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Johnson & Johnson: A
Leaky Pipeline
Diversified health-care company Johnson & Johnson likely will be the first in the U.S. to sell a revolutionary device that treats clogged arteries. The tiny scaffold, or stent, does such a good job of decreasing the risk of arteries reclosing after a surgical procedure to open them that a federal regulatory panel recently unanimously recommended approval. The device, called Cypher, is already approved in Europe, and is now headed for final clearance from the Food & Drug Administration.
When that happens, the product is expected to become a blockbuster, with at least $1 billion in sales in its first 12 months on the market. Johnson & Johnson's (JNJ ) medical-device division then likely would drive near-term performance at the New Brunswick (N.J.)-based company, which sells drugs, devices, diagnostics, and consumer products like baby shampoo. And assuming Cypher's approval, JNJ's growth in 2003 could surpass that of other large drugmakers. Wall Street forecasts average 2003 earnings per share of $2.62, a 17% rise over 2002 levels.
Little wonder JNJ stock has thrived in this year's tough market, up 7% since Jan. 1, while the broader Standard & Poor's 500-stock index remains stuck in neutral. That performance helped put JNJ at a lofty No. 4 (down from No. 1 in 2002) on the 2003 BW50 ranking. Yet investors have reasons to be cautious about JNJ, including nagging worries about growth in drugs, its primary business.
"SHALLOW RAVINE." Taking that into account, the current share price, around $57 on Mar. 25, may be too high. "It's a good company, but...it's not necessarily a great investment," says Shao Jing Tong, analyst at independent research firm Mehta Partners. JNJ's "pipeline is pretty weak," he adds. Tong doesn't recommend buying the stock above $50. (Neither he, nor Mehta's mutual funds, own JNJ shares.)
Fair or not, the drug pipeline is what JNJ is judged on, and it's quite likely that the stock's luster will fade when investors realize JNJ has very little on the pharmaceuticals horizon beyond Cypher. Competition in key JNJ drugs for anemia and rheumatoid arthritis also has investors nervous. And patent expirations on two existing drugs are looming. Tong predicts growth will drop to the single-digit rate starting in 2005.
That may be the most bearish view. Most analysts expect JNJ's growth, which has been upwards of 15% a year for the last several years, will fall to around 10%. Certainly, that's no disaster. But "there's a shallow ravine in 2004 and 2005," says Jan Wald, an analyst at AG Edwards. Wald rates the stock a buy, though his price target is just $58. (He owns the shares personally, while his firm has no investment-banking relationship with JNJ.)
MARKET-SHARE BATTLE. Owen Fitzpatrick, managing director of U.S. equities at Deutsche Bank Private Wealth Management says he's debating cutting back on JNJ. "We think we're on the tail end of this being a strong buy." (Fitzpatrick does not own shares, and the firm doesn't have a banking relationship with JNJ.)
While Cypher almost certainly will be a hit, it won't be a cure-all. It will enjoy U.S. market dominance for just seven or eight months, until around November, when a similar product from Boston Scientific (BSX ) is expected to get regulatory clearance. If the clinical data for that stent are anything like JNJ's, watch for a market-share battle in 2004 and beyond. More drug-coated stents should be coming out in following years from device makers Medtronic (MDT ) and Guidant (GDT ). Cypher "won't provide long-term sustained growth," Tong says.
One growth strategy JNJ may consider is acquisitions, especially in the booming medical-devices division. It declined to comment for this article, but industry watchers say JNJ has the heft and the cash to buy major names like Boston Scientific, St. Jude Medical (STJ ), or Guidant. It would have to work through antitrust concerns on any deal, but Cranna expects Guidant and St. Jude (No. 10 on the BW50) would be most attractive since they have cardiac-rhythm management products like defibrillators and pacemakers, which JNJ lacks in its portfolio.
SHOPPING AROUND. JNJ is already in the process of making one drugmaker acquisition, its planned $2.4 billion buyout of Scios (SCIO ), which is expected to close mid-2003. That would boost revenue growth, but not for two or three more years. Scios is developing a rheumatoid-arthritis drug and has a heart-failure treatment, called Natrecor, already on the market. Tong figures that Natrecor sales will be between $500 million to $1 billion at their peak.
Adding growth like that would help. JNJ earned 47% of its $36.3 billion in annual sales from pharmaceuticals. Sales of its anemia drugs, Procrit and Eprex, have remained solid, making up over 11% of revenue in 2002. Yet the rate of growth "was slowed in the latter half of the year as a result of new competition" and reports of a rare blood condition in kidney-failure patients, JNJ said in its annual report. Concern about the kidney-failure side effect seems to be fading, but the competition remains. Amgen (AMGN ), with its anemia treatment Aranesp, is able to compete in more markets that were previously off-limits.
Competition for other treatments is heating up too. Sales of JNJ's rheumatoid arthritis drug Remicade surged 80% in 2002, but future growth of 15% to 20% is more realistic, Tong says. Manufacturing issues that hindered sales of Amgen's Enbrel, a rival arthritis drug, have been solved, experts say.
PATENT PROBLEMS. "Overall, Enbrel has a somewhat better profile," adds Tong. JNJ has seen good results from tests of Remicade as a psoriasis treatment, but most analysts are predicting that Enbrel will also be the drug of choice for the skin disease. Meanwhile, Abbott Labs' (ABT ) Humira was recently approved for rheumatoid arthritis and is also expected to be a potential psoriasis drug. JNJ did not return calls for comment.
A slow new-drug pipeline and increasing competition aren't JNJ's only challenges, though. Patent expirations are also coming up. And any dent in the drug business is unwelcome, since some 61% of 2002 total operating profit of $9.5 billion came from drugs.
The loss of patent coverage for pain killer Duragesic, which had $1.2 billion in worldwide sales in 2002, could have the biggest impact, coming at a time when Cypher's growth pace starts topping out. Duragesic, which is among JNJ's biggest revenue earners, is expected to lose patent protection in 2004. "If there's a tactic on Duragesic, I'm unaware of it," says Bruce Cranna, analyst at Leerink Swann & Co. (Cranna does not own shares, and his firm doesn't have a banking relationship with JNJ.)
TOO HIGH? JNJ's popular birth-control drug Ortho Tri-cyclen will lose patent protection at the end of 2003. But JNJ should be able to offset some of the lost revenue there with a patch-based contraceptive called Ortho Evra, and Tri-cyclen is a relatively small source of annual revenue.
For now, the Cypher launch should give JNJ some breathing room. Even so, with the pipeline looking weak, it appears headed for a period of unspectacular growth in the near term. At these prices, buy-and-hold investors likely would want to wait for a sell-off that pushes the price lower as an opportunity to wade in.
MARCH 24, 2003