Here are the numbers from the press release:
“Johnson & Johnson will acquire Synthes for CHF159 per share, or $21.3 billion. Upon completion of this transaction, Synthes and the DePuy Companies of Johnson & Johnson together will comprise the largest business within the Medical Devices and Diagnostics segment of Johnson & Johnson.
Under the terms of the agreement, each share of Synthes common stock, subject to certain conditions, will be exchanged for CHF55.65 in cash and CHF103.35 in Johnson & Johnson common stock. The transaction has an estimated net acquisition cost of $19.3 billion as of the close of business on April 26, 2011, based on Synthes approximately 119.5 million fully diluted shares outstanding and approximately $2 billion in cash on hand as of signing.
Under the terms of the agreement, each share of Synthes common stock will be exchanged for CHF55.65 in cash and CHF103.35 in Johnson & Johnson common stock, provided the volume weighted average Johnson & Johnson common stock price, as calculated in CHF, is between CHF52.54 and CHF60.45 [roughly $60-69 USD] during the 10-day trading period ending on and including the trading day that is two trading days prior to the transaction closing (calculation based on World Market Fix rate for each of the trading days in the 10-day trading period). Each Synthes share exchanged would be converted into CHF55.65 in cash, plus not more than 1.9672 and not fewer than 1.7098 shares of Johnson & Johnson common stock.”
First off, let’s look at Synthes: revenue rose nearly 9% in 2010 to $3.87 billion, and net income increased 10% to $908 million; on a simple P/E basis, Johnson & Johnson paid 21.26x 2010 earnings (off the $19.3 billion number, which includes the $2 billion cash/equivalents/marketable securities Synthes holds). From 2006-2010, revenues and free cash flow increased 11.43% and 21.92% per annum, respectively, strong numbers that make the P/E look reasonable, especially for an acquisition (where executives freely spend shareholders' money, often destroying value along the way). I will be reading Synthes 10-K over the coming days, and will look to provide better insight into the company as soon as possible.
The real reason I wrote this article was to look at the financing. The cash/stock split instantly jumps out to shareholders, especially considering the current valuation of Johnson & Johnson stock. As noted above, the split for the CHF159 per share acquisition price was 35% (CH55.65) in cash, and 65% (CHF103.35) in Johnson & Johnson stock. Management said that the structure (35/65) will stay the same, regardless of whether or not the company can use cash from outside the U.S. in a way that is cost efficient. Management’s reasoning was largely based on maintaining financial flexibility and their AAA credit rating. But for many shareholders, the use of so much equity is striking because many believe that the shares are undervalued, meaning that Johnson & Johnson is paying a large portion of the deal with an undervalued asset.
For the valuation of the deal, the stock component was structured with a 7% collar on the upside and downside for the Johnson & Johnson shares, with the final point at either end becoming the fixed exchange rate for the Synthes shareholders. At the low end of the collar, with Johnson & Johnson stock right around $60, there’s a commitment of 1.9672 shares to be issued per Synthes share. In this scenario, assuming the 65% mix holds, the company would need to issue around 230.75 million shares, adding roughly 8.4% to shares outstanding (which stood at 2.738 billion at the end of 2010). Essentially, if one believes shares are 20% undervalued then the additional implied value that is being given away is nearly $3 billion (or 14% in additional acquisition cost). As an owner, I’m not happy with diluting my ownership, especially when using an undervalued asset.
As management made clear, the transaction is largely focused on growth, which Synthes has consistently achieved in the past; this is music to the ears of Johnson & Johnson shareholders, who have seen revenues sputter over the past four years. However, the company’s decision to pay with equity still seems odd to those of us who believe that the stock is undervalued. Overall, I am happy with the purchase and the price, but less than ecstatic on the use of 80 cent dollars as the currency used to finance the deal.