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Will J&J Acquire a Growth Pill?

By Amy Tsao Johnson & Johnson (JNJ) likes to remind shareholders that it's the No. 1 or No. 2 player in most of its businesses. From medical devices to prescription drugs to over-the-counter remedies, the New Brunswick (N.J.)-based giant with $42 billion a year in revenue is the industry's most diversified company. But that hasn't stopped its shares from faltering lately. J&J stock is trading at around $53, well off a two-year high of $65 reached in March, 2002.

The share price reflects investor worry about whether the outfit can maintain 10% annual growth in coming years. The main threats to that pace are emerging competition in its coronary stent business and market-share losses in its key franchise in red-blood-cell products. Michael Dauchot, medical-devices analyst at Pimco RCM, says he sold J&J stock late last year after holding it in his global health-care fund and biotechnology fund for years.

FATTER TARGETS? Dauchot isn't alone in being dissatisfied with J&J. Its "performance hasn't been there," says Gary Wolfer, vice-president at the trust division of Univesc Corp. He likes J&J for the long term but has been reducing his position in the stock lately.

What could get investors excited about J&J shares again would be a sizable acquisition. The company is showing signs that it understands it needs to make bold moves to assuage concerns about growth prospects. Nearly all drugmakers seem to be making small deals lately, essentially bets on early-stage and unproven drugs at unestablished outfits. But J&J, with a strong track record of acquisitions, might be keen on seeking bigger targets.

The right deal would be a boon. J&J is losing market share on red-blood-cell-boosting products to a new Amgen (AMGN) drug. Heather Brilliant, drug analyst at independent stock researcher Morningstar, figures that the franchise, J&J's largest, could decline up to 8% annually in the next few years. Other big drugs -- antipsychotic Risperdal and arthritis treatment Remicade -- also face competitive threats. For now, analysts on average see earnings per share rising 11%, to $2.95, in 2004 with help from cost cutting. Revenues are forecast to increase 10% in 2004, to $45.9 billion, but gain just 6% in 2005.

WORTHWHILE PREMIUM. Which companies might J&J be interested in? The deal with the most bang may be the most unlikely. Shao Jing Tong, an analyst at New York City-based health-care research firm Mehta Partners, says a union of Merck (MRK) and J&J would make a powerhouse in the long term -- if both could put aside fears of larger mergers. The two companies have continued to say they're not looking at megadeals, but Tong sees a great match -- culturally, geographically, and strategically. J&J declined to comment on its acquisition strategy.

More likely is one of a handful of specialty drug concerns. These already have midsize products on the market but, with J&J's global reach, could potentially become much bigger. Among them: Cephalon (CEPH), maker of stay-awake pill Provigil; Allergan (AGN), which sells anti-wrinkle injection Botox; and Forest Labs (FRX), maker of drugs for depression and Alzheimer's. On the devices side, analysts see cardiovascular-products maker St. Jude Medical (SJM) as an appealing candidate.

J&J would probably have to shell out a substantial premium for any buyout. Shares of midsize drugmakers are rising as they're increasingly viewed as potential targets by major pharmaceutical concerns struggling with generic competition and new-treatment delays or failures. But analysts say paying up could be worthwhile for J&J. "It's going to be dilutive, but I don't think they'll have any choice," says Dauchot, who expects that J&J could announce an acquisition in the next six months. In the long term, a buyout is a smart move that "both J&J and investors can stomach."

LEAVE THE "COMFORT ZONE." J&J has made a good start in this direction, analysts say. It has a new partnership with rival Guidant (GDT), in which Guidant will help market J&J's Cypher drug-coated stent. "That gives J&J a position it didn't have before," says Jan Wald, analyst at A.G. Edwards. Wald sees the deal lasting through 2005, when Guidant starts to sell a competing stent.

If the venture proves fruitful, the two companies might consider merging. "It wouldn't surprise me if the chance of an acquisition goes up by then," Wald says. Moreover, he wants most to see J&J "step outside the comfort zone and make a larger acquisition that's maybe dilutive for long-term benefit."

J&J has a long and successful history of growing through acquisitions. About two years ago, its Cypher stent was not yet on the market, and it knew it was heading into a period of lackluster growth. To counter that, it bought Alza in spring, 2001, a midsize concern with several marketed drugs -- for urinary incontinence, pain, and attention deficit disorder -- as well as expertise in reformulating difficult-to-take medicines. J&J paid about $10.5 billion in stock, and the deal was neutral to the bottom line in 2002 and added to it thereafter.

BIG CASH HOARD. In the short term, J&J is headed for a similarly troubled patch as Boston Scientific (BSX) talks about trying to steal market share from the giant with its competing Taxus stent, due for U.S. approval in the coming weeks. The Guidant-J&J partnership should help "shore up the business [for J&J]," Wald says. It won't stop Boston Scientific from taking market share, but it should help keep the decline from being too steep, he adds.

While J&J's growth dilemma is one shared by many pharmaceutical outfits, analysts expect that it could find a remedy soon. At the end of 2003, it had $5.4 billion in net cash, and it's one of the few corporations of any kind with a triple-A credit rating. If J&J gets aggressive on the M&A front, investors likely would benefit. Tsao covers the markets for BusinessWeek Online and is a Street Wise columnist

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