J&J-Synthes Takeover Obscuring Recalls in Makeover: Real M&A
Synthes, the largest maker of devices to treat bone fractures and trauma, has an operating margin of 35 percent, the highest among medical-products makers including J&J with market values of more than $5 billion, according to data compiled by Bloomberg. Synthes has increased the amount of net income generated per dollar of revenue for seven straight years to the best in the industry, while J&J’s profit margin declined in two of the past four years, the data show.
J&J, with almost $28 billion in cash at its disposal, is in talks to acquire Synthes, a $19.4-billion company with only $98 million in debt, as it seeks to revive its image after product recalls and lawsuits over failed artificial hips. The world’s second-biggest maker of health-care products would gain a device company with almost 50 percent of the trauma market. Synthes’s operating margins are 45 percent higher than Smith & Nephew Plc (SN/), which investors had speculated was a target for J&J.
“J&J had a severe challenge to its premier reputation given all the recalls,” said Michael Holland, who oversees more than $4 billion, including J&J shares, as chairman of Holland & Co. in New York. “This relatively bold step to buy a premier company is a significant move to regain their luster.”
J&J’s shares rose as much as 1 percent yesterday before closing down 0.2 percent at $60.46 on the New York Stock Exchange. That was still the third-best performance in the Dow Jones Industrial Average, which slid 1.1 percent as Standard & Poor’s cut its outlook on U.S. long-term debt to “negative.”
Synthes advanced 5.6 percent to 146.5 Swiss francs in Zurich yesterday to give it a market value of 17.4 billion Swiss francs ($19.4 billion). The West Chester, Pennsylvania-based company said in a statement that it’s in talks with J&J about a possible combination. Synthes doesn’t intend to provide more information until a definitive agreement is reached or talks are terminated, it said.
William Price, a spokesman for New Brunswick, New Jersey- based J&J, declined to comment in an e-mail.
J&J climbed 3.7 percent to $62.69 on the NYSE today after the company reported first-quarter earnings that beat the average estimate from analysts and raised its full-year forecast. Synthes gained 0.6 percent to 147.4 francs in Zurich.
‘Change the Focus’
J&J is considering an acquisition of Synthes after product recalls cost the company $900 million in sales last year. J&J removed almost 200 million packages of Tylenol, Motrin and other over-the-counter medications tainted by nauseating odors or improper ingredients. Its DePuy unit has also withdrawn 93,000 hip implants that failed at higher-than-expected rates, forcing repeat surgeries.
After the company’s McNeil Consumer Healthcare unit was charged on March 10 with violating U.S. law, the Food & Drug Administration expanded oversight of three manufacturing plants for at least five years. The settlement doesn’t preclude future criminal charges, the agency said at the time.
“They want to change the focus of the conversation,” said Erik Gordon, a University of Michigan business professor in Ann Arbor who studies the biomedical industry. J&J is “probably thinking, ‘Let’s have the conversation be the potential upside of something,’” he said.
While Synthes and J&J may “fit together,” J&J should be focused on fixing its in-house recall problems, he said.
Synthes had an operating margin of 35 percent in 2010, the best among 17 medical-product companies with market values greater than $5 billion, including J&J at 27 percent, data compiled by Bloomberg show. The company’s efficiency turning revenue into operating income also topped rivals specializing in medical instruments such as Minneapolis-based Medtronic Inc. (MDT), St. Jude Medical Inc. in St. Paul, Minnesota, and Boston Scientific Corp. (BSX) in Natick, Massachusetts.
Synthes improved its profit margin to 24.6 percent last year from 6.1 percent in 2003, the data show.
“They have great margins,” said Michael Liss, a Kansas City, Missouri-based portfolio manager at American Century Investments, which oversees $109 billion and owned about 7.8 million shares of J&J as of Dec. 31. “It only helps J&J’s margins overall.”
Synthes has attractive margins because it’s in the orthopedics market and has implemented efficiencies, Gilgian Eisner, a spokesman for the company in Solothurn, Switzerland, said yesterday.
J&J had looked at buying Smith & Nephew, Europe’s biggest marker of artificial hips and knees, a person familiar with the plan who declined to be identified because the discussions were private said in January. The U.K. device maker had a 16 percent profit margin in the 2010 calendar year. The London-based company declined 3 percent yesterday, the most since January, after Synthes confirmed it was in talks with J&J.
An acquisition of Synthes would push J&J’s share of the $5.5 billion orthopedic trauma market to 54 percent from about 5 percent, and boost earnings between 4 percent and 5 percent in each of the next three years, Larry Biegelsen, a Wells Fargo & Co. analyst in New York, said in a note to clients yesterday.
The trauma market will grow faster than replacement hips and knees, according to Biegelsen.
J&J’s share of the $9 billion spinal-care market would almost double, he said. The company may have to divest some of Synthes’s spine business, according to Lisa Bedell Clive, a London-based analyst with Sanford C. Bernstein & Co.
‘Called Into Question’
Prices for Synthes’s trauma devices may succumb to the pressure that has narrowed margins for other medical devices, according to Michael Weinstein, a JPMorgan Chase & Co. analyst in New York.
The sustainability of Synthes’s profits “has been and should be called into question,” he wrote in a note yesterday.
Synthes’s exclusive arrangement with the Swiss AO Foundation may draw antitrust scrutiny from U.S. regulators, Bernstein’s Clive said. The non-profit teaches courses for surgeons using only Synthes products, leading to many becoming Synthes customers, she said.
Like J&J, Synthes has also grappled with product recalls. After reports that its Synex II Central Body components had failed in six people, leading to pain and loss of height for some, Synthes recalled the spinal implants in 2009.
The company was also ordered to sell its Norian unit, which pleaded guilty in November to one felony and 110 misdemeanor counts for conducting an unauthorized trial of its bone-mending cement products. Three patients died, according to the U.S. Justice Department.
J&J built up $19.4 billion in cash and near cash items and $8.3 billion in short-term investments as of the end of last year that could be tapped for acquisitions, compared with $16.8 billion in total debt, according to data compiled by Bloomberg.
The maker of health-care products is one of only four U.S. companies to have the top credit rating from both Standard & Poor’s and Moody’s Investors Service. Irving, Texas-based Exxon Mobil Corp. (XOM); Microsoft Corp. of Redmond, Washington; and Automatic Data Processing Inc. (ADP) in Roseland, New Jersey, are the others, data compiled by Bloomberg show.
J&J is also ranked AAA in Bloomberg’s Company Credit Ratings, which analyze borrowers based on indebtedness, profitability and other financial ratios. Even if J&J added long-term debt equal to the current market value of Synthes, it would still have a rating of A2L, the fourth-highest investment grade level. J&J’s combined cash and short-term investments outstrip the market capitalization of Synthes by about $8.2 billion, the data show.
Synthes, which is not rated by S&P or Moody’s, had total debt of $98.4 million at the end of last year, compared with $736.6 million in cash and near-cash items and $1.25 billion in short-term investments, data compiled by Bloomberg show.
An acquisition of Synthes for about $20 billion would be the biggest deal in J&J’s 125-year history, surpassing the $16.6 billion purchase of New York-based Pfizer Inc. (PFE)’s consumer health care business in 2006. Pfizer is the world’s largest maker of medical products by sales.
“J&J is what it is. It’s a big powerhouse,” said Harry Rady, who oversees $270 million as chief executive officer of Rady Asset Management LLC, a hedge fund in La Jolla, California. “They could choose to allocate resources to fight all these small battles, or they could make a transformational acquisition like this to really change the face of the company.”
Overall, there have been 7,336 deals announced globally this year, totaling $713.1 billion, a 29 percent increase from the $553.3 billion in the same period in 2010, according to data compiled by Bloomberg.
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