Johnson & Johnson (JNJ): New Drugs and Better Manufacturing Make This Stock a Buy

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Johnson & Johnson (NYSE:JNJ) stands alone as a leader across the major health-care industries. The company maintains a diverse revenue base, a robust research pipeline, and exceptional cash flow generation that together create a wide economic moat.

Johnson & Johnson (NYSE:JNJ) holds a leadership role in diverse health-care segments, including medical devices, over-the-counter medicines, and several pharmaceutical markets. Contributing just over 37% of total revenue, the pharmaceutical division boasts several industry-leading drugs, including the rheumatoid arthritis drug Remicade. The medical device and diagnostics group brings in 41% of sales, with the company holding controlling positions in many areas, including DePuy’s orthopedics and Ethicon Endo-Surgery’s surgical devices. The recent acquisition of Synthes positions the company as a leader in the fast-growing trauma segment. The consumer division largely rounds out the remaining business lines. The 2007 acquisition of Pfizer Inc. (NYSE:PFE)‘s consumer business solidified Johnson & Johnson’s position in this market.

Johnson & Johnson (NYSE:JNJ)

Johnson & Johnson (NYSE:JNJ) reported strong first-quarter results that slightly exceeded the expectations. New drug launches drove the drug division’s to strong 11% year-over-year growth in the quarter. The cardiovascular drug Xarelto, oncology drug Zytiga, and immunology drug Stelara represented robust growth from new product launches.

While emerging competition with Novartis AG (ADR) (NYSE:NVS) and Allergan, Inc. (NYSE:AGN) will probably slow the gains of these drugs over the remainder of the year, first-mover advantage and strong efficacy profiles of the drugs will lead to continued gains. Further, with limited patent losses remaining with key marketed products, I believe the drug division is poised for solid gains over the next several years.

Novartis – “A strong competitor”

Novartis AG (ADR) (NYSE:NVS) derives its strength from a diversified operating platform that includes branded pharmaceuticals, generics, vaccines, diagnostics, eye-care products, and consumer products. Although the majority of Novartis’ competitors focus solely on the high-margin branded pharmaceutical segment, Novartis runs several complementary operations that reduce overall volatility and create cross-segment synergies. While the late 2012 patent loss on Diovan and manufacturing problems in the consumer division will weigh on near-term growth of the company.

Novartis AG (ADR) (NYSE:NVS), like all branded pharmaceutical firms, faces a number of considerable threats, including extended new drug approval times, pricing pressure from the managed-care industry, and political pressure to rein in drug costs. Also, increasingly aggressive generic drug companies are attacking patents on branded drugs several years before expiration dates. Further, following several acquisitions, the company faces integration risk in bringing together all of the business lines.

Points to consider

The following points may harm Novartis AG (ADR) (NYSE:NVS) revenue in the upcoming quarter:

  • In late 2012, the company’s hypertension leading drug Diovan lost patent protection, creating a massive gap in sales as the drug represents close to 10% of Novartis’ total sales.
  • The major acquisitions during the past couple of years continue to face integration risks as they are folded into Novartis.
  • The dual operations of branded pharmaceutical and generic pharmaceutical operations may diverge, leading to conflicting management direction.

FDA Draft Guidance stokes generic Restasis fears:

The Food & Drug Administration issued draft guidance on establishing bio equivalence for cyclosporine, the generic form of Allergan’s dry-eye drug, Restasis. The draft guidance suggests the FDA may not require a generic competitor to enroll human clinic trials to establish similar efficacy with Allergan, Inc. (NYSE:AGN)’s version.

The FDA’s draft guidance, however, reinforces concerns that emerging competition on Allergan’s key products, including cosmetic Botox and Restasis, could weaken the company’s economic moat down the road. The FDA announcement also raises concerns that Restasis will face generic competition. Personally, I think this ophthalmic drug would face limited competition, helping to uphold the drug’s contribution to Allergan, Inc. (NYSE:AGN)’s bottom line. Additionally, management continues to advance a reformulated version of Restasis in clinical trials, which should help protect the company’s overall dry-eye franchise.

Growth and profitability

On the consumer front, Johnson & Johnson (NYSE:JNJ) is turning the corner on correcting major manufacturing problems, and branding power appears strong with the reintroduction of several key over-the-counter drugs.

Research and development efforts are resulting in next-generation products. The pharmaceutical group has a robust late-stage product pipeline with several potential blockbusters in late-stage development or recently approved. The company has also created new medical devices, including ceramic orthopedics and minimally invasive surgical tools.

These multiple business lines generate substantial cash flow. Johnson & Johnson (NYSE:JNJ)’s healthy free cash flow (operating cash flow less capital expenditures) is more than 20% of sales. Strong cash generation has enabled the firm to increase its dividend for the past 50 years, and it is expected to continue. It also allows Johnson & Johnson to take advantage of acquisition opportunities that will augment growth.

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