Johnson & Johnson (JNJ) operates under three segments: Pharmaceutical (eighth largest in the world), Medical Devices and Diagnostic (the largest in the world) and Consumer (6th largest in the world). We had earlier expressed our stance that despite the fact that JNJ holds a diverse product portfolio, it faces numerous challenges in attaining any significant stock price appreciation. At the current level, the stock is fairly valued and is a lucrative investment for dividend seeking investors. We will discuss the opportunities and difficulties that the company faces and how it should react to them.
Below is a chart showing the breakdown of total sales (U.S. and worldwide) for the quarter ended September 2012. Medical Devices and Diagnostics (MD&D) remained the largest contributor to revenue, followed by the Pharmaceutical and Consumer units.
Chart 1: Segment Breakdown
Compared to the same period of last year, all segments posted a YoY growth except the Consumer segment. The table below lists their respective percentage changes:
Although OTC Pharmaceuticals and Nutritional, Skin Care and Oral Care franchises achieved operational growth, currency headwinds caused a net decline in the revenue figures. Its other franchises such as Baby Care, Women Care and Wound Care showed negative operational growths.
The underperformance of the Consumer segment was expected. In the chart below, we have plotted annual sales of the segment to show the declining trend. Currency headwinds and a competitive environment in the markets have and continue to put pressure on the sales figure. Given the nature of products offered in this segment, it is difficult to compete based on brand names alone, and, therefore, pressure on prices contributes to a fall in revenue.
We do not forecast any improvement in Europe given the ensuing austerity measures and failure on the part of European institutions to resolve long-standing issues. Given this, the segment will continue to underperform. Furthermore, the presence of other major consumer-product companies such as Unilever (UN) and P&G (PG) will dampen JNJ's ability to pass on cost increases to consumers.
Chart 2: Decline in Consumer segment sales
In the chart below (Chart 3), we have attempted to show the correlation between the U.S. Consumer Sentiment Index (which shows the level of consumer optimism) and quarterly sales of JNJ's Consumer segment. The graph reveals that the percentage changes in quarterly sales of the segment have changed roughly in tandem with the percentage change in the U.S. Sentiment Index. If concerns surrounding the U.S. and European economy persist, the Consumer segment will continue to lag behind.
Chart 3: Correlation between the Sentiment Index and the Consumer segment
We included an overview of the Pharmaceutical segment in our previous article on JNJ. The sales for the segment were up by 7%, driven by strong performance shown by key products and the launch of Zytiga. Zytiga is a one tablet a day medicine for the treatment (in combination with Prednisone) of metastatic, castration-resistant prostate cancer. Remicade is a biologically approved drug for the treatment of immune-mediated inflammatory diseases. Prezista is approved for the treatment of HIV and Velcade is used for the treatment of multiple myeloma.
The following table shows the percentage increases in the above mentioned key products.
Table 2: Top performers for the Pharmaceutical segment
Much like the other pharmaceutical companies around the world, JNJ has had to suffer due to a series of patent expirations. Back in 2008, JNJ lost patent protection for its antipsychotic drug, called Risperdal, followed by Topamax, an antiepileptic drug, in 2009. Last year, JNJ had to see the patent expiration for Concerta, Levaquin and Invega. With the sole exception of Invega, both Concerta and Levaquin witnessed declining sales for the quarter (Table 3). Another near-term expiration is that of Aciphex in 2013.
Table 3: Revenue changes for the third quarter
( 10.2 % )
Concerta and Levaquin had sales of $1.3 billion and $1.4 billion, respectively, for year-end 2010, accounting for 12% of the total revenue of the Pharmaceutical segment and 4% of the total revenue of the company. Their combined share in the segment had fallen to 7.7% for the year 2011 and a mere 4% for the last quarter. If we project this share for the full fiscal year 2012, we see that the company will have lost more than $2 billion in annual revenue.
The patent expiration of Aciphex in 2013 will further dampen pharmaceutical revenue. The drug, intended for relief from the symptoms of Acid Reflux Disease, contributed $1.0 billion, 3.1% of the total revenue of the Pharmaceutical segment. Judging from the past performance of drugs that have lost their patent protection, we can expect a revenue decline of 50% for Aciphex for the next year. This 50% decline amounts to nearly $500 million in annual sales. With the widespread availability of generics in the following years, revenue would fall even further.
Without complicating things, if we wish to estimate the impact of the patent losses that the company has faced and will face in the near term, we can apply a discount rate of 70% to peak sales of the aforementioned drugs i.e. Risperdal, Topamax, Concerta, Levaquin and Aciphex. Invega will be discounted at a lower rate due to its recent robust performance.
2009 Sales (MM)
*Invega was discounted at a lower rate of 30% given its recent robust performance
Given the above calculations, the fall in revenue due to the major patent losses is estimated to be around $4.5 billion. The pressure arising from this scenario calls for an expedited revival of the segment with new products and a diversified product pipeline. Below we have tabled the performance of the recently launched products:
Based on the two tables (4 and 5) above, total revenue from the newly launched products would need to grow at a compound annual rate of 32%. Zytiga has been the star performer recently and is expected to exceed sales of $1 billion. A snapshot of selected products in the pipeline shows that two are in the registration phase: 1) Canagliflozin (Cardiovascular and Metabolism) and 2) Bedaquiline (Infectious Diseases). Furthermore, five more products are expected to be filed for between 2012 and 2015.
However, there are several limiting factors that may dampen the potential of a number of JNJ's recently introduced medicines. For example, Zytiga, in the Oncology Department, will face competition from Medivation's (MDVN) Xtandi for prostate cancer. Similarly, Incivo (Hepatitis C) will have to face pressure from Merck's (MRK) Victrellis, a drug that promises to boost the chances of recovery while considerably cutting back on the recovery time.
In our previous article, we provided a detailed overview of the MD&D segment and the future plans of the company to expand into emerging markets. The key takeaways from the analysis included the fact that the acquisition of Synthes in June 2012 has been a key contributor in performance. The acquisition was intended to tap the large market of orthopedics, estimated at $5.5 billion. The benefits are tangible as medical device sales increased by 12.5%.
This acquisition led to 68% operational growth in the orthopedics franchise in the recent quarter. After the acquisition, the company will become the leader in the orthopedics market and is well positioned to grab a large market share. Should it manage to attain a 50% market share, the revenue contribution of the orthopedic franchise would stand at $2.5 billion. A more bullish 60% share would make the contribution stand at $3.3 billion.
The product portfolio of Synthes includes five major groups in trauma, spine, knee, bio-materials and power tools. Apart from expanding JNJ's orthopedic portfolio to one of the deepest in the world, the acquisition would also benefit JNJ through Synthes' exposure to a number of emerging markets such as China, Russia and India. JNJ estimates the trauma and knee markets to grow by 7% and expects a rebound in the spine market at a rate of 5%.
However, given the austerity measures in Europe and the expected tax imposition on medical-device manufacturers, JNJ's MD&D segment will feel the pressure and witness reduced margins in the process. Given the lackluster demand for medical devices around the world, we forecast an annual growth rate of 3% for the segment. Under current law, beginning 2013, JNJ will pay a 2.3% excise tax imposed on the sale of certain medical devices. JNJ estimates that the tax will amount to between $200 and $300 million in 2013.
The company has paid uninterrupted dividends since 1944 and has increased its payouts numerous times. The company has a diverse product portfolio and is one of the most trusted brands around the world. It has generated healthy and stable cash flows over the years. We calculated its three-year average dividend coverage ratio to be 2.3x, highlighting its ability to make regular payments to its shareholders. With a debt-to-equity ratio of 30% and a 34x interest coverage ratio, it is one of the few companies worldwide to receive a AAA credit rating.
Given its robust cash flow position seen above and the aforementioned facts, we do not forecast any limitations in the company's ability to pay its healthy dividend. Before JNJ embarks on another acquisition, it will first have to completely assimilate Synthes into its folds. With acquisitions likely to be limited in the coming years, the cash flows seem to be enough to satisfy its investors.
We reiterate our earlier stance on JNJ. It is a stock that pays healthy and consistent dividends, but we believe that most of the good news for the company has already been priced in the stock. Although the company has a diverse product portfolio, a growth rate that would send the stock beyond its all-time high of $70 seems to be absent. Although the consumer sector would benefit once economic recovery kicks in, growth in the MD&D segment would be dampened due to austerity measures.
The stock has progressed with time amidst issues ranging from lawsuits and product callbacks and it seems that these issues are too small to bring the gigantic healthcare company down. The stock is up 6.30% YTD, given a one-year return of ~14%, and boasts a healthy dividend yield of 3.51%. Concerns regarding its newly launched products and the global economy will dampen any prospects of the company's stock reaching new yearly highs. We continue to believe that JNJ should follow its competitors such as Abbott (ABT) and look for potential spin-offs to unlock the hidden shareholder value.