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Johnson & Johnson Changes Tone on Synthes Deal

May 11, 2011 | About:
Alex Morris

Alex Morris

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It is interesting to see how the Synthes deal is playing out, and how management has changed their tone since a wave of concern about the structure of the acquisition surfaced (my original article here, along with the Oracle of Omaha’s opinion on it here). As I noted at the time, “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.”

On May 3, Dominic Caruso, the chief financial officer of Johnson & Johnson (JNJ) spoke to analysts at the Deutsche Bank Health Care Conference. Here is what he had to say a week later when the equity/cash balance was questioned:

“We are evaluating various alternatives to finance the transaction in the most efficient way possible. So, I’ll just leave it at that. We have plenty of opportunities to do that. It will depend on how we integrate the businesses going forward. So, it’s a little too early to comment any further on that.” That seemed like a contradiction to the original statement, but not one that many shareholders are going to complain about.

On Tuesday, Alex Gorsky, vice chairman of the executive committee of Johnson & Johnson, spoke to analysts at the Bank of America Merrill Lynch Health Care Conference (BAC). When asked (yet again) about the terms of the Synthes deal, here is what he had to say:

“They’re evolving as we speak. Dominic highlighted during the conference call and has in a few other events since then. At the announcement of the merger, the proposed merger agreement, we presented what we feel was an appropriately conservative case. We’re looking at a lot of our options and implications around our use of outside U.S. cash, the balance, stock, and cash in the overall deal. And we’ll be working our way through that in the coming months. So more to follow.”

It is interesting to see that management originally said that O.U.S. cash would not be used regardless of its efficiency, yet now suggests that this is an option that they will consider. Again, something I’m happy to hear, but not quite in line with what was originally stated; which brings up a couple questions:

1. What will be management’s estimate of intrinsic value? Certainly this will affect their view on the opportunity cost of using stock. More importantly, how has this changed since the deal was originally announced? One must assume that bigger shareholders voicing concern made management reconsider their original estimates…

2. What about Synthes? I’m not an expert on M&A, but assume the structure is set when the deal is signed (as discussed originally, 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). Can this deal be adjusted? To what extent? Any readers with insight on this topic, I would love to hear your thoughts.

Overall, it’s good to see the deal (apparently) moving away from the 65/35 split as originally outlined; it is going to be interesting to see how this deal closes when all is said and done.

About the author:

Alex Morris
I am a recent graduate from the University of Florida; I received a finance degree as well as a real estate minor during my time at UF. I will be sitting for Level 1 of the CFA Exam in December 2011, as well as for my series 65 exam. I am a value investor, plain and simple.

Rating: 3.9/5 (9 votes)

Comments

extramiler
Extramiler - 2 years ago
Haven't followed this real closely even though I own J&J, but my assumption is that they are talking about flexibility around using outside U.S. cash vs. inside US cash, rather than reducing the cash/stock ratio that was announced with the deal. Of course if they do change the ratio to use less stock and more cash, all JNJ shareholders should be very happy.

As for intrinsic value of Synthes, that is not usually how it works. Usually the CEO decides he wants to do a deal, and then the corporate development (M&A) lackeys construct a spreadsheet that justifies the transaction. If the spreadsheet does not initially justify the deal, certain assumption are tweaked until it spits out the "right" number. Buffett has written extensively about this, he and Munger have made many comments about it, and that has been my experience also working on many M&A transactions for public companies. Cheers.

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