JNJ: A Healthy 5-Star Bet

04/28/2006 12:00 am EST


Stephen Biggar

Director, Product Strategy, Argus Research Corporation

Another highly anticipated event at each Money Show is the Standard & Poor's panel, in which its leading analysts discuss the market's best opportunities. Here's a sample of a recent favorite from Stephen Biggar, director of US Equity Research.

"With its pharma and consumer-products units both healthy, S&P thinks Johnson & Johnson (JNJ NYSE) should enjoy many happy returns. Despite some near-term operating challenges, particularly within its pharmaceutical segment, we think J&J 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 healthcare 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 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.

"Its 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. Total pharma sales in 2005 actually declined 3.2% in the US, as the Duragesic erosion joined with the loss of patent protection on both Ultracet 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. 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.

"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. 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. 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. 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.

 "J&J's Lifescan division is among the leading participants in the blood glucose monitoring market. 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.

"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. Its major brands include Neutrogena; Tylenol; Motrin, Imodium, Mylanta, and Pepcid; Carefree and Stayfree; Band-Aid; Reach; Splenda, and Benecol.

"We derive a relative valuation target price of approximately $73 a share. Our discounted cash flow model indicates intrinsic value of $61 a share. And, based on 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. Our three-stage blended valuation approach results in our target of $67.30. Adding in the current $1.32 dividend suggests a total return for J&J of about 19% over the coming 12 months. We have a 5 STARS (strong buy) rating."

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