On Tuesday, Dominic Caruso, CFO and VP at Johnson & Johnson (JNJ, Financial), presented at the Morgan Stanley Global Healthcare Conference. Most people know the back story on JNJ and where they stand today, so I won’t waste too much time on that topic. The one item that has been a key focal point in investor discussions as of late is the Synthes acquisition. A bit of the background from the press release in April when the deal was announced:
“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.”
At the time of the deal, the concern was the use of so much equity financing, when many investors felt the stock was substantially undervalued. 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. At the time of the deal, management said that the structure (35/65) would not change, regardless of whether or not the company can use cash from outside the U.S. in a way that is cost efficient, based on the fact that they wanted to maintain their financial flexibility and AAA credit rating.
Many investors felt this was value destructive; Warren Buffett said he would have rather seen more cash financing, while well-known value investor Bill Nygren voted with his feet, selling out of his position in the period ending 6/30/2011 (commentary – “We eliminated our position in Johnson & Johnson after the company announced a stock-financed acquisition that we believe will decrease its per-share value.”)
Over time, management has changed their tone, saying in May that “we are evaluating various alternatives to finance the transaction in the most efficient way possible,” what I consider to be a roundabout way of saying pretty much nothing.
On Tuesday, Mr. Caruso was asked, “They are sitting on massive amounts of cash and they are going to dilute me as the shareholder and not use that cash; how do you reconcile that with the investor?” Here is his response (with bold markings added by me for emphasis):
“In terms of using all our cash to do a transaction like that I would love to use all our cash to do that type of transaction. Of course, Synthes is a U.S. corporation. Most of our cash is outside the U.S.; significant tax burden associate with doing the transaction that way.
We structured the transaction to meet the needs of both parties and, as I described, there has to be a willing buyer and a willing seller anytime you do a transaction. The terms constitute the willingness of one party and the other, but I would say that what we have done is we have
modeled it in the most conservative way we could possibly model it, which in that most conservative way is very minor dilution, in our opinion (1% to 2% dilutive in the first year).
Given the premier asset we are acquiring, we think that that is okay. Investors may disagree, but we think that that is okay. Plus we believe that there is plenty of opportunity to make the transaction less dilutive for shareholders. We are working on that. We are making good progress on that.
It has to do with utilizing more cash by us in the transaction, less net shares being issued over all. We can’t give you any more definitive information on that, because that entirely depends on the structure and the regulatory approvals that we need to obtain in order to affect that optimal structure. So there is a range between the most conservative that we modeled in a very optimistic scenario. We are working our way through that and, obviously, we are going to try to be more towards the more optimal scenario as possible.”
The OUS explanation is certainly logical; however, it doesn’t explain why management couldn’t simply issue low interest debt (based on their AAA credit rating) and solve that issue. With $26 billion in cash at the time and consistent free cash flow generation in the low-teens (billions), they certainly could have raised more than $7 billion (35% of deal value) and still kept their AAA rating.
In regards to the second bolded section, I really think this statement says a lot: “Investors may disagree, but we think that that is okay.” Certainly, management’s job isn’t to call up the investors everyday and ask them what they want them to do; however, it is important to remember that the investors are the owners of the business, and at the end of the day they own the company, not the management.
The fact that prominent investors like Mr. Buffett and (formerly) Mr. Nygren have an issue with the structure of the deal isn’t something that management should flippantly refer to as a difference of opinion; it is a real issue that should have been adequately addressed. Instead, management has kicked the can a bit further again, saying that “there is plenty of opportunity to make the transaction less dilutive,” which they are “working on.”
The easiest way to make it less dilutive — use less equity, like investors have been advocating since the deal was announced five months ago.
“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.”
At the time of the deal, the concern was the use of so much equity financing, when many investors felt the stock was substantially undervalued. 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. At the time of the deal, management said that the structure (35/65) would not change, regardless of whether or not the company can use cash from outside the U.S. in a way that is cost efficient, based on the fact that they wanted to maintain their financial flexibility and AAA credit rating.
Many investors felt this was value destructive; Warren Buffett said he would have rather seen more cash financing, while well-known value investor Bill Nygren voted with his feet, selling out of his position in the period ending 6/30/2011 (commentary – “We eliminated our position in Johnson & Johnson after the company announced a stock-financed acquisition that we believe will decrease its per-share value.”)
Over time, management has changed their tone, saying in May that “we are evaluating various alternatives to finance the transaction in the most efficient way possible,” what I consider to be a roundabout way of saying pretty much nothing.
On Tuesday, Mr. Caruso was asked, “They are sitting on massive amounts of cash and they are going to dilute me as the shareholder and not use that cash; how do you reconcile that with the investor?” Here is his response (with bold markings added by me for emphasis):
“In terms of using all our cash to do a transaction like that I would love to use all our cash to do that type of transaction. Of course, Synthes is a U.S. corporation. Most of our cash is outside the U.S.; significant tax burden associate with doing the transaction that way.
We structured the transaction to meet the needs of both parties and, as I described, there has to be a willing buyer and a willing seller anytime you do a transaction. The terms constitute the willingness of one party and the other, but I would say that what we have done is we have
modeled it in the most conservative way we could possibly model it, which in that most conservative way is very minor dilution, in our opinion (1% to 2% dilutive in the first year).
Given the premier asset we are acquiring, we think that that is okay. Investors may disagree, but we think that that is okay. Plus we believe that there is plenty of opportunity to make the transaction less dilutive for shareholders. We are working on that. We are making good progress on that.
It has to do with utilizing more cash by us in the transaction, less net shares being issued over all. We can’t give you any more definitive information on that, because that entirely depends on the structure and the regulatory approvals that we need to obtain in order to affect that optimal structure. So there is a range between the most conservative that we modeled in a very optimistic scenario. We are working our way through that and, obviously, we are going to try to be more towards the more optimal scenario as possible.”
The OUS explanation is certainly logical; however, it doesn’t explain why management couldn’t simply issue low interest debt (based on their AAA credit rating) and solve that issue. With $26 billion in cash at the time and consistent free cash flow generation in the low-teens (billions), they certainly could have raised more than $7 billion (35% of deal value) and still kept their AAA rating.
In regards to the second bolded section, I really think this statement says a lot: “Investors may disagree, but we think that that is okay.” Certainly, management’s job isn’t to call up the investors everyday and ask them what they want them to do; however, it is important to remember that the investors are the owners of the business, and at the end of the day they own the company, not the management.
The fact that prominent investors like Mr. Buffett and (formerly) Mr. Nygren have an issue with the structure of the deal isn’t something that management should flippantly refer to as a difference of opinion; it is a real issue that should have been adequately addressed. Instead, management has kicked the can a bit further again, saying that “there is plenty of opportunity to make the transaction less dilutive,” which they are “working on.”
The easiest way to make it less dilutive — use less equity, like investors have been advocating since the deal was announced five months ago.
