Heart to heart

WHEN Medtronic, a maker of stents, pacemakers and other medical devices, said on June 15th that it would buy Covidien, a competitor, for $43 billion, it gave a variety of reassurances to anxious American politicians. To be sure, the deal will let Medtronic reap the benefits of being based in Ireland for tax purposes, as Covidien already is (see article). But Medtronic is promising that its operational headquarters will stay in America and that it will invest an extra $10 billion to develop new technology there, supporting local jobs. And, beyond the tax gains, there are good business reasons for Medtronic to want to buy Covidien.

The medical-device industry has a growing number of customers, thanks to patients who are ageing (particularly in America, Europe and Japan) and newly rich (in China, for example). Yet firms also face less lucrative trends. For many years, they made small improvements to existing gadgets, then hawked their marginally better but much pricier tools to doctors. Since their customers were not particularly cost-conscious, device-makers were able to run themselves with luxurious inefficiency. As a share of sales, their selling, general and administrative costs are more than double those of a typical industrial company, according to the Boston Consulting Group.

This comfortable living is increasingly untenable. Straitened European governments are scrutinising the value of new medical products ever more closely. Even America is starting to rein in its extravagant health spending, and becoming reluctant to overpay for incremental innovation. As American hospital operators consolidate, medical-device companies can no longer woo individual doctors over filet mignon, but must present their wares to sceptical, centralised hospital bureaucracies.

Medtronic, like many other device firms, is trying to respond to these changes. Last year it announced a new business to help hospitals become more efficient—it wants them to start seeing it as an ally, not an adversary. Its collaborations include running two catheter labs for Britain’s National Health Service. Medtronic is also seeking to develop not just slightly improved products, but much better ones. Its new implanted heart monitor, about the size of a paper clip, sends a patient’s data to his doctor and nurses, so they can immediately spot problems. And Medtronic has enthusiastically chased growth in emerging markets. In 2012 it spent more than $800m buying Kanghui, a Chinese maker of replacement hips and knees.

Covidien will help it do more. As in any merger between similar firms, there will be scope for cutting overlapping costs. Their product ranges are complementary: Medtronic excels at specialist gear for cardiology, neurology and diabetes; Covidien’s strengths include tools for general surgery. In rich countries, being able to offer bundles of kit will give the group a better negotiating position with governments and hospitals. And in emerging markets, Medtronic will be able to reach a broader set of patients, notes Matthew Dodds, an analyst at Citigroup. Medtronic’s sophisticated implants are well suited to upmarket urban hospitals in China, for example. But even less advanced hospitals are likely to buy Covidien’s sutures and staples, used in all kinds of surgery.

The combined company will have annual revenues of $27 billion—about the same as the medical-device sales of the market leader, Johnson & Johnson. The deal must win the approval of shareholders and regulators. But unlike AstraZeneca, which has so far shunned Pfizer’s advances, Covidien seems to think a merger is as good an idea as Medtronic does.