Tuesday, April 26, 2005

J&J and Guidant: Getting to the heart of the deal

In 2005, the total domestic sales of medical devices are projected to be $35 Billion (S&P 500 report). This industry has positive longer-term fundamentals, including growing global demand for quality health care, an aging population and rising R&D outlays, leading to a steady flow of new diagnostic and therapeutic products in areas such as cardiology, orthopedics, oncology, and minimally invasive surgery. Approximately $15 bn of this pie is derived from the cardiovascular business. The major products in this business are implantable pacemakers, defibrillators for the heart and vascular devices such as catheters, and stents. These products, which typically target small patient populations, have strong growth potential but are also at significant risk of becoming obsolete. For companies specializing in the high-tech sector, new products (those introduced within the preceding two years) typically account for more than 30% of sales.

Johnson & Johnson, based in New Brunswick, N.J., is a manufacturer of health care products, as well as a provider of related services, for the consumer, pharmaceutical and medical devices and diagnostics markets. There are more than 200 operating companies under the J&J umbrella. J&J has always managed to keep its diversified portfolio of companies more or less happily under one corporate organization. J&J’s large pharmaceutical business, like the rest of the drug industry, is facing patent expirations, intensifying competition, and a dearth of new products.

J&J’s role as a diversified health care conglomerate is challenging because some product lines make much more money than others. Dealing with a wide array of products under one corporate roof certainly requires different management skills than big pharmaceutical companies usually exhibit. This also lowers the overall margins in the boom times. But when times are harsh, J&J's diversification strategy has its advantages. In 2004, medical devices accounted for about 36% of J&J's sales, prescription drugs accounted for 47%, and 17% came from consumer products.

It is getting more difficult to achieve any sort of product differentiation in a maturing cardiovascular industry. Investors who have become accustomed to more than 10% growth rates expect the same going forward. One way to increase sales and maintain the growth levels is through consolidation. The effectiveness of the sales force is critical, as they have to be able to convince the doctors on superiority of the products. Also global reach is increasingly becoming important.

Guidant, one of J&J’s competitors is a world leader in the design and development of cardiovascular medical products. Guidant was spun-off from Eli Lilly in 1994. The company capitalized on breakthroughs in heart stents and pacemaker-defibrillator technology to become one of the world's top medical device makers (surpassed only by Medtronic). The $47 billion J&J realized that the Indianapolis based Guidant would be a good acquisition as it would provide J&J a big piece of the fast-growing market for implantable defibrillators and pacemakers. For years, the health-care giant had held acquisition talks with Guidant. The deal could boost the slowing revenue growth over the next few years. Guidant's heart stent business was also attractive, although its failure to develop a drug-coated version put it behind J&J and Boston Scientific. In 2002, Guidant lost a major patent suit filed by Boston Scientific against its partnership with Cook Group for developing a drug-eluting stent. This increased the pressure brought about giants like J&J and BSX and further reduced its already dwindling share in the stents market. This may have made Guidant view its acquisition by J&J favorably.

The Guidant acquisition announced in December 2004 is the largest business deal in J&J's 118-year history. The combination of J&J and Guidant could capture up to 80% of the market share with cardiac devices, superior stents and ICDs. If regulators let J&J hold on to Guidant's stent operation, combining J&J expertise in drug coating with Guidant's popular stent could help J&J catch up to market leader Boston Scientific Corp. And a deal could also help J&J add some strong managers from the Guidant ranks. Linking up with J&J would give Guidant considerable financial resources to fund such projects as well as major marketing and sales power to launch new products. Adding Guidant also will add to J&J's operating profit picture. Analysts say that by the end of 2006, prescription drugs will account for "slightly more" than half of J&J’s operating profits. Some analysts view the acquisition as a shift in emphasis toward devices for J&J.

Compared to pharmaceuticals, the innovation for medical device and cardiovascular care is one of the most important and fastest growing sectors in healthcare industry. J&J needs strategic business expansion into promising sectors. In the past, J&J relied on smaller acquisitions to develop its device portfolio and has been less successful in its attempts to dominate the endovascular and cardiac markets. Therefore, the acquisition of Guidant is a strategic move and the acquisition makes J&J a player in the high-revenue cardiac rhythm management market for the first time and enables J&J to utilize Guidant’s technology to strengthen its drug-eluting stent platform. The global presence of J&J is also a big advantage.

The concerns about the deal are issues such as general industry and market conditions, cultural differences between two merging companies, and regulatory approval from Federal Trade Commission from anti-trust point of view. Guidant's entrepreneurial approach could clash with J&J's buttoned-down management style. The choice for J&J now, is between licensing the drug and spinning off the stent business of Guidant. By spinning off the stent business, J&J could potentially lose some revolutionary technology that is in the works and create their own nemesis. However, we find that the J&J acquisition of Guidant that is expected to close in the third quarter of 2005 is definitely beneficial for both parties and the market as a whole. Even though the acquisition looks pricey ($23.9bn cash and stock), it will be a good addition to the J&J wagon.

Alli Kandaiah, Kamal Jha and Kenji Yaguchi

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