Don't Miss Johnson & Johnson's Rebound

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Should you invest in a giant healthcare company that has managed to shoot itself in the foot over and over again in recent years? Alex Gorsky, who recently took over as CEO of Johnson & Johnson (NYSE:JNJ), faces a sea of problems that have damaged the company's reputation.

Problems with quality control have forced recalls of some its best known products, including Tylenol and Motrin. There has also been a huge recall of 93,000 artificial hips made by DePuy, a Johnson & Johnson subsidiary. Of course, it is somewhat hard to recall hips that have already been installed in the patients. The hips have a failure rate of almost 30%. The company has set aside $3 billion to cover the charges resulting from this recall and resulting litigation. Another headache involves Risperdal, Johnson & Johnson's schizophrenia drug. A federal judge has ordered the company to pay $1.2 billion for improperly marketing the drugs to juveniles and the elderly.

On top of it all, Gorsky has to figure out how to successfully integrate Swiss medical device maker Synthes (SYST.VX) into Johnson & Johnson after that $21 billion acquisition is still undergoing review by U.S. regulators. The leadership change is an important step in returning confidence in the company, although it would have been more convincing if former CEO William Welden had also stepped down from the chairmanship.

Despite the problems, I think that Johnson & Johnson is a buy now, because 1) it is relatively cheap with a reasonable dividend; 2) it markets a large number of well-known consumer products and over-the-counter drugs; 3) it has a large pipeline of drug candidates that should give the company increasing profits in the future; and 4) the Synthes acquisition will improve the growth rate.

Johnson & Johnson trades at a price-to-earnings ratio of about 17, half of the industry average. It pays a dividend of about 3.8%, better than the industry average of 2.5%. Its operating margins and net profit margins are a little better than average. Its growth rate at around 5% is not spectacular, but then it is already a huge company.

Johnson & Johnson divides its operations into three segments: consumer, pharmaceutical and medical products and diagnostics. The consumer products division is a gem, with lots of well-known brand names with a long history behind them, like the Johnson & Johnson's baby care products, Band-Aid, Tylenol, Motrin, Sudafed, Listerine, Neutrogena, Zyrtec, and Pepcid-AC. Total sales in the consumer division were $14.8 billion in 2011.

The prescription drugs marketed by the pharmaceutical division will not be so familiar to the consumer, but include some very important products. Remicade is a monoclonal antibody used to treat autoimmune diseases, like Crohn's disease and ulcerative colitis. Johnson & Johnson recorded sales of over $5 billion for Remicade last year. International sales were up over 50%, as Johnson & Johnson took over some territories from Merck (NYSE:MRK). Remicade competes with another monoclonal drug, Humira, marketed by Abbott Labs (NYSE:ABT), which also recorded sales of over $5 billion last year.

Johnson & Johnson has five other drugs with sales of over $1 billion annually. They are Procrit, used to increase red blood cell counts, particularly after chemotherapy, the schizophrenia drug Risperdal, Velcade, used to treat multiple myeloma, Concerta, used to treat attention-deficit disorder and other psychological conditions, and Prezista, a protease inhibitor used to treat HIV infection. Johnson & Johnson is thus well-diversified in its product portfolio.

In the medical products and diagnostics business, the most important products are the joint reconstruction products made by DePuy ($5.6 billion in sales in 2011), and the Ethicon sutures and endo-surgery products (sales of $10 billion in 2011). DePuy faces competition in the U.S. and internationally from Stryker (NYSE:SYK), Zimmer (ZMH), Biomet and Smith and Nephew (NYSE:SNN). Ethicon competes with companies like Allergan (NYSE:AGN) and C.R. Bard (BRD).

The Synthes acquisition will be complementary to DePuy, adding products in the craniofacial area and spinal area. Despite its European roots, only 20% of Synthes sales are in Europe, with over half in North America. Synthes has grown its revenues by 15% annually over the last 10 years, so it will add some growth to Johnson & Johnson .

Johnson & Johnson has a fairly large pipeline of drugs in late stage trials:

Xarelto is a blood thinner that already has been approved for deep vein thrombosis and to prevent stroke in patients with atrial fibrillation. On Wednesday, May 23, a FDA panel will vote on whether to extend that to preventing clot formation in patients with acute coronary syndrome. If approved, it is expected to add about $300 million to the drug's annual sales.

Simponi, a tumor necrosis inhibitor like Remicade, was approved last year for rheumatoid and psoriatic arthritis, and is in phase III trials for ulcerative colitis.

Stelara is a monoclonal antibody drug that suppresses the immune system through the inhibition of interleukins 12 and 23. In a phase III trial, it was found to be more effective than Amgen's (NASDAQ:AMGN) Enbrel in treating plaque psoriasis. It is also in phase III trials to treat psoriatic arthritis and Crohn's disease.

Canagliflozin is an interesting new drug for the treatment of type II diabetes, currently epidemic in the U.S. and affecting even larger populations in India and China. Canagliflozin blocks reabsorption of glucose by the subtype 2 sodium-glucose transport protein in the kidneys, causing blood glucose to be eliminated in the urine. In early clinical trials, the drug was found to improve glycemic control while also causing weight loss in the patients, an important secondary goal in type II diabetes. This could be a very big drug for Johnson & Johnson if the results are confirmed in the phase III trials.

At a minimum, Johnson & Johnson is a safe, defensive stock with a reasonable dividend. The product recalls have been expensive, but probably did not damage the company's reputation that much with consumers, who tend to have short memories and strong brand loyalty. The company's healthy drug pipeline and its acquisition of Synthes should set the stage for stronger growth in the future.

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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