Johnson & Johnson's Traumatic Purchase

About a month ago, the rumors started up that Johnson & Johnson (NYSE: JNJ) was looking to make a significant purchase of $10 billion or more. And earlier this week we got our answer: Swiss medical device maker Synthes has agreed to be purchased for about $21.6 billion. Let's dig in and see what this means for Johnson & Johnson investors.

Synthes already controls half of the $5 billion trauma market and pulls in almost $1 billion in annual sales from its spine division while competing with Zimmer (NYSE: ZMH) and Alphatec (Nasdaq: ATEC). Post-merger, Johnson & Johnson's DePuy division will be the leader in trauma, hips, and extremities, and second in spine and knees. And it won't just be in a slight lead; its nearest competitor, Stryker (NYSE: SYK), will pull in only about half of DePuy's projected revenue.

One sticking point is the structure of the deal. It was originally assumed by most analysts that Johnson & Johnson would be using its cash from outside the U.S. to fund the majority of the purchase. By turning that low-interest cash into a productive acquisition, some thought that this deal would be accretive to the tune of about 5% of 2014's earnings, but J&J was forced to go a different route.

It turns out that Synthes is not the Swiss company it is made out to be! Although it doesn't trade on U.S. exchanges and is founded by a Swiss billionaire, Synthes in fact has a headquarters in the not-at-all foreign locale of West Chester, Penn. As a result, Johnson & Johnson will issue stock to pay for 65% of the deal, adding roughly an additional 8% to the share count in the process. Worse yet, this will turn what was initially assumed to be a really positive deal into one that is slightly dilutive for the next couple of years.

And then there is the Federal Trade Commission. Whether this deal can stand is also up for debate. Johnson & Johnson is projecting confidence, but my money is thinking the health-care giant won't come out unscathed. Likely victims are J&J's own trauma unit or a spine unit from one of the two companies.

It's an outside possibility, but if the FTC puts the kibosh on the whole thing, that leaves Johnson & Johnson likely looking for a relatively smaller and more acceptable target. Several names that were bandied around before news of the Synthes deal leaked including high-tech equipment maker Intuitive Surgical (Nasdaq: ISRG), which would pair up well with Johnson & Johnson's Ethicon division; and low tech hospital suppliers CR Bard (NYSE: CRB) or CareFusion (NYSE: CFN), both of which have key synergies while providing increased access to emerging markets. An international diagnostics player, like France's bioMerieux, could also make a lot of sense.

Assuming it's basically smooth sailing for this deal, where does it leave investors? On one hand, Johnson & Johnson looks to have paid a fair price for a company that is a natural fit, even if it has to divest the spine business, but J&J missed out on the opportunity to put its large stockpile of foreign cash to work. That's frustrating. With the share dilution, it may be some time before existing shareholders see any marked gains from this deal. I'm not super excited, but over the long term, it looks like the juice was probably worth the squeeze.