How JNJ Bought Synthes and How it Almost Didn’t Happen-Part II

Last week in Part I:  With U.S. healthcare reform in the offing and troubles with the Office of Inspector General as well as scandals among some of its former executives, Synthes and its CEO, Hans Wyss decided to explore the sale of their company.  Despite strong bids from three private equity firms and a low ball bid from Bill Weldon at JNJ, the Synthes’s board decided that JNJ was their best alternative.

As they say, nothing is done until it’s done.

We Need a Higher Price

On February 10, 2010, Synthes’ board asked 13-year board veteran Amin Khoury to call JNJ’s Chairman and CEO Bill Weldon.

When he reached him, Khoury told Weldon that Synthes had received an all-cash offer (non-binding) from another party and that was higher than JNJ’s bid.  If JNJ wanted Synthes, the price would have to move up—to CHF 160 per share.  But, also important, said Khoury, was that any purchase by JNJ would have to be structured in way that there would be no price or closing risk.  Market conditions, in other words, could not be a factor.

A few days later, February 16, Bill Weldon called Khoury and raised JNJ’s offer to CHF 155 per share ($18.5 billion).  The offer, Weldon told Khoury, was subject to complete due diligence and was a final bid.  He had no authority to go higher.  (The final price would eventually rise to $21.3 billion).

But, Wait, There’s Still More

Apparently CHF 155 was good enough to let the word sink deeper into both companies that the largest, most far reaching merger in the history of orthopedics was in the works.

All through March teams from both organizations plowed through truckloads of product, market, organizational, financial, contractual, sales, distribution and intellectual property materials.

On March 28, Synthes’ legal counsel, Shearman and Sterling, gave to JNJ the draft merger agreement.

One more issue popped up.  And it was the toughest one of all—management compensation as a condition of closing.

Literally on April Fools’ Day, Synthes’ compensation committee met to look at a plan to incentivize the very executives that would be essential to transfer the Synthes operations to JNJ.  These were extraordinarily tricky and potentially explosive discussions.  At the end, the committee recommended lucrative severance payments to 16 executives plus two other senior executives, as well as retention bonuses and a reward bonus pool for other groups of key employees.

By now, seven months after that fall Synthes board meeting where Khoury was authorized to being exploring the sale of Synthes, rumors began circulating on Wall Street about a merger. On April 18 Synthes issued a public statement disclosing that, yes, it was in merger talks with JNJ.

That same day Mike Mahoney, JNJ’s Worldwide Chairman of Medical Device and Diagnostics, called Synthes to say that they could not go along with the severance compensation packages the board had approved for senior management.  JNJ wanted to change the agreement—before merging. No changes in the compensation plan, no merger.

Synthes came back to Mahoney saying, in effect, we won’t discuss anything related to executive compensation until you complete negotiating the terms of the merger agreement and that the shareholder voting agreement is basically done.

Oh, and JNJ raised the price to CHF 159.00 per share on April 25, with 65% of the consideration being in the form of Johnson & Johnson stock (subject to a 7% “collar”) and 35% of the aggregate consideration being in the form of cash.  If the deal didn’t happen, JNJ agreed to pay Synthes a “reverse termination fee” of $650 million.

With a new, higher price on the table, Mahoney came back to the issue of executive compensation and even offered to talk to the affected senior executives himself.  All day and all night on April 25, Gorsky for JNJ and Khoury for Synthes worked over the transaction terms. The key sticking item: the damn Synthes retention and severance arrangements.

That same day, both boards of directors unanimously approved the merger terms.

The next day Mahoney had a conference call with the 15 Synthes executives whose deal compensation JNJ and Mahoney specifically wanted to change.  Making it even more difficult, the deal had already been approved by Synthes board.  No one has disclosed how long the call lasted or what was said.  All that is known is that at the end of that call, by some miracle, the Synthes execs agreed to change their compensation in order to get the merge done.

That same night, April 26, the merger agreement and voting agreement were signed.

The press release hit the wires on April 27, 2011.

Synthes’s Management Compensation

Payment at Closing

Retention Payments

Single Trigger Payment

Double Trigger Payment

President and CEO

$7, 959, 501

$3, 979, 757

$30, 967, 287

$53, 256, 693

Chief Financial Officer

3, 076, 896

1, 538, 448

11, 003, 985

19, 959, 383

President – European Operations

-0-

5, 285, 028

7, 337, 893

11, 311, 145

President – Spine

-0-

2, 475, 030

3, 323, 148

7, 049, 145

President – Trauma

-0-

2, 169, 570

2, 966, 741

6, 332, 015

President – CMF

-0-

1, 654, 110

-0-

-0-

President – Power Tools

-0-

615, 460

-0-

-0-

-0-

13, 311, 972

-0-

-0-

Source:  Johnson & Johnson

On June 12, 2012, Johnson & Johnson announced that it has received all regulatory approvals for the $21.3 billion deal.

Hans Wyss, with 45.8 million shares and 38.6% of Synthes received an aggregate value of more than $8 billion.

Financial Impact

By paying for the Synthes purchase through its off-shore pharmaceutical company, JNJ was able to book an increase per share of $0.03 – $0.05—a sharp reversal from its earlier guidance to Wall Street analysts that the purchase would dilute earnings by $0.22 per share.  Next year, 2013, Johnson & Johnson has told its investors that for the first full year of the combined businesses, Synthes will add about $0.10 – $0.15 per share to earnings.

What Now?

JNJ’s new CEO, Adam Gorsky, had his debut call with Wall Street’s analysts a couple of weeks ago.  One of his more memorable comments was: “We are the largest, most innovative and comprehensive orthopedic and neurological business in the world. Our integration work is well underway our regional and functional leaders represent a combination of talent from both DePuy and Synthes. We have already organized a combined sales force of in-house and contract resources. Meanwhile, our manufacturing, marketing and other functional teams are actively at work on implementation of their integration plans.”

DePuy’s sales for the June quarter included a couple weeks of Synthes results so, instead of $1.5 billion in quarterly sales, DePuy reported $1.6 billion.  In this coming third quarter, DePuy’s reported sales are expected to rise to $2.3 billion, 66% higher than last year.

In the galaxy of billion dollar operating units that is JNJ, DePuy Synthes Companies now ranks #1 in terms of annual sales—more than $9.8 billion in 2013, over $10 billion in 2014.  DePuy Synthes is now more than four times larger than Cardiovascular Care (formerly Cordis), 40% larger than General Surgery, 2.3 times larger than McNeil and  twice as large as Remicade.

All told, DePuy Synthes will now contribute close to 14% of mother JNJ’s total sales and those sales, most analysts are forecasting, will deliver 30% operating profit margins, rivaling the profitability of JNJ’s Pharmaceutical unit.

For 2013, most forecasters are saying that DePuy Synthes will ship in excess of $3 billion of hip, knee and extremity implants and instruments making it the #1 supplier in those sectors.

Before Synthes – 2011

After Synthes – 2013est

$1, 244

21%

$1, 275

13%

1, 407

24%

1, 445

15%

281

5%

297

3%

1, 033

18%

1, 841

19%

282

5%

3, 304

34%

600

10%

641

7%

963

17%

1, 012

9%

$5, 809

100%

$9, 815

100%

Source:  RRY Publications LLC

The New DePuy Sectors – % of Total

Source: RRY Publications LLC and Wells Fargo Estimates

Already, by way of clever financial engineering, the transaction has made money for JNJ.

Culturally, the effect of the JNJ corporate culture on Synthes should be, we think, an overall positive. JNJ pays its employees well, allows them quite a bit of work flexibility with many senior executives working from home or remote locations.  The pace of work at JNJ is notoriously heavy with senior executives routinely working 12-14 hour days.  Politics, of course, is also a key fact of the JNJ life and turning the mother ship is not easy nor fast.

Synthes’ culture had been buffeted lately with the Office of Inspector General investigations, the defections of senior people—some of whom went into active competition with Synthes—and began to feel sclerotic, reactive but with a European patina.

How will JNJ’s brand focus, credo values style align with the former Synthes folks?  We think it will play well.  Well enough, we think, to actually deliver something that may look like, sound like and walk like—synergy.