Medtronic–Covidien Merger: Deal Analysis and Synergies

Background and Strategic Rationale

In June 2014, Medtronic — the world's second-largest maker of medical devices — agreed to buy Covidien, a smaller company in the same industry. The deal was valued at $42.9 billion and was structured as a cash-and-stock transaction. It was executed at a 29% premium over Covidien's June 13, 2014 closing price. Medtronic's CEO described the deal as a "strategic and operational alignment," and there were immediate benefits anticipated from relocating the combined company's headquarters to Dublin, Ireland — Covidien's base of operations (Cortez & Welch, 2014). The company disputed the tax argument, noting that it did not believe its 18% effective tax rate would change significantly with the move (Kelly & Roumeliotis, 2014). The core value driver cited was an expected $850 million in annual savings projected to accrue from synergies in back-office operations, supply chain, distribution, and manufacturing (Cortez & Welch, 2014).

Medtronic was founded in Minneapolis in 1949 and built a medical equipment business spanning the globe. It was the second-largest supplier in the industry, after Johnson & Johnson, and remained in that position following the merger. Medtronic's initial breakthrough came with the development of a battery-powered pacemaker, and the company eventually began investing heavily in research and development in order to succeed as an innovator in the industry.

Covidien's history dates to 1903, though the modern company was formed in 2007 when it was spun off from Tyco. Covidien was Ireland's largest business, with a global presence and over 39,000 employees. The company had a market capitalization of just $18.4 billion before the merger (Coyle, 2014). Having been spun off from an American parent, Covidien was trading on the NYSE at the time of the acquisition.

Both companies sold medical devices, making this a merger of two direct competitors — albeit ones with arguably complementary product lines. The medical devices industry is comprised mainly of large, global players. Depending on the country, these firms either self-distribute or work through wholesalers, servicing a variety of hospitals, medical clinics, and physicians' offices. Products in this industry range from commodities — standard goods with little differentiation — to highly innovative products. The latter category typically carries some form of patent protection, though this varies by country. Companies that pursue an innovation strategy compete on both marketing and R&D spending. The largest markets for medical devices are in the developed world, where healthcare spending per capita is much higher and demand for high-end devices is correspondingly greater. Because there are hundreds of thousands of different medical devices and supplies, the industry can be fragmented depending on the product category. Major players produce thousands of unique products and work through wholesalers to reach specific target markets.

Synergy in this industry takes several forms. First, it can manifest in the product mix: redundant products can be eliminated and the remaining one produced at greater scale. Alternatively, the product mix of two firms may be complementary, generating marketing and distribution synergies. There are also patent synergies. Much of the value of medical equipment companies — especially those with an R&D focus — lies in their intellectual property. By pooling resources, laboratories, researchers, and patents, there is greater potential for developing innovative new products. While new products represent an unknown in terms of commercial success, the potential for R&D synergies is real. Marketing and production economies of scale, as well as administrative consolidation, are additional areas where synergies can be achieved.

The tax dimension is a subject of debate but forms an important backdrop to this merger. At the time of the deal, US corporate taxes were widely perceived as uncompetitive, as other countries had been simplifying their tax codes and cutting corporate rates to attract global businesses. Coyle (2014) argues that Medtronic would be able to park $13 billion in cash in Ireland without paying US tax — a significant savings, though this interpretation was disputed by Medtronic's CEO, who was clearly mindful of the political ramifications. Two months after this deal, another high-profile corporate tax inversion was completed when Burger King acquired Tim Hortons and relocated its headquarters to Canada (Rocha & Ho, 2014). Such deals were becoming increasingly common and generated considerable political controversy in the United States.

Industry Analysis

The medical equipment industry was growing at the time of the merger, driven by aging populations in Western markets and rising wealth in emerging markets that was expanding demand for healthcare services. In 2014, Medtronic ranked as the third-largest firm in the industry with revenue of $17.1 billion, just behind General Electric and well behind Johnson & Johnson. Covidien ranked tenth, with revenue of $10.4 billion. The combined entity would generate approximately $27.5 billion in revenue, compared to Johnson & Johnson's $28.7 billion. The industry is highly fragmented, with forty companies reporting $2 billion or more in annual revenue. Some companies were specialists in a particular equipment type — Fresenius, for example, generated $15.2 billion in dialysis products — while many others operated as divisions within larger conglomerates. The competitive landscape ranged from industrial products firms (Toshiba, Siemens, Philips) to pharmaceutical companies (Novartis, Bayer, Abbott Laboratories) (MDDI, 2014). While no single company competes across all product categories, most categories feature multiple competitors.

The top firms in the industry maintain an R&D focus as a primary source of competitive advantage. To encourage investment, regulators in some markets provide patent protection and temporary monopolies on new equipment, making R&D a viable long-term strategy. Many firms within the industry had similar R&D capabilities and accessed the same distribution channels to reach the same customers. Sales teams therefore focused on influencing end buyers directly as a means of building product preference. This is one of the areas where merger synergies are most readily available, particularly at the sales force level.

The industry was showing signs of slowing growth at the time of the deal, which had spurred calls for increased consolidation. Merger and acquisition activity was seen as a way to extract value in slow-growth conditions. This consolidation was making the industry more concentrated: 69% of segments had the top five firms accounting for more than 75% of the market, up from 44% in 2004 (Cha, Copp & Pellumbi, 2014). The companies at the top of the industry in 2013 were largely the same as those that had led in 1999, but most had relied on mergers and acquisitions to maintain their market positions (Ibid). In that respect, the Medtronic–Covidien deal was a continuation of a well-established industry trend, with dozens of major deals completed each year among the leading players.

Conclusion

The Medtronic purchase of Covidien, announced in 2014 and finalized in January 2015, is a notable deal for several reasons. First, Covidien was in healthy financial condition and did not look like a typical takeover target. Medtronic therefore had to pay a significant premium — 29% at announcement, rising to approximately 50% by close — to complete the acquisition. For Covidien shareholders, the deal was clearly advantageous. The second noteworthy aspect is the uncertainty surrounding whether the projected synergies are sufficient to justify the premium. Some synergies are evident, but an annual savings of $850 million, discounted at 12% over ten years, delivers a present value of approximately $4.8 billion — considerably less than the premium of over $9 billion paid at the time the deal was originally announced.