Seeking Alpha
Long only
Profile| Send Message|
( followers)  

Investment Conclusion

Johnson & Johnson (NYSE:JNJ) has gone through three very difficult years as EPS increased only slightly from $4.63 in 2009 to $5.00 in 2011. The most important challenge faced was the loss of patents on the major drugs, Risperdal, Topamax, Levaquin, Duragesic and Concerta which saw aggregate sales drop from $5.8 billion in 2009 to an estimated $2.2 billion in 2012. I estimate that this will reduce EPS by about $0.80 per share over that time frame. A second very important issue was the worldwide recession that led to reduced spending by both governments and individuals on health care products and pressure on pricing. This is not easily quantifiable, but it was profound. There were also the unexpected challenges with the DePuy ASR hip recall, the precipitous decline of drug-eluting stents and the quality control issues at McNeil consumer products.

I believe that the company is now turning the corner and heading into a period of faster growth beginning in 2013. By mid-year 2012 the patent loss challenges will be behind the company and an impressive array of new drugs should cause a significant acceleration of pharmaceutical sales through 2015. This is the most important factor in the turnaround. The McNeil situation is beginning to be resolved and should lead to an upswing in coming years as some of its iconic consumer brands re-enter the market. The drug eluting stent business has been exited and the operational costs of the DePuy ASR hip recall ($800 million or $0.25 per share so far) have largely been incurred.

World economic growth prospects remain subdued with the potential for a heightened crisis to occur at anytime and anywhere, with Europe being the most likely candidate. Still, economic conditions in the U.S. are improving and emerging markets are growing at impressive, albeit lesser rates than in the 2000 to 2007 boom period. Barring a meltdown in Europe, it seems likely that the world economy and financial stability will improve over the coming years. This may also reduce the unpredictable effect of currency rate volatility on EPS.

JNJ still faces some strong headwinds in 2012, especially in the first half of the year as there is still a difficult sales comparison from the last of the patent challenges. The turmoil in Europe continues to be a drag on unit growth and pricing. On top of this, another problem has arisen from the strength of the dollar. JNJ estimates that if the dollar stays at current levels throughout the year that it would reduce the company's guidance for operational EPS by $0.13 per share from a range of $5.18 to 5.28 to $5.05 to $5.15. This compares to $5.00 in 2011. The final issue is that the acquisition of Synthes is expected to close this spring and I estimate that it could have a negative impact on EPS of $0.10 in 2012. However, I think that JNJ will find ways to offset this impact through share buybacks, cost cutting or other measures. For the full year 2012, my base case is that EPS will be up only modestly from $5.00 in 2011 to $5.10 in 2012.

After the company gets through 2012, I see acceleration in EPS to the range of 10% per annum in the 2013 to 2015 period. I think that JNJ is very attractive based on the projected acceleration in earnings and as a dividend play with its 3.7% current yield. I am estimating that the dividend will increase to $3.15 in 2015 which would be a 4.8% yield based on current prices. I think that the combination of stock price appreciation in line with or possibly better than EPS growth of about 10% per year and the dividend yield has the potential to produce a total return of 10% to 15% for JNJ stock for the 2012 to 2015 period. I would much prefer having my money in JNJ over having it in a treasury debt issue; the yield is higher and the risk of principal loss may be less. While Chairman Bernanke has indicated the Fed intends to keep interest rates low for the next 18 months or so, I believe that it is probable that rates will then begin to rise causing a loss of principal on debt issues. For those seeking current income and less principal risk, I think that JNJ may be a better investment than US treasuries.

My estimates for JNJ's sales, EPS and DPS for the 2012 to 2015 period are shown below.

FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 FY 2015
Sales (millions) $61,897 $61,587 $65,030 $68,954 $73,599 $78,470 $83,447
EPS $4.63 $4.76 $5.00 $5.10 $5.64 $6.19 $6.74
DPS $1.93 $2.11 $2.16 $2.37 $2.61 $2.87 $3.15
% Increase
Sales (millions) -3% -1% 6% 6% 7% 7% 6%
EPS -4% 3% 5% 2% 11% 10% 9%
DPS 8% 9% 2% 10% 10% 10% 10%
Source: SmithOnStocks Estimates for 2012 to 2015, JNJ Financial Results

JNJ'S Guidance for 2012

JNJ is such a large and diverse company that company guidance is much more important as a starting point in discussing its outlook and investment thesis than for smaller and less diverse companies. JNJ's practice is to give guidance based on a constant year over year currency rates. In other words, the official guidance is based solely on expected operating results and ignores the potential impact of currency rate fluctuations.

On this constant currency basis, JNJ is guiding to an operational sales increase of 4% to 5% for 2012, which would result in sales of about $67.7 to $68.3 billion. This compares to the operational growth rate of 2.8% in 2011. While the company does not predict the potential impact from currency rate fluctuations, it notes that if rates remain at current levels throughout 2012 it would decrease the rate of sales growth by about 3% and result in reported sales of approximately $65.6 billion to $66.5 billion. Sales in 2011 were $65.0 billion.

Global pricing pressure is expected to continue and JNJ estimates that this will reduce operating margins by 0.5% to 1.0%. However, the company believes that operating trends can offset this and anticipates higher operating margins in 2012 over 2011. Non-operating income is expected to decrease slightly. The tax rate in 2011 was 20.1% but is expected to be between 21% and 22% in 2012.

JNJ's full-year 2012 EPS guidance on a constant currency basis and excluding any non-recurring items is $5.18 to $5.28, an increase of 3.5% to 5.5%, which compares to $5.00 in 2011. However, if currency rates remain at current levels through 2012, the company would expect a negative impact of $0.13 per share resulting in slightly lower EPS of $5.05 to $5.15. The company also cautions that the first half of 2012 will have tougher EPS comparisons than the second half of the year, as the two formerly large selling drugs Levaquin and Concerta only began to see generic competition in the middle of 2011.

The company is not including any estimate in its 2012 guidance for the potential dilution from the Synthes acquisition because it has not yet closed. I think that Synthes could dilute EPS by $0.10 per share in 2012 while adding $3 billion of sales. I am basing my 2012 estimates sales and EPS estimates for JNJ on the assumption that currency rates stay at current levels and Synthes closes this spring. As a result, my single point estimate for sales in 2012 is $69 billion and for EPS $5.10. This compares to $65.0 billion and $5.00 in 2011. I would emphasize that I think that 1Q, 2012 and 2Q, 2012 could be flat or show modest EPS declines.

Company Overview

The analysis of Johnson & Johnson is more difficult than any of the other big pharmaceutical and biotechnology companies because of its much greater diversity. It divides its worldwide business broadly into three segments: (1) it is largest medical device company in the world, (2) the pharmaceutical business is made up of the eighth largest traditional pharmaceutical firm in the world and the sixth largest biotechnology company, and (3) it is the 13th largest consumer company. JNJ employs 118,000 employees in 60 countries and runs a decentralized business comprised of 250 operating companies. A summary of my sales projections for the three major business segments for 2012 through 2015 is shown below:

FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 FY 2015
Worldwide Sales
Consumer 15,803 14,590 14,883 15,141 15,693 16,433 17,230
Pharmaceutical 22,520 22,396 24,368 25,225 27,317 29,756 32,149
Medical Devices & Diagnostics 23,574 24,601 25,779 28,588 30,589 32,281 34,067
Total Worldwide Sales 61,897 61,587 65,030 68,954 73,599 78,470 83,447
Worldwide Sales
Consumer -2% -8% 2% 2% 4% 5% 5%
Pharmaceutical -8% -1% 9% 4% 8% 9% 8%
Medical Devices & Diagnostics 2% 4% 5% 11% 7% 6% 6%
Total Worldwide Sales -3% -1% 6% 6% 7% 7% 6%
Source: SmithOnStocks Estimates for 2012 to 2015, JNJ Financial Results
US Sales
Consumer 6,837 5,519 5,151 5,409 5,625 5,800 6,000
Pharmaceutical 13,041 12,519 12,386 12,132 13,169 14,272 15,436
Medical Devices & Diagnostics 11,011 11,412 11,371 13,395 14,332 15,049 15,801
Total US Sales 30,889 29,450 28,908 30,935 33,126 35,121 37,238
Foreign Sales
Consumer 8,966 9,071 9,732 9,732 10,068 10,633 11,230
Pharmaceutical 9,479 9,877 11,982 13,093 14,148 15,484 16,714
Medical Devices & Diagnostics 12,563 13,189 14,408 15,193 16,257 17,232 18,266
Total Foreign Sales 31,008 32,137 36,122 38,018 40,473 43,349 46,209

FY 2011 Results

Total sales for 2011 were $65 billion, an increase of 5.6%. Operational sales growth was 2.8% while foreign currency translation effects increased sales by 2.8%. Investors focus on JNJ's non-GAAP adjusted EPS which excludes one-time events. By this measure, EPS was $5.00 in 2012, up 5.0% from $4.76 in 2010. The company generated free cash flow of $11.4 billion. This was the 28th consecutive year of increase in adjusted EPS and the dividend was increased for the 49th consecutive year.

Pharmaceutical sales were $24.4 billion in 2011; the rate of increase in operations (excluding currency effects) was 6.2%. This was helped by the new products Stelara, Simponi, Zytiga, Incivo, and Invega/Sustenna, the acquisition of Crucell and the greater contribution to sales of Remicade and Simponi resulting from the restructuring of the agreement with Merck.

Medical Devices and Diagnostics had sales of $25.8 billion, up 4.7%, with operational growth of just under 2%. Excluding the sales of drug-eluting stents, a business which was exited at the end of 2011, operational sales growth was 3%. On a global basis, European austerity measures, pricing pressures in developed countries and a slowdown in elective surgeries were all significant headwinds. The DePuy ASR hip recall added further pressure.

Consumer had sales of $14.9 billion, up 2.0%; there was a modest operational decline of just under 1%. Excluding the remediation and supply issues associated with the McNeil consumer business, acquisitions and divestitures; the core business of iconic consumer brands had operational growth of about 2%.

The Outlook for 2012 and Beyond

The pharmaceuticals business began its resurgence in 2011 based on less impact from sales lost due to patent expirations. The last of the big patent losses occurred with Levaquin and Concerta beginning in mid-2011. Starting in the second half of 2012, there will be little impact from patent expirations. Without the patent expiration drag, the business is poised to accelerate growth based on recent product launches and potential new drugs in the pipeline.

A significant contribution from new products began with the introduction of Stelara, and Simponi in 2009. The company also introduced three significant new products in 2011: Zytiga (abiraterone) in prostate cancer, the anti-coagulant Xarelto (rivaroxaban), Incivo (telepravir) for hepatitis C and a number of smaller products. It also acquired Crucell and gained greater economic interest in Remicade and Simponi following the restructuring of the agreement with Merck.

The turnaround in JNJ, if I am correct, will be led by the pharmaceutical business based on the renaissance of new products. The following table shows my estimates for major products through 2015.

Sales Projections for Key Pharmaceutical Products
$ millions FY 2009 FY 2010 FY 2011 FY 2012 FY 2013 FY 2014 FY 2015
Growth Products
Risperdal Consta 1,425 1,500 1,583 1,776 2,019 2,297 2,613
Velcade 933 1,080 1,274 1,465 1,641 1,838 2,058
Prezista 592 857 1,211 1,453 1,671 1,922 2,210
Invega 393 424 466 525 576 410 335
Stelara 393 738 997 1,258 1,529 1,811
Intellence 239 306 320 368 423 487
Zytiga 296 854 1,200 1,575 2,050
Incivo 64 555 875 900 825
Xarelto 7 175 155 375 525
Simponi 226 410 536 583 633 689
TMC-435 550 800
Sub-total 3,343 4,719 6,355 8,656 10,346 12,451 14,402
Mature Products
Remicade 4,304 4,610 5,088 5,333 5,727 6,050 6,284
Eprex/ Procrit 2,245 1,934 1,623 1,404 1,264 1,137 1,023
Aciphex 1,096 1,006 961 823 725 638 562
Doxil 308 402 206 375 340 310
Other 5,718 5,330 6,429 6,576 6,397 7,037 7,740
Sub-total 13,363 13,188 14,503 14,341 14,487 15,202 15,920
Patent Expirations
Levaquin 1,550 1,357 623 61 60 35 25
Topamax 1,151 538 488 322 250 200 175
Concerta 1,326 1,319 1,268 893 648 488 362
Duragesic 888 748 589 494 401 326 270
Risperdal 899 527 542 457 366 293 234
Sub-total 5,814 4,489 3,510 2,228 1,724 1,342 1,067
Worldwide Sales 22,520 22,396 24,368 25,225 26,557 28,996 31,389
Source: SmithOnStocks Estimates for 2012 to 2015, JNJ Financial Results

Potential Upsides and Downsides to Watch for in 2012

The world economic outlook is still volatile with the focus of investors being on Europe and the slowing of growth in the BRIC and other emerging countries. JNJ's sales and EPS could change appreciably if there is a sudden change in world economic growth. In my view, we are more likely to see a strengthening of the world economy, but no one can rule out a blow-up. Currency rates are close to impossible to predict and fluctuations could cause a significant change in reported sales or EPS.

JNJ has a meaningful interest in HCV for which the landscape is changing rapidly. Companies are scrambling to assemble a combination of HCV drugs that work by different mechanisms of action and could lead to an all oral HCV drug regimen. See my report Some Biotechs May Benefit from Hepatitis C Treatment Market Shifts. This has led to the acquisition of Pharmasset (VRUS) by Gilead (NASDAQ:GILD) and Inhibitex (NASDAQ:INHX) by Bristol-Myers Squibb (NYSE:BMY) at very hefty premiums. JNJ has not yet entered into this bidding war for HCV assets. Investors will watch closely to see how JNJ approaches this business issue. Will it also go for dilutive acquisitions or rely on its pipeline and partnering?

JNJ has rights in many significant foreign markets, notably Europe, to Vertex's (NASDAQ:VRTX) telepravir which Vertex markets as Incivek and JNJ as Incivo. Investors are already apprehensive that Incivek will have a very short product life in the US before second generation protease inhibitors enter the market and displace it. I would point out that JNJ is less affected than Vertex by this issue because it probably has the best of the second generation protease inhibitors with TMC-435, which could enter world markets in 2014. Currently, Incivek growth has stalled out in the US. This may be due to patients not being willing to start the difficult to tolerate HCV regimen in which Incivek is combined with interferon and ribavirin, during the holiday season. However, there is growing speculation that doctors are warehousing less severely ill patients waiting for new drugs like JNJ's TMC-435. The rollout of Incivo in Europe is lagging the US and it will be closely watched by investors.

There are two new Factor Xa inhibitors that I believe are a significant advance in anticoagulation therapy, Eliquis of Bristol-Myers Squibb and Xarelto of JNJ. I think that these drugs will replace much of warfarin usage over time in treating patient with atrial fibrillation. See my report Anticoagulant Blockbuster Drugs are Here. However, there are some who believe that warfarin will continue to dominate the market because of its established efficacy and generic price. Another issue is that most analysts think that the clinical data on Eilquis is superior to Xarelto in atrial fibrillation and I am inclined to agree. The expectation is that Eliquis will dominate the atrial fibrillation market and Xarelto will be a distant second. However, Xarelto has shown much more impressive results than Eliquis in acute coronary syndrome. So far, the launch of Xarelto has been slow and the Xarelto/ Eliquis battle will be closely watched following the launch of Eliquis in the next few months.

Johnson & Johnson, Pfizer (NYSE:PFE) and Elan (NYSE:ELN) all have meaningful stakes in bapineuzumab, the most clinically advanced new drug for Alzheimers. Topline data on an extensive phase III trial will be reported before yearend 2012. Most analysts and many physicians expect the trial to fail, but a minority is more optimistic. There are really no effective drugs for Alzheimers so that success in this trial could present a major commercial opportunity for JNJ. I have no opinion on the potential outcome and am just waiting for the results.

The pace of the return to the market of the McNeil consumer products will also be watched. From an operational standpoint, the recall of DePuy ASR hip is largely behind the company having already cost about $800 million However, the product liability settlements could be massive and investors may be surprised from time to time on this front.

Declines in elective surgery have been a depressant for the medical devices segment and is currently running down about 0.5%. JNJ believes that the market is close to a bottom as these surgeries can only be put off for so long.

CEO Bill Weldon's View on JNJ's Strategic Outlook

CEO Bill Weldon made some comments on the strategic outlook for JNJ during the fourth quarter conference call that I found especially interesting. He talked about three major forces that are shaping healthcare and JNJ's businesses: (1) macroeconomic conditions, (2) government payers and regulators, and (3) industry trends.

He said that macroeconomic conditions have been incredibly challenging for the last several years due to slowing economic growth, uncertainty in financial markets, high unemployment and the resulting pressure and focus on healthcare costs. These have all contributed to reduced healthcare spending. In addition, the volatility of currency exchange rates continues to be an issue.

Mr. Weldon felt that that these negative dynamics were balanced by positive demographic trends. He said that populations in the developed world are aging rapidly and older patients consume more healthcare. Those over the age of 65 consume an average of seven times more healthcare per year than those under that age. Global expansion and growth, while lower than a few years ago, still leads to growing demand for healthcare, especially in emerging markets, where access has been historically low. Growing national wealth allows governments to expand access. Over the past five years, the global healthcare market has had compounded annual growth of nearly 7%, and he expects it to see strong mid-single-digit growth over the next five years. He anticipates that growth in emerging markets including Brazil, Russia, India, and China will be much better.

Healthcare spending generally tracks with the growth of GDP; as nations have more money to spend, they address essential needs like healthcare. He stated that emerging markets are projected to grow their share of global GDP from 36% in 1980 to 57% in the year 2020. He projects that over the period of 2010 to 2020, 35% of the growth in healthcare spending will be coming from emerging markets. At the same time, the aging populations of developed countries and high per capita spending will continue to be important.

Government involvement with healthcare is an ever increasing drag on growth. Government payers are requiring more cost effective solutions and that impacts the pricing of healthcare products and services, particularly for "me too" and older products. The regulatory environment has also become much more intense in its scrutiny of new products leading to delays in product approvals and more product failures.

In the highly competitive healthcare world, bringing new innovations to market requires significant investments and access to technology beyond the resources that JNJ or any other company can develop on their own. JNJ is looking to complement organic growth with acquisitions and collaborations. In this regard, JNJ is extremely well positioned with its AAA balance sheet, strong free cash flow and strong global reach. The difficulty for smaller biotechs to attract enough capital to bring a new drug through to commercialization means that they have to turn to companies like JNJ to commercialize their products. This creates access to a wealth of new technology that JNJ can potentially take advantage of.

Source: Johnson & Johnson: The Turnaround Is Starting And I Am A Buyer