The $43 billion Medtronic (MDT) and Covidien (COV) deal announced on June 15th raised a lot of hoopla from investors. Both companies have exceeded earnings estimates in Q1 2014 and the combined company is expected to become the global market leader in the cardiovascular and vascular markets with $27 billion in combined revenues.
MDT is the fourth largest medical devices manufacturer in the world, behind Johnson & Johnson, Siemens, and GE. Their three product lines are:
- Cardiac and Vascular, comprising 52% of sales,
- Restorative Therapies, comprising 38% of sales, and
- Diabetes, comprising 10% of sales
Customers include hospitals, clinics, healthcare providers, and government institutions. Organic growth in the past has been slow, forcing MDT to grow through acquisitions. Over the past 3 years, MDT has made 5 acquisitions, excluding COV, in the areas of orthopedics, advanced surgical equipment, diabetes, vascular diseases, and antibiotic drugs. These acquisitions helped MDT penetrate global markets and expand its product portfolio. Over the past year, MDT’s stock price elevated by 20%, driven in large part by their strong and consistent financial performance. Sales growth expanded in non-US countries by 2% over the prior fiscal year, and is projected to continue to increase as MDT acquires more clients internationally.
Recently, Medtronic beat earnings estimates by 6.75% lead by growth in sales of diabetic equipment. Key highlights from the Earnings Report are as follows:
- Q4 2014 EPS of $1.10 surpassed analyst estimate consensus by 7 cents and exhibited a YoY growth of nearly 7%
- EBIT margins were 24.02% and EBITDA margins were 29.01% and are consistent with the previous 3 years
- Free cash flow growth was recorded at 3.1% YoY
Market IQ currently places MDT in the top right quadrant of the Quality/Value chart indicating high Quality and investment Value. The company’s high value with respect to industry competitors can be seen in areas such as price-to-earnings, price-to-book, and price-to-free cash flows.
- MDT’s current P/E of 21x sits below the industry average of 29x and historically MDT has traded at a P/E of approximately 17x
- When accounting for OUS cash flows, MDT currently trades at a P/FCF of 52x, well below the industry average of 171x
- Additionally, MDT returns value to shareholders by using cash flows to pay dividends, with a dividend yield of 1.78%, 60bps higher than its peer group
Based on Market IQ’s Valuation metrics, MDT is inexpensively priced (See below)
The Company’s Qualitative strengths can be seen in the following areas:
- MDT has a debt-to-total asset ratio of 34% signalling a high capacity to take on debt if needed
- MDT’s gross margins sit around 77%, compared to 67% for the industry average including 59% for COV
- MDT’s net income margin of 18% is 4% higher than the industry average. Over the past three years, MDT was able to maintain a high profit from operations margin of above 20%
The Bull Case: OUS Cash Flows
Outside the U.S. (OUS) sales in FY 2014 amounted to $7.8 billion USD and $1.8 billion in cash flows which would have been taxed at the corporate tax rate of 35% if the money was brought back into the US . By reallocating to Ireland through the COV acquisition, MDT could unlock that overseas cash for R&D, capital expenditures, and acquisitions. Furthermore MDT’s effective tax rate will decrease by 100-200 bps. By pooling the market positions of COV and MDT, the resulting company will have number one positions in the majority of the vascular and cardiovascular market. MDT is using the cash flows opened by the merger to fund the acquisition so minimal cost cutting measures need to be implemented.
As seen in the graph below, The combined company will hold close to 25% market share in cardiovascular and vascular medical equipment, posing a real threat to Johnson & Johnson.
Using OUS cash flows also ensures that there will be no decline in R&D expenditure, which has been put to great use lately. MDT has recently reported the OpT2mise trial results, which showed that MDT MiniMed insulin pumps are better at glucose control than insulin injections, marking a breakthrough in the diabetic market. 20 million people worldwide currently face the problem of insulin replacement therapy. This puts MDT in strong position to becoming the top producer of medical equipment in multiple areas.
The Bear Case: Government Intervention
Government intervention poses another risk for the long term sustainability of moving headquarters overseas. Tax avoidance could cost the US government $17 B over the next decade. Furthermore, cash trapped overseas by multinational US companies not wishing to pay the 35% tax has accumulated to $1trn. Obviously the government realizes this and may take measures to restrict companies from with offices still in the US or incentivize companies to come back. If the trend of moving overseas through acquisitions continues, which seems eminent , the government will no doubt step in very soon. In a letter to lawmakers on tax policies in Congress, the Secretary of Treasury Jack Lew addressed the issue of tax inversion and is making a push towards changing the tax laws.
The COV - MDT deal has been one of the warmly received deals this year. Investors see this deal as a win-win from both sides due to the strategic fit and the cash flows that MDT is able to free up. While this acquisition could see potential upside, Investors should still be weary of the uncertainties that both companies face. How will the new company better meet consumer needs and whether revenue synergies will be realized will ultimately dictate the success of the acquisition.