Johnson & Johnson (NYSE:JNJ) recently reported its Q2 results, which were mostly in-line with our expectations. To see our full analysis of JNJ’s Q2 earnings, refer to our note Johnson & Johnson’s Steady Growth Offset By Currency Impact. In July, JNJ completed the acquisition of orthopedics company Synthes. In addition, there have been several developments in its pharmaceutical franchise in the last couple of months. We have updated our model to reflect these developments.
We maintain our price estimate of $74 for JNJ, which is about a 5% premium to the current market price. Below we discuss the major changes made in our model.
Synthes Acquisition Makes Medical Devices & Diagnostics JNJ’s Biggest Division
Synthes’ product portfolio consists of five primary product groups in trauma, spine, knee, bio-materials and power tools. The acquisition has brought a wide portfolio of medical devices for orthopedics market and now the combined JNJ/Synthes orthopedic division is one of the broadest orthopedic portfolio globally. We believe the Synthes acquisition will lend support to the company’s efforts to tap growth opportunities in the orthopedics market. Further, it also brings the Synthes’ vast exposure to fast growing emerging countries including China, India and Russia. JNJ expects the trauma and knee markets to grow 7% and believes the spine market could rebound to a 5% growth rate.
We have incorporated the Synthes acquisition in our model and renamed the Depuy division as Orthopedics. Due to changes in the reporting structure, we have clubbed the company’s Ehicon Endosurgery and Ethicon to make one subdivision, Surgical Devices.
Barring short-term hiccups relating to product recalls, including hip implants and surgical mesh (the company is phasing out its surgical mesh products following a flurry of lawsuits), we are optimistic on the prospects of the medical devices business. We expect the company to register a healthy 4%-6% growth in Orthopedics revenues while we estimate its market share will remain stable at close to 11%. However, a strong U.S. dollar and pricing pressure following healthcare reforms may continue to pose a concern for JNJ in the short term.
Further, we expect Medical Devices & Diagnostics EBITDA margins to increase as the acquisition synergies will result in cost savings. Due to the these factors, the business now contributes more than 50% to JNJ’s value, according to our estimates.
Pipeline Critical For Pharmaceutical Segment
Growth in medical devices segment has been offset by recent developments in the pharmaceutical division. Xarelto, a blood thinning drug with blockbuster potential, was rejected even as the company filed a second application for approval (Read JNJ Knocks On FDA Door A Second Time For Broader Use Of Anticlotting Drug Xarelto). In addition, JNJ had to dump the development of Alzheimer drug Bapineuzumab (Read Pfizer and Johnson & Johnson Dump Alzheimer Drug After Failed Clinical Trials). However, Zytiga, a prostate cancer drug, continues to hold promise as the drug has received a priority review status for larger use. This means the drug could be approved in about six months. The FDA usually grants this status for drugs that either show strong efficacy in treatment or where no treatment exists currently (Read JNJ Updates: Strikes Cancer Deal, Zytiga Gets FDA Priority Review Status). We have incorporated these developments accordingly.
J&J, like any other major pharmaceutical giant, has been battling revenue losses due to patent headaches in recent years. It lost its patents on Concerta and Levaquin in 2011, while Invega and Aciphex are losing patent exclusivity in 2012 and 2013. This will put at risk nearly $2.5 billion in revenues. Remicade, its biggest blockbuster biologic with sales of more than $5 billion in 2011, will also lose patent protection in 2014, affecting its sales in immunology drugs segment. Given the aforementioned loss of patent/market exclusivity and pressure across some franchises, J&J’s pipeline is critical for future growth of this segment. Over the 2012-2015 period, the company plans to file 11 new products and over 30 line extensions.
We have also lowered our 2012 margins expectations from pharmaceuticals and consumer healthcare divisions due to a strong U.S. dollar. The consumer healthcare division is the most affected as close to two-third of its sales are from international markets.