Johnson & Johnson Looks to Turn the Fading Ortho Diagnostics Unit Into Cash

While Foolish readers know all too well that a good turnaround story can drive excellent shareholders, sometimes discretion is the better part of valor and it makes more sense to just get out and move on. That is the attitude of Johnson & Johnson (NYSE: JNJ  )  with respect to its Ortho Clinical Diagnostics, or OCD, business, with the company openly acknowledging that it has begun discussions to sell this long-underperforming unit.

All things considered, investors may end up surprised with how much J&J ultimately gets for this unit. While it has a small presence in the overall global diagnostics market (about 4% to 5%) and sales have been declining due in part to a lack of reinvestment, past deals between Agilent and Dako and Danaher (NYSE: DHR  ) and IRIS and Beckman Coulter suggest that a $5 billion price tag may be a pretty realistic estimate at this point.

What are they good at?
When considering who might buy Johnson & Johnson's diagnostic business, it's important to consider what it is and where it remains relatively competitive.

J&J is still a strong top-five player in clinical chemistry, immunoassay, and transfusion products. All told, OCD exited 2012 with about 5% share of the professional diagnostics market which includes clinical chemistry and immunoassays. Although the company hasn't reinvested in this business to stay on the leading edge, the Vitros platform is still a credible contender in the automated chemistry market, and JNJ has retained a viable platform in immunoassay.

Last and not least is the transfusion market, where J&J OCD remains a significant player in the reagents and tools used for blood typing and antibody screening. Although Immucor gained quite a bit of share from Johnson & Johnson (due to its investments in automated systems), J&J OCD can still boast roughly one-third market share around the world in what is really just a three-company industry.

J&J Ortho Clinical Diagnostics has virtually no presence in the fast-growing molecular diagnostics arena, where companies like Roche, Abbott, and Novartis have already seen early success. Likewise, point of care, urology, hematology, and advanced staining/pathology are not notable areas for the company.

Who Might Step Up?
When it comes to a sale of OCD, I certainly wouldn't rule out the possibility that a financial buyer (a private equity investor, or consortium of such investors) will be the ultimate winner. J&J has been harvesting cash out of OCD for some time now and under-investing in the business (which suggests that stripping out costs won't be a major opportunity for a financial buyer), but investors in challenged diagnostics companies like Dako have come out well in the past, and they may see this as a similar opportunity

I would be surprised if Abbott (NYSE: ABT  ) , Roche, or Siemens had major interest. Abbott is most keenly interested in boosting its overall growth profile, and building up faster-growing areas like molecular diagnostics, and I don't see a J&J OCD buy adding much more than operating synergies. Likewise for Roche and Siemens, though their relatively strong presence in Europe versus North America could reduce the extent of the overlap.

Becton Dickinson  (NYSE: BDX  ) could have some interest. The company has a presence in molecular diagnostics and strong share in areas like culture media, blood culturing, STD and HAI testing. Buying OCD would certainly broaden the company's base of business and the "fixer upper" nature of OCD could fit well with BD's solid operating capabilities. The biggest downside here, though, would be that BD is really focusing on getting customers to adopt its BD Max molecular diagnostics platform and developing additional assays -- buying OCD could be seen as a distraction to that goal.

Danaher could have some interest, particularly given the rich cash flow characteristics of the transfusion business, but again there are overlaps in immunoassay and clinical chemistry that could reduce the leverage from a deal. There's also a question of Danaher's competing priorities including the dental business; nearly half of Danaher's revenue comes from health care and life sciences; and management seems reluctant to overweight the business in any one direction. Moreover, while the company has billions of dollars in "dry powder" and hasn't done a large deal in a while, product ID and automation seem to be the areas Danaher is most interested in building through deals.

General Electric  (NYSE: GE  ) is a more interesting case. GE has made it known that the company would be open to expanding beyond its traditional "Big Iron" diagnostics and imaging operations, and the company did buy cancer diagnostics company Clarient almost three years ago. Moreover, GE once thought it had a deal to acquire Abbott's diagnostics business many years ago. J&J's OCD may be more of a fixer-upper than GE typically likes to buy, but GE already has a presence in selling big-ticket capital equipment to hospitals around the world, and the addition of a potentially margin/cash-flow rich stream of recurrent consumables would fit the GE model.

So, who is left? Mindray and Qiagen might like the idea of owning J&J OCD, but the rumored purchase price roughly matches their current market capitalizations. Likewise, Sysmex would find it to be a stretch. Sony and Samsung are not names that normally spring to mind when thinking about medical technology, but both have made it clear that they wish to diversify into health care and J&J OCD has the sort of global presence that could facilitate such a strategy.

The bottom line
Even though J&J's OCD business saw sales fall about 4% in 2012 and another 6% in the second quarter of this year, I still do believe it is quite probable that the company will get its reportedly targeted multiple of 2.5 times trailing sales, or about $5 billion in cash. Once the deal is done, I would expect that the cash will go toward the previously announced share buyback, though I wouldn't rule out a deal in medical devices as I outlined earlier.

Looking across the industry, though, I think the possibilities of a strategic sale are limited, with General Electric, BD, Danaher, and perhaps Sysmex as the most likely interested parties. With that, I expect a financial buyer to emerge with the winning bid, though that would mostly likely just start the clock on an eventual IPO or sale to a strategic buyer.

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