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X File: Johnson & Johnson Completes Merger with Synthes

Ralph is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I recently have been re-watching episodes of the X-files via Netflix, and introducing this quirky television series to my daughter (12).  She is hooked and ‘Wants to Believe’.   As a Johnson & Johnson (NYSE: JNJ) shareholder, I got a similar excited but uneasy feeling when reading the details of today’s closed merger of JNJ with Synthes.  The announced details surrounding the deal appear shareholder friendly, but some also have my tin foil hat buzzing.

The intent to merge with Synthes started simple enough.  Johnson & Johnson for years had been transforming more and more into a medical device company.  In 2001, the medical device and diagnostics (MD&D) unit was 34% of revenues, with operating margins (OM) of 18%, and playing second chair to pharmaceuticals at 46% of revenues with OM of 33%. But fast forward to 2010, and MD&D had become the largest percentage of revenue at 40% compared to pharmaceuticals 36%, and the OM of MD&D had improved to over 33%.  MD&D has been a key growth driver for the company for the past decade.  Operating margins took a hit in 2011, as charges were taken to exit the cardio-stent business, but the unit was still JNJ’s largest source of revenues.  So there was not a great deal of surprise that JNJ would look to the medical device area for a large acquisition, which it announced with orthodepic device maker Synthes just over a year ago.

What did surprise was the structure of the deal, which was part cash and part stock.  Guesses as to why JNJ would use stock initially varied from an inability to effectively access the overseas cash hoard for the acquisition (Synthes was US based, despite being listed overseas), wanting to maintain JNJ’s increasingly rare corporate AAA rating, and to estate considerations for Synthes founder and his family who owned a large share of the corporation.   All seemed sensible.  I do not recall many conspiracy theorists coming forward with wild speculations that JNJ might have a trick up their sleeve; a scheme in place to use their outside-US cash to buyback (or pre-acquire) the stock used for the acquisition.  Yet this seems to have been the case.

After months of being cagey on conference calls regarding the possibility of a share buyback to offset the Synthes acquisition, JNJ chief financial officer (CFO) Dominic Caruso, in cahoots with J.P. Morgan (NYSE: JPM) and Goldman Sachs (NYSE: GS) provided one heck of a ‘smoking’ press release.  It starts out simple enough, noting that the US regulatory approval had been obtained to complete the merger and that, as the European approval concessions were in place, the deal would close almost immediately.  But then it gets a bit strange.  The press release also notes that the Irish subsidiary of JNJ, Janssen would be undertaking an immediate accelerated share buyback, and then use these shares in the closing of the deal.  The shares would be obtained from JP Morgan and Goldman Sachs.  The large banks borrow the shares they sold to Janssen, effectively going ‘short’ JNJ to the tune of ~ $12.9 billion.  The 8-K filing provides added detail.  It notes that on June 13, 2012 both JPM and GS will each provide Janssen with 101,870,028 shares (borrowed) for which Janssen would pay each $6,425, 961,366 ($63.08 per share).  Despite what appears to be some hedged language in the press release, such as that this was for an ..” initial purchase price of $12.9 billion” and was subject to terms  including adjustments upon the occurrence of certain events under which the ASR agreements may be extended or canceled,” I did not see much in the 8-K to imply this might ‘adjust’ (but I’m no corporate lawyer, so I may well have missed  something).  The result is Synthes, which will be managed from within JNJ by the MD&D Depuy unit, will in fact be owned by the pharmaceutical Janssen unit.  Conspiracy buffs have to admire the structural layers the company is wrapping around this acquisition.  The means of doing the share buyback seems clearly designed to accomplish using JNJ's non-US cash, via Janssen in Ireland, to complete the acquisition without subjecting it to repatriation taxes.  Clever.  Maybe too clever.

I expect that every large US company with a substantial amount of overseas cash is looking closely at this today, particularly the tech giants like Microsoft and Apple.  I love the irony of this occurring on a day when J.P. Morgan CEO Jamie Dimon was testifying before congress on issues related to large losses due to a hedging strategy gone sour.  If only a congressperson could have been current enough to have asked, ‘So Mr. Dimon, how will you be hedging your multibillion dollar short position in JNJ that you established today?’

As a shareholder of JNJ, I’m at first inclined to cheer this. I like the Synthes acquisition conceptually and JNJ becoming even more of a device company.  I should like that JNJ is trying to “ effectuate the acquisition in a tax efficient manner in accordance with applicable law.”  I ‘Want to Believe.’

Problem is, I don’t.

For starters, my inner Fox Mulder is bothered by these large money center banks (dare I say – financial manipulators) having a substantial short position in the company I own.  I note that Yahoo! (via Edgar) noted JNJ had a short interest of ~48M shares at the end of last month, a number that just increased over 4 fold.  I am also greatly discomforted by the cautionary language in the 8-K filing. “ While Johnson & Johnson believes that these transactions will allow it to effectuate the acquisition in a tax efficient manner in accordance with applicable law, it is possible that the Internal Revenue Service could assert one or more contrary positions to challenge the transactions from a tax perspective. If challenged, an amount up to the total purchase price for the Synthes shares could be treated as subject to applicable U.S. tax at approximately the statutory rate to Johnson & Johnson, plus interest.” That sounds a bit more than ‘boilerplate’ to me.  And while I don’t doubt the legal team considered all this, I am not as comfortable with the opinions of JNJ management as I once was.  Despite recent changes, this is still the same core management that is seeing increasing delays in getting its consumer products manufacturing back up and running, and that once thought its Risperdal marketing plan was a good idea.  That past marketing plan is now resulting in billions in legal settlements.  Instead this feat of financial engineering feels more like the ‘good idea’ that was the reverse merger of Merck (NYSE: MRK) with Schering-Plough to protect Remicade from JNJ.  It may help, but perhaps won’t be as effective as intended.

So I don’t believe, and I’ll personally be looking to reduce my holding in JNJ in the coming days, hopefully while the bloom is still on the rose.

I acknowedge there is still a lot to like with JNJ.  The increased device focus should serve it well in the coming years.  The pharmaceutical segment is again showing signs of growth.  The pipeline is strong, as indicated by a recent showing at the American Diabetes Association. And consumer products won’t have a lean presence on retail shelves forever (at least I hope not).   Heck, even a J.P. Morgan analyst thinks enough of the company to offer a ‘rare upgrade’ on the stock. [Does he not know his own company is short this equity by billions of dollars?  Is some Morley smoking consultant having a little chat with him as we speak?  Or is this ‘all part of the plan’ at JPM?].  Still, with the unease related to this deal, and Europe being both tough on pricing and a bit lax paying its healthcare bills, I’m inclined to step aside for a time.

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Ralph Casale

Helical Investor


TMFHelical owns shares of Apple and Johnson & Johnson. The Motley Fool owns shares of Apple, Johnson & Johnson, JPMorgan Chase & Co., and Microsoft. Motley Fool newsletter services recommend Apple, Goldman Sachs Group, Johnson & Johnson, and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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