Health-Care Stocks: A Dose of Reality from J&J

It's likely to be some time before health-care companies begin to enjoy the fruits of any economic recovery, judging by Johnson & Johnson's (JNJ) slight third-quarter revenue miss on Oct. 13. To be fair, the profits the company reported were higher than anticipated. But that stemmed mostly from cost-cutting and an unexpectedly low tax rate, while analysts and investors want to see signs that sales are improving.

The New Brunswick (N.J,) company earned $1.20 a share in the third quarter, beating analysts' $1.13 consensus estimate and the year-ago results of $1.17 a share. Revenue fell 5.3% from last year to $15.1 billion, with nearly half the decline coming from an adverse foreign currency impact. Analysts were looking for $15.22 billion in sales in the latest quarter. "Companies are not going to be given credit for financial management. They're going to be given credit for sales [growth]," says Jan David Wald, an analyst atNoble Financial Group in Boston. "Health-care companies can drop more [money] to their bottom line. That's not evidence of strength anymore."

Johnson & Johnson shares were down as much as 3% during trading on Oct, 13 before closing 2.4% lower at $61.01.

Medical Device Tax The selling probably came in response to the disappointing sales numbers, but market sentiment wasn't helped by a 14-9 vote by the Senate Finance Committee — just hours after the company's earnings conference call — approving a $829 billion overhaul of the U.S. health-care system. Health-care reform is widely expected to put additional pressure on health-care companies' earnings.

The Senate health-care bill includes a provision to impose a $40 billion tax on the medical device industry over a 10-year period, That would amount to $4 billion a year, which is said to be apportioned among companies according to their market share. Johnson & Johnson is reportedly trying to get the medical device tax reduced by half or more.

If the tax ends up being only 1% of sales, "companies can find some other cost cuts and maybe do some other restructuring if they have to in order to offset it," says Jeff Jonas, an analyst at Gabelli (GBL). "But if it's 3% to 4% of sales, that's too big. That's going to really eat into their profits." Gabelli owns shares of Johnson & Johnson.

Baby-Care Weakness Johnson & Johnson's global pharmaceuticals sales fell 14.1% to $5.3 billion, with 2.2% of the decline caused by negative currency translation effects. In the U.S., increased competition from generic products was especially damaging for sales of Johnson's anti-psychotic drug Risperdal, and Topamax, a drug for treating epilepsy and migraines.

Consumer sales worldwide dropped by 2.7%, to $4.0 billion, from the third quarter of 2008. Weakness in the baby-care products line does not bode well for other health-care companies directly connected to consumers, as opposed to hospitals and other commercial customers, says Wald at Noble. Baby-care products are one category he says he thought would have been somewhat immune to the weak economy.

A decline in sales of up to 20% for elective procedures such as breast implants and wrinkle removal is further "evidence that the closer you get to touching the consumer, the more likely you were to run into problems," he adds.

Health-Care Uncertainty Worldwide sales of $5.8 billion for the medical devices and diagnostics division were 2.3% higher than a year ago. The company's orthopedic joint reconstruction, spine, and sports medicine products and minimally invasive surgical products were big contributors to the growth in this business. On the conference call, the company said it had already repurchased shares worth $8.9 billion and will complete the buyback of the remaining $1.1 billion in shares at a slower pace than initially expected.

The company shared a fairly conservative view on the pricing of medical devices over the next few years, says Jonas at Gabelli. Much of the pressure on prices will be due to hospitals having to give back $155 billion over 10 years to the Medicaid program as part of the health-care reform, he says.

All the uncertainty around health-care reform has pushed stock valuations down across the health-care industry, arguably too far, according to Linda Bannister, an analyst who covers pharmaceutical companies for Edward D. Jones "Once we have some clarity, as long as it's not more of a burden on these companies than the current bill outlines, these stocks should have a relief rally," she says. It's hard to predict the timing of such a rally, however, she concedes.

"Buy" Rating on J&J Attractive dividend yields are paying investors to ride out that uncertainty, she says. The yield on Johnson & Johnson's dividend is now 3.21%, and it's more than 5% for some of the pure-play pharmaceutical companies.

Bannister has maintained a "buy" rating on Johnson & Johnson because "we think their pharma pipeline will drive a resumption in revenue growth in 2010 and 2011, [which] bodes well for the shares."

During the third quarter, the U.S. Food & Drug Administration approved Stelara, a drug for plaque psoriasis, and Invega Sustenna, an extended release, injectable treatment for adult schizophrenia. On Oct. 6, the European Commission approved Simpon, an injectable treatment for rheumatoid arthritis and psoriatic arthritis.

Flat Sales for J&J On Oct. 13, Standard & Poor's Equity Research reaffirmed its buy rating on the stock and its 12-month price target of $70, which equates to 14.3 times projected 2010 earnings of $4.90 a share. S&P said it believes Johnson & Johnson "is correctly addressing its challenging pharma business through recent acquisitions and alliances in vaccines, and new oncology and Alzheimers drugs."

Still, Wald at Noble says he expects to see flat sales for Johnson & Johnson and its peers until the economy has turned around and consumers feel more comfortable, He wouldn't be surprised to see up to a 6% decline in Johnson & Johnson's worldwide sales in the fourth quarter.

In spite of the challenges facing health-care companies, analyst Rick Wise at Leerink Swann & Co. says he sees sales stabilizing in dollar terms, but he too believes the recovery will be very gradual.

Watching Health-Care Giants After Johnson & Johnson's report, Wall Street will be watching two other health-care giants this week for additional clues. Analysts expect Abbott Laboratories (ABT) to report earnings of 90¢ a share on Oct. 14, vs. 79¢ a year ago. Baxter International (BAX), reports on Oct. 15, with analysts expecting the firm to earn 97¢ a share, up from 88¢ in the third quarter of 2008.

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