By Brad Perriello and Brian Johnson
UPDATED June 16, 2014, with additional comment from Leerink Partners analyst Danielle Antalffy.
The union of Medtronic and Covidien, expected to close late this year or early in 2015, would create the world’s largest pure-play medical device company with enough scale to rival Johnson & Johnson‘s (NYSE:JNJ) medtech operation (the combined entity’s annual revenues would be about $27 billion, compared with J&J’s medtech top line of roughly $28 billion).
The merger is the 2nd mega medtech deal to be announced in the last month. Aside from its effects on Medtronic and Covidien, already 2 of the largest companies in the space, the deal radically reshapes the medical device landscape and could augur a sea change for small- and mid-cap medtech players.
The outlook for Medtronic
The strategic benefits for Medtronic and Covidien go beyond the so-called "inversion" that will nominally lower the combined company’s overall tax rate, former Medtronic CEO Bill Hawkins told MassDevice.com today. The main benefit is expected to be a surge in cash flow, as Medtronic re-incorporates in Ireland to gain access to cash generated overseas, Hawkins told us.
"It’s not a matter of reducing their tax rate. It’s more about having access to the cash they generate, to be able to fund R&D in the U.S., to pay dividends and buy back shares," he said. "The focus will be on reinvesting in innovation with the cash they generate, driving synergies to give them room for margin expansion."
"I think dividends and buybacks and organic investment will be a near-term priority, while MDT will likely turn to mid-cap M&A in the medium term," Leerink Partners analyst Danielle Antalffy told MassDevice.com via email.
The deal also adds major inroads into the hospital market, Hawkins said, which has been a focus both for Covidien CEO Jose Almeida and Medtronic chief Omar Ishrak.
"It’s a terrific strategic fit. These businesses are very complimentary. It plays to the whole notion of size and scale and ‘power alleys,’" Hawkins said. "Medtronic is well-positioned in many different areas, and this just gives them a lot more critical mass to be truly a major supplier in this consolidating healthcare landscape."
From a products standpoint, Hawkins noted that the merger strengthens Medtronic’s neuroscience unit with the addition of Covidien’s neurovascular business, an area absent from Medtronic’s portfolio. It also bolsters Medtronic’s peripheral vascular business and gives it access to general surgery, to compete against Johnson & Johnson in the minimally invasive surgery space, he said. Plus it adds an entire new vertical in respiratory, Hawlins explained.
And the Medtronic/Covidien merger gives the combined entity a huge footprint in emerging markets.
"The complementary nature of what they’re doing globally gives them critical mass in these very exciting, critical markets," Hawkins told us. "Joe Almeida is a very strong leader and is doing a nice job in building strength for Covidien in emerging markets. The combination of Covidien and Medtronic makes their emerging markets now almost a $3 billion to $4 billion business, if not more."
The outlook for the rest of medtech
The deal also reflects a new economic reality for large strategic medical device companies. In the 5 years leading up to the recession of 2008, top-line growth in the medical device industry was a robust 12%; in the 5 years after the recession, growth slowed to just 3%, according to Piper Jaffray’s Jon Salveson, vice chairman of investment banking. Hawkins said he expects the merger to drive other large companies to unite.
"This will very likely trigger further consolidation within the industry, as others seek to compete in size and scale. You now have 2 companies, Johnson & Johnson and Medtronic, that make up almost 15% of the medtech industry," he explained.
Morgan Stanley analyst David Lewis agreed, writing in a note to investors that the deal makes sense but not for traditional reasons.
"This deal could potentially be the first of many," Lewis wrote. "Structural pressures have made it more critical for device companies to use their balance sheets to achieve lower tax rates, drive cost synergies, or return greater cash to shareholders. In addition, large-cap companies may need to gain scale to compete more effectively in the future environment."
Hawkins said the outlook is different for small- and mid-cap players in the space.
"Size and scale can play in certain areas, but ultimately innovation is what wins in the medtech space. That’s what’s so special about the medtech space, is that it continues to reward real innovation, whether it’s in the form of products, or business models or payment methods. The market values innovation," he said.
Antalffy told us that the MDT/COV mega-merger likely means less M&A activity for smaller companies as the mid-caps look to gain scale in order to compete.
"I definitely think this pushes back the timeline for small-cap acquisitions. The focus seems to be on acquiring scale vs. growth in the near term," she wrote.
Layoffs in Boston, hiring in Minneapolis?
The meg-deal also means a shift in the center of gravity between 2 of the 3 main legs of the U.S medtech tripod, Boston and Minneapolis. Medtronic plans to maintain its presence in Minnesota, where it employs about 8,000 workers, and to shift Covidien’s operations there from its base in Mansfield, Mass., Ishrak told the Minneapolis Star-Tribune.
"The current operating headquarters of Covidien in Boston will, in effect, be integrated into Medtronic in Minnesota," Ishrak told the newspaper.
Anatomy of a deal
Bill George, the Harvard Business School professor who led Medtronic just prior to Hawkins, said on SquawkBox today that the buyout is "a totally friendly deal."
"Joe Almeida approached Omar Ishrak is my understanding," George said "They just fit like a glove, and it’s going to have great value for earnings per share and everything else."
Medtronic is planning to use some of the $13 billion to $14 billion it has trapped overseas to help fund the buyout, George said.
"Medtronic is planning to use Covidien to broadly expand its position, to enhance its R&D, to spend more," he said.