J&J's Rx for the Anxious Investor


By Amy Tsao Investing in big pharmaceutical companies used to be considered safe during tough times. But not in this latest economic downturn. The tried-and-true recipe for success among the giants -- relying on one or two blockbuster drugs to keep revenues flowing -- is faltering. It's a sign of the times that venerable powerhouse Merck (MRK) issued an earnings warning in late June after sales of its top drugs slowed. The news sent the No. 3 drugmaker's stock tumbling 10%.

Merck isn't alone. Other pharmaceutical companies have been dealt bitter blows. American Home Products (AHP) recently was denied regulator approval for a new bone-fracture treatment, and Schering-Plough (SGP) says manufacturing troubles will keep the company from making a follow-up drug to its allergy-buster Claritin.

Plus, there's fierce competition from generic drugmakers, which cuts severely into drug-company profits, growing support for legislation to control drug prices on Capitol Hill, and all the uncertainties surrounding clinical drug trials. Small wonder investors no longer see drug stocks as havens.

Johnson & Johnson (JNJ) appears to be the exception, however. Its pharmaceutical business is in good shape compared to others. With multibillion-dollar drugs like Procrit for anemia and the antipsychotic Risperdal, J&J remains a formidable player in the high-margin pharmaceutical business. And its more staid health-care businesses act as a buffer in hard times, something pure drug companies don't have.

DIVERSE PRODUCTS. In 2000, J&J rang up $12 billion in drug sales, which accounted for 41% of $29 billion in total revenues and 60% of operating profit. The New Brunswick (N.J.) company is the biggest medical-device maker in the world. Medical products account for 35% of J&J's total revenues, while the low-margin consumer-products division, which makes products like Tylenol and Band-Aids, accounts for the remaining 24% of revenues. "It's a much more diverse portfolio than just the pharmaceutical business. That benefits it," says Tim Ghriskey, senior portfolio manager at Dreyfus Corp.

Is it too late to seek shelter with J&J? True, company shares have run up considerably in the past couple of months, hitting an all-time high of $108 in June. But at around $50 (after a 2-for-1 split) and with a price-to-earnings ratio of 29, the stock trades close to its peers. And many analysts expect it to resume a steady climb as pure-play drug stocks struggle and the market seeks companies with dependable earnings.

"I would say it can return 10% to 15% over the next 6 to 12 months. That would be enough for some investors" in an environment where returns are hard to come by, says Michael Dauchot, an analyst at Dresdner RCM Global Investments.

Make no mistake. Prescription drugs are crucial to J&J's overall health. That's why the company poured $2.9 billion into drug research and development in 2000. The 2001 budget for drug R&D will be $3.3 billion, says Jeff Leebaw, a J&J spokesperson. While highly diversified in health care, J&J has some share of worries on the drug development front: Top drugs are coming under pressure from new competitors and the bulk of its pipeline is very early-stage.

NEW APPROVALS, OLD DRUGS. Still, J&J has no serious patent expirations to contend with over the next several years -- and that's a far different picture from its rivals. And it has a strategy in place to bridge the gap between existing drugs and new drugs due in three to four years. The addition of drugs from its recent acquisition of Alza (AZA) and new marketing approvals on several old drugs should offset some of the pressure caused by slowing growth of its biggest-selling drugs. And analysts don't overlook J&J's staples: partnering with smaller companies for drugs and midsize acquisitions offers growth potential.

In part, the company aims to increase drug sales by getting additional approvals for drugs already on the market. It's not unusual for drug companies to take this tack, but J&J has made it a top priority. For one, it's testing its epilepsy drug Topamax for treating several other diseases including obesity, mania, and migraine. With an upturn in the economy's fortunes and a little luck, the company could turn the drug, which brought in $309 million in sales in 2000, into a blockbuster.

J&J is also looking for extensions on its recently approved Alzheimer's drug Reminyl and antipsychotic Risperdal, which is coming under pressure from the introduction of Pfizer's Geodon. "If you're proactive, you can get some new [uses for the drugs] before you lose patent protection," says Dilip Phadnis, analyst at the Rowin Group, a Maywood (N.J.)-based consulting firm.

BUILDING BLOCKBUSTERS. "Its pharmaceutical business has the potential to be a true growth story," says Tom Dechamps, an analyst at Mehta Partners. He expects J&J could have eight drugs with sales over $1 billion each on the market in 2005. "If it can grow this many products to be true blockbusters then it would show its intensified efforts are paying off." The company aims to have some 32 early-stage drugs in testing by the end of 2001.

In the near term, Dechamps expects some revenue-generating drugs from the Alza acquisition to hit the top line. With J&J's huge sales force, annual sales for attention-deficit-hyperactivity drug Concerta could grow to $500 million to $700 million, and sales of incontinence drug Ditropan could reach $500 million, the company says. It's already working out ways to use Alza's drug-delivery technologies to extend the life of patents on drugs like Topamax and Risperdal.

J&J's biggest near-term threat concerns its red-blood cell booster Procrit, which pulled in $2.7 billion in sales in 2000. Analysts fear that the company's biggest seller, which was developed by Amgen (AMGN), will be pounded by sales of Amgen's second-generation Aranesp, due to be approved some time this year. "While the pipeline is still a bit of problem, they had a good story to tell" at the investor meeting this June, says Rita Freedman, an analyst at PNC Advisors. Freedman was comforted by the outlook for Procrit, which by her estimations, should still squeeze out sales growth through 2002. "The existing product line has a better outlook than I expected," she says. "That was key for me."

ARTERIAL OPENING. Meanwhile, medical products could give J&J a boost over the next couple of years. This part of the business, which includes sundry devices and supplies, should grow about 9.6% in 2001, says Kurt Kruger, an analyst at Banc of America Securities.

That's about in line with industry growth rates, but J&J could break away from the pack in 2003 with 20% growth when its drug-coated stent, an implant used to keep arteries open, is expected to receive FDA approval. Trial results from Europe will be released this September, and they should indicate whether the product does a better job than existing stents.

"This could develop into a $3 billion opportunity in 2003," Kruger says. Thanks to the new stents, he's expecting the overall medical-products business to rope in $15.4 billion in sales in 2003, up from $9.2 billion in 2000.

SLOW AND STEADY. The smallest piece of the puzzle, consumer products, isn't a big grower, but does it provide a steady stream of cash. "Occasionally, they come up with some product lines that give them a little extra growth," says Freedman, noting the company's success with the Neutrogena skin-care line in 1999.

The division, which makes low-priced products like tampons, body lotion, and shampoo, is insensitive to recessionary forces. Freedman says management has done well in consolidating this division and keeping costs under control. She's looking for low single-digit growth.

It won't be all clear sailing for J&J. There's no guarantee the company will get additional marketing approvals on existing drugs even though it will have to front the cost for any new trials. And if pure-play pharmaceutical stocks pick up speed again, J&J may not run as fast as the pack.

"When pure pharma is running hard, this company is more diversified and therefore doesn't have that big kick to the upside," Ghriskey cautions." But for now, J&J's diversified business could offer safety that other drug companies can't. Tsao covers financial markets for BusinessWeek Online in New York


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