I know Johnson & Johnson (NYSE: JNJ) very well. I live in the heart of big pharma country: Princeton, N.J. And I have been interacting regularly with many people in this industry, including all levels of the Johnson & Johnson management for years.
Johnson & Johnson is a company that my peer analysts and I have admired for decades. And this well-deserved admiration goes well beyond the financial community.
Let me tell you why.
JNJ has a sound business model that emphasizes the development and marketing of top quality drugs and benchmark consumer products. Its strong and stable profit margins - with gross profit north of 70% – and its consistent growth over more than a century are matched by only a handful of companies.
But JNJ is much more than a successful business model. The company is permeated by a strong culture of responsibility that is embodied in its credo. While many companies have a set of corporate principles, JNJ actually believes and practices theirs. Johnson & Johnson employees take their responsibilities very seriously and they act quickly, prudently and fairly to fix problems.
JNJ’s credo is an admirable declaration of business principles that was crafted by Robert Wood Johnson, its former chairman, back in 1943. In its time, it was a revolutionary set of statements. Today, validated by the company’s history of success throughout the world, we can see its immense value in supporting enduring stockholder value growth and contributing to the communities around the globe.
This credo has led to the continuous development and marketing of superior products, delivered efficiently and with care for its customers. Johnson & Johnson products have become highly valued brands around the world for billions of consumers over more than a century.
Having remained true to its principles, Johnson & Johnson enjoys huge financial strength, diversification across products, clients, suppliers and geographies, economies of scale, profitability, growth and low volatility in its margins. The diversification of risks, high value-added products, and the market leadership of its many brands have led to superior, enduring growth and profitability.
The company’s strong ethical compass minimizes the likelihood of potential costly mistakes. And the inelastic demand of its products means highly predictable revenues. The latter quality is invaluable in these uncertain economic times and demands a market premium for its stock.
However, with the freezing of the banking industry in 2008, and its impact on the U.S. economy this year, JNJ revenues took a hit. Additionally, patent losses took some 4% off of sales. While a hit of this magnitude would be negligible for most industries, JNJ’s tradition of dependable sales and earnings growth made it particularly relevant.
I believe that 2010 will bring a 7% sales increase as sales and profits will be helped by the weak dollar, which will give sales abroad a boost.
New products and acquired businesses in drugs will kick in, as well. I’m thinking of new drugs, like Xarelto (an anti-clotting agent), Simponi (for arthritis) and Intelence (for HIV), and cardiovascular and orthopedic medical devices. Sales of existing drugs like Levaquin and Remicade, could also pick up, and medical devices and consumer products will be aided by the improved global economy.
The growth in volumes that we currently are seeing will keep helping JNJ’s generous gross and operating margins. In addition, JNJ is achieving large savings from cost cutbacks and added synergies from newly acquired businesses. Finally, the company’s robust pipeline is likely to deliver welcomed surprises to 2010 revenue and profit estimates.
JNJ eliminated some 3% of its workforce in 2007 and earlier this year let go some 900 employees in its drugs business. That was followed by the vertical realignment of its business units in August and the elimination of another 8,000 jobs globally – mostly middle management.
All of this cost restructuring will improve JNJ’s bottom line by about $850 million in 2010 and double that in 2011.
The company’s restructuring should also help the stock price notably. But there are short-term risks to these assumptions – mainly because of unpredictability of Congressional reforms to healthcare and current litigation risks to be clarified this week.
Some negative impact from healthcare reform is implicitly included in the pharmaceutical industry, with lower estimates than would be warranted under normal conditions.
Additionally, the Department of Justice (DOJ) is about to adopt a final position and take some action regarding an investigation that was launched four years ago. JNJ's attorneys are scheduled to meet with DOJ officials this week in order to try to avoid prosecution for an investigation of the company’s marketing tactics for its Natrecor heart drug.
This situation is already partly discounted in the price of the stock, but the worst possible outcome is not.
Let me explain.
JNJ is defending its position that it did not engage in illegal marketing of the drug. The DOJ, which has not yet determined its final position, joined a whistleblower lawsuit that is claiming JNJ marketed the drug for off-label use in chronic heart conditions. There were some reports in 2005 that repeated use of the drug brought dangerous side effects and Medicare discontinued reimbursement of the drug outside of hospitals.
Should JNJ be charged and convicted criminally, it could have to pay a big fine and be excluded from Medicare and Medicaid. This would be very serious, as many valuable drugs would not be available to patients.
I learned a long time ago not to try to predict law rulings. But, given JNJ’s clean track record, valuable drugs and strong ethical compass, I’m willing to put my money on a possible outcome where JNJ either does not get indicted or avoids management distractions by settling without an admission of criminal guilt. Both of these developments should lead to much higher prices for JNJ’s stock next year, provided the government’s healthcare reform plan is not draconian.
Of course, even in the case of a bad reform, we still have very strong long-term outlook for this company, which has excelled around the world over more than 120 years.
JNJ is trading at a low 14 times earnings and with a very attractive and defendable yield of 3.11%. Given the stability of cashflows and the strong measures that JNJ is taking to improve its cost base and reinvest, this is a cheap valuation that discounts a lot of downside already.
Hence, we are going to play it by taking an initial position prior to this week’s developments.
Johnson & Johnson stock rose 20 cents, or 0.31%, Friday to close at $64.36 a share. That’s just shy of its 52-week high of $65.28 a share.
Recommendation: Buy an initial position in Johnson & Johnson (NYSE: JNJ) prior to any announcements related to Natrecor (**). Add to JNJ after the announcement. We will reevaluate the timing of further additions to our position prior to the health care reform.
(**) – Special Note of Disclosure: Horacio Marquez holds no interest in Johnson & Johnson.
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