Rule Maker Portfolio J&J's Savvy Acquisition

The Rule Maker's newest addition, Johnson & Johnson, recently announced a $10.5 billion acquisition of Alza Corp. This acquisition provides J&J with an attractive combination of drug platform technologies and pharmaceutical products. Especially promising is that Alza's drug delivery technologies can be applied to J&J's own drugs, which should both increase the sales and, in many cases, extend the lifecycle of J&J's commercial drugs. This could add tremendous value down the road for J&J.

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By Zeke Ashton
April 3, 2001

Yesterday, we announced the latest addition to the Rule Maker Portfolio, Johnson & Johnson (NYSE: JNJ). I am very excited about the inclusion of J&J within our portfolio, because the company truly embodies what Rule Maker investing is all about. Let's recap some of the company's accomplishments, as presented by Chairman and Chief Executive Officer Ralph S. Larsen in the 2000 annual report.

  Some of  Johnson & Johnson's accomplishments in the year 2000 include:

  • Sales increase for the the 68th consecutive year.
  • The dividend was increased 14.3%, representing the 38th consecutive year of dividend increases.
  • Cash flow (from operations) increased to nearly $6.6 billion, up from $3.4 billion five years ago.
  • The year-end market valuation was $146 billion, up from $25 billion 10 years ago.

The big news at J&J is its recently announced $10.5 billion acquisition of Alza Corp. (NYSE: AZA), a drug delivery specialist that has shown impressive growth over the past three years. In fact, Alza has been making strong progress on the yellow brick Rule Maker road, and I believe that J&J is making the acquisition at an opportune time and is paying a reasonable price. Considering that the Alza purchase is a big deal for us as brand-new J&J shareholders, I'll spend the rest of today's article looking at what our company is getting for its $10.5 billion purchase price.

Alza is headquartered in Mountain View, Ca., and is made up of two primary business segments: Alza Technologies and Alza Pharmaceuticals. 

We'll look at Alza Technologies first, since drug delivery remains Alza's core expertise. Alza Technologies develops drug delivery technology, and provides research, product development, and manufacturing services to other drug companies, as well as for in-house pharmaceutical development. Alza has developed several drug-delivery techniques that can improve existing drugs by increasing the availability of the drug, reducing the necessary dosage, or adding convenience. These technologies include sustained-release oral drug formulation, drug patches, drug implant systems, advanced injection technology, and liposomes, which are microscopic lipid spheres that carry the medication to its destination in the body. 

Alza uses its technology to help other drug companies develop better drugs, and those customers pay Alza for its contract research and manufacturing services, as well as royalties and milestone payments on the drugs themselves. Products that Alza has developed or manufactures for other companies include the Nicoderm patch to help smokers kick the habit, and Glucotrol XL, Pfizer's once-a-day drug for Type II diabetes. 

Alza's customer list is a veritable who's who of big pharma companies, including Pfizer (NYSE: PFE), Aventis (NYSE: AVE), Pharmacia (NYSE: PHA), Bayer, Knoll Pharmaceuticals (now part of Abbott Labs (NYSE: ABT)), and J&J's Janssen. In 2000, Alza earned $281.2 million in royalties and fees from its partners.   

Next, let's look at Alza Pharmaceuticals. Building upon its core skills of drug delivery technology, Alza has grown the sales of its own pharmaceutical products from nearly nothing in 1995 to more than $477 million in 2000. Alza has focused its drug development efforts on the urology, cancer, and central nervous system markets, and has brought two very impressive drugs to market in the past two years. In 1999, Alza launched Ditropan XL, a once-a-day drug for overactive bladder. Ditropan XL managed a strong launch with sales of $87 million in 1999, and more than doubled to $179 million in 2000.  That strong start, along with the expected launch of the product in Europe, augurs well for this product's future growth. It's not out of the realm of possibility to expect 2000 sales of $250 million and peak sales that could approach $500 million annually. 

The second new drug, Concerta -- for attention deficit hyperactivity disorder (ADHD) -- was launched in August 2000 and did more than $67 million in sales by the end of the year, with $43.5 million in the fourth quarter alone. Concerta competes directly with Ritalin, but is a sustained-release formula that allows once-a-day delivery. Considering that the vast majority of Ritalin patients are kids, Concerta is a real improvement over Ritalin, which must be administered multiple times per day, often at school. The short-term sales prognosis for Concerta was also helped by news yesterday morning that a patch version of the product, in development by Noven Pharmaceuticals (Nasdaq: NOVN), will be delayed, and most likely won't be on the market until 2003. Alza expects 2001 sales of Concerta to be $200 million.

In its cancer area, Alza's best seller is Doxil, which the company picked up in its 1999 acquisition of SEQUUS. Doxil is marketed in the U.S. primarily for the treatment of ovarian cancer, although it has some secondary indications as well. Outside the U.S., the drug is marketed by Schering-Plough (NYSE: SGP) as Caelyx, which announced the European Union approval for treatment of ovarian cancer near the end of last year. Doxil generated $82.4 million in sales in 2000, up from $66.2 million in 1999, and Alza expects 2001 sales of around $100 million. 

That's three new products with combined expected 2001 sales of about $550 million, and which Alza supplements with a modest portfolio of niche drugs that are expected to deliver another $150 million in 2001 sales. In all, Alza expects total 2001 sales of its own drugs to be in the neighborhood of $700 million, an increase of more than 45% from 2000. 

What I don't have space for today is an overview of Alza's drug pipeline, but let me just say that the company has a full pipeline of drug candidates, both on the Alza Pharmaceutical side and in development for corporate partners. 

Add it all up, and you've got 2000 sales of more than $920 million, and Alza expects another 20% in growth in 2001. (If you're looking at Alza's actual 2000 sales of $988.5 million, well, $68 million of that number consists of contract R&D that Alza received from its own research subsidiary, Crescendo Pharmaceuticals. I don't count that as real revenue.)  In 2000, Alza generated $223 million in net income and almost $300 million in free cash flow.   

Now let's talk about the price. At $10.5 billion, J&J is paying about 40 times 2001 expected earnings. That's a steep price to pay, but Alza has a very good chance to grow 20% annually for the next two or three years.

Looking at Alza in combination with J&J, there are reasons why I especially like this deal:

  • Alza has traditionally marketed its own products in the U.S. and licensed its products for sale to corporate partners outside the U.S. With J&J's huge worldwide sales and distribution capabilities, J&J will likely distribute Alza's new products internationally, while also generating incremental sales in the U.S.
  • Alza's drug-delivery technologies can be applied to J&J's own drugs, which should both increase the sales and, in many cases, extend the lifecycle of J&J's commercial drugs. This could add tremendous value down the road for J&J.
  • Finally, Alza's marketed drugs are very early in their respective lifecycles, and have most of their growth still ahead of them. 

I also think J&J has done very well with their acquisitions in the past. Over the past decade, J&J has acquired 42 companies, including the large acquisition of biotech pioneer Centocor that has worked out well for J&J shareholders. I think that in a couple of years, we'll be saying the same thing about Alza.

Zeke Ashton is a co-manager of the Rule Maker Portfolio. He wrote most of this article while using J&J products, including but not limited to: Q-tips, Band-Aids, Baby Shampoo, and especially Mylanta. Zeke does not own shares of J&J or Alza, but owns shares of Schering-Plough. To view all of his holdings, see his profile. The Motley Fool is investors writing for investors.


 

Rule Maker Portfolio


4/3/01 as of ~8:30:00 PM EDT

Ticker Company Price
Change
Daily Price
% Change
Price
AXPAMER EXPRESS(1.72)(4.33%)37.99
CSCOCISCO SYSTEMS(1.31)(8.71%)13.75
INTCINTEL CORP(0.78)(3.03%)25.00
JDSUJDS UNIPHASE CORP(2.63)(15.73%)14.06
KOCOCA-COLA CO(1.19)(2.60%)44.66
MSFTMICROSOFT CORP(2.44)(4.37%)53.38
NOKNOKIA CORP ADS(1.68)(7.33%)21.25
PFEPFIZER, INC0.070.18%39.02
SGPSCHERING-PLOUGH(0.36)(1.02%)35.10
TROWT.ROWE PRICE GRP INC(1.38)(4.47%)29.38
YHOOYAHOO INC(2.63)(18.75%)11.38

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(1/6/1998)
Rule Maker(5.32%)(8.38%)(8.38%)(36.95%)(33.95%)
Comparable S&P 500n/an/an/an/a0.44%
S&P 500(3.44%)(4.64%)(4.64%)(16.20%)13.24%
S&P 500 (DA)(3.39%)(4.57%)(4.57%)(15.98%)15.02%
NASDAQ(6.17%)(9.09%)(9.09%)(32.28%)4.95%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (1/6/1998)
Rule Maker(16.38%)
vs. S&P 5000.56%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
2/3/9866PFE27.4339.0242.24%
2/3/9859MSFT49.3553.388.15%
5/26/9866AXP36.0037.995.53%
2/13/98147INTC27.4425.00(8.88%)
2/3/9856TROW33.6729.38(12.76%)
8/21/9844SGP47.9935.10(26.86%)
2/27/9827KO69.1144.66(35.38%)
6/23/98182CSCO24.7213.75(44.02%)
2/15/00117NOK40.9521.25(48.11%)
2/17/99106YHOO57.6011.38(80.25%)
2/15/0032JDSU100.7514.06(86.04%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
2/3/9866PFE$1,810.57$2,575.32$764.75
2/3/9859MSFT$2,911.79$3,149.13$237.34
5/26/9866AXP$2,375.95$2,507.34$131.39
2/3/9856TROW$1,885.70$1,645.00($240.70)
2/13/98147INTC$4,033.23$3,675.00($358.23)
8/21/9844SGP$2,111.70$1,544.40($567.30)
2/27/9827KO$1,865.89$1,205.82($660.07)
6/23/98182CSCO$4,498.75$2,502.50($1,993.22)
2/15/00117NOK$4,791.64$2,486.25($2,305.39)
2/15/0032JDSU$3,224.00$450.00($2,774.00)
2/17/99106YHOO$6,105.72$1,205.75($4,899.97)
 
Cash: 
Total: 
$23.06
$22,969.56
 


Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.