19 in cash and 0.956 shares of Medtronic for each share they are currently holding. This values the company at $93.22 per share, a 29% premium compared to Friday’s closing levels. Shareholders of Covidien will hold some 30% of the outstanding shares of Medtronic following the deal closure.

The board of directors of both companies have already approved the deal which is expected to close in the fourth quarter of this year, or in the first quarter of 2015.

Strategic Rationale

The new combination will even have a more comprehensive product portfolio, reach and opportunities to grow. The pro-forma business employs some 87,000 employees in some 150 countries.

Underlying the deal rationale are three fundamental reasons. Medtronic will gain many more innovative capabilities given the impressive portfolio of leading products in Covidien’s pipeline.

The strong foreign exposure, even into emerging markets, brings a lot of global reach thanks to Covidien’s operations. And finally are the revenue and cost synergies, allowing the new combination to package therapies and solutions throughout the healthcare system.

Financial Implications

The deal includes the famous “inversion” with regards to Medtronic’s tax structure, which results in Medtronic becoming domiciled in Ireland for obvious tax reasons. The company’s real operational headquarter remains in Minneapolis were Medtronic is currently employing 8,000 workers.

Medtronic estimates that the deal is accretive to cash earnings by 2016, the first full fiscal year after the anticipated closure of the deal. The transaction is seen accretive to GAAP earnings by 2018. By that year, the deal should result in $850 million in pre-tax cost synergies. Note that this estimate excludes any revenue synergies which are likely to be achieved.

Pro-Forma Calculations

For the fiscal year ending on April of 2014, Medtronic posted revenues of $17.0 billion, which up 2.5% on the year before. The company posted an 11.6% drop in earnings to $3.06 billion.

Medtronic held a strong balance sheet with $14.2 billion in cash and $11.9 billion in debt, resulting in a modest net cash position of $2.3 billion. The cash component of the deal calls for $15.9 billion in cash being transferred to Covidien’s shareholders. This most likely requires still a significant bridge financing or credit line to be arranged despite the large cash balances.

Given that Covidien holds $1.2 billion in cash and $5.0 billion in debt, the pro-forma business will operate with roughly $17 billion in net debt. The company posted revenues of $10.2 billion for its most recent fiscal year, which is up 3.9% on the year before. Earnings fell by 10.8% to $1.70 billion.

The number of outstanding shares of Medtronic will increase from roughly 1.00 billion to 1.43 billion shares following closure of the deal based on these terms. Based on Friday’s closing price, Medtronic’s equity will be valued around $87 billion. However shares of Medtronic have risen to $66 in early trading on Monday, boosting the valuation to $94 billion.

The new pro-forma combination will have revenues of around $27 billion and post earnings of close to $4.8 billion. This values the new pro-forma equity at 3.4 times annual revenues and 19-20 times annual earnings. The company anticipates $850 million in pre-tax synergies, or roughly $743 million after tax. This increases earnings towards $5.5 billion, valuing the business at 17 times pro-forma earnings on the back of the anticipated synergies.

Note that potential tax savings might be minimal. Covidien paid an effective tax rate of 16.2% over its past fiscal year, while Medtronic had an effective tax rate of 17.3% last year. This is barely above the statutory tax rates of 12.5% for Irish-based companies.

Continued Commitment To The US

The move by Medtronic to “move” into Ireland might be politically sensitive, something which the company appears to realize as it attached a dedicated segment in the press release “demonstrating the commitment to the US.”

Medtronic believes medical devices are among the US’s most valuable exports and it stresses the commitment to R&D within the country.

The company will commit $10 billion in technology investments in the coming decade in areas like early stage venture capital, R&D and acquisitions in the US on top of its existing plans.

Takeaway For Investors

The $93.22 offer implies a roughly $9.5 billion dollar premium which Medtronic is offering for Covidien, little over 11 times anticipated annual pre-tax synergies. Given the run-up in Medtronic’s shares in early trading, this premium has increased a bit more.

Note that the deal allows Medtronic to use its overseas cash without repatriating it, thereby avoiding billions in taxes to be paid if it wished to bring the cash home.

The new giant is also a more formidable competitor for Johnson & Johnson (JNJ) and to the healthcare system at large. As hospitals and medical centers are concentrating their purchases, being a more formidable supplier in the area is key in terms of product offerings as well as pricing power.

Medtronic will gain expertise beyond its current offerings like heart devices, spinal implants and insulin pumps to new areas like weight-loss surgery.

The rationale for the deal is expected to be driven by real cost synergies as anticipated tax synergies will be very limited despite the inversion move. The $850 million in pre-tax synergies are huge in absolute terms but don’t forget that Medtronic is offering nearly a ten billion dollar premium to get its hands on Covidien. Shareholders in Covidien will furthermore hold nearly a third of the equity in Medtronic, being able to participate in the expected synergies.

The success of the deal will largely depend on anticipated revenue synergies which are not specified and hard to estimate. Note that Medtronic paid a $9.5 billion premium for Covidien based on Friday’s prices and that its own shares trade some 9% higher in pre-market trading, thereby adding another $7.5 billion in equity value. As such an incremental $17 billion in value for Medtronic seems a bit steep based on the facts as outlined currently.

Therefore I am not convinced about the deal rationale for the moment, and will hold off making an investment on the back of the deal unless more gets announced regarding the size of potential revenue synergies.