2 Short-Term Risks For Johnson & Johnson

| About: Johnson & (JNJ)

By Joseph Hogue, CFA

Johnson & Johnson (NYSE:JNJ) may be a hold or neutral strictly on a fundamental basis but two factors could pressure the company in the near term. One issue, the continuing problem within its quality control procedures, is something the company has struggled with for the last two years but it has yet to find a solution. Another issue, and possibly a bigger surprise to valuation, is the risks to revenue from competition with its anti-clotting drug Xarelto.

The company and its subsidiaries conduct R&D, manufacturing, and sales within 250 operating companies in the Healthcare field. Business is primarily in three segments: consumer, pharmaceutical and medical devices with 24%, 36%, and 40% of 2010 sales respectively. The company provides a fairly diversified play internationally with 52% of sales and stronger growth coming from overseas.

The stock is currently range-bound between its 52-week low of $57.50 and the high of $68.05 per share. At $65.26, just 4.1% off the high and trading at 13.3 times trailing earnings; there could be more conviction for deeper value plays in the sector. The dividend yield of 3.5% will make it a staple of many dividend portfolios but is less meaningful without price appreciation. Forecasted earnings-per-share growth for the next four quarters is only 3.3% on a year-over-year basis. The lack of revenue growth is somewhat mitigated by a relatively strong operating margin of 22.2%, higher than the industry average.

Deeper value may be found in competitors like Novartis (NYSE:NVS) at 10.6 times trailing earnings and significantly higher revenue growth. Abbot Labs (NYSE:ABT) forecasted earnings-per-share over the next four quarters is 10.6% year-over-year and is slightly cheaper at 12.5 times trailing earnings. The Health Care Select SPDR (NYSEARCA:XLV) trades at about the same trailing price-to-earnings ratio of 13.0 times but provides diversification across the sector.

Slow Development and Quality-Control Issues

The company announced last year that it would close two factories and take a $500 million to $600 million charge against earnings related to its discontinued line of Cypher and Cypher Select drug-coated stents. The product once enjoyed a 51% share of the market and had annual sales of $2.6 billion, but competitors and a lack of development decreased share to 16% and sales of about $400 million in 2011. There were also some concerns that the stents caused blood clots after being implanted. This combined with the slow development process of the Nevo stent, which was also discontinued last year, has plagued the company's pipeline.

Issues with quality control and processes are nothing new to the company. The past two years have seen numerous recalls and a warning last February by regulators over the company's failure to meet specifications in consistency in the manufacturing of its heart devices. The U.S. Food & Drug Administration (FDA) and the Justice Department took supervisory control of three plants in March of last year after several recalls prompted a criminal investigation of safety issues.

Risks to Xarelto Revenue

More recently, the company has seen the possibility of increased competition to its anti-coagulate drug Xarelto. The drug was supposed to be a key revenue generator from the $3 billion acute coronary syndrome (ACS) market and was approved for multiple uses. It has already been approved for stroke prevention in patients with atrial fibrillation, as well as for clot prevention after certain surgeries. The company is now petitioning the FDA for approval in patients to reduce the risk of thrombotic cardiovascular events as well.

The FDA has given fast-track approval with priority review for Bristol-Myers Squibb (NYSE:BMY) and Pfizer's (NYSE:PFE) competitor Eliquis. A decision is expected in March of this year, which means that Xarelto has just three months to deliver the market share on which JNJ has been forecasting revenue. Recent clinical data for Eliquis shows it may be safer and more effective than the warfarin-alternative Xarelto. If this is true, it could significantly displace the drug before expected revenue materializes.

Cost Cutting May Provide some Margin Improvement

The closure of its Cypher factories, and subsequent layoff of about 1,000 employees, may provide some improvement in gross margin as costs come down. The company has less debt on its balance sheet than peers with a total debt-to-equity ratio of 0.3 times relative to the sector average of about 0.5 times. This means the company could increase its return on equity by increasing leverage to the sector average. Return on equity is already well above the sector average at 19.2% versus an average of 13.9% for peers.

Institutional Shareholder Services currently ranks the company as Low Concern in all governance risk indicators: Audit, Board, Compensation, and Shareholder Rights.

Long-term investors may still want to hold on to the stock for reasons I outlined in a previous article. The company still may be one of the best 'boring' stocks you will ever own, but short-term problems may pressure the share price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.