The (second) worst deal ever
In the biggest M&A blunder since AOL/Time Warner, Boston Scientific paid too high a price to snatch Guidant away from archrival Johnson & Johnson. Here's how it happened.
(Fortune Magazine) -- On a warm August evening in Manhattan, the former leaders of medical-device maker Guidant joined their investment bankers in a private room at the tony Bouley restaurant to celebrate the sale of their company to Boston Scientific (Charts). Sipping rare bordeaux, they marveled over the wild bidding war between Boston and rival Johnson & Johnson (Charts), which had netted them a premium price of $27.3 billion for their company, reeling from a series of damaging product failures.
Boston Scientific had held its own bash on May 1, just after the deal closed. Boston's investment bankers, Merrill Lynch and Bank of America, organized the feast at the St. Regis Hotel in New York City. But the day of the event, thunderstorms in the New York area played havoc with arriving flight schedules. Boston co-founder Pete Nicholas, CEO Jim Tobin, and CFO Larry Best sat for hours in a drafty hangar on Hanscomb Field in Bedford, Mass., while their lawyers and investment bankers, as well as lower-level executives, partied into the night. The stormy weather turned out to be an omen, because while the lawyers and bankers were of course well paid for their efforts, the deal turned into a deluge of bad days for the Boston brass.
In late June, Boston Scientific issued recalls or warnings on almost 50,000 Guidant cardiac devices and acknowledged that it could take as long as two years to fix its safety problems. On Sept. 21, Boston issued a profit warning that shocked Wall Street, sending its already beaten-down shares plunging another 9.2 percent in a single day. Since it announced the bid for Guidant last December, Boston's stock has dropped a stunning 46 percent, wiping out $18 billion in shareholder value in a matter of months. Indeed, the deal is arguably the second-worst ever, trailing only the spectacular AOL Time Warner debacle (see "Buyer's Remorse," page 112). "It's like the movie The Money Pit," Matthew Dodds, an analyst at Citigroup, says of Boston's handling of the deal. "Once you've put enough in, you'll go all the way till it's done, regardless of the value."
Today Boston CEO Tobin finds himself spending two days a week at Guidant's St. Paul headquarters so he can personally manage continuing product calamities at the business he fought so hard to buy. Right now, he tells Fortune, Guidant's operations are producing zero profit. That's right, Boston is earning zip on a multibillion dollar investment. Part of the reason is that Tobin hasn't cut expenses to match the steep drop in sales. "We need to spend in a way that will solve our product problems and maintain our excellent sales force until the market bounces back," he says.
But it will take far more than an uptick in sales to rescue Boston from this fiasco. To discover how a seasoned team of shrewd dealmakers came to pay so much for so little, Fortune pored over thousands of pages of corporate filings and interviewed more than 15 board members, executives and lawyers involved in the deal (almost none of whom would speak for attribution). What emerges is a roller-coaster tale of bet-the-franchise corporate brinkmanship, miscalculation and overreaching. It is a stark lesson on how the single-minded pursuit of victory can blind even brilliant execs to the true costs of a deal. It's also a study in wildly contrasting personalities locked in gladiatorial combat: the colorful, swashbuckling crowd from Boston vs. the cautious, by-the-book executives at Johnson & Johnson, who, despite their stiff bearing, proved as tough as they are proud. And it sheds new light on the surprisingly brutal world of the medical-devices industry, which helps save thousands of lives a year but is marked by deep personal animosity and ferocious combat in the the marketplace and the courtroom - where the battle over Guidant continues.
In late September, Johnson & Johnson sued Boston, Guidant and Abbott (Charts) for $5.5 billion, claiming they violated terms of its deal with Guidant. Indeed, Johnson & Johnson has reason to be sore. While it seemed to win by losing - it isn't saddled with Guidant's woes - it also enabled a powerful competitor to emerge: Abbott Labs, the quiet kingmaker in this otherwise disastrous merger, which, by playing both sides of the deal, came out as the one clear winner.
The target: a graying Guidant
Spun out of drug giant Eli Lilly (Charts) in 1994, Guidant was a reflection of the two very different men who ran it: Jim Cornelius and Ron Dollens. Cornelius, Guidant's chairman, was Lilly's former CFO, a taciturn numbers man who helped Guidant generate huge earnings gains from tiny dollops of new capital (He's now serving as interim CEO at Bristol-Myers Squibb (Charts)). Dollens, a sunny extrovert, was a supersalesman who had run Lilly's medical-devices business. As a sales manager in San Francisco in the early '80s, Dollens reveled in his unhipness, sporting plaid pants and wide ties in a trendy town.
Under this well-matched pair Guidant combined technical innovations and a powerhouse sales force to capture around 35 percent of the $10 billion market for pacemakers and defibrillators by 2004. During that ten-year stretch the stock surged 2,200 percent, driving Guidant's market capitalization to about $20 billion and making its executives rich.
And after ten years of trench warfare in the famously combative industry, Cornelius and many of the Lilly crowd who ran Guidant were ready to savor their success. Cornelius and his wife, an artist, were spending long stretches at their spectacular oceanfront home in Hawaii. In mid-2004 Dollens, the only CEO in Guidant's history, announced he would retire at year's end. A top operating official, Jay Graf, left his post in July 2004. Other key execs, now wealthy, were ready to follow suit.
As the invitations went out for Dollens's gala retirement party, to be held at a management retreat in Lake Tahoe, Guidant's board launched a search for a CEO and hired J.P. Morgan and Morgan Stanley to help explore a sale. Boston Scientific wasn't the first suitor; Johnson & Johnson - a venerable giant looking for a dose of growth - expressed an interest. Yet Guidant swiftly rejected its initial bid of $68 a share. Guidant's stock had been soaring on takeover rumors and was already close to what J&J was offering. Cornelius & Co. were looking for a premium.
Besides, they had their eyes on a potential CEO. After rejecting four internal candidates, Guidant's board embraced Joseph Hogan, then 47, a fast- rising executive in General Electric's medical division. The board hoped that the problem of Guidant's future was solved - until GE came back at Hogan, offering to make him chief of GE Medical Systems, the company's trophy $10-billion-a-year business. Hogan decided to stay put.
So when J&J CFO Bob Darretta called his counterpart at Guidant in November 2004 to discuss a new deal, he found a receptive audience. And with its stock up almost 15 percent since the last offer, J&J could sweeten its bid without offering more shares. In December, J&J proposed paying $76 a share, or $25.4 billion, with 60 percent in stock, 40 percent in cash. Guidant accepted. And no wonder. At that level, J&J was paying a huge multiple of almost 50 times Guidant's earnings.
A prize beyond Band-Aids
By J&J standards, CEO William Weldon is a revolutionary. A burly former forward for Quinnipiac University's basketball team, he boasts a crushing handshake, a broad smile and a shock of white hair that he's always brushing off his forehead. He came aboard in 2002 determined to shake up the venerable maker of Band-Aids, Tylenol and baby powder, and his plans included making bolder acquisitions.
As Weldon saw it, Guidant was just what the doctor ordered. After decades of double-digit gains, J&J's sales, now $51 billion a year, were jogging along at a middling pace, and J&J's pharmaceutical business was a laggard. By adding Guidant's pacemakers and defibrillators to its product lineup, J&J could improve its position with hospitals and cardiologists. And there was a bonus: Guidant had a highly promising drug-coated stent in development, the Xience and a proprietary technology for implanting stents called Rapid Exchange that was already extremely popular with doctors. Adding those products to J&J's existing stent business could provide a dramatic jolt.
The one complication was that the Federal Trade Commission might very well ask J&J to divest Guidant's "interventional cardiology" business - consisting of stents and the balloons, guide wires and other gear used to implant them - as a condition for approving the deal.
So J&J turned on the D.C. charm. Over the next ten months, in a series of meetings, letters and phone calls, J&J's lawyers argued that the competitive landscape could be maintained if Johnson & Johnson shared Guidant's delivery technology with one rival. In a stunning success for J&J, the FTC accepted the argument, requiring J&J to license Rapid Exchange to a single competitor. Medtronic, America's largest device maker, eagerly courted J&J for the privilege. But instead Johnson & Johnson turned to what seemed at the time to be a less threatening player - Abbott Labs. That decision would come back to haunt J&J.
The trouble begins
Guidant CEO Dollens agreed to postpone his retirement to shepherd the transaction with Johnson & Johnson. But what should have been a victory lap turned into a slog through the swamp. In March of 2005 a 21-year-old student named Joshua Oukrop, who had a Guidant defibrillator implanted in his chest, died of a heart attack while bicycling. The defibrillator short-circuited, failing to release the shock that could have saved his life.
Guidant had discovered the short-circuiting problem three years earlier and had corrected it in new models. Yet the company never informed doctors that devices already in use carried a small but potentially fatal risk of failure. Oukrop's cardiologist complained to Guidant that it should immediately warn doctors about the short-circuiting problem. With the story about to break in the New York Times, Guidant finally came clean, issuing a recall of the flawed defibrillators in June.
But the bleeding didn't stop there. A series of damning investigative stories in the Times then detailed problems with several other models. Over the next few months Guidant issued recalls on 290,000 devices, covering a dozen types of defibrillators and pacemakers. By late October, Guidant's stock dropped from the mid-70s to the mid-50s.
Johnson & Johnson's Weldon still wanted to buy Guidant - just at a lower price. He cut his offer by $6 billion, from $76 a share to about $58 a share. Guidant's directors were indignant, according to former board members. They believed that J&J was trying to use Guidant's temporary misfortunes to, in a favorite phrase at board meetings, "steal the company." When they rejected the offer, Johnson & Johnson sued to abrogate the sales contract, and Guidant countersued.
But at the same time the parties kept talking and J&J cranked its offer up to $63 a share. Still unhappy, Guidant's directors didn't have a lot of options: There was no one to run the company if they spurned J&J, and they also worried about a "bomb in the basement" - additional product blowups that could destroy even more of Guidant's value. On Nov. 15, Guidant grudgingly accepted the new offer. It seemed to be totally at the mercy of J&J. But that was about to change.
Enter the wedding crasher
Boston Scientific in late 2005 was a spectacular growth company running out of ways to grow. It was founded in 1979, when Pete Nicholas and scientist John Abele borrowed heavily and raised $800,000 to buy a tiny manufacturer of devices for minimally invasive surgery. Boston flourished thanks to a series of bold acquisitions engineered by two men who loved the rush of dealmaking, Nicholas and Larry Best, the CFO who arrived in 1992. Nicholas is married to the former Ginny Lilly, a great-great granddaughter of the founder of Eli Lilly, where Nicholas started his career as a drug salesman. An avid yachtsman, Nicholas prides himself on audacity, on confounding competitors with unexpected plays. By mid-2004 Nicholas had parlayed his cards at Boston into a net worth of $4 billion.
In the merger game, Nicholas found a perfect partner in Best. A former accountant at Ernst & Young, Best is a mercurial street fighter who, as one friend puts it, "doesn't like to lose and doesn't lose very often." He thinks nothing of picking up the phone to upbraid analysts who give Boston poor reviews. For Best, it's a point of pride that Boston is still managed like a fast-growing startup.
For all Nicholas's dealmaking prowess, his best move may have been the 1999 hiring of Jim Tobin as CEO. Tobin, a veteran drug exec who excels at launching new products, orchestrated the debut of the Taxus drug-coated stent in early 2004. The Taxus quickly grabbed more than half the market from its only competitor, J&J's Cypher. By early 2006 Taxus accounted for more than 60 percent of Boston's operating profits.
The success of the Taxus made Boston a major power but left the company without a follow-up act. The stent business, though highly profitable, is growing at just 5 or 6 percent a year. So Boston was on the prowl for another big acquisition. In fact, Nicholas and Best had long coveted Guidant - the two companies talked about a merger in the early 1990s. "But as we both became a big deal, we didn't think we could get antitrust approval," says Tobin, who adds that he was impressed by the ruling J&J secured from the FTC.
The prospect of J&J winning Guidant was especially galling to Boston because of the bad blood between the two firms. According to chairman Nicholas, the feud dates back to the mid-1990s, when J&J proposed buying Boston. When Boston refused, Nicholas told Fortune in 2004, J&J struck back with a barrage of lawsuits. "After that it was all-out warfare," says Nicholas. "Both sides went to full battle dress."
On Nov. 1, 2005, Pete Nicholas of Boston Scientific called Guidant's Cornelius. The two pharma veterans had been friends since they went through the same internship program at Eli Lilly together 39 years before. Nicholas informed Cornelius that Boston was interested in buying Guidant. According to people familiar with the conversation, he told Cornelius that he thought J&J was trying to stick it to Guidant, using its leverage to capitalize on its temporary woes.
Cornelius, at that point still locked into a contract with J&J that prevented him from discussing a merger with another bidder, told J&J about the call the next day. But J&J and its investment bankers didn't take Nicholas's overture seriously. They reckoned that Boston wasn't big enough to buy Guidant. They also assumed that Boston would need many months to go through an antitrust review, just as J&J had, and that the harried Guidant board would never accept such a delay. Those were all valid points. But J&J had underestimated Boston's resourcefulness and, most of all, its hunger for Guidant.
Abbott switches sides
Boston desperately wanted to bid, but it had a lot of work to do. In early November, just after Nicholas called Cornelius, the Boston deal team huddled at the company's sprawling campus in the Boston suburbs. Gathered in the conference room were Nicholas, Best, and Tobin, along with lawyers from Shearman & Sterling and bankers from Merrill Lynch. Just as J&J had assumed, they faced two major challenges: Boston had to raise money, since it didn't have enough in its own coffers to finance a deal. And it had to arrange to sell Guidant's interventional cardiology business, since keeping it would likely invite a long antitrust review that the Guidant board would never tolerate.
On Dec. 5, Boston announced its intention to make a $72-a-share bid for Guidant. To solve both its antitrust and financing problems, a few days later Tobin put in a call to Abbott CEO Miles White. "We have some ideas to discuss," he said, according to someone familiar with the conversation. "I thought you might," replied White. Renowned for its HIV and epilepsy drugs, Abbott (2005 sales: $22 billion) had signed on with J&J to license Rapid Exchange in the event of a deal, but J&J and its lawyers had failed to include language that would have blocked Abbott from helping Boston. White would exploit that mistake for all it was worth. The two CEOs turned the negotiations over to subordinates who hammered out the details of a deal that would catapult Abbott to the front ranks of the most lucrative medical-device market ever.
Rather than just a license for Rapid Exchange, Abbott would get the Xience stent, inherit the crack sales force and own Guidant's entire interventional cardiology business, including its spectacular product pipeline and state-of-the-art manufacturing. In return, Abbott would go a long way toward financing the deal. It agreed to buy Guidant's stent business from Boston for $3.8 billion and to lend Boston $700 million at a bargain interest rate. J&J was furious.
Over the next month the Boston team hunkered down again at headquarters to do its due diligence on Guidant, living on hoagies and salads, conducting meetings that started at 8 A.M. and went long into the evenings. The lawyers and investment bankers were amazed at the tenacity and stamina of Nicholas, then 64, who fired off question after question about Guidant's recalls. It was Tobin who assured the team that while the problems were serious, they were "manageable" and that the Guidant franchise wasn't "permanently impaired." On Jan. 8, Boston made its official bid, with Abbott as its partner: $72 a share, topping J&J by $9, or more than $2.9 billion. The game was on.
From weakness to strength
With Boston's offer in hand, Guidant's board - led by Cornelius, who replaced Dollens as CEO in November - played the two bidders like a virtuoso. On Jan. 11, J&J raised its bid to $68 a share. That was $4 below Boston's bid, yet the Guidant board continued to back J&J, provoking howls of protest from institutional investors and Boston CFO Best. But the board's posture had been carefully calculated.
"The shareholders thought we favored J&J, but we didn't," says a former Guidant director. "We wanted to keep Boston bidding as long as possible. We weren't going to get the highest bid from Boston once we said we preferred their offer." Sure enough, on Jan. 12, Boston raised its bid to $73. J&J came back at $71.
Once again the Guidant board endorsed J&J. A two-buck-a-share advantage, it seemed, wasn't going to be enough for Boston to prevail. The Guidant board also wanted a deal that was virtually certain to close, and to close quickly, which meant no antitrust hassles. The main sticking point: In its deal with Abbott, Boston had insisted that Abbott not license Rapid Exchange and other technology to other firms. Guidant feared that the provision would take months of antitrust review to get approved.
Guidant had read Nicholas and Best just right: For the next round, they would do just about anything to win. On Sunday, Jan. 15, the Boston deal team met in Natick, Mass. In the conference room that morning, Larry Best told the group that Boston shouldn't make another "incremental bid." "We need to make a bid that ends this, to swing for the fences," said Best, according to one person in the room. Best proposed $80, and Nicholas and Tobin agreed. The rest of the day, Best worked on hammering out a new agreement with Abbott. In a rapid-fire series of phone calls to Abbott COO Richard Gonzalez, Best persuaded him to increase the price Abbott would pay for the Guidant assets by $300 million, and buy $1.4 billion in Boston stock - in effect, Abbott was financing most of the increase in Boston's offer. Boston also dropped its pet provision, the co-exclusivity agreement with Abbott, to ensure quick antitrust approval.
On Jan. 17, Boston delivered its knockout offer of $80 a share, or a total of $27 billion, 52 percent in cash and 48 percent in stock. It also agreed to a "hell or high water" clause saying that no matter what the FTC required, it couldn't walk from the deal. Nor could it escape if any of the products having problems suffered more recalls or lawsuits, or otherwise caused financial damage. If the deal didn't close by March 31, Boston would also pay interest for each additional day. (The parties agreed on a rate of 6 percent a year, which ended up costing Boston $90 million.) Finally, Boston expanded the "collar" that would require it to hand over more shares if its stock price dropped. (In the end Boston had to increase the shares handed to Guidant's stockholders by 16 percent.)
J&J still had a week to counter. A board meeting - 13 months after J&J and Guidant signed their first deal - was held by conference call, hosted by Weldon from J&J's headquarters in New Brunswick, N.J. Directors expressed astonishment at Boston's final offer. Weldon and CFO Darretta reminded the board that J&J had run five- to seven-year profit projections, making the most optimistic assumptions about Guidant's growth, and it still couldn't justify an offer above $71. Weldon said that J&J "won't chase this deal to a price that doesn't make sense for the company." J&J made no further offer.
Boston had won. At a celebratory investor presentation in late January, it heralded the deal as historic. It predicted double-digit growth for the troubled cardiac-device market in 2006 and big market-share gains for Guidant. The forecasts proved spectacularly wrong.
Tallying the score
The leaders of Boston viewed the deal as an unalloyed triumph. In May the board granted big bonuses to six executives who'd helped orchestrate the merger. CFO Best received a special one-time package worth about $1.2 million. And the deal was widely lauded.
The Institutional Shareholder Services, the agency that advises stockholders on how to vote on mergers, praised the deal. No fewer than 13 analysts covering Boston, including those of HSBC, Lehman Brothers, and Sanford C. Bernstein, called it a winner, and placed an average target price of $36 on its shares. And Boston executives still insist their acquisition will pay off. "This is a transforming deal that makes us far better positioned for double-digit growth," CFO Best told analysts on a recent conference call, adding that it should be judged three or four years from now, not on today's temporary setbacks.
But the math never made sense. Today Boston's shares are languishing at $15, and even a major comeback at Guidant is unlikely to restore the stock to its glory days. In fact, the deal is an object lesson in the dangers of dilution. To buy Guidant, Boston increased its share count by 80 percent and took on $6.5 billion in debt - on which it is paying more than $300 million a year in interest. Yet Guidant will contribute exactly nothing to Boston's earnings this year, so Boston is already losing money on the deal.
And from this point, climbing out of the hole becomes almost impossible. In 2005, Guidant earned $355 million on cardiac devices; even if Guidant's earnings quickly return to that level, those profits would have to grow by 22 percent a year for 15 years for Boston to earn a 9 percent return on its $25 billion investment, estimates Steve O'Byrne, a valuation expert with Shareholder Value Advisors.
Guidant, on the other hand, secured an astounding price for its assets. Guidant shareholders who sold their stock before the deal closed on April 21 got virtually the full $80 a share, thanks to the collar and all the other generous protection provisions. Even loyalists who held on haven't fared too badly. Today, despite the decline in Boston's share price, they still hold a total package of cash and stock worth $66 a share, $3 more than they'd have received from J&J if Boston hadn't barged in.
Abbott is the other big winner. Its stock price has climbed 22 percent this year, to $48. Citigroup's Dodds reckons that by 2009, Abbott's operating earnings from the Xience stent and other Guidant assets will reach $650 million - about the same number he expects Boston's Guidant business to earn. Yet the deal cost Abbott a pittance compared with the $25 billion that Boston paid.
Abbott did suffer one setback. Its role didn't sit well with Johnson & Johnson. The Boston/ Guidant deal had barely closed when J&J ended a co-marketing agreement with Abbott for its Cypher stent. That move will prove costly to Abbott, at least temporarily. It was collecting around $120 million a year in commissions on Cypher sales. Now it will have to keep its sales force on the payroll while it waits for the Xience to reach the U.S. market, with no drug-coated stent to sell.
As for J&J, the outcome was a mixed blessing. To be sure, by not paying billions for an ailing company it dodged a disaster and got a $705 million breakup fee. And the deal has hobbled a rival, in Boston. But J&J also lost some ground. Abbott will soon be a potent competitor in stents. It wouldn't have been nearly as powerful if J&J had bought Guidant. Abbott can also license Rapid Exchange to new competitors, another negative for J&J. Nor can J&J deploy Guidant's technology for its next-generation stent. "J&J does not have a strong stent program going forward," says Glenn Reicin, a medical-devices analyst at Morgan Stanley.
Out in St. Paul, Jim Tobin - the best operating executive in the medical-devices industry - is attacking Guidant's product woes, establishing an independent quality division that reports to top management and pushing a new technology called Latitude, a system that monitors heart problems from a box at the patient's bedside. "Doctors understand the life-saving benefits of these devices and double-digit market growth will come back," says Tobin.
For Tobin, reviving Boston's flagging business is more than a matter of pride: He holds grants of restricted stock that give him $14 million if the stock reaches $35 and $150 million if it gets to $75. Tobin thinks his package will still pay off. He's so confident, he says, that he won't push the board to reprice his shares. Tobin believes in the kind of wow-the-critics heroics Boston is renowned for. But this time Boston made a deal that's beyond redemption.
Eugenia Levenson contributed to this article.