Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

Johnson & Johnson

In the pharmaceutical and medical device industries, a company’s products are protected
from direct competition for a number of years by patents. So although a competitor can
attempt to come up with their own drug to meet the same medical need, they cannot copy
the company’s exact molecular compound. When it is difficult for a competitor to
develop a substitute, a patent gives the company many years of a virtual monopoly on
that particular drug, with the lack of competition enabling the company to charge a high
price per unit without losing market share. And even in the case where multiple
companies have their own patent protected drug with the same use, the companies usually
end up sharing the market while keeping prices high (as we will see later, they need to in
order to recoup their investment). Although in most countries this pricing power is
somewhat blunted by the strong bargaining power of governments procuring drugs for
Medicare (U.S) or nationalized health care (most other developed countries), the average
profit margins in this industry are impressive, typically exceeding 20%. But when patents
expire, the revenue stream associated with the drug falls sharply as generic
pharmaceutical companies churn out copies in large volume at a fraction of the cost.
They can do this because most drugs are quite cheap to manufacture, but very costly to
develop; that is the reason for patent protection, to insure that the companies that conduct
the research and development can obtain a reasonable risk adjusted return on their
investment. Due to the effects of patent expiration, a pharmaceutical company’s revenue
can be quite volatile, although this volatility is reduced for larger companies with broad
and diverse product portfolios, and a large drug development pipeline. There is one class
of pharmaceutical, biological drugs, which can provide a more sustainable revenue
stream after patent expiration because it is much more difficult1 for a generic company to
prove that their version of the drug is a suitable replacement, unless they engage in costly
trials.

Due to the high profit margins and return on capital usually obtained by companies in the
pharmaceutical and medical device industries, these companies typically command above
average price to earnings multiples, but recently this has reversed, and these companies
are now priced at a discount to the overall market. This is partly due to concerns about
research and development pipelines and the possibility of the Medicare administration
using its strong bargaining position to drive down drug prices. Neither of these is cause
for worry over the long-term. Drug pipelines are typically volatile, but any company with
strong financial strength should have the ability to hang on until their pipeline improves,
and most pharmaceutical companies already derive half their revenues from overseas,

1
This is because biological pharmaceuticals are much more difficulty to copy than chemical
compounds.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

where governments have already brought down the price of drugs to a level well below
that in the United States.

1 Company Analysis

Business Summary

Johnson & Johnson has three business units, all of them focused on healthcare. The
pharmaceutical business develops new chemical and biological compounds used in the
prevention and treatment of various diseases. The medical devices and diagnostics
business develops products used to diagnose and treat various health problems. The
consumer health care segment owns many valuable brands such as the J&J baby care
product line, Neutrogena, Listerine, and Tylenol.

Revenue by Region

Asia-Pacific &
Africa
14%
Other
Western
Hemisphere
8%
United States
52%

Europe
26%

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Revenue by Segment

Consumer
24%
Medical
Devices
36%

Pharmaceutic
al
40%

Operating History (3.5)

Ten Year Operating History

ROAA OPM RORE RORE+D InvTurn GM E/FCF E/E+D-C
32.0% 25.5% 15.7 10.3% 3.1 70.2% 0.96 1.04
3.5 3.5 3.5 <- Rating
ROAA: Return on Adjusted Assets; OPM: Operating Margin; RORE: Return on Retained
Earnings; RORE+D: Return on Retained Earnings & Change in Debt; GM: Gross Margin;
InvTurn: Inventory Turnover; E/FCF: Earnings to Free Cash Flow; E/E+D-C: Earnings to
Earnings+Depreciation-Capex

Johnson & Johnson’s high return on retained earnings plus depreciation shows that it can
profitably grow its business through the re-investment of capital.

Excluding restructuring charges, earnings and revenue have basically risen since 1985
(earliest data), and dividends have been increased since 1970 (earliest data). Earnings
grew from 1972 to 1997 at an annualized rate of 14.2%; this period covered multiple
recessions, two of them severe2. Over the same period, the SP500 had an annualized EPS
growth rate of 8%.

Future Prospects (3.5)

The company’s competitive advantages include strong brands protected by patents in the
pharmaceutical and medical devices business units, and strong consumer brands in the

2
From Jeremy Siegel’s “Stocks for the Long Run”, chapter on nifty fifty.

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

consumer business unit. The company invests a good portion of its revenue (12.5%) back
into research and development, which should provide a continued supply of health care
innovations to replace those losing patent protection. The company’s diversification is
also an advantage, in that when say the pharmaceutical pipeline starts to run dry, the
company can continue to invest heavily in research and development using the revenue
from the other business lines. Yet another advantage is the company’s management
structure. The company is a collection of over 250 operating companies that are each
extremely focused on a particular market segment, with the parent company providing
financial strength, strategic direction, allocation of capital, access to distribution
channels, and economies of scale with marketing. Financial strength is also high, and the
company possesses a rare AAA long-term issuer credit rating. This gives the company a
low cost of debt capital to help fund acquisitions. J&J has a well-diversified product line,
with the largest revenue from a single brand (the drug Risperdal) being only 7% of the
company’s total revenue.

Customer Bargaining Power

Currently, no single customer exceeds 10% of revenue; the largest customers are
probably government agencies, such as Medicare and Medicaid in the United States.

In Europe the customers for pharmaceuticals and medical devices are primarily
governments running national health programs. This concentration gives the governments
good bargaining power, but on the other hand, the products they are purchasing are
unique (and often protected by patents), which gives the company strong bargaining
power as well. In the United States the customers are more fragmented. In 2006
prescription drugs accounted for 10% of U.S. health care costs; Europe is probably
similar. Although this does make pharmaceuticals a significant expense, which tends to
make customers bargain harder, it is by no means the largest expense, and the fact that
new drugs are initially protected by patents should keep pricing power intact.

The largest risk to J&J’s competitive position is a potential increase in buyer bargaining
power in the United States if the U.S. health care system became nationalized in the same
sense as Europe’s. Perhaps a more likely scenario would be that Medicare and Medicaid
take more advantage of their large volume of pharmaceutical purchases to increase their
bargaining power. We can get an idea of how this will affect profitability by looking at
sales in Europe and other countries with nationalized health care systems. A report
complied in 20033 compiles a price index of pharmaceutical prices in eight different
countries as compared to the price in the United States. It appears that in many countries
where the price of single source patent protected drugs is lower due to price regulation,
government bargaining power, or both, that generic drug use is proportionally lower; this
allows a company to attain higher margin on branded off-patent drugs as compared to the
United States. Combining on and off patent drugs, 7 of the 8 countries analyzed has
prices roughly 75% of that in the United States, whereas Japan had prices 20% higher
than in the United States. Since this it is possible that these countries might increase their

3
“Prices and Availability of Pharmaceuticals: Evidence from Nine Countries”, Danzon

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

use of generics, we should also look at price differentials of on-patent drugs only. Here
we find that the price differential in seven out of the eight countries averaged around 65%
of the price in the United States, with Japan being around 40% more expensive. This
analysis may be pessimistic, in that lower European prices may be partially attributable to
lower incomes in Europe as compared to the United States. Pharmaceutical companies
came to the conclusion some time ago that it makes sense to use tiered pricing based off
of what a particular market can afford. As a matter of fact, when we adjust for per-capita
income differences, the price discrepancy between Europe and the United States
disappears.

To date I have been unable to obtain comparable data on the medical device industry, but
it seems likely that it is susceptible to the same risks. For a potential scenario, let’s
assume that prices in the United States falls to a level similar to that of Europe, while at
the same time governments globally take more advantage of generic drugs.
Consequently, realized prices for on-patent drugs and medical devices falls to 65% of
current levels. Currently, 44% of J&J’s pharmaceutical and medical device revenue is
generated internationally, so total pharmaceutical and medical device revenue would fall
to 80% of current levels4. Since this revenue accounts for 84% of J&J’s operating profit,
we could expect earnings to fall to 83%5 of current levels. Although not good, this
scenario would not be catastrophic, and we could still expect long-term growth in excess
of global GDP from this new equilibrium.

Supplier Bargaining Power

Raw materials are available from multiple sources. The bulk of the value of the
company’s products is created in the manufacturing process; consequently, profits are
well insulated from price swings of raw materials. Total employment costs are 23% of
revenue, and employees not unionized.

Barriers to Entry

A key to success in the pharmaceutical industry is having the resources to fund many
different potential drug candidates in parallel. To see why, let’s say it costs a drug
company $1M to push a potential drug through development, but this only results in a
marketable drug 1 out of 100 tries; but when the trial is successful, the product will
generate $200M in annual revenue. So a small company that can only afford to research
one possible drug at a time has only have a 1/100 chance in each year of creating
anything, and will likely go bankrupt soon. But with scale, the law of averages works in
your favor. Since each drug test can be considered statistically independent, there is a
99/100 chance that each attempt will end in failure. But if a company can fund 100
research projects in parallel, the odds that all of these will fail are only 0.99100 , or 36%. If
a company can fund 1000 projects in parallel, the odds of all failing is nearly zero, and
4
Current: 44 + 56, reduce 56 to 65% of current levels -> 44 + 36.4 = 80.4
5 €
Current: 16 + 84, reduce 84 to 80% of current levels -> 16 + 67.2 = 83.2

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Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

the odds that 75% of the trials will succeed are 1− 0.99 250 6, or 81%. The large scale
required to maintain profitability in this industry can be considered a barrier to entry.

Medical devices also need to undergo FDA trials, which makes their development
€
somewhat risky, although less so than pharmaceuticals. Many of these devices have
proprietary product differences, strong brand recognition, or both.

The primary barrier to entry into the consumer health industry are economies of scale in
advertising and research combined with access to distribution channels, although private
label products won’t have a problem getting shelf space.

Overall, capital requirements are extremely high for successful entry into any one of
J&J’s businesses. Any potential new entrant into the pharmaceutical or medical device
industry would need a large sales force to communicate the advantages of new products
with doctors and hospitals. All three of J&J’s segments benefit from cost advantages
stemming from economies of scale in both R&D and marketing, and differentiation
stemming from a reputation for quality products.

Threat of Substitutes

Since pharmaceuticals and medical devices are necessary for the maintenance of good
health (not to mention life in extreme cases), a significant decrease in use is not likely.
The largest threat of substitutes comes from generic pharmaceuticals. Once a drug loses
patent protection, associated revenue usually rapidly falls to a fraction of what it was. As
discussed earlier, this effect is more pronounced in the United States. One way to
mitigate the effect of generic drugs would be to develop more compounds with lower
sales, perhaps by targeting more precise conditions. Research has shown that for drugs
with sales less than $50M, generic competition falls off rapidly. A similar threat of
substitutes is possible in the medical device industry as well, although currently, the
generic medical device industry is in its infancy. One reason for this is that while most
drug compounds are easily copied, there is considerable engineering and technical know
how required to manufacture medical devices and diagnostic equipment. For this reason,
the risk of reduced profitability due to a lull in innovation is greatest in J&J’s
pharmaceutical subsidiary.

Intensity of Rivalry

Industry growth is expected to remain strong, product differentiation exists (with patents
providing protection from copying), and sunk costs are relatively small compared to
profits (high ROA). All these factors serve to reduce the intensity of rivalry.

6
This is just one minus the odds that 25% will fail, 250 is 25% of 1000

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Pipeline Risk

One of the reasons the barrier to entry is so high in the pharmaceutical industry is that
new drug trials are very expensive, and do not often result in a profitable product. This
raises the question of whether a company has a sufficiently robust development pipeline
to replace existing drugs that go off patent. The average effective patent lifetime for a
new drug is 11.5 years. However, most drugs do continue to generate revenue after they
go off patent; a study conducted in the mid-1990’s showed that revenue fell by 43% the
first year after patent expiry, and 42% the next year, and roughly 10% annually
thereafter. On the other hand, sometimes a generic manufacturer can successfully
challenge a patent in court, so let’s leave the effective life at 11.5 years. Consequently,
with an evenly distributed patent expiration schedule (often an optimistic assumption),
we can expect 8.7% of the company’s revenue to be lost each year.

Looking at a paper7 that investigated the revenue of new products introduced from 1988-
1992 in the U.S., it appears that the mean revenue generated by new products was around
$150M in 1992 dollars. Let’s assume that global sales were around twice that, or $300M
in 1992 dollars. In 2008 dollars, this would be around $450M per new product.
Therefore a company losing 8.7% of it’s pharmaceutical revenue each year would need to
introduce new drugs at a rate equal to total pharmaceutical sales (in millions of dollars)
multiplied by 8.7% and divided by $450M. Johnson & Johnson had 2008 pharmaceutical
sales of $24,500M, so they would need to introduce roughly 4.7 drugs every year.
Looking at their 2008 development pipeline, we find that they have either filed or had
approved 18 compounds, which gives them a comfortable margin. The margin is
probably necessary, as the actual distribution of new drug revenue is highly volatile, with
only 3 out of 10 recouping development costs. Their phase III pipeline has 25
compounds, and we might expect 2/38 of these to become new products over the next
couple of years.

Since this is a rough analysis, let’s do a differential analysis with several other
pharmaceutical companies:

Company Pharmaceutical New Filed or Phase III (2) Largest

Revenue products Approved Product
Needed (1)
J&J $24,500 M 4.5 18 (400%) 25 (370%) 15%
Pfizer $48,300 M 9.3 1 (11%) 25 (180%) 25%
Merck $23,000 M 4.4 2 (45%) 9 (137%) 18%
Glaxo-Smith-Kline $44,900 M 8.7 24 (275%) 29 (223%) 18%
Novartis $26,300 M 5.1 13 (254%) 28 (367%) 22%

7
“The Distribution of Sales Revenues from Pharmaceutical Innovation”
8
“Research and Development in the Pharmaceutical Industry”, CBO 2006 page 23, figure 3-2.

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Abbot Labs $16,700 M 3.2 5 (156%) N/A (3) 27%

(1) number is parenthesis is the ratio of filed or approved to new products needed
(2) Number in parenthesis is the ratio of 2/3 of phase III compounds to new products needed
(3) Abbott Labs does not publish a development pipeline, but 2008 AR indicated 5 new
drugs

It is pretty clear from the differential analysis that J&J has one of the best drug pipelines
in the industry. Aside from its pipeline, J&J has the highest financial strength of
companies that compete in the pharmaceutical industry. Not only is J&J the only
company in the industry with an AAA credit rating, but J&J also has a much broader
revenue diversification, with pharmaceutical revenue accounting for roughly 50% of total
revenue.

Risks to Competitive Position

Risks to J&J’s competitive position include:

• Computing power increases to the point where drugs can be completely modeled
using simulators, negating the need for costly trials. The FDA would also need to
sign off on this. This would significantly reduce the scale required to successfully
compete. This is actually fairly likely at some point in the future; the question is
when. Most likely, the computing power is at least a decade away, with perhaps
another decade of regulatory buy-in. Still, existing patents will lock in cash flows
for a few more years after this occurs.

• Changes to patent law that allows earlier generic competition.

• The company fails to innovate at the same rate as in the past, and suffers
decreased profitability due to competition from generics. This risk is greatest in
the company’s pharmaceutical subsidiary. To date, the company continues to
innovate, with 30% of 2008 sales coming from products developed over the last
five years, and 12% of 2008 sales coming from products developed in 2007.

• Increased buyer bargaining power. This was discussed in detail, and the modeled
scenario looked manageable.

Growth Potential

With the aging population in the United States and Europe, the health care market should
be pretty robust for the foreseeable future, and the total available market for health care
should easily grow in excess of global GDP. Older people tend to require more medical
care, which should positively affect the demand for both pharmaceuticals and medical
devices due to the aging population in the company’s core markets, while the overall
global increase in population should increase the demand for the company’s consumer

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products. J&J’s three business segments are probably among the most recession-proof
industries.

Contributing to positive short to medium term prospects, JNJ’s pharmaceutical pipeline is

very strong, with 32 compounds currently in Phase III trials, and 7 filings and 5 approvals
during 2006. This is for a $24B pharmaceutical division. Compare this to Pfizer’s 8
compounds in phase III, with three filings and four approvals, with Pfizer being a $51B
pharmaceutical company. JNJ has eight times the potential new drugs adjusted for
revenue as compared to Pfizer. And Johnson & Johnson has a similar advantage over
Merck and Novartis.

Financial Strength (3.5)

Credit Rating Ave. Maturing Debt to Earnings Fixed Charge Pension Benefits
Debt to RE Cov. Paid / PBT
AAA 0.07 0.62 25.5 3%

With a debt to earnings ratio of 18%, the company could easily pay off its entire debt in a
single year. Maturing debt is covered over 20X by earnings in any given year. The
company’s total pension obligation is only 1.3 times earnings, and consequently should
not become an issue, even though it is currently only 71% funded.

Management

To date, management has done a good job balancing organic growth with acquisitions.
Basically acquisitions are not required for growth, but are pursued opportunistically, with
management not being afraid to walk away from the table if the numbers don’t look good
(as they did with Guidant). The decentralized structure also works well; we have seen
that adjusted for revenue, the pharmaceutical business is much more productive than
Johnson & Johnson’s rivals.
Summary

Operating History Financial Strength Future Prospects Combined Rating

3.5 3.5 3.5 3.5

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Page 10 of 12
Copyright © 2008 by Brian Gaudet, All rights reserved, including the right of reproduction in whole or in part in any form

2 Products

2.1 Medical Devices

2.2 DePuy

• Early Intervention Solutions: Soft tissue repair products for the knee and
shoulder. Visualization equipment to aid in non-invasive surgery

• Intermediate Intervention: Partial knee replacements, joint fluid replacements,

and vertebrae augmentation

• Joint Replacement: Hip, Shoulder and Knee

• Fracture Repair: Wrist &Hip

• Spinal Repair:

2.2.1 Ethicon

• Surgical Supplies: Dermabond Topical Skin Adhesives, used to close minor

incisions without sutures. Absorbable, non-absorbable, and specialty sutures.
Surgical mesh. Wound Drainage

• Specialized Surgical Supplies: Bariatric surgery, urologic surgery, hernia surgery,

plastic surgery

2.2.2 Cordis

• Heart and Vascular Disease: Drug eluting stents, dilation catheters, guide wires.

• Biologics delivery Systems: Cardiac visualization, navigation products allow

mapping of optimal delivery sites.

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2.2.3 Biosense Webster

Products include 3-D cardiac mapping and navigation systems, ablation products for
treating arrhythmia, and a wide range of catheters.

2.2.4 Lifescan

Lifescan’s products improve the quality of life of diabetics. Products include OneTouch
blood glucose meters, test strips, lancing systems for blood collection, and diabetes
management software.

2.2.5 Animas
Insulin delivery systems

2.2.6 Ortho Clinical Diagnostics

Products include clinical chemistry and immune assay systems of various sizes and
features.

2.2.7 Veridex

Veridex is a company that provides doctors with diagnostic oncology products.

Cellsearch is a blood-testing assay that determines prognosis of patients with various
forms of cancer. GeneSearch is an assay for breast lymph node testing.

2.2.8 Acuvue

Contact Lenses

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