Johnson & Johnson Completes Synthes Acquisition

Johnson & Johnson (JNJ) has cleared the final hurdle set by European antitrust authorities and completed its acquisition of Synthes Inc. JNJ sold the trauma division of DePuy Orthopaedics Inc. to placate European Union (EU) regulators. Satisfied, the EU has given the go-ahead to JNJ, which had correctly predicted earlier this year that buyout would be completed in the second quarter of 2012.

JNJ announced its intent to buy Switzerland-based Synthes more than a year ago, but European officials feared the move would give JNJ a virtual monopoly in the orthopedics sector. JNJ wanted to fold Synthes into DePuy Orthopaedics to create, according to the company, possibly the world’s largest orthopedics business. “The proposed acquisition would remove a competitor from some markets which are already concentrated,” EU antitrust chief Joaquin Almunia said in a prepared statement last fall when the EU began its investigation of the proposed merger. “The commission needs to make sure that effective competition is preserved in order to maintain innovation and prevent harm to patients.”

Selling the trauma section of DePuy, regulators reasoned, would preserve competition. As a result, EU managers green-lighted the JNJ-Synthes union.

Originally set at $21.3 billion, Forbes reports that the acquisition now is valued at $19.7 billion. The magazine also claims that JNJ is minimizing its U.S. tax bill by using a $12.9 billion stock swap between its Irish subsidiary, Janssen Pharmaceuticals Inc., and its bankers JPMorgan Chase and the Goldman Sachs Group Inc.

JNJ stated in a U.S. Securities and Exchange Commission 8-K filing—a form used to notify shareholders and investors of information pertinent to their interests—that it would use foreign earnings from Janssen to purchase $12.9 billion of its own shares from Goldman Sachs and JPMorgan. These shares, plus some cash, then will be given to Synthes to fund the acquisition. JPMorgan and Goldman will borrow and buy 203.7 million JNJ shares in the open market over the next year. JNJ will use cash held at Janssen to repay the bankers’ JNJ stock, the company noted in a June 12 filing.

The result of such financial acrobatics is that Janssen will, in effect, purchase Synthes in proxy for JNJ, thereby allowing JNJ to avoid U.S. taxation. The move is sparking a change of opinion from analysts about the benefits of the acquisition and JNJ’s shares, which have underperformed the Dow Jones Industrial Average in the past year, while also reigniting a heated debate about taxation on hundreds of billions in foreign earnings at many of the largest companies in the United States.

The share swap with two of Wall Street‘s biggest banks will replace any stock issuance to fund the cash and stock deal for Synthes, which could have diluted shareholders and led to a hefty tax bill.

That move is expected to “finance the transaction in an efficient manner to enhance shareholder value,” said JNJ in a June 12 press release that announced the Federal Trade Commission’s approval of the Synthes acquisition. As a result, the company said the merger will add up to five cents to its 2012 earnings per share (EPS) and 15 cents to its 2013 EPS after previously forecasting EPS dilution of up to 22 cents.

“Instead of a dilutive stock issuance followed by a share buyback program, the company has borrowed stock through an accelerated share repurchase agreement, which transforms the transaction into an accretive deal,” wrote Jefferies & Company Inc. analyst Jeffrey Holford, who upgraded JNJ’s shares to buy from hold, boosting his price target for the company by nearly 6 percent to $72.

Holford calculates that the move increases JNJ’s earnings per share by roughly 3 percent in 2012 and up to 5 percent annually between 2013 and 2017. While JNJ pointed to a mid-year close of the merger, a divestiture of its DePuy trauma business to Biomet, and combined sales between Synthes and what remains of its DePuy’s orthopaedics business as reason for its EPS gain, Holford notes that his earnings estimate and rating change “largely ignore the impact of the Synthes merger.”

Although regulatory approvals and a string of analyst upgrades on June 13 are key developments for JNJ, which has underperformed the Dow in the last 12 months, the real story may center on the financial engineering of the stock repurchase arrangement.

“The completion of the Synthes acquisition creates the world’s most innovative and comprehensive orthopedics business and reflects our long-standing strategy of leadership within attractive health care markets,” said Alex Gorsky, JNJ CEO. “The combination of these two leaders—Synthes and DePuy—will enable us to better serve clinicians and patients worldwide, bring new innovations to the marketplace in orthopedics and neurologics, and strengthen our ability to compete in developing markets.”