J&J Renews Commitment To Devices With Synthes Deal

Rumors that Johnson & Johnson was looking to exit cardiovascular devices and perhaps go so far as to divest their entire device business apparently can be put to rest in light of the company’s recently announced plans to acquire orthopedics leader Synthes Inc.

Rumors that Johnson & Johnson was looking to exit cardiovascular devices and perhaps go so far as to divest its entire device business apparently can be put to rest in light of the company's recently announced plans to acquire orthopedics leader Synthes Inc. [See Deal] The $21.7 billion deal – the largest acquisition in J&J's history – bolsters the company's lagging DePuy Synthes orthopedics division by enhancing its spine business and making it the leader in the trauma market, a relatively small but fast-growing orthopedic sector.

J&J's support for orthopedics is also notable for coming at a time when DePuy is facing internal challenges related to the recent recall of a hip implant system. In response to a question about why his company would make a deal in orthopedics rather than in one of its other signature sectors, William Weldon, chairman and CEO of Johnson & Johnson, called orthopedics "an extraordinary opportunity" with a market potential he estimated at $37 billion, terming it "probably the largest opportunity in the whole medical device area."

The deal, which isn't expected to close until 2012 after the requisite regulatory review, also provided some badly needed good news to an orthopedics sector that's been caught in a bit of a tailspin of late. Indeed, some analysts believe the acquisition could not only help J&J but also could provide a needed financial boost to the entire orthopedics space. Michael Matson, senior analyst at Mizuho Securities USA Inc., called the deal a "vote of confidence in orthopedics."

For years, Johnson & Johnson had been rumored to be shopping for an orthopedics company, but the company's reported target had always been Smith & Nephew Inc. and its line of hip and knee implants. J&J zagged instead, eschewing the large joint business in favor of an area where company executives say they see faster growth in the orthopedics sector – trauma fixation devices. The acquisition would make J&J number one in trauma products with 56% of the market, a dramatic move up from the number five position it currently holds with only 4%. Plus, it would plug the company into a sector that analysts anticipate will be growing at a 7% clip. This is in stark contrast to the near zero growth – or worse – that Johnson & Johnson has reported recently for its spinal and large joint reconstruction businesses.

To fuel future orthopedic growth, J&J executives are betting heavily on the company's ability to market orthopedic products effectively in developing markets. In a call with analysts, Alex Gorsky, vice chairman of the company's executive committee, called trauma "the foundation of orthopedics in the emerging markets" where sales are growing about two to three times the rate of that in the US. "Even in spite of some macroeconomic issues, we've continued to see very good growth, and as the economy returns, we would expect that to potentially pick up even more," Gorsky predicted.

One interesting element of the acquisition is how J&J is boosting trauma fixation – which the company estimates to be a $5 billion market – rather than spine as a key driver of future growth, not just for Johnson & Johnson but for the orthopedics sector as a whole. But it's important to note that the Synthes acquisition also would add to J&J's spine business, enabling it to solidify its position as number two with a 22% market share to go along with its number two position in large joint reconstruction with 21% of that market. Michael Mahoney, chairman of the company's medical device and diagnostics businesses, told analysts that spine – at about an $8.5 billion worldwide market – remains an important part of J&J's orthopedics business, even as pressure by third-party payors and other macroeconomic factors have dragged the growth rate down to 2%. "We do believe longer term that the spine market will continue to grow at closer to a 5% rate in the outer years based on the unmet need, the terrific opportunity with back pain, and with the expansion of both the developed and emerging markets," he said.

The Synthes deal should help quell rumors that J&J may be looking to get out of the device business. The rumors were generally tied to the precipitous decline of the company's once dominant coronary stent business, leading some to speculate that J&J was looking to divest its Cordis CV group (whose sales dropped 4.7% last year), coupled with DePuy's woes resulting from the recent hip implant recall. Johnson & Johnson's continuing commitment to its device business should not really take anyone by surprise, however, given that medical devices now compose the largest of the company's business sectors, accounting for 40% of J&J's sales, compared with 36% for pharma and 24% for consumer products. Synthes, which last year had sales of $5.9 billion, will only further enhance medical devices and diagnostics as the current crown jewel of J&J's business.

The acquisition comes at a welcome time as, company-wide, Johnson & Johnson has reported disappointing growth over the past two years. In 2010, the company reported $29.5 billion in US sales, a 4.7% decrease from 2009, when it experienced a similar 4.4% drop compared with 2008 figures. Worldwide sales decreased 0.5% to $61.1 billion in 2010, compared with a 2.9% decrease in 2009. The medical device and diagnostics business has outperformed its pharmaceutical and consumer counterparts in recent years, with the latter two reporting $22.4 billion and $14.6 billion in 2010 sales (decreases of 0.65% and 7.7%, respectively, from 2009 numbers). The device business reported sales of $24.6 billion in 2010, representing an increase of 4.4% over the prior year, with operational growth of 3.4%. US sales were $11.4 billion, an increase of 3.6% over the prior year. International sales were $13.2 billion, an increase of 5% over the prior year.

DePuy's orthopedic business reported sales of $5.6 billion in 2010, a 4% increase over the prior year. But the orthopedic reconstruction segment – comprised largely of traditional ortho products including hip and knee implants – has struggled since the company issued a worldwide voluntary recall of its ASR XL acetabular system and ASR hip resurfacing system used in hip replacement surgery, principally sold between 2003 and 2009. The recall came after patients receiving those implants had unusually high revision rates. In the first quarter of this year, DePuy reported a 2% loss in sales compared with the first quarter of last year, an improvement over the 6% loss reported in the fourth quarter. DePuy's spine business actually reported a 1% gain in sales over the same quarter last year, a definite improvement over the 3% drop reported in the fourth quarter.

Medical device venture capitalists are certainly breathing a sigh of relief, knowing that J&J will continue to be one of the few remaining, large potential acquirers for start-up companies. Indeed, the current breadth of Johnson & Johnson's device business is rivaled only by Medtronic PLC J&J has been willing to take advantage of its deep pockets and pull the trigger on major device deals. Although it fell short of Boston Scientific Corp. in the bidding for Guidant, the company paid $785 million for interventional ENT pioneer Acclarent in 2009 and followed that with last year's $480 million acquisition of Micrus Endovascular, a stroke company. [See Deal] [See Deal] [See Deal] [See Deal] But there's a potential downside as well. Analysts suggest the purchase also might convince rivals to keep up. "We continue to believe that the JNJ-Synthes deal will trigger more consolidation in orthopedics," wrote Larry Biegelsen, senior analyst at Wells Fargo Securities. "JNJ's growing scale in the orthopedics market will likely force other large players such as Stryker [Stryker Corp.] and Zimmer [Zimmer Biomet Holdings Inc.] to bulk up by acquiring mid-size players." A consolidation of acquirers obviously wouldn't be a good development for start-ups.

Because J&J is paying for Synthes mostly in stock – just 35% of the payment is cash – the deal reportedly will be accretive in 2012 and the company will remain well-heeled with cash for future acquisitions. (Given Johnson & Johnson's hefty balance sheet, its use of stock to ink the deal took some by surprise because it creates additional unwelcome earnings pressure.) The next logical target area for a device acquisition: cardiovascular, where J&J needs to boost its declining Cordis business. Within Johnson & Johnson, there historically has been a school of thought linking opportunities for growth in both the CV and orthopedics markets to ensure the company's place in the two largest medical device sectors. The CV acquisition target most often suggested: Edwards Lifesciences Corp., to take advantage of its leadership position in percutaneous valves, thought to be the next blockbuster device market and an area from which J&J is currently absent. Stay tuned.

– Tom Salemi