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Medical Device ETF in Focus as Medtronic Buys Covidien

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The second largest U.S. medical device manufacturer Medtronic (MDT - Free Report) agreed to buy Irish rival Covidien for $42.9 billion in cash and stock in order to cut corporate tax rates. This is because the business tax rate in Ireland is just 12.5%, much lower than that of 35% in the U.S., which is considered the highest tax rate in the world.

As per the terms of the deal, Medtronic will pay $93.22 per share to Covidien shareholders, representing 29% premium on Covidien's stock price as of Friday. The agreement marks the largest deal in the healthcare sector so far this year (see: all the Healthcare ETFs here).

The acquisition, expected to close in the fourth quarter of this year or early 2015, will likely result in annual pre-tax cost synergies of at least $850 million by the end of fiscal 2018. After the completion, business of both companies will be combined to form Medtronic plc. The move will allow Medtronic to take advantage of the so-called ‘tax inversion’ by moving its headquarters to Ireland, which has low tax rates.

While the merger will help Medtronic to reduce its global tax burden by gaining access to almost $14 billion in cash overseas, it would also broaden the company’s scope beyond its array of heart devices, spinal implants, insulin pumps and other products into new areas ranging from surgical staplers to ventilators (read: Medical Device ETF Investing 101).

The merged company will become one of the largest providers of medical devices in the industry with 87,000 employees in over 150 countries. The combination would generate about $27 billion in total revenue, including $3.7 billion from emerging markets, and is expected to be accretive to cash earnings in 2016 and beyond. Further, the combined company would be in a better position to compete with the medical devices’ industry leader Johnson & Johnson (JNJ).

Given that the deal was announced in the weekend, these two stocks and the medical device ETFs are in focus. Both stocks have the potential to ride higher on merger synergies in the days ahead and look to fuel a rally in iShares U.S. Medical Devices ETF ((IHI - Free Report) ).

IHI in Focus

This ETF provides targeted exposure to U.S. medical device stocks by tracking the Dow Jones U.S. Select Medical Equipment Index. The fund holds about 49 securities in its basket and charges 46 bps in fees per year. Medtronic takes the second spot at 10.94% of assets while Covidien makes up for the fifth position in the basket with 6.45% share (read: Medtronic Earnings Drags Medical Device ETF Lower).

The product has a definite tilt toward large cap securities with 72% of assets, followed by 17% in mid caps and the rest in small caps. From a sector look, about one-fourth of the portfolio is allocated to medical equipment while medical supplies and pharmaceuticals take the remainder. In terms of style, the ETF is nicely spread across a variety of growth, value and blend stocks.

IHI is less popular and less liquid in the healthcare space, with AUM of $696.2 million and average daily volume of around 102,000 shares a day. The fund has added 6.3% so far this year, lagging the broad healthcare fund (XLV - Free Report) , which has returned nearly 8% this year.  The fund currently has a Zacks ETF Rank of 3 or ‘Hold’ rating with Medium risk outlook, suggesting room for upside.

Bottom Line

Lately, ‘tax inversion’ is gaining popularity. Such deals have raised concerns among U.S. lawmakers as these would erode government revenues by giving corporates a way to evade tax. A similar move was attempted by the U.S. largest drug maker Pfizer (PFE) to acquire the second-largest British drug maker AstraZeneca (AZN) for $120 billion. The deal however failed (read: Deal ETFs in Focus on Flurry of M&A Activity).

Given the slew of M&A activities and changing dynamics of the healthcare industry, investors seeking to tap the latent opportunity could invest in this medical device ETF.

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