In many respects Wednesday's announcement that Johnson & Johnson (NYSE:JNJ) was acquiring Synthes was not much of a surprise. Many analysts have gone in print with the prediction that JNJ would do deals to improve its growth prospects, and deflect attention away from management's failures, and Synthes was a very logical candidate.
In true modern JNJ fashion, though, even this straight-forward and logical deal has some lingering questions to it. The deal structure is a bit puzzling, and leads to at least two major questions: is JNJ done, and can it maintain the quality of the company it is buying?
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The Terms of the Deal
Although the movements of JNJ shares and currency could alter the final deal value, at the time of announcement, JNJ's acquisition of Synthes was a $21.3 billion deal, with a net value of $19.3 billion after stripping out Synthes' cash. At this price, JNJ is paying a bit more than four times trailing revenue (enterprise value to sales), which is arguably a slight bargain for a company of Synthes' quality and market position.
The deal terms call for JNJ to pay a total of 159CHF per share, with approximately one-third of that in cash and the remainder in JNJ stock. The stock component will be collared, though, between 1.71 and 1.97 shares. This structure does leave some risk for Synthes shareholders as JNJ's stock could slide or currency could move against them. (For more, see Mergers And Acquisitions: Understanding Takeovers.)
What JNJ is Getting
Unlike the informal interest JNJ had in Smith & Nephew (NYSE:SNN), this deal for Synthes really strengthens JNJ's orthopedic franchise. Synthes is far and away the number one player in trauma, with nearly 50% share, and JNJ is insignificant here. Synethes is also a significant player in spinal care, and this combination will essentially double JNJ's share.
Assuming the deal is done with no antitrust problems, JNJ will be far ahead of Smith & Nephew and Stryker (NYSE:SYK) in trauma (a relatively attractive market within ortho) and a major player alongside Medtronic (NYSE:MDT) in spine. At least in theory, JNJ is taking a major step into the growth areas of orthopedics, though it should be noted that growth in spine has been decelerating.
A Curious Deal Structure
JNJ has a very large amount of overseas cash that cannot be repatriated without significant taxation. This has been one of my leading theses on why JNJ would be interested in an overseas deal, but this transaction does not necessarily solve that problem. Because the share component of this deal is so large, JNJ is going to see dilution in 2012 (more cash would have meant accretion), and there's still a question of what to do with the cash. (For more, see Prescribing Healthcare Stocks For Your Portfolio.)
Perhaps JNJ will use its cash to offset the dilution from the Synthes deal. Or maybe JNJ is pondering further deals. This $21 billion deal for Synthes is a large move (almost the same value as Stryker today), but its not prohibitive to further deals. JNJ's pharma business is looking better with drugs like Stelara and telaprevir, so this may not be the area of focus unless the company wants to expand into generics (say, a deal for Dr. Reddy's (NYSE:RDY)). Other interesting overseas targets could include Cochlear, bioMerieux, or perhaps even Hypermarcas.
The Bottom Line
Synthes is a good company, and it could certainly benefit JNJ shareholders to have this asset in the fold. The question, though, is whether JNJ's management team is up to the job - there is a recent track record here of buying assets and then failing to make the most of them. Likewise, the nature of the deal is going to lead to more questions about just what management has in mind for the near future and whether an additional deal is on the way.
In the wake of this move, life just got harder for companies like Medtronic, Stryker and NuVasive (Nasdaq:NUVA), and perhaps NuVasive becomes a target for a company interested in bulking up a bit in spine. Stryker still seems like the better bargain in this space today; JNJ is certainly undervalued relative to the potential of the business, but current management has a long way to go in convincing me that they are capable of realizing that potential. (For more, see Strykers's In The Right Medical Space.)
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