I have not been what you would call a supporter of healthcare giant Johnson & Johnson (JNJ) in my articles on Seeking Alpha, my old article on why I sold the shares having generated quite a bit of controversy. Companies and stocks are not static entities, though, and every responsible investor owes it to themselves to revisit stories and theses from time to time.
In With The New
Quite a lot has changed at J&J over the past year. Although the device market is still pretty sluggish, the company has been active in shuffling its deck. The company decided to throw in the towel and cede the drug-coated stent market to the likes of Abbott Labs (ABT), Boston Scientific (BSX), and Medtronic (MDT), while significantly strengthening its orthopedics business with the acquisition of Synthes. Once this deal closes (probably in the first half of 2012), JNJ will be a much bigger player in spine and trauma.
The company's pharmaceuticals business has also come on stronger. Drugs like Remicade, Velcade, and Prezista have come on strong, as have newer drugs like Xarelto. Even more could be on the way, though, from drugs like Zytiga (prostate cancer), bapineuzumab (Alzheimers), canaglifozin (diabetes), and siltuximab (oncology), all of which could be billion-dollar babies.
Last, and not at all least, JNJ has announced that long-time CEO Weldon will be retiring from the position in favor of Alex Gorksy (current head of devices and diagnostics). While Gorsky will not single-handedly change the company overnight, this transition does remove an ongoing point of contention for many shareholders and could mark a change in company priorities and resource allocation.
What The Company Still Has To Do
One of the most significant challenges for CEO-to-be Gorsky is convincing the Street that JNJ can still be a dynamic player in healthcare and not simply a bloated growth-by-acquisition lump.
Certainly the company has benefited from acquisitions and R&D investments in the drug business, and a lot of the expected growth is still at risk. Zytiga has relatively limited patent coverage and could yet face serious competition from Medivation (MDVN) and Sanofi (SNY) in the prostate cancer space. Likewise, Xarelto has been something of a disappointment thus far, and JNJ's entry into the Hep C mosh pit will have to share space with a host of companies including Gilead (GILD). Last and not least, while the Alzheimer's drug bapineuzumab is a high-potential drug, depending upon any drug for this disease has been an invitation to pain.
The bigger issue in my mind is what the company will do in its devices and diagnostics business. The company's Ethicon and Ethicon Endo-Surgery businesses have done reasonably well and hold their own with the likes of Covidien (COV), Bard (BCR) and Boston Scientific. Other areas, diagnostics in particular, have been hampered by a multi-year lack of innovation and competitive product introduction. There are several market/product groups at JNJ that really need some refocused and recharged R&D; a decision that could impinge on margins in the short term, but should pay off over time.
Consumer health is also going to take some additional work. The company is not past the impact of the numerous product recalls, and JNJ is in for years of image-repairing brand rebuilding. Luckily this is still a business with strong intrinsic profitability and it can still be a valuable cash flow contributor in the future - particularly if the company can accelerate its growth in emerging markets like Brazil, Indonesia, China, and India.
The Bottom Line
I have long had, and still have, serious questions about whether JNJ is philosophically suited to be an innovative and market-responsive company. My biggest fear is that the company stints on R&D and/or misallocates internal resources and has to resort to splashy M&A activity to keep the growth rate lurching forward. Although this would not imperil the dividend over any reasonable foreseeable time period, it would reduce earnings quality and reliability to a meaningful degree.
I do believe that JNJ can maintain mid-single digit free cash flow growth, and I think the current free cash flow yield (expected 2012 free cash flow divided by enterprise value) is very close to being very interesting. As it stands now, I peg fair value at just over $78, good enough for about 20% undervaluation at today's prices.
For a company of JNJ's quality, to say nothing of the prospect of improving performance with the management shift, 20% undervaluation is just about enough to make the shares interesting again to me. What's more, rival stocks like St. Jude Medical (STJ), Covidien, Bard, and Medtronic have performed such that JNJ is actually looking relatively cheap. Although Stryker (SYK) is cheaper still and probably my first choice among the group, JNJ looks like a pretty strong option overall.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
