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J&J and Guidant: Buyer Beware

The Nov. 15 news that Johnson & Johnson (JNJ) and Guidant (GDT) had agreed on a new deal came as a bit of a surprise to investors. Guidant, which had sued J&J to complete the transaction under the original terms, saw its stock climb more than 8% after agreeing to a $21.5 billion buyout, about $4 billion less than originally planned.

That the two companies found a way to team up, however, should not have surprised anyone. Sure, both companies were playing hardball. J&J stated it was not required to follow through on the deal because Guidant's recent defibrillator recalls had a "material adverse effect" on the device maker. Guidant countered with its lawsuit. But the bottom line is that events over the last few months made this deal more important than ever for both Guidant and J&J.

Let's look at J&J first. The company's pharmaceutical business, which now accounts for about 44% of J&J's $51 billion in annual sales, is in a funk. Pharmaceutical sales growth this year and in 2006 are expected to be almost nonexistent, according to SG Cowen. Among the reasons: declining sales due to intensifying competition for its $3.3 billion anemia drug Procrit, and the launch of generic versions of such key products as Duragesic, a patch for chronic pain.

DRUG PROBLEMS At the same time, like others in the industry, J&J's drug pipeline needs a replenishing. In late October the Food & Drug Administration informed the company that its drug for premature ejaculation, dapoxetine, was not going to be approved by the agency. While J&J says it is committed to addressing the FDA's concerns, analysts now wonder if the drug will ever reach the market. Unfortunately, market analyst Datamonitor figures dapoxetine was the only potential blockbuster on J&J's near-term horizon.

While J&J would clearly like to strike some deals, either acquisitions or licensing arrangements, to add new drugs to its lineup, prices for such transactions are being bid up by other companies desperate for new products. "Large pharmaceutical companies have grossly bid up valuations," says Jon Fisher, portfolio manager at Fifth Third Asset Management.

That's why J&J wants to expand its reach in medical devices. The company has had a major hit with its drug-coated stent, a device used to prop open arteries and prevent reclogging after angioplasty. Analysts figure combining Guidant's popular stents with J&J's drug-coating expertise could produce a winning, next-generation device. And Guidant also gives J&J a foothold in implantable cardiac defibrillators, a fast-growing market.

"DEEPER THAN ANTICIPATED DAMAGE." For Indianapolis-based Guidant, the motivation to make the deal work was even stronger. Its reputation has been hammered by poor handling of defibrillator recalls. Guidant has been slapped with a number of lawsuits stemming from those problems and has received subpoenas from the Justice Dept. in connection with some of its devices. Guidant, under investigation by 34 states, has been sued by New York State Attorney General Eliot Spitzer.

Some on Wall Street were surprised by the weakness of Guidant's third quarter results, announced Nov. 7, which showed a 57% plunge in earnings, as well as declining sales. Citigroup analyst Matthew Dodds wrote in a recent report that sales for the third quarter were $70 million lower than he expected, indicating "deeper than anticipated damage" in the core business. Dodds wrote that he didn't believe Guidant wanted to end up in a court fight with J&J over the collapsed deal because that could result in the airing of "dirty laundry" about device recalls.

The question now is how J&J integrates Guidant. While the health-care giant is known for acquiring outfits and letting them run autonomously, few who follow the stock expect that to happen here. More likely, they say, J&J will take control of the business to ensure the operation has a complete handle on the safety issues that have plagued Guidant. Indeed, it was Guidant CEO Ronald Dollens' hope to retire that led him to sell to J&J in December, 2004.

SERIOUS COMPLICATIONS. Plenty of pitfalls loom, however. Back in 1994 J&J made a hostile acquisition of interventional cardiology company Cordis. J&J's top-down management of that operation led to an exodus of talent and major delays in the development of new devices.

Morgan Stanley analyst Glenn Reicin warns that J&J needs to be careful to avoid a repeat of those headaches with Guidant. "J&J needs Guidant's deep middle-management bench and the cooperation of senior management," Reicin wrote in a Nov. 15 report. For J&J, the hard work is only just beginning.


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