Covidien Inversion Deal Under Scrutiny by Options TradersOliver Renick
Speculation Medtronic Inc. will modify its offer for Covidien Plc as sentiment worsens toward tax inversions is fueling demand for bearish options.
Covidien contracts betting on declines in the Dublin-based hospital products company are among the most expensive in the Standard & Poor’s 500 Index, according to data compiled by Bloomberg on a measure of options costs known as skew. Medtronic, the Minneapolis-based device maker, said in June it will pay about $42.9 billion for Covidien in a tactic partly aimed at freeing $14 billion of overseas cash.
Now investors are concerned the deal’s terms will change after Walgreen Co. last week turned away from a tax inversion strategy in its acquisition of Zug, Switzerland-based drugstore chain Alliance Boots GmbH. Traders trying to profit from takeovers lost more than $20 billion on Aug. 6 as 21st Century Fox Inc. dropped its bid for Time Warner Inc., Sprint Corp. ended its pursuit of T-Mobile US Inc. and Walgreen shares slumped.
“After Walgreen, there is more risk around inversions,” Jim Strugger, a derivatives strategist at Stamford, Connecticut-based MKM Holdings LLC, said via phone. “Also, after what happened with Time Warner and Sprint, you put those two elements together and there’s likely to be more demand to add protection in deals.”
Gary Ellis, Medtronic’s chief financial officer, said in June that while the company plans to buy Covidien with or without the inversion, it would reassess the decision if the laws changed. Covidien shares closed at $87.11 in New York, almost 9 percent below the current value of Medtronic’s $95.66 offer.
The current spread implies a 64 percent chance the deal will be completed, according to a formula calculated by Bloomberg that tracks the target’s price relative to the offer.
Fernando Vivanco, a spokesman for Medtronic, declined to comment, as did Peter Lucht, a spokesman for Covidien.
“Our expectation is that the transaction will close as planned,” Lucht said in an e-mail.
Tax inversions entered the spotlight in July as President Barack Obama urged Congress to act against companies using cross-border mergers to escape U.S. taxes. On Aug. 5, U.S. Treasury Secretary Jacob J. Lew said the department was exploring options on limiting the practice.
In an inversion, a U.S.-based company shifts its legal address outside the U.S. to lower its corporate income tax bill, typically by buying a smaller foreign business. The deals, which are legal, allow companies to make use of the profits it records in some foreign subsidiaries without first having to pay U.S. income tax.
While the Covidien deal is attractive because of the tax advantages Medtronic will gain by changing its legal residence, it’s part of a bigger strategy aimed at breaking loose from its historic dependence on heart pacemakers and defibrillators, Medtronic Chief Executive Officer Omar Ishrak said in June. Covidien shares are up 28 percent this year.
Demand for bearish contracts isn’t surprising following a string of abandoned or altered deals this month, said Jim Smith, an options strategist at OTR Global Trading LLC. Walgreen shares have dropped 9.9 percent since announcing its headquarters would stay in Chicago.
The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 options prices known as the VIX, jumped 5.9 percent to 13.15.
Puts betting on a 10 percent drop in Covidien cost 11.9 points more than calls betting on a similar gain, according to data on three-month contracts compiled by Bloomberg. The price relationship called skew was 7.8 points on Aug. 5, the day before Walgreen’s statement.
There are 1.3 puts outstanding for each call on Covidien, compared with a ratio of 0.55 on June 2, data compiled by Bloomberg show.
“This is related to the inversion, get burned twice and you may look stupid,” Smith said in a phone interview from Purchase, New York. “Merger arbitrage guys have to keep that in the front of their mind in this case.”
The deal, which Medtronic estimated will be complete by early 2015, is likely to go through regardless of the policy on inversions, according to Jason Wittes, an analyst at Brean Capital LLC. Medtronic has agreed to pay Covidien a breakup fee of $850 million if the transaction is abandoned.
“Medtronic certainly has the wherewithal to pay that, but I still anticipate this deal closing,” Wittes said in a phone interview from New York. “It will be a little more challenging if regulations change, but my sense is this is still going to happen.”
While the deal won’t lower Medtronic’s tax rate significantly, the inversion gives greater flexibility in using its cash, according to Michael Matson, an analyst at Needham & Co. Covidien’s tax rate is about 17 percent, while Medtronic’s is 19 percent, he said in a July 24 report.
While Democrats and Republicans have criticized the practice, each party has a different approach to solving it. Republicans want to lower the corporate tax rate -- now set at 35 percent -- as part of a broad revamp of the U.S. tax code. The U.S. has the highest rate in the developed world.
Democrats are pushing a more targeted approach to make it effectively impossible for U.S. companies to buy smaller foreign businesses and take their addresses for tax purposes.
“One concern is that Medtronic will walk away and not do the transaction if inversion legislation goes through,” Joanne Wuensch, a managing director at BMO Capital Markets Corp. in New York, said by phone. “The other is that, if the transaction goes through, it may be in a form that’s not as economic or appreciative.”