Last December we showcased 2004’s largest domestic transaction: Johnson & Johnson’s (NYSE: JNJ) purchase of medical device maker Guidant Corporation (NYSE: GDT) in a deal worth $25.4 billion. During the 11 months since its announcement, this deal has unfolded—and nearly unraveled—in ways the parties to the transaction may not have anticipated.
As months of due diligence wore on, the media reported on safety problems with some of Guidant’s implantable heart defibrillators and pacemakers, the attendant product recalls and the inevitable lawsuits. This news, along with a 22% decline in GDT’s stock price from mid-December 2004 to mid-November 2005, naturally prompted JNJ to question the wisdom of completing the deal on its original terms.
A period of intense negotiation ensued. Guidant wanted to get the deal done, and had already tipped its hand by taking preliminary steps to integrate its business into JNJ’s. And although JNJ would also benefit by closing the deal, it smelled an opportunity and used the “material adverse effect” clause in the merger agreement to open a wedge in negotiations. What followed was a classic study in brinksmanship. JNJ signaled that it was not happy with the original price and valuation, and that it would walk away from the deal without appropriate accommodations. Anxious to get the deal done, Guidant responded by suing JNJ to complete the deal; but in doing so, they blinked. One week later, terms of a revised deal, more favorable to JNJ, were announced.
Johnson & Johnson now proposes paying $21.5 billion, or $3.9 billion less than the original $25.4 billion. Under terms of the revised agreement, JNJ will offer $33.25 in cash and 0.493 shares of stock (currently worth $29.83), or a total of $63.08, for each share of GDT stock, as compared with the original $30.40 in cash and $45.60 in JNJ common stock. As something of a sop to GDT and its negotiators, JNJ agreed to let the value of the revised deal rise or fall in relation to its share price.
As for valuation, the revised price offers 5.8x (current) revenue and 21.5x EBITDA, compared with the original multiples of 6.7x and 30.4x, respectively. Taking into account GDT’s cash on hand, the net cost to JNJ effectively drops to $19 billion, which would lower the respective revenue and EBITDA multiples to 5.1x and 19x. The corresponding original multiples, taking into account cash available and the financials at the time, were 6.4x revenue and 28.6x EBITDA. So JNJ emerges with better terms.
But what we’re wondering is, What does the $4 million difference between the original and the revised price tags really represent? Is that the amount that JNJ truly believes is needed for any further retooling of the defective devices and for legal reserves to defend against lawsuits and potential awards? In part, perhaps. But we also suspect that part of that amount represents a genuine savings coup for JNJ because the recalls had left GDT with jarred nerves and the unenviable prospect of protracted legal battles and an uphill climb to rebuild market share and a tattered reputation if the deal didn’t go through.
Among the cacophony of analysts’ voices, Sherwood Small, a fund manager with Boston Private Value fund, seems to have been in tune with the negotiations. Two weeks before the revised terms were announced, Mr. Small made the following observations, “Everyone knows [Guidant] is not worth $76 per share anymore, but if the offer is in the high $60s and J&J says $62, you guess where they’ll meet. There’s an old saying in the M&A business—a dollar for peace.” Just 8 cents off the final price, Mr. Small seems to have nailed it.
By the way, the revised agreement also contains a “material adverse effect” clause, but only for future events. When the deal goes through, now expected to be sometime in January 2006, several lines of business will have to be sold off to satisfy anticompetitive concerns. Abbott Laboratories (NYSE: ABT), for example, is already angling to license certain catheter technologies from JNJ, predicated on the closing of the Guidant deal.