Johnson and Johnson (JNJ) is one of the ten largest pharmaceutical companies in the world with a current market cap of $180 billion. Pharmaceutical industries have faced many challenges in recent years, including patent expiration, competition from generics, clinical trial setbacks, product liability litigation, healthcare reform, and increased government regulation. JNJ's stock price fluctuations in recent years are due to some of these aforementioned factors, leading us to evaluate its intrinsic value for the purposes of investment strategy.
We decided to write a 4-part series to better analyze each aspect of JNJ's business in detail with the goal of deriving an estimated intrinsic value for this international corporation.
In Part 1, we provide an overview of JNJ's business strategy, its product segments, drug pipelines, company specific issues, and our approach in analyzing this company as a whole.
In Part 2, we will focus on JNJ's existing products, patent expirations, and product liability issues. We will analyze how the Synthes merger and new products launched in 2011 will add to JNJ's top line.
In Part 3, we will analyze JNJ's drug pipelines. JNJ has filed 6 New Drug Applications (NDAs) in 2012. FDA actions for these new drugs are expected at the end of 2012 to early 2013. We will analyze the likelihood of these drugs getting FDA approval and how these new products will contribute to JNJ's revenue growth in the future.
In Part 4, we will analyze JNJ's financial reports and derive a 5-year financial projection for the company. The projection will enable us to derive an estimated intrinsic value for JNJ and provide the basis for investment strategies.
Part 1: JNJ business model and major business issues specific for the company
In Part 1, we provide an overview of JNJ's business strategy, its three product segments, drug pipelines, company specific issues, and our strategy to analyze this company as a whole (JNJ 2011 annual report, JNJ Q2-2012-release-results).
JNJ owns 250 operating companies based in 60 countries around the world over three business segments: consumer products, pharmaceuticals, and medical devices. Consumer product segment generated $15B (or 23%) in sales in 2011 with a revenue growth of 2% from prior year. Pharmaceutical segment contributed $24.4B (or 37.5%) in sales in 2011 with 8.8% increase over 2010. Medical device segment contributed $25.8B (or 40%) in sales in 2011 with 4.8% increase in sales over 2010.
This diversification over three business segments provides stability to its revenue stream over past decades. This is ever more important in light of the facts that there is no shortage of setbacks or challenges in the pharmaceutical industry. Recent setbacks for JNJ include the Children's Tylenol recalls, the McNeil facility shutdown, the Depuy replacement Hip recalls, and a failed clinical trial for an Alzheimer's drug.
These facts may make one question why anyone bothers to analyze pharmaceutical companies like JNJ at all. The answer is that the pharmaceutical industry has historically generated high double-digit net profit margins. In the case of JNJ, its 3-year average net profit margin is 18.8%. Several pharmaceutical stocks, including JNJ, offer 3-4% dividend yield. Thus, this sector provides both growth and income and has been an important part of portfolio management strategies. As with any investment, the key to profiting from an investment is always to purchase the stock at a discount. We believe that JNJ has an attractive intrinsic value that is not reflected in its current stock price.
JNJ's consumer segment sells household products and over-the-counter medicines such as Band-Aids, Neutrogena, and Tylenol. The remediation and supply issues associated with the McNeil Consumer Healthcare over-the-counter (OTC) business have been settled with FDA and the company expects that those products will be reintroduced throughout 2012.
In the medical device segment, JNJ has strategically wound down its stent business and moved toward other more profitable business such as orthopedics. The acquisition of Synthes, Inc in Q2 2012 will make JNJ the world's largest supplier in orthopedic devices. As Synthes generated $4B in sales in 2011 (Synthes 2011 annual report), we expect that Synthes will contribute as much as 5-6% of JNJ's revenue in the future.
Pharmaceuticals represent JNJ's most profitable segment and have produced several blockbuster drugs that benefit patients in oncology, inflammation, autoimmune diseases, and infectious disease areas. Patent cliffs have threatened several big pharmas, including Pfizer (PFE), Merck (MRK), Eli Lilly (LLY), Bristol-Myers-Squibb (BMY), Sanofi (SNY), and AstraZeneca (AZN), with the patents of some blockbuster drugs already expired or due to expire over the next several years.
Fortunately for JNJ, patent expiration is not an imminent threat. For example, the patent for JNJ's best-selling drug, Remicade, will not expire until 2018. Furthermore, it is more difficult to generically manufacture biologics-based drugs, such as Remicade, than standard chemical-based drugs. Therefore, we do not anticipate that a decline in Remicade sales will be as onerous as others believe.
JNJ has also been actively developing new products for autoimmune diseases, such as SIMPONI (another anti-TNF drug), STELARA (an IL12/IL23 antibody), and sirukumab (an IL6 antibody). These drugs have solid biological roles in autoimmune diseases. In addition, JNJ has aimed to introduce 11 products from 2011 to 2015 (see Part 3 for details) (JNJ-Q22012-pipeline ). As such, JNJ is well positioned to weather any patent expiration issues.
In the following series, we will evaluate the revenue and earnings growth rate for existing products, the probability of success and timeline for new product launches for the next five years, and assumptions and estimates used for 5-year financial projections. We will also factor in litigation and product liabilities costs in the financial models to better reflect pharmaceutical business model in general. At the end of the series, we hope to derive an intrinsic value for JNJ's stock price to aid in investment strategy.
 Remicade is an anti-TNF antibody for rheumatoid arthritis and other autoimmune diseases and has annual sales of $5.5B.
Disclosure: I am long JNJ.