Johnson & Johnson: Don't Sell This Defensive Gem

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Johnson & Johnson (NYSE:JNJ) is a long-term defensive asset positioned for a significant uptick in capital appreciation in 2013. The second quarter earnings report showed that total revenues in many segments of its expansive portfolio were hindered by negative currency impacts offsetting operational growth worldwide. Johnson & Johnson also faces a settlement with the DOJ and potential litigation from several states over Risperdal marketing campaigns. These events may reduce earnings and public perception in the market through the remainder of 2012.

For more promising near-term investments, interested investors should look for opportune entry points in the second half of 2012 or look into comparable rivals at a discount like Pfizer (NYSE:PFE), Merck (NYSE:MRK) or GlaxoSmithKline (GSK). Current shareholders should hold for the long term. A derivative settlement with shareholders over breaches of fiduciary responsibilities is creating top-down mandates to improve quality control and assurance beginning in 2013. There is an opportunity for Johnson & Johnson to improve organically in the long term, but there are significant headwinds to endure until that time comes.

Among the large-cap pharmaceuticals over $100 billion, Johnson & Johnson has the highest price per share. Its current price is around 22 times earnings, while its beta is around 0.55. Similarly, Abbott Laboratories (NYSE:ABT) has a beta around 0.3 and a price of around 21.5 times earnings. However, Abbot's sales growth over the past five years is around 11.5% compared to Johnson & Johnson's sales growth of 4.05% for the same time period. Merck has the highest sales growth over this time period at around 16.24%, while its beta is around 0.64 and its price is closer to 20 times earnings. GlaxoSmithKline is the only one in this group with a lower 5-year sales growth at around 3.35%, however its price is only 14.4 times earnings and it has the highest dividend yield amongst the five at around 4.89% annually.

GlaxoSmithKline also has a higher operating margin and lower price to sales ratio than Johnson & Johnson. Pfizer has had the largest decrease in sales YOY at around 8.6% compared to Johnson & Johnson's 0.74% decrease YOY. However, Pfizer has the highest gross margin at around 80% and the second highest operating margin at around 20% behind GlaxoSmithKline's 28%.

Of these major pharmaceuticals exceeding a $100 billion market cap, Johnson & Johnson has the highest price to sales ratio at around 2.9 and the highest forward price of 12.6 times earnings. Its PEG ratio, beta, profit margin and dividend yield are among the third highest of these big five. It's noteworthy that Johnson & Johnson's current ratio is around 1.75 and its quick ratio is around 1.42. Both of GlaxoSmithKline's corresponding ratios are significantly lower and its debt to equity ratio is around 2.4, while Johnson & Johnson's is around 0.29.

For the second quarter of 2012, Johnson & Johnson reported $16 billion in sales. This is a 0.7% decrease YOY, there was operational growth of 3.5%, but the negative currency impact was 4.2%. For the first half of 2012, Johnson reported around $32.6 billion in sales, this was a decrease of around 0.5% YOY. In the first half of 2012, Johnson & Johnson spent over $3.4 billion on R&D, this was a 5.8% decrease YOY. In the second quarter it spent over $1.7 billion on R&D, this was a decrease of around 6.2% YOY. Currency fluctuations had a negative impact of 2.7% in the first half of 2012 and a negative impact of 4.2% in the second quarter. There was a negative currency impact on nearly every segment across the board. Sales in the U.S totaled over $7.3 billion in the second quarter. This was a 1.2% decrease YOY. Total international sales were over $9.1 billion, operational growth of 7.1%, but a negative currency impact of 7.5% made a deficit of 0.4% YOY.

Sales in Europe exceeded $4.1 billion, operational growth was 1.6%, but alongside a negative currency impact of 9.9%, sales were down 8.3% YOY. The greatest growth was in the Asia-pacific, Africa division and the Western Hemisphere, excluding the U.S. Total sales increased 5.2% and 12%, despite the negative currency impact of 2.5% and 10.4%, respectively. In the second quarter, Oral Care had operational growth of 7.5% due to the increased international sales of Listerine. Women's Health had an operational decline of 8.7% due to divesting brands back in 3Q11. Wound Care operations declined by 3.7 % due to increased competition in the market. Immunology operational sales grew 18.2% YOY due to SIMPONI and REMICADE sales, alongside the increased territories in Canada, Australia, Mexico and Brazil relinquished by Merck through agreements in 2011. Oncology also had strong growth of 14.1% YOY, due to sales of ZYTIGA for specialty prostate cancer patients. Despite the few highlights, there was marginal growth, mostly stifled by negative impact of currency fluctuations.

Johnson & Johnson suffered minor revenue losses in the second quarter due to the shortage of supply of its cancer drug Doxil. This hampered clinical trials from approving supplemental treatments, as well as supplying current patients. Johnson & Johnson has been using a rationing program to allocate the remaining supply and continues to search for a short-term solution until Doxil production is resumed towards 2013.

Johnson & Johnson and the DOJ have reportedly reached a settlement agreement that's likely to exceed $2.2 billion for marketing Risperdal for mental illnesses that were not approved by the FDA. Pfizer settled for illegal marketing in 2009 for around $2.3 billion, GlaxoSmithKline recently did as well. Johnson & Johnson faces similar charges from possibly 40 states in the U.S. It's had a claim by Pennsylvania dismissed by a judge, while it's already been ordered to pay over $320 million to South Carolina and over $250 million to Louisiana as well.

Johnson & Johnson is due in court in September to finalize the proposed settlement of derivative actions from plaintiff shareholders. The shareholders wanted to bring individual executives and management to litigation due to neglecting fiduciary responsibilities ranging from 1990 through 2011. Johnson & Johnson, alongside the defendants, refuted the claim and hired independent specialty investigators that proposed restructuring and reformations in quality control and assurance in conjunction with checks and balances was more appropriate. The proposed settlement calls for top-down accountability, a five-year commitment and the implementation of a Product Risk Management standard as well. This will take effect in 2013 and will essentially restructure and improve Johnson & Johnson organically regarding corporate governance.

Johnson & Johnson submitted multiple new drug applications to the FDA and the EMA during the second quarter. Applications were focused on oral applications for diabetes, prostate cancer supplements like ZYTIGA and drugs for embolisms and tuberculosis as well. It has completed its first medical device acquisition in China and is reportedly working towards acquiring ELSKER, one of its main competitors in China as well. Johnson & Johnson has long-term potential for growth and recovery, but this will largely be happening mid-2013 and thereafter.

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

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