JNJ Looks Good, But Is There Enough Momentum?

Richard is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Regardless of what you’ve heard, size always matters – even in business. Otherwise, the now infamous “Too big to fail” expression would never be used to reference every perceived villainous operation on Wall Street. Conversely, there are also those that are “Too big to succeed.”

Healthcare giant Johnson & Johnson (NYSE: JNJ) is the perfect example. Although the company has been rejuvenated following its merger with Synthes, I worry that JNJ’s stubbornness may hurt its long-term potential. Plus, the fact that the stock is trading at a significant premium to much nimbler rivals Pfizer and Covidien only intensifies the situation.

Things Seem Ok Now, But For How Long?

For JNJ, 2012 was a tale of two halves. The company lacked identity until the completion of the Synthes merger. And upon the arrival of new CEO Alex Gorsky, JNJ seemed revitalized. But the company is not without flaws as JNJ still struggles in some key areas -- most notably, its devices and diagnostics business.

For instance, although Q3 produced one of the best performances for JNJ in terms of revenue growth (+9%), the company’s diagnostics business continues to slip behind Abbott Labs and Covidien. And based on a subpar performance in surgery, it is also likely that JNJ is ceding market share to smaller rival CR Bard.

Nonetheless, the company’s turnaround is impressive, including launching eight new products over the past three years – with more to come. Investors can point to Synthes and its unusual fianancing as the primary catalyst. Before the deal, the stock had been in a freefall until reaching bottom at $62 per share. Since then, shares have surged almost 20%. But will a pullback follow?

Suits and Quarter Expectations

The stock has been on a considerable run, helped by the removal of much uncertainty, particularly now that new leadership seems fully established. Then again, investors want assurances that the momentum can continue.

In an industry where one new drug can turn the fortunes of a company, that’s not impossible. Conversely, it’s also an industry where one lawsuit -- or in this case, several suits -- can become crippling. As Q4 approaches, investors will want to know more about possible settlements that will impact the company’s bottom line.

A story on Bloomberg revealed that JNJ is in a “mesh of a mess.” To date, there have been roughly 1,800 lawsuits related to the failure rate of the company’s vaginal mesh implants. According to reports, the product is said to have failed 27% of the time, including 20% in the first 6 months.

Linda Gross, a South Dakota nurse, is the first plaintiff in the suit, resulting in JNJ opting to discontinue the product, citing it’s no longer commercially viable. Nevertheless, this has not stopped bullish optimism from analysts, including Deutsche Bank which upgraded the stock to “buy” while raising the price target from $75 to $82. In a research note, the analyst stated:

"For the past several years, JNJ has weathered through patent expirations, a general slowdown in utilization trends, and challenges with its OTC businesses. As we look ahead to 2013, we believe JNJ will see improving trends. We expect recent and new drugs to continue to drive pharma sales. J&J should continue to work through the McNeil Consent Decree and return products to market.”

The market overall seems to agree. And management has given the Street plenty of reasons to be optimistic. It helped that JNJ recently raised the low end of its full-year guidance in Q3 by 2 cents from a range of $5.25 - $5.32 to $5.27 - $5.32. For Q4, the Street is looking for $1.17 in earnings per share on revenue of $17.67 billion – representing a year-over-year growth of 9% and 3.5%, respectively.

Can JNJ Find Growth in New Drugs?

Regardless of how this quarter turns out, drug companies are always about the future or that next huge product that can turn the tides. To that end, JNJ is striving to be the leader in primary care for prostate cancer with a product called Zytiga, which has an approval date of April 15, 2013.

Zytiga will compete head on against Dendreon’s (NASDAQ: DNDN) Provenge, which has an advantage of being first to market. Despite this lead, analysts are getting more excited about Zytiga, one reason being the difference in cost. For instance, one treatment of Provenge costs $93,000 whereas JNJ makes Zytiga affordable at $5,500 per month.

In the practical sense, JNJ’s Zytiga is clearly more appealing. Also, there have been reports that patients have had a tough time receiving reimbursements from insurance companies upon using Provenge. It also helps that 20% of doctors have indicated less Provenge use in favor of Zytiga – this according to analysts at Baird.

As highly regarded as Zytiga is, it’s nonetheless disappointing that JNJ has avoided the obesity drug market where Arena (NASDAQ: ARNA) and Vivus have become “kingpins.” For Arena, its story has been about Belviq. The drug recently earned FDA approval, which arrived as a surprise because there were reported risks related to tumors and valvulopathy.

Nonetheless, Belviq was approved with relative ease by 18-4 vote of a panel that includes the FDA’s own experts. Certainly this is a welcomed sign for Arena since the FDA felt the company has done enough to alleviate concerns related to side effects. Since then, Arena’s stock price has been a 4-bagger. That JNJ has shown no interest in this market is a concern. But for now, it’s hard to complain about its direction.

Bottom Line

JNJ has always had a good name and with the arrival of new CEO Alex Gorsky, the company seems poised for sustained growth. Then again, I still believe that the best route for JNJ would be to take a page out of Pfizer and break up some of its segments. In the meantime, although a bit of uncertainty remains regarding the mesh-related suits, investors should be encouraged by the underlying performance in both the drug business and the orthopedics segments.

The company is currently trading at 14 times 2013 estimates of $5.09 and $5.40 for expected 7% growth in 2013. This is while JNJ carries a free-cash-flow yield of 7%. If the company can continue to grow free cash flow in mid-to-single digits, the stock can carry a fair value above $80 per share, which is (at least) 12% above current value. This presents a solid return when combined with one of the best yields on the market at 3.3%.

rsaintvilus has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Dendreon and Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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