Initial Buy Recommendation (JNJ, $62.69)
I believe that Johnson & Johnson will experience an acceleration in earnings based on an outstanding pipeline of new drugs. I am recommending purchase.
Perspective on Stock Performance
Johnson & Johnson (JNJ) is coming off three poor years in which its unit volume and sales have been flat. It has suffered from a host of issues including: (1) patent expirations of key ethical drug products, (2) continuing efforts to control health care spending in developed countries with Obama care exacerbating the US situation, (3) the world economic slowdown and (4) quality control issues in its consumer business that caused a sharp drop in product sales. In this tough environment JNJ was only able to scrape out an increase its EPS from $4.57 in 2008 to $4.78 in 2010; the annual dividend increased from $1.80 to $2.11.
The stock performance has not surprisingly been poor. The Dow Jones Industrials have bounced 90% off their closing low of 6,457 on March 9, 2008 while JNJ is up only 40%. Throughout 2008, the stock traded in a price range of $55 to $72 and the price range so far in 2011 has been in a lower $58 to $64 range. Investors have had little to cheer about.
The stock closed at $60.02 on April 14th and has since had a nice move to a recent close of $64.39 on April 20th. The bounce in the overall market helped, but the stock also responded to two positive events. On April 15th, the company announced that it had concluded its lawsuit with Merck concerning Remicade on very favorable terms. Then the first quarter sales and earnings report on April 19th was better than expected and the company raised its full year sales and earnings guidance. It had guided for 2011 EPS of $4.80 to $4.90. It raised the guidance to $4.90 to $5.00, up 3.0% to 4.6% from 2010. About $0.08 of this $0.10 increase in EPS guidance was due to favorable foreign currency effects and only $0.02 was due to operational and other matters.
Stock Opinion
The question for investors is whether JNJ is still mired in its miseries of the last few years and we have just seem a bounce due to market resurgence and a knee jerk reaction of investors to the increase in EPS guidance, which when closely examined was not overly impressive.
I am recommending purchase of Johnson & Johnson. The primary reason behind my recommendation is an outstanding new product outlook in the ethical drug business. I also think that the company should have its consumer products manufacturing issues behind it in 2012 and I think that the improving world economy will aid the medical devices and diagnostics and consumer businesses. On the negative side, JNJ will continue to sail into headwinds from healthcare cost control measures in the US and Europe. Moreover, the company is about to face generic competition on two key drugs: Levaquin loses exclusivity in the US in June of 2011 and Concerta in May of 2011. I estimate that combined sales of these products will drop from $2.7 billion in 2010 to $1.9 billion in 2011 to $1.0 billion in 2012 and $483 million in 2013.
Johnson & Johnson could be viewed as a mutual fund investing in health care assets. It is a multinational conglomerate with operations spread over the globe. There is no one product that can drive the company. JNJ operates through 250 operating companies doing business in 60 countries and prides itself on decentralized management. Its executive committee allocates capital to each business in a manner similar to how portfolio managers allocate their capital to individual stocks. It is an aggressive acquirer of new products and businesses.
Johnson & Johnson is a difficult company and stock to analyze because of its diversity. It has three large sectors of business: ethical pharmaceuticals, medical diagnostics and devices and consumer health products. The following table provides a snapshot of my expectation for sales of its three business segments and my EPS and DPS projections.
| Summary of Key Investment Variables | |||||
| (billions) | 2009 | 2010 | 2011 | 2012 | 2013 |
| Sales (billions) | |||||
| Pharmaceuticals | $22,520 | $22,396 | $25,266 | $27,392 | $29,474 |
| Medical diagnostics and devices | 23,574 | 24,601 | 25,436 | 26,537 | 27,984 |
| Consumer products | 15,803 | 14,590 | 14,685 | 15,189 | 15,882 |
| Total sales | $61,897 | $61,587 | $65,387 | $69,118 | $73,340 |
| Pretax Income | $15,755 | $16,947 | $18,400 | $20,318 | $22,457 |
| EPS | $4.40 | $4.78 | $4.96 | $5.48 | $6.05 |
| DPS | $1.93 | $2.11 | $2.28 | $2.51 | $2.76 |
| Percentage Increase | |||||
| Pharmaceuticals | 8% | -1% | 13% | 8% | 8% |
| Medical diagnostics and devices | 2% | 4% | 3% | 4% | 5% |
| Consumer products | -2% | -8% | 1% | 3% | 5% |
| Total sales | -7% | -1% | 6% | 6% | 6% |
| Pretax Income (millions) | -7% | 8% | 9% | 10% | 11% |
| EPS | -4% | 9% | 4% | 10% | 10% |
| DPS | 8% | 9% | 8% | 10% | 10% |
| P/E @ price of $64.39 | 14.6x | 13.5x | 13.0x | 11.8x | 10.6x |
| Dividend yield @ price of $64.39 | 3.0% | 3.3% | 3.5% | 3.9% | 4.3% |
What my analysis indicates is that pharmaceuticals will lead to acceleration in sales and earnings for JNJ in 2012 and 2013. The estimates for sales growth could be conservative as I do not include any contribution from acquisitions although this is an integral part of the company’s strategy and even as I am writing this there is discussion in the business news of a potential major acquisition of the European medical device company Synthesis. My projection of acceleration in pharmaceutical sales is based on my enthusiasm for two potential blockbuster drugs, telepravir and abiraterone. Although my sales projections for these products are dramatic (especially for telepravir) there is potential that they could yet be low.
From an overall market standpoint, I think that JNJ’s earnings will be accelerating in 2012 at the same time that the strong earnings growth experienced by more economically sensitive companies in the beginning stages of this economic recovery begins to wane. This should make JNJ relatively more attractive in comparison to the broad market and could attract momentum players. I also sense that the pessimism that has gripped drug and device companies is beginning to ease as stocks are responding positively to new product approvals and positive news announcements. I believe that the drug group as a whole could end its long period of under performance. I expect that if this occurs, JNJ will be near the head of the performance pack.
It is always difficult to project stock price behavior because there are so many variables that can affect the market overall and JNJ in particular. My way of thinking is that the current price earnings ratio is likely to be retained over the next year with the positive change occurring in the fundamentals. If so, in two years the company would be selling at a P/E of about 13 based on 2013 EPS projections; this would point to a price of $79. I think that it can be argued that the factors I have discussed could lead to a modest expansion of the P/E multiple to perhaps 14 (the current P/E ratio on the S&P 500) or 15. This would result in a price of $85 to $91. These estimates suggest that the stock price has the potential to increase 23% to 41% over the next two years and with the projected dividend yield of 3.3% would produce a two year respectable total return of 26% to 44%.
There are a number of other issues that support my positive investment thesis on JNJ. In the balance of this report, I go over these.
Valuation is reasonable and expectations are low
I have never been persuaded that P/E ratios and dividend yield are the key factors in an investment decision; I view them as supportive measures to other more critical judgments. That said, I think that the estimated P/E ratio of 13.0 based on 2011 EPS and current dividend dividend yield of 3.3% are reasonable when viewed against the estimated 13.9 P/E for the S&P 500 and its current dividend yield of 1.9%. Moreover, the P/E ratios of companies in health care and especially those with important involvement in ethical pharmaceuticals have been in a near continual decline over the past decade due to concerns such as health care reform, lack of research productivity and loss of patent exclusivity on key drugs. Warren Buffet has said “Be fearful when people are greedy and greedy when people are fearful.” I think that the P/E ratio and dividend yield of JNJ are more reflective of fear than greed.
Financial strength, strong cash flow and consistency in performance are also important
JNJ with its AAA credit rating may be a better credit than US sovereign debt.
It generated $14 billion of free cash flow in 2010 or $5.04 per share. It could use this money to buy back 8% of its capitalization each year or to make acquisitions or some combination. These could add meaningfully to EPS growth potential but are not included in my estimates.
For performance consistency, one of the best measures is the dividend record. JNJ has increased its dividend in 48 consecutive years. This speaks to a strong and flexible business model that has been proven by the test of time.
Positive fundamental changes are very important
JNJ passes my tests for valuation, financial strength, cash flow and demonstrated ability of its business model to deliver over the long term but these are not the most critical part of my Buy recommendation. They are helpful or necessary but not sufficient. My investment decisions are driven much more by the potential for change, specifically acceleration in the rate of earnings and sales growth. It has been my experience that this is the most important driver of near term stock prices. I believe that there is the potential for acceleration in sales and earnings growth for the period beginning in 2012 as compared to the lackluster 2008 to 2010 period. This is critically driven by my anticipation that JNJ will receive approval and launch two key new ethical drugs this year that have blockbuster potential.
The first blockbuster is telepravir for hepatitis C which JNJ licensed from Vertex for the European, South American, Middle Eastern, African and Australian markets. There is enormous pent-up demand as HCV patients have anxiously awaited this drug. I see JNJ launching the product in 3Q or 4Q, 2011 and reaching sales of $2.8 billion in 2012. The second potential blockbuster is abiraterone for prostate cancer. This drug should receive approval in the US and Europe at any time. I see it as having broad potential in hormone resistant prostate cancer. It is likely to have a slower and steadier sales ramp than telepravir but I see it reaching sales of $465 million in 2012 and $645 million in 2013.
It is also possible that a third drug, the anticoagulant Xarelto (rivariboxan) could be approved in 2011 if issues on potential liver side effects have been successfully answered to the satisfaction of the FDA. If so, I see this drug as having sales of $338 million in 2015.
A fourth drug, TMC-278 (rilpivirine) is a product for HIV that could also be approved in late 2011. It is a second generation non-nucleoside reverse transcriptase inhibitor that is active against Sustiva resistant mutations. It is more potent that JNJ’s similar drug of the same class Intellence and can also be dosed at once per day. It seems non-inferior to Sustiva and has a better side effect profile. Sustiva is often part of the backbone of HIV therapy and TMC-278 has the potential to replace substantial Sustiva usage.
For those of you who want more detail on these two telepravir, abiraterone and rivariboxan, look for upcoming separate reports on each that should be published shortly.
The effect of the new products on overall sales performance is shown in the following table.
|
Worldwide Pharmaceutical Sales ($ millions) |
|||||
|
|
2009 |
2010 |
2011 E |
2012 E |
2013 E |
|
New Products |
|||||
|
telepravir |
0 |
0 |
400 |
2,750 |
3.700 |
|
Stelara |
175 |
393 |
472 |
562 |
1.092 |
|
abiraterone |
0 |
0 |
70 |
465 |
645 |
|
Simponi |
125 |
226 |
279 |
330 |
429 |
|
ripivirine |
0 |
0 |
6 |
175 |
338 |
|
Sub-total |
300 |
619 |
1,237 |
4,551 |
6.594 |
|
|
|
|
|
|
|
|
In-Line Growing Products |
|||||
|
Remicade |
4.304 |
4.610 |
5,241 |
5,786 |
5,915 |
|
Risperdal Consta |
1,425 |
1,500 |
1,660 |
1,864 |
2,119 |
|
Velcade |
933 |
1,080 |
1,222 |
1,405 |
1,574 |
|
Prezista |
592 |
857 |
1,070 |
1,284 |
1,477 |
|
Intellence |
198 |
239 |
288 |
320 |
368 |
|
Invega |
393 |
424 |
436 |
439 |
484 |
|
Sub-total |
7,845 |
8,710 |
9,917 |
11,098 |
11,937 |
|
|
|
|
|
|
|
|
Mature Declining Products |
|||||
|
Eprex/Procrit |
2,245 |
1,934 |
1,588 |
1,524 |
1,183 |
|
Aciphex/ Pariet |
1,096 |
1,006 |
910 |
887 |
718 |
|
Doxil/ Caelyx |
125 |
308 |
563 |
588 |
601 |
|
Concerta |
1,326 |
1,319 |
942 |
719 |
423 |
|
Duragesic |
888 |
748 |
594 |
497 |
399 |
|
Risperdal |
899 |
527 |
452 |
420 |
284 |
|
Topamax |
1,151 |
538 |
324 |
260 |
90 |
|
Levaquin |
1,550 |
1,357 |
958 |
578 |
60 |
|
Sub-total |
7,730 |
6,380 |
5,374 |
4,893 |
3,698 |
|
|
|
|
|
|
|
|
Other Pharmaceuticals |
6,645 |
6,687 |
7,563 |
7,614 |
7,245 |
|
|
|||||
|
Worldwide Sales |
22,520 |
22,396 |
24,092 |
28,157 |
29,474 |
Source: JNJ financial documents and SmithOnStocks estimates
Getting consumer products manufacturing problems behind the company
I consider the new ethical drug outlook as being critical, but it also appears that the consumer products manufacturing mess could be resolved by the end of 2011, if we are to believe JNJ’s timeline. This could create a positive swing in sales and earnings as this issue penalized sales by $900 million in 2010. I think that this is as important from a psychological side as from a financial standpoint. The steady stream of negative news on product recalls has created a negative psychological aura around the company.
JNJ will get through its patent cliff in the next year
The final issue for positive change is the patent situation in ethical pharmaceuticals. All of the major pharmaceutical firms are facing difficult challenges as important products that account for large percentages of their total sales are coming off patent. JNJ is no different as it has experienced large generic impacts from patent expirations on Topamax and Risperdal. Importantly, it is still facing challenges in the coming year as Levaquin loses patent protection on June 2 in the US and Concerta will have competition from an authorized generic in early May. Hence, we have one more year of tough comparisons from generics; however, it will end in mid 2012. One good thing is that JNJ will be finished with its patent cliff earlier than other major pharmaceuticals, most of whom will have their patent cliffs extend into 2013 and 2014. This puts JNJ in a somewhat better light than its peer ethical drug companies.
JNJ is well positioned to achieve growth in emerging markets.
One of JNJ’s major opportunities is to leverage its broad diverse product line in emerging markets. It can offer low priced cost effective products-usually older ones that have been replaced by newer ones in developed countries-in emerging markets. Then as incomes and medical infrastructure improve, JNJ can introduce its more sophisticated products. For example, it can sell over the counter medicines and local remedies in the poorest of countries and then gradually over time introduce more effective and higher value added ethical drugs.
In the 2010 annual report, I was struck by a story about a Chinese orthopedic surgeon who was using 1980s US technology. While outdated in the US, in his area of China this was a dramatic improvement in the quality of care. Over time, the ability to use and pay for newer technology will improve and at some point in the distant future may be on a par to developed countries. In the meantime, JNJ is establishing market presence and enjoying good returns. The enormity of the global market opportunity is brought home by the following table that JNJ presented in its 2010 10-K.
|
Global Healthcare Markets |
|||||
|
Sales ($ millions) |
CAGR |
||||
|
|
2005 |
2010 |
2015 |
2005-2010 |
2010-2015 |
|
Developed markets |
$3.8 |
$5.0 |
$6.4 |
5.5% |
4.9% |
|
Emerging markets |
$0.5 |
$1.0 |
$2.1 |
13.8% |
14.9% |
|
Worldwide |
$4.3 |
$6.0 |
$8.5 |
6.7% |
6.9% |
Source: JNJ 10-K
JNJ’s sales of $65 billion represent about 10% of this global market. It is a major player and yet has a small market share that it should be able to expand significantly.
Acquisitions are an integral part of the JNJ strategy.
JNJ has always relied on acquisitions to be a major driver of growth and this will certainly continue. It has the financial strength to make major acquisitions while having little impact on the balance sheet. Critically, it can take newly acquired products into its global distribution system and leverage or magnify returns.
Like all portfolios, there have been good acquisitions and bad, but the good far outweigh the bad. Centocor, Tibotec and DePuy have made major contributions while Scios was a major flop and Alza was a disappointment. On balance, JNJ has been extremely astute in its acquisitions and the company would be a much less attractive company today, if it had not pursued acquisitions. Over the last decade or so JNJ has made 13 acquisitions in which it has paid more than $0.8 billion. These are listed below:
|
Large Acquisitions of JNJ over 1998- 2011 Period |
|||
|
Acquired company |
Business |
Purchase Price ($billions) |
Year acquired |
|
Crucell |
Biopharmaceutical |
$2.0 |
2011 |
|
Acclarent |
Ear, nose, throat devices |
$0.8 |
2010 |
|
Assets from Elan |
Alzheimer immunotherapy program |
$1.0 |
2009 |
|
Cougar Biotechnology |
Oncology-abiraterone |
$1.0 |
2009 |
|
Mentor Corporation |
Aesthetic devices |
$1.1 |
2009 |
|
Conor |
Vascular devices |
$1.4 |
2006 |
|
Assets from Pfizer |
Consumer healthcare |
$16.6 |
2006 |
|
Scios |
Biotechnology |
$2.4 |
2003 |
|
Tibotec |
Biotechnology |
$0.8 |
2002 |
|
Alza |
Drug delivery |
$12.3 |
2001 |
|
Inverness |
Diabetic devices |
$1.3 |
2001 |
|
Centocor |
Biotechnology |
$4.9 |
1999 |
|
DePuy |
Orthopedic devices |
$3.7 |
1998 |
Disclosure: The author of this article owned shares of Johnson & Johnson at the time this note was written. This should be taken into account as it may introduce bias into the conclusions and interpretations that are made. In reading this note, you acknowledge that you have not used it as the sole basis of your decision making and that all investment decisions are based on your own analysis. An investment in Johnson & Johnson carries substantial risk and investors could potentially lose much of their investment. The reader acknowledges that he/she has carefully read the Investment Approach, Terms/Conditions and Disclosures sections in the About Us section of the website. The reader acknowledges that he/she will not hold SmithOnStocks accountable for any investment loss that may be incurred if a decision is made to invest in Johnson & Johnson
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