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Patent expiration is one of the number one reasons for pharma companies' revenue deterioration. The industry giant, Johnson & Johnson (NYSE:JNJ), is expected to witness revenue loss of $2.27 billion due to two patent expirations in 2013. Aciphex, the heartburn medicine, is expected to lose $860 million and another drug, Procrit, is expected to lose $1.41 billion. Then in 2018, Remicade, an autoimmune diseases drug, will face a patent cliff in the U.S. (2015 in the EU). Question is; what will be the long-term impact on the stock price?

There is some good news for the company. Johnson & Johnson recently added a few more products in its pharmaceutical and Medical Devices and Diagnostics (MDD) business. Also, the FDA has granted Breakthrough Therapy Designation for the drug "ibrutinib", which treats patients with B-Cell malignancies like relapsed or refractory mantle cell lymphoma (MCL) and Waldenstrom's macroglobulinemia (WM). With 5,000 new MCL cases and 1,200 WM cases reported every year, it can be a big market for Johnson & Johnson's ibrunitib.

The company also has a few more drugs hitting the market, for instance Zytiga for cancer, Invega for schizophrenia and Invokana for type-2 diabetes. So basically, patent gain and expiration are two of the industry's biggest components. A pharmaceutical revenue loss of $1.41 billion will have little impact on Johnson & Johnson, which reported annual revenue of $67.22 billion in 2012.

Another big positive for the company is integration of Synthes in its MDD line, which is now witnessing significant progress. Given that the medical device industry is expected to grow at a CAGR of 9.6% to 2015, and Synthes has a strong foothold in the growing market of China, India and Brazil, we believe that the acquisition will witness significant cost synergies and Johnson & Johnson will enjoy a majority share in the trauma market. FDA has also approved Johnson & Johnson's Sedasys system, a device to sedate patients during endoscopic examinations. This device is expected to hit the market in the beginning of 2014 with a potential market of 15 million patients in the U.S.

Johnson & Johnson has more demand from developing markets than in the home market, which can offset the influence of bad media in the recent past in the U.S. Hence, Johnson & Johnson's expanding pipeline assures durable growth in the future.

Meanwhile, Johnson & Johnson's consumer business segment is relatively a low-margin business. Improving sales mix in its pharmaceutical segment and cost synergies, with and expansion of its MDD segment, will support the faster growth in the margins.

Talking about liquidity, Johnson & Johnson enjoys a constant solid liquidity position. The company had $21.1 billion of cash and marketable securities and $5.6 billion of free cash against the debt of $16.2 billion at the end of 2012. The aggregate maturities of long-term obligations for 2013 are only $1.5 billion, $1.8 billion in 2014, $898 million in 2016 and $1 billion in 2017. Given the 5% to 6% top-line growth, and improving margins in pharmaceutical and MDD segments, a free cash flow of ~$7.2 billion is expected in 2013.

Valuation

The company expects earnings of $5.35 to $5.45 per share for 2013, which puts the stock trading at a forward P/E of 15.9 times. Taking into account the industry P/E of 15.7 times, the stock looks fairly justified at the current market price. The company does has an excellent history of raising dividends, having done so for the last 51 years consecutively. The quarterly dividend rate recently increased from $0.61 per share to $0.66 per share. Its current dividend yield is around 2.9%.

Johnson & Johnson's close peers are Pfizer (NYSE:PFE) and Novartis AG (NYSE:NVS). Novartis owns Sandoz, the second largest generic company, hence, Novartis enjoys growth of both patented and off-patent drugs. Pfizer is sitting on a cash pile of $24 billion, against its current market value of $207 billion. The company creates a free cash flow of $18 billion and has a payout of 45%, which promises steady dividend growth in the future.

What makes Johnson & Johnson stand out among its peers is diversification. The company has good exposure to pharmaceutical, consumer and MDD segments. JNJ holds a cash of $21 billion and has a market value of $240 billion. This indicates that the company is valued at 11 times of its cash position. The company's outstanding dividend history is also a big positive for investors.

Further stacking Johnson & Johnson up against its peers and we see that Johnson & Johnson towers above the competition with respect to market cap and revenue generation.

The comps

JNJ

PFE

NVS

Industry Average

Market Cap ($ billion)

240.4

206.5

184.1

n/a

Revenue (TTM) ($ billion)

68.6

57.6

57.8

n/a

EPS

3.7

2.1

3.9

3.3

P/E ratio

23.3

13.8

19.0

14.2

PEG

2.5

4.0

2.7

n/a

Price to sales

3.5

3.6

3.2

2.2

The above estimates do, however, show that Johnson & Johnson trades above Pfizer and Novartis on a price to earnings and near the top on a price to sales basis. However, when taking into account Wall Street's expected growth in EPS, Johnson & Johnson is a relatively better investment, having a PEG of only 2.5, compared to Pfizer's 4.0 and Novartis's 2.7.

Bottom line

Moody's believes that the global pharmaceutical industry outlook will remain "stable" for 2013 and 2014 as relatively fewer top-selling drugs will lose their patent protection in 2013 and the negative effects of the patent cliff will move away, which will give a boost to the earnings growth in 2014.

Considering the weak economic scenario, Johnson & Johnson might face operation issues related to its existing domestic franchises. Looking at the positive side, the company's revenue losses due to patent expirations are expected to ease by sale of new launched drugs. The synergies with Synthes will result in operational efficiencies and the strong cash position mitigates the financial risk and ensures a good credit profile. By and large, Johnson & Johnson looks to be a promising investment.

Source: Is Johnson & Johnson Heading Off The Patent Cliff?