Johnson & Johnson: Strong Pipeline, Compelling Valuation

Business Summary:

Johnson & Johnson (JNJ) has three business units, all of them focused on healthcare. The pharmaceutical business develops new chemical and biological compounds used in the prevention and treatment of various diseases. The medical devices and diagnostics business develops products used to diagnose and treat various health problems. The consumer health care segment owns many valuable brands such as the J&J baby care product line, Neutrogena, Listerine, and Tylenol.

Analysis of Pharmaceutical Pipeline:

One of the reasons the barrier to entry is so high in the pharmaceutical industry is that new drug trials are very expensive, and often do not result in a profitable product. This raises the question of whether a company has a sufficiently robust development pipeline to replace existing drugs that go off patent. The average effective patent lifetime for a new drug is 11.5 years (“Effective Patent Life in Pharmaceuticals”, Henry G. Grabowski, 2000).

However, most drugs do continue to generate revenue after they go off patent; a study conducted in the mid-1990’s showed that revenue fell by 43% the first year after patent expiry, and 42% the next year, and roughly 10% annually thereafter. On the other hand, sometimes a generic manufacturer can successfully challenge a patent in court, so let’s leave the effective life at 11.5 years.

Consequently, with an evenly distributed patent expiration schedule (often an optimistic assumption), we can expect, on average, 8.7% of the company’s pharmaceutical revenue to be lost each year.

Looking at a paper (“The Distribution of Sales Revenues from Pharmaceutical Innovation”, Grabowski, 2000) that investigated the revenue of new products introduced from 1988-1992 in the U.S., it appears that the mean revenue generated by new products was around $150M in 1992 dollars. Let’s assume that global sales were around twice that, or $300M in 1992 dollars. In 2008 dollars, this would be around $450M per new product.

Therefore a company losing 8.7% of its pharmaceutical revenue each year would need to introduce a number of new drugs each year equal to total pharmaceutical sales (in millions of dollars) multiplied by 8.7% and divided by $450M.

Johnson & Johnson (JNJ) had 2008 pharmaceutical sales of $24,500M, so they would need to introduce - on average - roughly 4.7 drugs every year to replace drugs going off patent.

Looking at their 2008 development pipeline published on 4/15/2009, we find that they have either filed or had approved 17 compounds, which gives them a comfortable margin. The margin is probably necessary, as the actual distribution of new drug revenue is highly volatile, with only 3 out of 10 recouping development costs. Their phase III pipeline has 20 compounds, and we might expect 2/3 of these to become new products over the next couple of years (see “Research and Development in the Pharmaceutical Industry”, CBO 2006 page 23, figure 3-2).

Since this is a rough analysis, let’s do a differential analysis with several other pharmaceutical companies. Both Johnson & Johnson and Novartis (NVS) break down a drug’s status between the U.S. and E.U. markets, so in order to make a like for like comparison between the other companies, I only counted each drug once. If a compound was approved in one region and submitted for approval in another, I counted it as a single approval.

Likewise, if a compound was submitted for approval in one region and is in phase III in another, I counted it as a single submission.

The pipeline data for Novartis and Abbott Labs (ABT) is from their 20-F and 10-K filings, respectively, and the pipeline data for the other companies comes from their pipeline updates on their company website.

The following table indicates each company’s 2008 revenue from pharmaceutical sales, the estimated number of new products needed each year to keep pharmaceutical revenue constant (revenue * 0.087 / 450), and the status of each company’s drug pipeline at the date indicated in the first column.

The last column indicates the percentage of pharmaceutical revenue attributed to each company’s best selling drug. It is pretty clear from the differential analysis that J&J has one of the best drug pipelines in the industry.

Valuation:

Using my valuation model - which aside from a small adjustment for a company’s financial strength roughly assumes a ratio of intrinsic value to demonstrated earnings power equal to that of an average company – I estimate JNJ’s per-share intrinsic value to be $76.

This is an estimate of the sum of the expected value of future discounted cashflows (in today’s dollars) accruing to an owner of a share of the company’s common stock, and uses a real (inflation adjusted) 5.5% discount rate.

At the market close on 5/22/2009, JNJ’s share price was $54.77, giving a ratio of estimated intrinsic to market value equal to 1.4, and a price to sustainable earnings ratio equal to 12.1. The algorithm for calculating sustainable earnings per share and my valuation model used in estimating intrinsic value can be found on my website.

The following table illustrates JNJ’s ten-year operating history. I calculate return on adjusted assets as the ten-year average of operating profit (adjusted for non-recurring items) divided by adjusted assets, where assets are adjusted by subtracting goodwill and other non-amortizable intangible assets (such as certain trademarks).

Operating margin is calculated as the ten-year average of adjusted operating profit divided by revenue, and return on retained earnings is calculated as the ratio of the difference between last year’s adjusted earnings per share and adjusted earnings per share ten years ago (both in today’s dollars) to the sum of the adjusted earnings retained over the ten years, also in today’s dollars.

I believe JNJ’s future prospects are good for several reasons.

First, all three of JNJ’s business lines have relatively high barriers to entry.

Second, I believe that JNJ’s decentralized management structure will create an environment where the company is likely to create new innovations in all three of JNJ’s business lines.

Third, the company’s revenue diversification should provide earnings stability in that if the pharmaceutical pipeline gets temporarily lean, the effect will be muted due to the contribution of the medical device and consumer products businesses.

Fourth, JNJ has a very strong balance sheet, and the company’s AAA credit rating gives it a low cost of debt capital that can be used, in conjunction with retained earnings, to finance acquisitions.

Another positive for JNJ’s future prospects is the aging population in the United States, Japan, and Europe; this should lead to a strong demand in the health care market for the foreseeable future, and the total available market for health care could easily grow faster than global GDP. Older people tend to require more medical care, which should positively affect the demand for both pharmaceuticals and medical devices due to the aging population in the company’s core markets, while the overall global increase in population should increase the demand for the company’s consumer products.

One risk to JNJ’s competitive position is that generic drug manufacturers sometimes attempt to market generic substitutes when a drug is still on patent (this is done through what is called an Abbreviated New Drug Application); this can reduce revenue from a product until the matter is resolved in court. A mitigating factor is that to date, there really is not any significant competition from generic medical devices.

Another potential risk is that if the United States goes to a single payer health care system, JNJ will lose bargaining power with its customers. In a future article, I will present some research that makes a case that this is not as large a threat as many think.

It is pretty clear from JNJ’s ten-year operating history and future prospects that this is an exceptional company, and our estimate of intrinsic value – which assumes a ratio of intrinsic value to demonstrated earnings power equal to that of an average company – is probably conservative.

I have owned the company’s shares since early 2003, and although the share price is currently close to what it was six years ago, the increase in earnings and dividends has been more than satisfactory, and I have been using the recent (late ’08 and early ’09) drop in JNJ’s share price to accumulate more shares.

Details of my valuation model, as well as a more in-depth analysis of JNJ can be found here.

Disclosure: I have a long position in Johnson & Johnson

Comments

[ValueInvest...:]

Great valuation. I also a long JNJ. It is so easy to be rich as long as you are not greedy. Buy good fundamental company with great product and management. Simple.

May 26 04:58 AM

[David Van K...:]

Even though your pipeline analysis is imprecise, I like it..."It is better to be approximately right than precisely long" (Warren Buffett). Thanks for bringing some clarity to a murky area and drawing meaningful comparisons between companies. JNJ is a terrific company. Its AAA credit rating is better than Great Britain's at the moment.

May 26 08:24 AM

[RiskReturnO...:]

Good analysis. Agreed on the conclusion.

Another great factor to holding JNJ and XLV ( Health Care ETF) is the seasonal out-performance vs SPY during the May to October period.

S&P has empirical data to show that you don't need to "Sell in May and Go Away", but instead, move into more defensive sector like XLV, which tends to out-perform SPY by 3-5% average annual rate. Not bad considering the possibility of pull back in broader market.

Full disclosure -- I'm long XLV with covered calls with strike price around 5% out of money, September 09 expiration.

May 26 12:35 PM

[spald_fr:]

J&J just spent US$ 1B to purchase Cougar Biotech, which has an excellent stream of oncology drugs under development, particularly for prostate cancer (baby boomer males will ALL eventually get prostate cancer: If 100 men live to be 100 years old, 100% of them will get prostate cancer by the time they are 100 years old).

May 26 12:49 PM

[TLassen:]

very good analysis of JNJ. I am long on the company as well, do you think they can maintain the 14% dividend growth in the current business environment?
I took the time to visit your website, must say I am very impressed. I am always interested in learning from fellow investors, will read the pdf file in great detail.

May 26 05:46 PM

[Brian Gaudet:]

TLassen,
I am not sure about maintaining 14% dividend growth (the latest increase was 6.5%), but I do think a long-term inflation-adjusted growth rate for earnings and dividends of 4% to 6% is doable; this assumes long-term global real GDP growth in excess of 4%, TAM for pharmaceuticals, medical devices, and consumer health products growing a bit faster than global GDP, and constant market share.


On May 26 05:46 PM TLassen wrote:

> very good analysis of JNJ. I am long on the company as well, do you
> think they can maintain the 14% dividend growth in the current business
> environment?
> I took the time to visit your website, must say I am very impressed.
> I am always interested in learning from fellow investors, will read
> the pdf file in great detail.

May 26 07:47 PM

[gilby:]

I don't agree with your analysis, JNJ hasn't launched a new product since 2001. Levaquin goes off patent which is over 1 billion in revenue, the new pain compound was given a CII not a CIII so generics will kill it. they are trying to license it out. the anticoagulant product was held up by the fda for further testing due to liver concerns. Ultram ER hasn't met forcast since launch. On top of that, for the last 7 years they have laid off from the sales force. The last layoff being close to 1000 reps, you don't do that when you supposedly have numerous products in the pipeline waiting to launch.....

May 28 03:15 AM