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Source: Covidien

Medtronic's acquisition of Covidien this January was the largest in the history of the medical device industry. It combines the resources and products of the largest medical device player in the world (Medtronic) with that of another company with significant reach inside operating rooms all over the world.

Given the changing dynamics of the $110 billion medical device industry, an acquisition by Medtronic was inevitable. The introduction of President Barack Obama's health care law in 2012 was a big game-changer in the health care industry. All players in the industry, from payers to medical professionals and establishment, have been scrambling to reinvent their businesses based on stipulations defined within the law. With its phalanx of rules and emphasis on accountability, the law has opened new markets to players in the health care industry and redefined rules for existing ones.

More importantly, it changes the industry's economics. The traditional fee-for-service model has been replaced with a value-based approach that measures patient outcomes to determine treatment costs. That changed approach can have a radical effect on medical device economics.

This is because medical devices, so far, were sold like typical consumer products with a fixed cost and maintenance and services contract. To recoup investment costs, medical professionals and institutions adopted a volume-based model for patient visits. Thus, the greater the number of patient visits (and, consequently, use of the medical device), the more the investment that was recouped.

But value-based health care penalizes readmission visits and lays emphasis on data transparency from medical devices. (Patients cannot access critical data related to their treatments currently.) Thus, medical device costs have become part of the patient outcome value-chain process.

To be sure, medical technology has always been a major contributor to health care expenses. In fact, recent research claims that medical technology is the dominant driver of rising health care costs. As such, the medical device industry will have to bear a major portion of costs as health care becomes more affordable. A report released by A.T. Kearney last year identified five new trends for the health care industry. Among these trends are power shifts to payers (health care insurance companies) and providers (establishments and cooperatives that provide health care services) and new health care delivery models with extended reach at home and outside. Medtronic's acquisition of Covidien makes sense when it is analyzed through the prism of these points.

The power shift to payers and providers has huge implications for the medical device industry because it places the onus of critical product decisions with these stakeholders. Because they are penalized for readmissions, providers will ideally look for products that provide maximum value at affordable costs. Part of this equation involves a product value chain that extends care beyond hospitals to ensure that readmission rates are minimal. Medtronic's acquisition of Covidien provides the former with access to a broad array of the latter company's products, which are used inside a surgical theater. This is especially helpful for Medtronic because it manufactures products, such as pacemakers, that are especially helpful to patients at home. Covidien's products enable the company to extend the value chain of its products inside a hospital.

While commenting on the acquisition, an analyst likened Medtronic's product mix after the acquisition to a "whole buffet." That product buffet will be especially helpful in developing an end-to-end services model. In fact, Ishrak is already putting the necessary elements in place with his "supply-and-service" model for medical establishments. This model envisages a business relationship where Medtronic charges medical establishment on the basis of services instead of products. Thus, the medical device company will finance and operate labs, in return for a fixed per-patient fee from medical establishments as well as usage of Medtronic's medical devices. The new model is interesting because it diversifies revenue mix for Medtronic and moves the company's focus away from products to services.

Indirectly related to the success rate is the reduced tax rate that will be available to the merged entity as a result of relocation to Ireland, which has a 12.5% corporate tax rate. Relocation of headquarters also enables the merged entity to creatively structure its finances to avoid additional tax on its income and move cash across geographies with minimal tax liabilities. All of this bodes well for the entity's operations in the United States. It is good for the company's stock price as Wall Street is obsessively focused on immediate bottom-lines. More importantly, it gives the company more cash to invest in cutting-edge technology and startups that may, eventually, drive down costs. Simultaneously, the merged entity can use the additional cash to expand its operational base to underserved communities here.