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The pharmaceutical industry has been subject to a major patent cliff as some of the strongest products lost patent protection. The damage to the industry was, for the most part, incurred in FY12 and therefore the outlook of the industry appears to be improving as the companies look towards new products in order to improve their performance. One prominent hurdle in their progress would be FDA approval for their new products as the administration has initiated strict measures to ensure the quality of products in the market.

The notion of recovery in FY13 is furthered by Moody's, as the rating agency improves the global pharmaceutical outlook standing to "stable." The report states that the industry will return to growth in FY13 as fewer products are subject to the patent cliff and growth in profits will continue into FY14 as the adverse effects of patent loss are mitigated. It has also been suggested that the outlook could even improve to "positive" if the introduction of new products is able to translate into higher profits for the industry.

What's Different about J&J?

Since the beginning of FY13, Johnson & Johnson's (JNJ) stock price has appreciated by 22.1%. This is because J&J is the largest player in the industry with respect to revenues. Introducing new and profitable products is absolutely essential but at the same time, the company's management evidently realizes that at such a big scale, the image of the company is also equally important. In order to maintain its brand and position in the industry, J&J has also launched a $20 million to $30 million corporate image campaign as estimated by Adage. The company is aiming to regain trust of its stakeholders by attempting to recover from the bad press which has occurred in the past.

At the same time, J&J is set to launch its own sedation drug device called Sedasys in early FY14 as reported by Reuters. The company estimates that the device is to be targeted at 150 million patients in the U.S. As the operations of the company spread across more than 60 countries, the product has the capacity to produce heavy gains and become a long-term success. Most importantly, J&J has attained FDA approval for the product. J&J has two patents (Aciphex and Procrit) expiring in FY13 but the business's diversification into other healthcare products is likely to reduce the damage. At the same time, J&J is set to introduce new products such as Sedasys in FY14 which are expected to improve profitability.

Elan Corp. Stakes:

J&J has reduced its stake in Elan Corp. (ELN) from 18% to 4.9% as the specialty pharmaceutical company failed to maintain its profitability.

Source: Bloomberg

The above chart presents the income statement of Elan Corp. and the sustenance of losses is clearly visible. The company has reported four negative annual earnings since FY08. Despite these losses, J&J has stated that it is expected to make a $213 million gain on its investment in Elan Corp.

Financial Analysis of J&J:

In recent years, pharmaceutical industry has been subject to some serious concerns. Specifically J&J has been subject to various difficulties, most important of which was bad press. Despite the difficult patch, J&J has continued its growth. Since FY08, the company's assets have reported a CAGR of 9.3%. The revenues have remained robust and the company maintained its position in the industry.


(Click to enlarge)

Data Source: Morningstar

The above chart shows a breakdown of ROE of three major pharmaceutical companies in FY11 and FY12. We see that J&J has maintained its ROE above 17% in the past two years as the net margin has been improved. At the same time, the company's financial leverage is under control. Novartis (NVS) has a similar level of financial leverage but lower ROE as the asset turnover has been restrained. Pfizer (PFE) on the other hand has improved its net margins substantially but the financial risk of the company is substantially above that of its competitors.

Furthermore, in Pfizer has been adversely affected by the patent cliff as the revenues declined by 12.5% in FY12 as compared to previous year. Other factors, such as loss of exclusivity of products and foreign exchange variations, also affected the revenues. J&J on the other hand showed robust performance as the revenues showed growth.

Conclusion

The most important starting point is that the industry is expected to recover. The outlook is improving as some of the major threats to the industry are beginning to subside. The recent decline in the industry's performance has also identified the stronger players and it appears that amongst the bigger companies, J&J is the most robust. The financial risk of the company is limited, the management of the company is making intelligent investments and the company is also focused on future growth. The new products will further the growth and financial strength of the company. Therefore, a buy recommendation is suggested for the long-term investors as the company's prospects will improve further in the coming years.

Source: Johnson & Johnson: Banking On Industry Revival