An employee works on the stent graft production line at the Medtronic Inc. assembly plant in Tijuana, Mexico, on Monday, Oct. 27, 2014. Minneapolis-based Medtronic Inc., the the world's biggest maker of heart rhythm devices, employs about 4,000 workers at this facility, its second-largest assembly plant. Photographer: David Maung/Bloomberg
© Bloomberg

It was the tax inversion that got away. Medtronic, one of the world’s biggest medical technology companies, has completed its $49.9bn takeover of Ireland-based Covidien, and shares in the combined company started trading on the New York Stock Exchange on Tuesday.

It is one of just a handful of deals to have survived a White House crackdown on inversions, in which companies slash their tax bills by acquiring a foreign company and redomiciling overseas. Other big transactions, most notably AbbVie’s £32bn takeover of Shire, collapsed after the US Treasury rewrote the rules.

Omar Ishrak, the Bangladesh-born chairman and chief executive of Medtronic, says that buying Covidien was as much about corporate strategy as tax: “We just followed the rules and the deal was done based on strategic merits. So that’s why it’s more resilient to some of the obvious things that the Treasury did.”

The combined company, with a market capitalisation of about $125bn, will be one of the biggest players in the fragmented “medtech” sector, manufacturing everything from standard pacemakers to precision tools and imaging devices for neurosurgeons.

While Mr Ishrak talks up the strategic merits of the deal, he acknowledges the company will get various tax benefits by inverting, shaving between 1 and 2 percentage points off its 18 per cent tax rate.

More importantly, it will provide Medtronic with much-needed cash to meet its pledge to return half of free cash flow to investors. Mr Ishrak says that, following the deal, the combined company will be able to utilise about 60 per cent of its free cash flow.

Previously, Minnesota-based Medtronic could only access about 35 per cent of its free cash flow, with the rest adding to a $14bn cash pile that is trapped overseas. If it had tried to repatriate these funds to the US, it would have had to hand about a third to the taxman, so it resorted to raising debt to fund shareholder dividends and buybacks. “Borrowing money to achieve that was not sustainable in the long term,” says Mr Ishrak.

Initially, Medtronic had intended to use its overseas cash pile to help finance the takeover of Covidien, although that plan fell foul of the US Treasury’s rule changes. Instead, in December it tapped the bond markets for $17bn — the biggest corporate debt sale of 2014 — at what Mr Oshrak describes as “a very favourable interest rate” of 3.6 per cent.

Inverting has not solved the problem of all that cash trapped overseas, however, which will remain largely inaccessible unless distant prospects for US tax reform start to improve. “Our return on investment capital gets hit by that. But at the end of the day, from an overall value creation perspective, the strength of the operational benefits . . . far outweigh that penalty,” says Mr Ishrak.

He says the trapped cash could be used to fund more acquisitions, although “deals like this don’t happen often enough for me to say there’s another 15 of them waiting around”. Before attempting any more big M&A, Mr Ishrak says the company will need to prove it can integrate Covidien.

“Our IT systems, our corporate capabilities — all will be stretched in having to do something as big as this and we need to understand for ourselves what our management bandwidth is. There’s a limit to everything,” he says.

There is also a limit to the number of smaller deals Medtronic can do, says Mr Ishraf. “To some degree we can come up with strategic development opportunities, but doing $14bn of ‘bolt-ons’ is not very viable,” he says.

As for cutting costs, Mr Ishraf identifies several areas where the company could reduce spending, including downsizing some of its corporate offices and regional headquarters. However, he is adamant that he will take a “thoughtful approach towards consolidation . . . which protects any customer-facing activity from any disruption at all.”

Mr Ishrak says the takeover of Covidien has much to offer aside from financial engineering. He singles out the development of a novel drug-coated balloon for opening up the arteries of patients with peripheral artery disease — a common condition that causes leg pain and increases the risk of heart attacks and strokes.

Both companies were working on competing balloons, but Medtronic’s device was more advanced and received approval from the US Food and Drug Administration earlier this month. Covidien had a superior distribution channel, however, and now the product will get to market more quickly, according to Mr Ishrak. The deal will also expand the company’s geographic footprint, he says.

The larger company will also have more bargaining power with hospitals and other buyers in a highly competitive industry which is dominated by smaller single-product suppliers that can use aggressive price cuts to win market share.

One of the ways Medtronic can fight back, says Mr Ishrak, is by using its much wider range of products to build tailor-made solutions for doctors and surgeons.

Ultimately, however, Mr Ishrak believes the healthcare system will move from a “fee per service” system, where Medtronic and others charge a fixed price for a product, to a “value-based” system, where medical companies are paid based on outcomes.

In the example of the drug-coated balloon, for instance, Medtronic might be reimbursed according to how many heart attacks it prevents.

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