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Johnson & Johnson vs. Goldman & Goldman: Street Whispers

NEW YORK (TheStreet) -- In Goldman Sachs' (GS) Tuesday downgrade of Johnson & Johnson (JNJ) to 'Sell,' Wall Street watchers might want to chalk up a win for reform... and bankers' love of advisory fees.

The Goldman research arm's bearish outlook on J&J -- predicated on a misguided M&A strategy -- comes months after Goldman's investment bankers helped seal the healthcare giant's largest-ever acquisition.

On the face of it, there's nothing surprising about Goldman's downgrade of J&J. After all, the company has significantly underperformed the Dow Jones U.S. Pharmaceuticals Index ( DJUSPR) in the past year and it faces an onslaught of competition from the likes of Pfizer (PFE), Abbot Laboratories (ABT), Covidien (COV) and Baxter International (BAX), who are in the process of spinning off non-pharma businesses, giving investors a choice of pure-play drug makers that may be industry aggressors in coming quarters.

The real surprise is how arguments floated by Goldman's research analysts appear to undercut the bank's front and center role as an adviser to J&J on its $19.7 billion acquisition of medical device maker Synthes, the largest deal in the company's 126-year history. The downgrade is especially noteworthy given that Goldman's advisory work for J&J was also likely considered to be a capstone 2012 success in a relatively weak year for dealmakers.

In April 2011, Goldman was the sole advisor to the Synthes acquisition, initially a cash and stock deal that was forecast by management to be dilutive to J&J's earnings per share. However, in June of this year, Goldman and JPMorgan (JPM) structured a complicated share swap where J&J could effectively use cash abroad instead of a secondary stock offering in the U.S. to finance the merger, magically turning what was a dilutive acquisition into an EPS accretive M&A overnight.

In fact, the deal, which exploited a loophole on how the Internal Revenue Service taxes foreign earnings, propelled the IRS to plug the hole shortly thereafter, according to a July 23 interview with tax expert Robert Willens. Talk about bankers adding value.

Give credit to Goldman for uncovering financial maneuvers to turn the Synthes acquisition from a 5 cent EPS drag on J&J's forecast 2013 earnings to a 15 cent benefit.

Other parts of the bank didn't seem to take notice, even if the swap radically changed perceptions on the deal, giving Jefferies and JPMorgan analysts reason to upgrade their outlook on J&J's shares.

In late May, as J&J was seeking European Commission antitrust approvals for its Synthes acquisition, Goldman Sachs research analyst Jami Rubin argued that the company's M&A ambition and its doubling down on a conglomerate corporate structure would backfire relative to the competition.

On Tuesday, Rubin underscored the argument, downgrading J&J to a 'Sell,' citing the company's M&A strategy and competitive threats to its drugs unit. "[JNJ's] focus on M&A versus cash returns to shareholders or a break-up strategy (like PFE, ABT, COV, BAX) puts it at a disadvantage as other companies get more aggressive," writes Rubin in the report, which argues J&J's stock is worth just $72, far below other estimates. In early afternoon trading, J&J's shares were off nearly 2% to $68.26.

Rubin goes on to argue that a focus on drug R&D pipelines and shareholder friendly management of corporate purse strings are the biggest catalysts to the pharma sector as a whole, and recommends companies like Pfizer, Abbott Labs, Covidien and Baxter International over J&J.

In March, Rubin floated the idea that Pfizer should consider breaking up to a bigger degree than management's plan to divest non-drugs assets like its animal health and baby nutrition units, signaling conviction behind the benefits of pure play pharma businesses over conglomerates.

The differing perspectives on J&J offered by Goldman by way of its investment bankers as an adviser to the company and its research analysts as an independent monitor on the company's share performance appear to add a new twist to the perception Wall Street research is compromised by the drive for lucrative M&A and IPO-related fees.

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