Why Covidien Stock Is Still Undervalued Despite the Medtronic Deal

NEW YORK (TheStreet) – You don't need me to tell you there's value in Covidien (COV). Just ask the management at Medtronic (MDT), which recently agreed to buy Covidien for $42.9 billion.

At a 29% premium to Covidien's prior closing price, the company's investors became wealthier overnight. The stock closed Wednesday at $89.29. Shares are up 32% on the year to date, outperforming the health care sector's 13% gain. But it's not time to get complacent.

Instead of thanking Medtronic, try to understand the nature of its proposed offer. You will find that Covidien is still undervalued by 8%. From my calculations, the stock is worth at least $97 per share. The company reports fiscal third-quarter results Friday.

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Prior to the announced deal, Covidien shares traded at around $72, as of the June 13 closing price. Medtronic made its move on June 15. On June 16, Covidien shares soared to an intraday high to $92.68 and closed at $86.75.

Over the past month, the stock has traded in a tight range between $88 and $91. This is because investors have not factored the implied value of Covidien based on Medtronic's offer.

First, the deal, which will be financed with $35.19 billion in cash and stock, values Covidien at $93.22 per share. This means Covidien is already discounted 4.4% based on Wednesday's closing price. That's money left on the table.

Second, the stock swap calls for Covidien investors to receive 0.956 shares of Medtronic for each Covidien shares they own. So, with Medtronic shares closing Wednesday at $63.37, this means an additional 4% discount has been added to the overall purchase price of Covidien.

The way I see it, there is a combined 8.4% premium that belongs to Covidien shares. Assuming that the deal closes by early 2015, investors who are willing to capitalize on the market's mistake will begin 2015 with potentially 10% to 12% annualized gains based on $4.45 earnings estimates.

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