Markets & Finance

J&J: Taking Stock of a Household Name


From Standard & Poor's Equity Research Services

Despite some near-term operating challenges, particularly within its pharmaceutical segment, we think Johnson & Johnson (JNJ

; $58) continues to offer one of the more consistent long-term growth rates among large-cap pharma/device outfits, and a valuation that's compelling relative to the S&P 500 and the company's health-care peers.

We believe investors will continue to gravitate toward J&J as one of the few remaining "safe havens" in pharma, and believe that a rising percentage of revenues and operating profits generated from non-pharma businesses will help drive valuation expansion.

We anticipate that J&J will pursue smaller strategic deals going forward, and believe some incremental sales growth will result. We also think J&J has a number of options available to enhance shareholder returns, including additional common-share buybacks, increased dividend payouts, and the separation of individual business units. In our view, the company offers a strong balance sheet and diversified growth. We have a 5 STARS (strong buy) recommendation on the stock, with a 12-month target price of $67 a share.

BIG WINNERS. The company generated 44% of 2005 sales from pharmaceuticals, 38% from medical devices & diagnostics, and 18% from consumer products. Looking into 2006, S&P projects that revenues will grow approximately 7.8%, to $54.5 billion, as 3.9% projected growth in pharmaceuticals joins with an 11.9% gain in the medical devices & diagnostics segment and an 8.9% increase in consumer-product sales.

The pharma business ranks among the largest in the world, with products in the anti-fungal, anti-infective, cardiovascular, contraceptive, dermatology, gastrointestinal, hematology, immunology, neurology, oncology, pain-management, central nervous system, and urology fields. During 2005, the company had eight compounds that generated over $1.0 billion in sales.

Much like the pharma industry as a whole, however, J&J faces challenges due to patent expirations and intensifying competition in several key therapeutic categories. During 2005, for instance, J&J lost patent protection on Duragesic, and U.S. sales of Duragesic fell 54%, to $582 million. Globally, Duragesic had 2005 sales of $1.6 billion, down 24% from the $2.1 billion generated in 2004.

EXPIRATION DATE. Total pharma sales in 2005 actually declined 3.2% in the U.S., as the Duragesic erosion joined with the loss of patent protection on both Ultracet (2005 sales of $175 million, down from $348 million in 2004) and Sporanox ($36 million, vs. $117 million).

We don't believe J&J faces another wave of significant patent expirations until late 2007, when the patent on Risperdal, an anti-psychotic medication, is set to expire. This expiration is quite significant, in our view, as Risperdal is presently generating the highest annual sales in the pharma division -- $3.6 billion in 2005. The company is hoping to limit the damage by developing a follow-on product, Paliperidone ER.

Our 2006 sales forecast for the pharma segment is $23.2 billion, excluding any potential swings from foreign-currency translations that may, in our view, remove 2% to 3% from reported growth. During 2006-07, we anticipate the potential launch of products including OROS Hydromorphone for chronic pain, DOXIL for multiple myeloma and breast cancer, Remicade for juvenile rheumatoid arthritis and psoriasis, and Paliperidone for schizophrenia.

STRONG SEGMENT. Johnson & Johnson's medical devices and diagnostics business unit offers a wide range of products. During 2005, this unit generated sales of $19.1 billion, representing approximately 38% of total revenues, and we estimate that total segment revenues in 2006 will reach $21.4 billion.

In recent years, the primary growth engine for this business segment has been the Cordis unit, which focuses on devices primarily used for treatment of cardiovascular diseases, most prominently the Cypher drug-coated coronary stent. Cypher, launched in the U.S. in May, 2003, is designed to reduce the incidence of vessel reclosure, or restenosis, following the implantation of a stent into a diseased coronary artery. During 2005, sales at Cordis rose 24% to $3.98 billion, including global Cypher sales of $2.59 billion. We think Cypher sales will grow in the high single digits over the coming three years.

Other core products within the device/diagnostics segment include orthopedic reconstructive joint and spinal hardware. We think the DePuy unit is the second-largest participant in the global reconstructive joint market, after Zimmer (ZMH

; 4 STARS, buy; $66). It manufactures and sells hip, knee, shoulder, elbow, and extremity devices. The Ethicon unit sells products used for wound closure and cardiovascular surgery, gynecological health problems, wound management, and circulatory health. We believe Ethicon currently maintains about 75% of the global sutures market.

MARKET LEADER. The Ethicon Endo Surgery division sells various products that are used in both minimally invasive and traditional surgeries. J&J's Lifescan division is among the leading participants in the blood glucose monitoring market, where it commands an approximate 30% share of a global market that is estimated by S&P at $6 billion. The Ortho-Clinical Diagnostics unit ranks among the larger manufacturers of diagnostic reagents and instruments that are used by hospital and clinical laboratories, and blood donor centers.

The Vistakon unit was the pioneer in the disposable contact lens business, launching its Acuvue brand in 1998. This brand is the market leader, and remains the most highly prescribed disposable contact lens in the U.S., based on S&P and industry estimates.

While we think most J&J investors tend to focus on the pharma and medical-device segments, in our view the company's consumer-products franchise remains an important contributor to sales, earnings, and cash flow. This division represents one of the world's largest sellers of consumer products, with 2005 sales of $9.1 billion.

BRAND EXPANSION. Its major brands include Neutrogena soap, Sundown sun-care products; Shower to Shower personal-care products; Tylenol acetaminophen products; Motrin analgesics, Imodium, Mylanta, and Pepcid stomach care products, Carefree and Stayfree feminine-hygiene products; Johnson's, Penaten and Natusan baby-care products; Band-Aid adhesive bandages; Reach toothbrushes; Splenda non-caloric sugar substitute; and Benecol food products.

The consumer-products division, in our opinion, is well-positioned to generate growth of 6% to 8% over the coming five years, aided by brand line extensions, new product offerings, and geographic expansion. We anticipate that 2006 sales from this unit will reach $9.9 billion, up nearly 9% from 2005.

At the end of 2005, the company had 17 stock-based employee-compensation plans in effect. During its discussion of 2005 financial results, J&J management noted that accounting for stock-option expense in 2005 would have lowered per share profits by 11 cents. We're looking for 2006 stock-option expense of 10 cents, and 2007 option expense of 13 cents.

GOOD PLANNING. We believe the roughly 3.5% EPS impact from stock-option expensing projected for 2006 is modest relative to both the medical-device and large-cap pharma group averages, and we don't think J&J's stock-option grants are excessive relative to peers or the S&P 500. As new accounting standards now require all employee stock options to be expensed, our operating estimates for 2006 and 2007 include projected option expenses.

Johnson & Johnson sponsors various retirement and pension plans, including defined benefit, defined contribution, and termination-indemnity plans, which cover most employees worldwide. We believe favorable pension plan adjustments will boost Standard & Poor's Core EPS by 2 cents in both 2006 and 2007.

In summary, we estimate Johnson & Johnson will generate 2006 S&P Core EPS of $3.71, after the removal of 10 cents of estimated stock-option expense and the addition of 2 cents related to positive pension plan adjustments.

RATIOS HIGH. Recently trading at about 16 times our option-inclusive 2006 EPS forecast of $3.70, the shares are priced at a modest 5% premium to the S&P 500, but below both the large-cap U.S. pharma (21 times) and medical-device (23 times) groups. On a 2006 p-e to estimated three-year growth (PEG ratio) basis, the shares were recently at 1.5, vs. 2.4 for the large-cap pharma group, and 1.8 for the large-cap medical-device group.

Although we believe the company's revenue diversity will allow for higher earnings growth relative to the overall pharma sector, we think the sector's PEG ratios are high by historical standards and believe a PEG of 1.8 is more appropriate for J&J, and in line with the longer-term historical average as well as medical-device peers. Utilizing our estimated three-year earnings growth rate of 11% and the 1.8 PEG, and applying the resulting p-e of 19.8 times to our 2006 EPS estimate of $3.70, we derive a relative valuation target price of approximately $73 a share.

The company is expected to generate free cash flow at the pace of about $900 million per month during 2006, and we believe free cash flow growth will compound at an approximate 6.6% pace from 2005 through 2009. We further assume a perpetual free cash flow growth rate of 4% and a current weighted average cost of capital of 8.7%. We believe these are appropriate assumptions based on our long-term expectations for sales growth, operating margins, depreciation and amortization charges, working-capital fluctuations, and capital-expenditure requirements. Our discounted cash flow model indicates intrinsic value of $61 a share.

BREAKUP SCENARIO. Although the company doesn't provide a detailed breakout of net earnings contributions by segment, operating profit contributions are available. In our opinion, these provide something of a basis to estimate net earnings contribution, which, in turn, form the basis for our relative valuation and sum-of-the-parts analysis.

We believe the pharma division will account for 55% of projected 2006 EPS of $3.70 (or $2.03), while the devices and diagnostics unit accounts for 32% ($1.18) and the consumer franchise contributes 13% (49 cents). Based on comparable valuations, our sum-of-the-parts analysis, we believe the stock would be worth about $67 in a breakup scenario.

In our opinion, all three approaches to valuing J&J are valid, and each yields a somewhat narrow range of outcomes. However, we would assign a higher weighting to the relative valuation approach in order to reflect our belief that the shares will trade primarily on the basis of expected earnings growth relative to both the pharma and medical device sectors. To a much lesser extent, we think the stock will be priced on a private-market basis that accounts for a scenario where J&J management looks to enhance shareholder returns by separating its operating divisions.

GOVERNANCE RISKS. Our three-stage blended valuation approach to J&J places a 45% weight on the P/E and PEG analysis, 15% on sum-of-the-parts, and 40% on DCF analysis, which results in our target of $67.30 a share. Adding in the current $1.32 dividend, our target suggests a total return for J&J of about 19% over the coming 12 months.

In our opinion, the corporate-governance policies at J&J are generally sound, and compare quite favorably to the company's pharma and medical-device peers. Items that positively affect our corporate-governance opinion include independent outsiders comprising more than 75% of the company's board of directors; both the nominating and compensation committees are comprised solely of independent outside directors; and the fact that the full board of directors is elected annually. No former CEO of J&J serves on the board, and the company's corporate-governance guidelines have been publicly disclosed.

Practices that we view negatively include shareholders not having cumulative voting rights in director elections; the chairman and CEO position is combined; there's no disclosure of term limits for directors; the board is authorized to increase or decrease the size of the board without shareholder approval; and there's no disclosure of a policy that limits the number of other boards on which directors of J&J may serve.

NEED TO ACQUIRE?. In term of stock options, the company's policy is to grant options to its employees for up to 1.6% of the issued shares of the company's common stock, plus the number of shares available from the previous year that weren't issued, as well as shares issued under the stock-option plan that expired or terminated without being exercised. We view this policy as reasonable.

There are risks to our recommendation and target price. The primary operational risks for J&J's pharma business include patent litigation and expirations, intense competitive pressures across several key therapeutic categories, and what we see as a relatively thin late-stage pipeline. We think J&J may be required to either acquire early-stage drugs or enter into strategic alliances with other drug companies in order to restore solid low double-digit revenue growth in this area.

Within the medical-device segment, from our perspective the most visible risk is the ongoing rapid maturation of the drug-coated coronary-stent franchise, which is resulting in sharply lower unit sales and eroding pricing across the industry. We believe the emergence of new entrants such as Abbott Labs (ABT

; 3 STARS, hold; $43) and Medtronic (MDT

; 3 STARS; $51) will accelerate this trend over the coming three years.

MEDICARE CHANGES. As such, we think J&J will likely seek out acquisitions in order to fuel additional sales growth. We believe acquisition-derived growth carries increased risk to investors relative to organically derived growth, largely reflecting the challenges of integrating large, technologically innovative organizations.

From a broader perspective, we believe the principal risks facing the stock will continue to be adverse changes to Medicare reimbursements for pharmaceuticals and/or medical devices, failure to successfully gain FDA approval on drugs in the clinical pipeline, and adverse outcomes on outstanding patent or other litigation.


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