MORGAN STANLEY DEAN WITTER In-Depth Page 1 Equity Research North America United States of America Johnson & Johnson Healthcare: Pharmaceuticals, Hosp. Supplies & Medical Tech. Reuters: JNJ.N Bloomberg: JNJ NYSE: JNJ Glenn M. Reicin Company Update May 24, 2000 ([email protected]) (212) 761-6494 John T. Boris ([email protected]) (212) 761-7585 EPO: Taking Some Comfort OUTPERFORM • Erythropoietin (EPO) is JNJ’s most important growth driver Price (May 19, 2000): $89.06 JNJ’s EPO brands will contribute close to 2.5% to corporate Price Target: $105.00 growth in 2000, but concerns are mounting about the franchise. 52-Week Range: $106.13-67.00 • Competitive pressures are intensifying… WHAT’S CHANGED TKTX and AMGN are both mounting challenges to JNJ. The Change of Target $101 to $105 ongoing TKTX/AMGN patent dispute is the most immediate. • …But the market is robust Strong market growth should shield JNJ. We are raising our 2005 estimates by $300 million. We were simply too pessimistic. • We are maintaining our Outperform rating We are increasing our EPS growth rate by 0.5% to 12.5%. If Amgen prevails against TKTX, growth will be even higher. Price: Abs. and Rel. To Market & Industry FY ending Dec 31: 1999 2000E 2001E 2002E EPS ($) 2.96 3.37 3.80 4.32 Prior EPS Ests. ($) Johnson & Johnson Acquired Centocor (CNTO) on 10/18/1999 (Left, CEPS ($) 3.98 4.46 4.95 5.54 Relative to S&P 500 Stock Index (Right) P/E 30.1 26.4 23.4 20.8 130 100 P/CE 22.4 20.0 18.0 16.1 90 120 Curr. Yield (%) 1.3 0.0 0.0 0.0 80 110 70 Market Cap ($ m) 125,664 Q’trly 2000E 2001E 2002E 100 EPS estmate curr prior curr prior 60 Enterprise Value ($ m) – 50 90 Debt/Cap (12/98)(%) – Q1 0.93A 1.04 – – – 40 80 Return on Equity (12/98)(%) 27.7 Q2 0.92 1.05 – – – 30 L-T EPS Grth. (%) 13.0 Q3 0.89 1.00 – – – 96 97 98 99 P/E to Growth 2.31 Q4 0.63 0.71 – – – Data Source: FactSet Research Systems Inc. Shares Outstanding (m) 1,411.0 E = Morgan Stanley Dean Witter Research Estimate. Company Description Johnson & Johnson is one of the world’s largest and most comprehensive manufacturers of healthcare products, serving the consumer, pharmaceutical, diagnostics, and professional markets. Please refer to important disclosures at the end of this report. MORGAN STANLEY DEAN WITTER Page 2 EPO: Taking Some Comfort Summary and Investment Conclusion ket for cancer as the primary driver of future industry Since the beginning of 2000, JNJ has not been a strong per- growth. We estimate that by the end of 2000, this portion of former. We believe that the poor performance of the stock the market will be 25% penetrated in the US and only 7% is due, in part, to concerns about the sustainability of the penetrated in the non-Japan overseas markets. This year, company’s erythropoietin (EPO) franchise. In this report, we estimate that the worldwide market (excluding Japan) we outline many of the issues that are involved. for EPO will approximate $4.7 billion in sales. This as- sumes that: 1) pricing erodes modestly, 2) penetration rates The EPO market is an important one for JNJ, as it controls for chemotherapy use grow to 45% in the US and 30–35% roughly 57–58% of the worldwide market (excluding Ja- outside the US, and that all other penetration rates for other pan). This product represents JNJ’s single largest brand, as indications (pre-surgical and HIV-associated anemia) do not it accounts for about 9% of corporate sales and probably increase dramatically. Based on these assumptions, we es- close to 15–20% of total corporate profits. Just as impor- timate the market for EPO will approach $7.7 billion by tant, EPO has been an important source of growth. We es- 2005. timate that this year, EPO will contribute roughly 2.5% to corporate growth. We are projecting total corporate sales We are projecting that JNJ’s total worldwide EPO sales will growth will approximate 9% worldwide. grow approximately 33% in 2000 to $2.7 billion. We be- lieve that this growth will begin to moderate dramatically in JNJ has several direct and indirect threats with respect to its the future. We are assuming that: 1) TKTX will eventually EPO franchise. As a reminder for investors, Amgen li- sell in all major markets (with its marketing partner Aven- censed EPO to JNJ in the mid-1980s. JNJ has the exclusive tis), 2) Amgen successfully introduces NESP worldwide, 3) rights to sell EPO for all indications in most countries out- Amgen will not succeed in reclaiming EPO from JNJ, and side the US and Japan. In the US, JNJ has the exclusive 4) pricing in the industry will only decrease modestly. At rights to sell EPO for all indications, except for end-stage this point, we are assuming that NESP will be priced at a renal disease (ESRD), which is the market that Amgen kept premium and that TKTX will elect to price its product at a for itself. 15% discount in the US and will receive a more modest 5– 10% discount in overseas markets from pricing authorities. The first “indirect” threat to JNJ’s franchise began in ear- nest on May 15 as Amgen and Transkaryotic Therapies After assessing these threats to the market, we are project- (TKTX) began a trial over the “validity” of Amgen’s EPO ing that JNJ’s EPO growth rate will decelerate to 15–16% in patents. This will determine whether TKTX will be able to 2001 and will be flat to down in the low single-digit range commercialize GA-EPO (Dynepo)in the US market. The in 2002. Thereafter, we are projecting a 3–6% decline be- second, more direct, threat pertains to Amgen’s second- tween 2003 and 2005. These revenue estimates are slightly generation EPO called NESP. This second-generation greater than our previous estimates, as the decline is less product will allow Amgen to compete with JNJ in all severe. In total, we are raising our 2005 EPO estimates by worldwide markets for which JNJ was exclusively licensed $300 million to $2.65 billion. Using these assumptions, we by the original AMGN/JNJ agreement. This product is ex- believe that JNJ can still maintain an 8–10% annual revenue pected to be launched in the US in 1Q00 and outside the US growth rate and a 12.5–13% normalized EPS growth rate. in 4Q00 for the treatment of renal disease. Additionally, This EPS growth rate is approximately 0.5% higher than our JNJ and Amgen continue to battle with each other in an previous estimates, and is now more in line with consensus arbitration process regarding the original licensing agree- growth rates. Interesting to note, JNJ believes that it can ment. Amgen is hoping to regain US marketing rights to still grow its franchise using the above assumptions, leading erythropoietin from JNJ. us to believe that we may still be too conservative. When examining these threats, one has to take into account Despite the robust nature of the market and the fact that JNJ the sustainability of growth for the EPO market in the near can still maintain a respectable corporate growth rate using term. As we look at the anemia market, it remains quite our assumptions above, we believe the stock will remain robust and under served. Specifically, we see the EPO mar- under pressure until certain near- to mid-term EPO uncer- Johnson & Johnson – May 24, 2000 Please refer to important disclosures at the end of this report. MORGAN STANLEY DEAN WITTER Page 3 tainties are resolved. Specifically, the outcome of the Am- year over year. JNJ’s share of this worldwide market ap- gen/TKT litigation and the announced pricing strategies for proximates 57–58%. While the renal dialysis market is both TKT and Amgen will both be at issue. close to full penetration, by our calculations, the oncology market has much more room to grow — we estimate that As such, we believe that the Amgen/TKTX litigation repre- the market is only 20–25% penetrated in the US and 5–7% sents an important psychological event for JNJ. If Amgen penetrated in international markets. were to win this case, we believe JNJ will begin to regain a multiple that is more comparable to other pharmaceutical While the market is still young, JNJ is fighting several bat- stocks. We estimate that this event would cause us to in- tles regarding EPO. First, it has an ongoing direct legal crease our EPO estimates by another $200 million, adding battle with Amgen regarding future marketing rights. Sec- modestly once again to our projected long-term growth rate. ond, it has an indirect and potentially a direct battle with TKT regarding the introduction of GA-EPO (trade named We believe that if Amgen does prevail, the stock could Dynepo) in the US and Europe. Third, it has a direct battle quickly move back up another 10% from current levels. If with Amgen regarding the introduction of a second- TKTX were to win, our long-term estimates would not generation EPO called NESP. We thought that an overview change from our current projected long-term EPS growth of this market and these various issues would be in order. rate. However, the physiological negative could force the stock back down to the low 80s, in our opinion. What’s at Stake for JNJ? What is Procrit/Eprex? Erythropoietin is used in the treat- Perhaps the best alternative for both Amgen and JNJ would ment of anemia by stimulating erythropoeisis or red blood be a worldwide partnership for NESP.