Johnson & Johnson's Deal For Synthes Closes: Healthcare Spending Will Grow

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Dividend Growth Portfolio holding Johnson and Johnson (NYSE:JNJ) announced today that it has received US regulatory approval to acquire Synthes, a Swiss multinational medical device maker. The deal was announced April 2011 and had been awaiting US approval, after receiving the go-ahead from the European Union nearly two months ago. The deal will make Johnson and Johnson the largest orthopedic company on the globe.

Though the purchase was initially pegged as dilutive to earnings by $0.22 per share, Johnson and Johnson announced the deal could actually boost adjusted earnings per share by $0.03-$0.05 in 2012 and by $0.10-$0.15 in 2013. The final value of the deal will be around $19.7 billion in cash and stock. Though we expect the acquisition to be modestly value-creating over time, we don't expect to make a material change to our fair value estimate of the firm's shares. The deal also underscores management's understanding that medical devices will be a huge and profitable market for years to come. With baby boomers continuing to age, they become more susceptible to falls, broken bones, and other injuries that Synthes' products help treat.

J&J currently yields in excess of 3.8%, and we think the diversified medical company will continue to grow its dividend long in the future. We like J&J's stable cash-flow generation, and we believe the company will eventually converge to our intrinsic value, offering some upside potential. J&J posts a Valuentum Dividend Cushion score of 2.5, meaning it can cover dividends with cash flow nearly 2.5 times during the next 5 years, after considering the health of its balance sheet.

More generally, we're fans of the long-term prospects of the medical-device industry thanks to the combination of an aging US population coupled with US government projections that suggest health-care spending will equal 20% of GDP by 2020, up from 17.9% in 2011. Though that increase may not seem like much, it translates into nearly $2 trillion in new health-care spending over just 10 years. We think the market is discounting the potential growth of the medical-device industry, as reflected in the prices of Medtronic (NYSE:MDT), Zimmer (ZMH), Intuitive Surgical (NASDAQ:ISRG) and St. Jude (NYSE:STJ). All four of these companies stand to benefit, and we think each of them have substantial upside potential over the long haul (click here for our valuation reports).

We like the medical-device makers and are even fans of some of the more mature drug companies like Abbott (NYSE:ABT), Pfizer (NYSE:PFE), and Bristol-Myers Squibb (NYSE:BMY). Among these firms, we believe Pfizer offers the most valuation upside. The firm will continue to face some tough sledding over the near term as a result of the loss of exclusivity of its largest drug Lipitor, as Ranbaxy Labs and Watson Pharma (WPI) are now selling a generic version. And even though we're not expecting substantial operating-income improvement anytime soon, Pfizer has a number of promising late-stage pipeline opportunities: Xalkori (for the treatment of ALK-positive advanced non-small lung cancer) and Eliquis (for stroke prevention in patients with atrial fibrillation. Pfizer is not alone in dealing with a patent cliff, as Eli Lilly (NYSE:LLY) will have to find ways to replace revenue from two of its largest drugs-Zyprexa and Cymbalta-while Merck (NYSE:MRK) will soon deal with the aftermath of the loss of exclusivity from blockbuster Singulair. Still, we like the pipelines of these firms and expect new drugs and M&A to replace much of what will be lost by the major drug firms in the next few years.

In Abbott's case, the decision to split the business into a research-based pharma company and a diversified medical-products company could unlock even more value for shareholders. Specifically, such a split (to be completed by the end of 2012) will allow two separate management teams to improve operations, implement cost savings, and allocate capital better than they could do as one entity. Though we like Abbot's valuation prospects, Bristol-Myers Squibb, on the other hand, doesn't look that cheap to us. Still, we continue to monitor the company's attractive future opportunities. Bristol-Myers Squibb recently released very promising results of a Phase I cancer drug (Investigational Anti-PD-1 Immunotherapy BMS-936558), as just one example.

We agree that all drug makers will likely benefit from increased spending over the long haul, despite having to navigate through the current patent cliff, but we think the valuation of generic drug maker Teva (NYSE:TEVA) is particularly compelling. With costs rising and the government having more influence on pricing, generic drugs will play a meaningful role in reducing costs. Further, Teva has incredible global exposure, and we think low-cost drugs will likely win out in a number of less wealthy countries. Abbott agrees, as it recently acquired Piramal's Healthcare Solutions division in India, which is the biggest generic drug company in the country.

All things considered, we believe the healthcare industry, especially in the United States, could be a very attractive space over the long haul, despite near-term regulatory changes. Johnson and Johnson, Teva, Medtronic, and Intuitive Surgical are our favorite ways to play the long-term secular growth in healthcare spending at this time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Some of the firms mentioned above may be included in our actively-managed portfolios.