Medtronic's Deal Is About More Than Taxes

Medtronic’s proposed $42.9 billion cash and stock acquisition of Covidien may amount to a “synthetic repatriation” of funds trapped offshore, which is addressed through a relocation of corporate offices to lower tax domiciles.  However, the fundamental issues behind this move, in our opinion, are strategic and product oriented. Medtronic’s growth rate has been lackluster for some time, despite their robust R&D spend. Meaningful new products outside their core electrophysiology/stimulation technologies have been disappointing.  Despite the CEOs coming in on a theme of building the future on emerging markets, that is a long grind, and it won't be as profitable or as protected as business in developed markets like the U.S. and Europe.  

With the acquisition of Covidien’s interventional and surgical products, the combined entity becomes much more important to large medical systems.  Opportunities for facilities, sales force and administrative rationalization abound. Combine these economic factors with the cash tax benefits and now there's something to consider for fundamental investors.

Higher topline growth and profitability with the Medtronic equity multiple can create significant value.  Integration risks and increased scrutiny by tax authorities, however, do pose real risks and additional costs.  Our point is that mega-cap companies which are already paying below statutory effective tax rates have every incentive to continue leveraging this situation, but the driving force, besides cash, is the search for higher revenue growth and profits to justify maintenance or expansion of a high P/E multiple

Now, there are protests from all sides.  Covidien shareholders say the bid is too low, while Medtronic shareholders say it is too high. All this is normal, and can go away. The Obama administration is protesting: the election campaign and campaign contributions will settle this issue.

It is important to remember that shareholders always want profitable growth, and they prefer it now to later.