Johnson & Johnson (NYSE:JNJ) shares shot down down about 2% in early morning trading after it announced it will pay about $30 billion for Actelion Ltd (OTCMKTS:ALIOF), makers of Tracleer, Uptravi and Opsumit. But as of the time of this writing, JNJ stock is warming up a bit, sitting at a drop of around only 0.10%.
Analysts and reporters (like this one) have been speculating for months about the deal.
Johnson & Johnson originally backed out of talks, at which point Actelion CEO Jean-Paul Clozel, who founded the company with his wife in 1997, began talks with Sanofi SA (ADR) (NYSE:SNY). While there was an assumption that JNJ stock would react well to the news, it’s down about 1.5% from the price it closed at on Jan. 23.
The price is a rich one, 30 times Actelion’s estimated 2018 earnings, and it will take months to complete.
The question for investors is whether this short-term pain will be worth it.
What JNJ’s Gorsky Gets
The deal was engineered by Alex Gorsky, who has been Johnson & Johnson CEO since 2012 after spending four years at Novartis AG (ADR) (NYSE:NVS), which like Actelion is a European drug maker.
The deal price represents almost 10% of JNJ stock’s market cap as of Jan. 26, but is affordable because the company had over $40 billion in cash and short-term securities on its books as of October, and less than $27 billion in debt on $140 billion in assets.
Unlike other recent deals between U.S. pharmaceutical companies and European entities, which include a move of the headquarters for tax purposes, this deal is not a tax inversion. It doesn’t even take out the whole target company.
Instead, Johnson & Johnson will spin-off the Clozels into a new entity, backed by “1 billion Swiss Francs in cash” (the Franc is currently at parity with the U.S. dollar) and distributed to current Actelion shareholders as a dividend. JNJ will hold 16% of that company and options to buy another 16%. The U.S. company will also get an option on ACT-132577, another hypertension drug now going through clinical trials.
The Clozels had rejected takeover attempts for years, preferring to retain their autonomy. This deal gives them that autonomy, and gives their shareholders a huge pay-out on the existing drugs. The price is 80% higher than where Actelion was trading as recently as Nov. 23, when news of takeover talks first began.
Where Does JNJ Stock Go From Here?
Johnson & Johnson has been trading at a market-matching price-to-earnings multiple of 19.75, and its gains have only matched the S&P 500 under Gorsky, because it is not seen as primarily a drug company. Instead most of its profits come from consumer products, shampoos, soaps, deodorants and over-the-counter medications like Tylenol, Pepcid and Sudafed. These are stable businesses with comfortable, but not earth-shaking margins.
For the three months ending Jan. 1, for instance, Johnson & Johnson had $3.8 billion in net income, $1.38 per share on $18.1 billion in revenue. The operating margins for a pure drug company like Merck & Co., Inc. (NYSE:MRK), which trades at a P/E of 33.41, can be twice as high. It’s easier to raise the price of a drug than a cream.
While reporting those results on Jan. 24, which traders took as an excuse to sell the stock, JNJ also said it will seek “strategic options” for its diabetes care division, admitting that results were hampered by a strong dollar and slower sales of medical devices.
For Johnson & Johnson, then, the Actelion deal could be part of a trend, where the company seeks the fat profits of branded drugs, but lower profits to be had from consumer products like Band-Aids. If that proves to be the case, especially if the company’s sales force can boost results from Tracleer, which is losing patent protection, then buying JNJ stock today may prove to be a very good move.
Dana Blankenhorn is a financial and technology journalist. He is the author of the sci-fi novella Into the Cloud, available at the Amazon Kindle store. Write him at [email protected] or follow him on Twitter at @danablankenhorn. As of this writing, did not hold a position in any of the aforementioned securities.