Covidien's Still Hungry

By Stephen D. Simpson, CFA | June 17, 2010 AAA

Nobody is going to accuse the management at Covidien (NYSE:COV), a diversified medical technology company, of being slow to make any changes. It was only two weeks ago that the company announced that it was entering the peripheral and neurovascular intervention markets by buying ev3 and largely exiting parts of the respiratory care market with a divestiture.

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Now the company is at it again, announcing Wednesday morning that it was acquiring small medical device maker Somanetics (Nasdaq:SMTS) for almost $300 million in cash. That deal represents a 32% premium to the closing price prior to the deal, and a valuation of nearly six times on a trailing price-to-sales basis. Given that growing small-cap medical technology companies generally trade for between four and six times trailing sales and get bought out at between five and eight times, this seems to be a fair deal for both parties. (For more on this topic, check out The Wacky World Of Mergers And Acquisitions.)

Not an Unfamiliar Business
Though mergers and acquisitions always carry certain risks, this deal appears relatively safe for Covidien. First of all, Covidien has been distributing Somanetics' products in Europe for some time now and has been a significant part of sales along with Edwards Lifesciences (NYSE:EW), which distributes product into Japan.

Second, Somanetics' core products and technologies, non-invasive blood oxygen measurement in the brain, is a logical fit for Covidien's Nellcor patient monitoring business. This deal should enable Covidien to package together more appealing total solutions (and harness technology into new applications) to compete with the likes of Masimo (Nasdaq:MASI) and Philips in the patient monitoring market.

Who Is Next?
With a cash outlay of $3 billion in June alone, Covidien is probably going to be done with sizable acquisitions for a little while. While some targets may accept Covidien stock, and the company could probably issue even more debt to facilitate a cash deal, affordability is not the only issue - Covidien management has to integrate both ev3 and Somanetics and that should be more than enough to keep management busy.

That said, just because Covidien may finally be satiated, that does not mean that other companies will not step up and do deals. M&A is a common and accepted means of growth in the medical technology space and that is unlikely to change. (For more, see A Checklist For Successful Medical Technology Investment.)

To that end, it wouldn't be surprising to see ZOLL Medical (Nasdaq:ZOLL), Immucor (Nasdaq:BLUD) or Volcano (Nasdaq:VOLC) get bids at some point. A detailed rundown of the buyout prospects for these companies is probably another piece in its own right, but suffice it to say that each of them has a leadership position in a growing market where larger rivals have dropped the ball and allowed themselves to get beaten on the basis of technology and product development.

The Bottom Line
Buying any stock solely out of expectations of M&A activity is a bad idea, even in a sector like medical technology where such activity is commonplace. Nevertheless, there is nothing wrong with identifying those companies where a buyout would make a certain amount of sense and present some downside protection.

Look, then, for companies with characteristics similar to Somanetics; companies with real products on the market, good growth (in the teens, at least), minimal or disorganized competition, and a technological edge. Not surprisingly, those are also the common traits of successful medical technology companies, so if stick to identifying small quality growth names with differentiated products, you will do well whether or not the company stays independent. (For related reading, see Investing In Medical Equipment Companies.)

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