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Johnson & Johnson

Target $73

NYSE: JNJ US Equity Current Price $64

Upside 13%

Company Data
Stock Data
Region New Jersey
Initiate with a BUY; Potential 12%
Country USA
upside
Sector Healthcare
Industry Major Drugs We are initiating coverage on Johnson & Johnson with a BUY
Ticker JNJ rating as we expect revenue to grow across all segments. Also,
Stock Exchange NYSE the restructuring program initiated in 2007 is helping to cut costs
Reporting Currency USD significantly. We believe FY2009 should represent the bottom
M. Cap (mn/bn) $182bn
both in terms of the company’s top-line and the downward trend
Fiscal Year End December
in profitability. We see a potential 12% upside from current
Shares Outstanding (mn/bn) 2,760mn
Face Value of share $1.00
levels.
52 Week High $66.20
52 Week Low $50.12 Revenue growth to be propelled by
Share Price Data Medical devices and diagnostics
90 segment
The strong international order pipeline is expected to trigger the
70
growth in MD&D segment. The US sales for this segment will
50 remain relatively stable. The consumer care business sales are
also expected to remain stable with additional efforts going into
30 avoiding OTC products recall. International pharmaceutical sales
May-09 Aug-09 Nov-09 Feb-10
will pick up with the introduction of new drugs to offset the
JNJ US S&P500 rebased
drugs going out of patent.
Shareholder Information
Steady margins; cost control measures
5% 3%
3%
State Street Corp. pay off
2%
1%
Vanguard Group Operating margins are expected to remain steady at 23-24%.
Restructuring efforts are expected to result in $1.4-1.7bn of
BlackRock
Institutional Trust savings when the full program gets implemented in 2011.
FMR LLC

Bank of New York


Attractive valuations; T Price of $72.3
86%
Mellon Corp.
DCF valuation method offers an upside potential of 12% with a
Others
WaCC of 7.62% and 2.5% terminal growth rate. We expect the
stock to reach our target price through top line and bottom line
growth.
Investment Thesis

Operational growth expected across segments; BRIC to lead


The consumer business is poised to grow at a healthy growth rate. We believe that the consumer business is
resilient considering it posted a 2% operational growth in a recessionary scenario in 2009 including private label
competition. With the growth in Brazil, Russia, India, China (BRIC) markets, the consumer business is well set to
take advantage. The company had an operational growth rate of 5% in BRIC markets in 2009.

Pharmaceutical business is likely to be boosted by the newer products like Prezista, Delcade and Invega to offset
and overcome the expiry of Levaquin and Topamax. Also significant growth is expected in larger products such as
Remicade, Concerta and Risperdal Consta.

The medical devices and diagnostics segment is expected to benefit from windfall orders relating to the African
markets. Though the margins in this segment are going to be flat, we expect volume orders from emerging markets
as well as WHO, UNICEF to offset the effect. The segment is well set to grow in the BRIC markets at double the rate
of global MD&D market.

Steady margins; Better cost controls


Operating margins are expected to be steady between 23-24%. The steadiness in margins despite significant pricing
pressures can be attributed to the mix of cost control measures and release of newer high margin drugs.
Restructuring efforts initiated in 2007 are expected to result in $0.8-0.9bn in savings in 2010, while the full impact
of $1.4-1.7bn will be felt in 2011 when the program gets implemented fully.

Margins Segment-wise Revenue

80% 30000
70%
Gross Profit 25000
60% Margin (%) Major Consumer
Franchise Sales
20000
50%
15000 Pharmaceuticals
40% Operating
Income
30% Margin (%) 10000
Medical Devices
& Diagnostics
20% 5000
Net Profit
10%
Margin (%) 0
0% 2007A 2009A 2011E 2013E
2007A 2009A 2011E 2013E
Strong drug and product pipeline
Robust pipeline of new medicines, devices and products is expected to be maintained through a mix of internal and
external sources. These newer products will be the drivers of sales as has been exhibited throughout the company’s
history. New products are expected to form 25% of net sales for Johnson & Johnson similar to its historical trend.

Continued investments in R&D are expected and we believe the recent acquisitions to be the new platforms of
growth. The company is believed to be in a better position than the rest of the industry moving forward when it
comes to patent expiration. The next expiry cycle, till 2014, will present an impact of only 4%, for Johnson &
Johnson, out of the $200bn at stake for the industry. The last five period patent expiry period ended in 2009 which
saw the company absorb $8.5bn or 10% of the industry impact.

Pharmaceutical Pipeline MD&D Pipeline

9 20
8 18
Approved (2009) Approved (2009)
7 16
14
6
In Registration 12 Filed (2009)
5
10
4
8
3 Planned Filings Approved/Filed
(2010) 6 (2010)
2 4
1 Planned Filings 2 Planned Filings
(2011-2013) (2010)
0 0
Time Period Time Period

US Healthcare reforms: Minimal Impact


The impact on gross revenues is not expected to be significant during the forecast period even though an
immediate impact of $60mn was felt from across-the-board Medicaid price cut in Q1 2010. US healthcare reform
bill is expected to impact about $11bn (or 6%) of the industry net trade sales in 2011 (as per company guidance)
while no real expansion will take place until the uninsured patients enter a marketplace in 2014. Johnson &
Johnson is exposed only in Medicare Part B instead of D and hence their impact will be lower than the industry for
2011 and forward.
Risks

Litigations
The healthcare sector is prone to litigations and the effects of litigation are certainly arduous upon the
pharmaceutical industry. However, due to the externalities associated with mass litigation, a company has no
choice but to become more risk adverse when developing drugs for mass public consumption. Johnson & Johnson
is exposed to some product liability lawsuits that may negatively impact its top line as well as bottom line.
Favourable outcomes may add to the company’s income from other sources. Some of the product liability law suits
outstanding are with regards to Risperdal, Ortho Evra, Levaquin, Duragesic, Cypher and Remicade.

Foreign Currency Translational Exposure


The company operates in 57 countries around the world with more than 50% of its business coming from its
international operations. This has a potential impact on its bottom line due to the currency fluctuations. An
appreciation of the US dollar with the basket of currency to which the company has net exposures may weaken the
investment rationale.

US Healthcare reform
While we don’t expect any impact in the forecast period out of the healthcare reforms, any such future trend may
affect the company’s the bottom line. The prediction by US FDA that the spending on healthcare is poised to grow
may either offset or deteriorate the company’s profitability.

Product pipeline
Our estimates are based on the assumption that the new products (drugs and devices) make it all the way through
clinical trials and are approved by the regulators. Depending on the drug’s stage of development, the probability of
success is greatly improved. But the failure to clear trials may affect our valuation.
Valuation

Using DCF method, we derived a TP of $72.3 which makes the company highly attractive. We have used a WaCC of
7.62% and a terminal growth rate of 2.5%.

(Dollars in Millions Except Per Share Figures) 2010E 2011E 2012E 2013E
EBIT 15394 15948 15289 15410
Tax Rate 35% 35% 35% 35%
EBIT(1-t) 10006 10366 9938 10016
Depreciation & Amortization 4288 4077 3778 3564
Funds from Operation 14294 14443 13715 13581
Change in Working Capital (953) (453) 769 (79)
Cash flow from Operation 13341 13990 14484 13502
Capital Expenditure (2874) (2971) (2659) (2680)
Free Cash flow from Operation 10467 11019 11825 10822
WACC 8% 8% 8% 8%
Period 1 2 3 4
PV factor 0.929 0.863 0.802 0.745
PV 9725 9513 9486 8067
PV of Cash Flows 36792
Terminal Value 216559
Discounted Terminal Value 161424
Terminal Growth Rate 2.5%
Value of Firm 198216
Cash and Cash Equivalents 15810
Value of Debt 14541
Implied Value of Equity 199485
No. Of Shares 2760 Sensitivity Analysis
WACC 7.62% WaCC

Cost of Equity 8% g 6% 7% 8% 9%
Cost of Debt (Pre-Tax) 3% 1% 77.0 64.3 55.3 48.5
Cost of Debt (Post Tax) 2% 2% 93.5 75.0 62.7 53.9
Growth
Rates

Weight of Equity 93% 3% 120.9 91.0 73.1 61.1


Weight of Debt 7% 4% 175.8 117.7 88.6 71.2
Risk free rate of return 4%
Market Rate of Return 10%
Beta 68%
Tax Rate 35%
No. of Shares 2760
Market Capitalization 182210
Market Value of Debt 14541
Market Value of Debt and Equity 196751
Competitive Analysis
The global healthcare market is expected to grow at a CAGR of 5% over the next 5 years, reaching $7 trillion by
2014. The global pharmaceutical market is expected to add nearly $300bn through 2014 topping $1.1 trillion,
according to market research firm IMS Health. Historically as the patients GDPs and economies expand, so does
their spending on healthcare. Increased access to quality healthcare means more patients, more investment and
more opportunity for innovation and growth.

Revenue (FY2009) Net Profits (FY2009)

70,000 Johnson & 14,000 Johnson &


Johnson Johnson
60,000 Pfizer 12,000 Pfizer

50,000 GlaxoSmithKline 10,000 GlaxoSmithKline

40,000 Roche Group 8,000 Roche Group

30,000 Sanofi-Aventis 6,000 Sanofi-Aventis

20,000 Novartis 4,000 Novartis

10,000 AstraZeneca 2,000 AstraZeneca

0 Abbott 0 Abbott
Laboratories Laboratories
Revenue Net Profit

Revenue (FY2009) Net Profits (FY2009)

60% 25% R & D S pendi ng

50% Net Profit 20%


Margin
40%
15%
30%
10%
20% Operating
Margin
10% 5%

0% 0%
Johnson &
Novartis
Johnson &

Pfizer

Laboratories

AstraZeneca

Roche
Novartis

Merck
Merck

Johnson
Johnson

Abbott

Though the outcome of R&D is always uncertain, novel products drive the bottom line of the company by giving a
first mover advantage or scope to charge premium. Newer drugs, historically, have been high margin generators.
The challenge of generics loom large as and when patents expire and can substantially erode the revenue of
companies which is why R&D as an on-going activity assumes monumental importance in this industry.
Company Overview
Johnson & Johnson engages in the research and development, manufacture, and sale of various products in the
health care field worldwide through its more than 250 companies located in 57 countries around the world. These
companies are organized into several business segments comprising of franchises and therapeutic categories.

Company Structure

Medical Devices &


Consumer Care Pharmaceuticals
Diagnostics

Advanced Sterlization
Baby Care Products
Central Nervous
System & Internal
Animas Corp.
Medicine
Skin & Hair Care

Cordis Corp.

Topical Health Care


DePuy Inc.

Biotechnology,
Oral Health Care Immunology & Ethicon Inc.
Oncology

Vision Care
Women’s Health

LifeScan Inc.
Over-The-Counter
Medicines Ortho-Clinical
Virology Diagnostics

Nutritionals
Virco BVBA

Consumer Care: The Consumer segment provides products used in baby care, skin care, oral care, wound care, and
women’s health care fields, as well as nutritional, over-the-counter pharmaceutical products, and wellness and
prevention platforms.

Pharmaceuticals: Pharmaceutical segment, representing the world’s seventh largest pharmaceutical business,
offers products in various therapeutic areas, such as anti-infective, antipsychotic, cardiovascular, contraceptive,
dermatology, gastrointestinal, immunology, neurology, oncology, urology, and virology.

Medical Devices & Diagnostics: The Medical Devices and Diagnostics segment primarily offers circulatory disease
management products; orthopaedic joint reconstruction, spinal care, and sports medicine products; surgical care,
aesthetics, and women’s health products; blood glucose monitoring and insulin delivery products; professional
diagnostic products; and disposable contact lenses.
Total Sales by Segment (2009) Medical Devices & Diagnostics

Total Sales: $62bn 17% 19% Ethicon Endo


Surgery
26% Ortho-Clinical
Diagnostics
38% Vision Care
10% 8%
Cordis

DePuy
M edi c al D ev i c es
11%
& D i agno s t i c s Diabetes Care
P har m ac eut i c al s
24% Ethicon
36% C o ns um er C ar e 11%

Pharmaceuticals Consumer Care


7%
19% Remicade OTC
10% Pharmaceuticals &
Procrit/Eprex
Nutritionals
34% Levaquin Skin Care
36%
Risperdal Consta
Baby Care
10% Concerta 12%
Topamax Women's Health
Aciphex
7% Duragesic Oral Care
4%
Risperdal 13%
4% 6% Wound Care /
5% Others Others
5% 6%
22%

Johnson & Johnson’s business model is primarily driven by its ability to innovate. With a global presence in more
than 57 countries, the company has broadened its business both organically as well as through key acquisitions. Its
acquisition strategy has been modeled to complement its in-house research and development. Healthcare segment
is driven by its on-going R&D activities to roll-over patent expiries by introducing new drugs. Johnson & Johnson
has been successful in maintaining a healthy product pipeline to drive its growth.
Financial Statements

Income Statement

(Dollars in Millions Except Per Share Figures) FY FY FY FY FY

2008A 2009A 2010E 2011E 2012E

Sales to customers 63747 61897 63720 65925 66472

Cost of products sold 18511 18447 18990 19777 19942

Gross profit 45236 43450 44729 46147 46530

Selling, marketing and administrative expenses 21490 19801 21196 21774 22600

Research expense 7577 6986 8140 8425 8641

Purchased in-process research and development 181 0 0 0 0

Restructuring 0 1073 0 0 0

Interest income -361 -90 -486 -649 -814

Interest expense, net of portion capitalized 435 451 298 410 395

Other (income) expense, net -1015 -526 0 0 0

Total Expense 28307 27695 29148 29960 30822

Earnings before provision for taxes on income 16929 15755 15582 16187 15708

Provision for taxes on income 3980 3489 3740 3885 3770

Net earnings 12949 12266 11842 12302 11938

Basic net earnings per share 4.62 4.45 4.29 4.46 4.33

Diluted net earnings per share 4.57 4.40 4.25 4.41 4.28

Cash dividends per share 1.80 1.93 2.08 2.25 2.43

Basic average shares outstanding 2803 2760 2760 2760 2760

Diluted average shares outstanding 2836 2789 2789 2789 2789


Cash Flow Statement
(Dollars in Millions Except Per Share Figures) FY FY FY FY FY

2008A 2009A 2010E 2011E 2012E

Cash flow from operating activities

Net earnings 12949 12266 11842 12302 11938

Adjustment to reconcile net earnings to cash flow:

Depreciation and amortization of intangibles 2832 2774 4288 4077 3778

Stock based compensation 627 628 0 0 0

Purchased in-process research and development 181 0 0 0 0

Intangible asset write-down (NATRECOR®) 0 0 0 0 0

Deferred tax provision 22 -436 0 0 0

Accounts receivable allowances 86 58 0 0 0

Changes in assets and liabilities, net of effects from acquisitions:

Increase in accounts receivable -736 453 -1040 -476 802

Increase in inventories -101 95 -531 -294 432

Decrease in accounts payable and accrued liabilities -272 -507 618 317 -466

Increase in other current and non-current assets -1600 1209 0 0 0

Increase in other current and non-current liabilities 984 31 0 0 0

Net Cash Flow From Operating Activities 14972 16571 15177 15926 16484

Cash flow from investing activities

Additions to property, plant and equipment -3066 -2365 -2874 -2971 -2659

Proceeds from the disposal of assets 785 154 0 0 0

Acquisitions, net of cash acquired -1214 -2470 0 0 0

Purchases of investments -3668 -10040 0 0 0

Sales of investments 3059 7232 0 0 0

Other (primarily intangibles) -83 -109 0 0 0

Net Cash Used By Investing Activities -4187 -7598 -2874 -2971 -2659

Cash flow from financing activities

Dividends to shareholders -5024 -5327 -5730 -6212 -6709


Repurchase of common stock -6651 -2130 -1100 0 0

Proceeds from short-term debt 8430 9484 0 0 -384

Retirement of short-term debt -7319 -6791 0 0 0

Proceeds from long-term debt 1638 9 82 83 499

Retirement of long-term debt -24 -219 -34 -35 -615

Proceeds from the exercise of stock options/excess tax benefits 1486 882 0 0 0

Net cash used by financing activities -7464 -4092 -6781 -6164 -7209

Effect of exchange rate changes on cash and cash equivalents -323 161 0 0 0

Increase in cash and cash equivalents 2998 5042 4322 7017 6616

Cash and cash equivalents, beginning of year 7770 10768 15810 20132 27149

Cash and cash equivalents, end of year 10768 15810 20132 27149 33765
Balance Sheet

(Dollars in Millions Except Per Share Figures) FY FY FY FY FY

2008A 2009A 2010E 2011E 2012E

ASSETS

Current assets

Cash and cash equivalents 10768 15810 20132 27149 33765

Marketable securities 2041 3615 3615 3615 3615

Accounts receivable trade, less allowances for doubtful accounts 9719 9646 10686 11161 10359

Inventories 5052 5180 5711 6004 5573

Deferred taxes on income 3430 2793 2793 2793 2793

Prepaid expenses and other receivables 3367 2497 2497 2497 2497

Total current assets 34377 39541 45434 53220 58602

Marketable securities, non-current 4 0 0 0 0

Property, plant and equipment, net 14365 14759 13346 12240 11122

Intangible assets, net 13976 16323 16323 16323 16323

Goodwill, net 13719 14862 14862 14862 14862

Deferred taxes on income 5841 5507 5507 5507 5507

Other assets 2630 3690 3690 3690 3690

Total assets 84912 94682 99161 105842 110106

LIABILITIES AND SHAREHOLDERS' EQUITY

Current liabilities

Loans and notes payable 3732 6318 5119 5345 4961

Accounts payable 7503 5541 6159 6475 6010

Accrued liabilities 5531 5796 5796 5796 5796

Accrued rebates, returns and promotions 2237 2028 2028 2028 2028

Accrued salaries, wages and commissions 1432 1606 1606 1606 1606

Accrued taxes on income 417 442 442 442 442

Total current liabilities 20852 21731 21149 21693 20843


Long-term debt 8120 8223 8271 8319 8203

Deferred taxes on income 1432 1424 1424 1424 1424

Employee related obligations 7791 6769 6769 6769 6769

Other liabilities 4206 5947 5947 5947 5947

Total liabilities 42401 44094 43561 44151 43186

Shareholders' equity

Common stock - par value $1.00 per share (authorized 4,320,000,000 shares; issued
3,119,842,000 shares) 3120 3120 3120 3120 3120

Accumulated other comprehensive income -4955 -3058 -3058 -3058 -3058

Retained earnings 63379 70306 76419 82509 87738

Less: common stock held in treasury, at cost 19033 19780 20880 20880 20880

Total shareholders' equity 42511 50588 55601 61691 66920

10584 11010
Total liabilities and shareholders' equity 84912 94682 99161 2 6