Rule Maker Portfolio J&J Strikes Again

In the past, Johnson & Johnson has succeeded in its approach to biotech acquisitions by paying full fare for premium assets. It appears that, with its $2.4 billion deal to acquire Scios, J&J has scored another long-term victory.

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By Zeke Ashton
February 12, 2003

I wondered when it would happen. I knew it was just a matter of time before we saw the next big biotech taken over by Big Pharma. With biotech stocks wilting to levels not seen in over a decade, you just knew it was coming. But since Bristol-Myers Squibb's (NYSE: BMY) $2 billion deal for the ImClone Systems (Nasdaq: IMCL) wonder drug Erbitux blew up like a party favor, no big pharmaceutical executive wanted to risk becoming the next burn victim.

On Monday, Johnson & Johnson (NYSE: JNJ) decided to step up to the biotech buffet table and pick out a tasty morsel, snapping up biotech survivor Scios (Nasdaq: SCIO) in a $2.4 billion deal. J&J doesn't shop in the discard bins, and price isn't an obvious bargain. But then again, trying to hit home runs isn't the J&J way when it comes to biotech acquisitions. Rather, the company is content to pay up for biotech companies after they've proven the value of their science by getting a unique drug to market and generating meaningful sales. By waiting, J&J sidesteps the risks of a negative FDA event, such as has occurred with ImClone's Erbitux, and also avoids the risk that the drug isn't a commercial disappointment post-approval, which is a real risk in a business where an estimated two out of every three approved drugs don't make back the cost of development.

But it's a delicate timing act. J&J always seems to make its move to buy big league biotech assets immediately after the major financial risks are gone, ensuring that it reaps the benefits of the products very early in the commercial life cycle. Acquiring differentiated drugs early in their commercial existence also ensures that J&J has maximum opportunity to bring its powerful marketing machine into play to fully exploit the potential of its new assets.

J&J's buyout of Scios is reminiscent of its first major biotech acquisition, that of biotech pioneer Centocor for $4.9 billion back in 1999. That deal had its critics, but it has turned out to be an absolute steal for J&J. So good, in fact, that when drug delivery specialist Alza became available in early 2001, J&J didn't hesitate. In a deal announced one day after J&J was added to the Rule Maker Portfolio, Alza was worth $10.5 billion. I thought that was a good deal for J&J at the time, and it certainly appears to have worked out nicely.

J&J's low-risk approach means that it has to pay full fare for its acquisitions -- but it ensures that the company also gets full value. Because it has to pay a portion of the discounted future value of its acquired products today, J&J's acquisitions can look exceptionally expensive to those uninitiated in the ways of the drug business. The Scios deal is no exception: The $2.4 billion price tag, at 30 times trailing-12-month revenues, looks ridiculously expensive for a company that lost $69 million through the first nine months of 2002. It's a price that would make Benjamin Graham roll over in his grave. But how expensive is it, really? Let's do some math.

The jewel in the Scios crown is Natrecor, the company's drug for congestive heart failure, which was approved by the FDA in August 2001. Natrecor has excellent commercial potential, considering it occupies the classic pharmaceutical sweet spot of being a novel drug targeting an under-served market. In fact, Natrecor was the first new treatment for acute CHF to be approved in some 14 years. Scios expects sales for the drug for 2002, its first full year on the market, to be somewhere in the $92 million to $95 million range, growing to $160 million to $170 million in 2003. Since previous biotech drugs that have enjoyed this type of launch have all gone on to become blockbuster successes, one can start to understand the hype. Natrecor was previously expected to eventually reach peak annual sales in the $350 million to $500 million range. If one makes some fairly reasonable assumptions, Natrecor could easily be adding some $200 million per year to J&J's annual operating cash flow within a couple of years.

But here's the beauty of the deal: J&J is one of the biggest and best pharmaceutical marketers in the world. If a company with limited resources like Scios was expected to fetch $350 million to $500 million in sales out of this drug, J&J can probably push that figure to the high end of the range at the very least, if not completely blow it out. In addition, it expects to investigate whether its drug delivery subsidiary Alza can develop new formulations of the drug that will both increase its clinical attractiveness and extend the product's commercial life. In short, I suspect that Natrecor alone will yield a reasonable return on J&J's investment. 

The opportunity for a home run comes with the Scios pipeline of drugs, which includes a promising drug for rheumatoid arthritis called SCIO-469, now in Phase 2 clinical trials, and another drug earlier in development. Of course, J&J isn't counting on any of these drugs to make it to market, but I would guess the chances of Scios' scientific team coming up with another commercial product in the next decade are reasonably good -- biotech is, after all, the ultimate in long-term games.

Of course, time will tell if J&J is making the right move here. But for a company that generates $6.5 billion in free cash flow annually and spends $4 billion on R&D every year, the $2.4 billion deal isn't a disaster if it doesn't turn out to be a big winner. After all, J&J will have probably generated enough cash between now and the time the deal closes in the second quarter to cover the entire cost of the acquisition. For now, though, it looks like J&J has struck another great biotech deal -- and there are still some juicy targets out there.

[What do you think about Johnson & Johnson's latest acquisition? Do you agree with Zeke's assessment? Your fellow Fools await your insights in the Johnson & Johnson discussion board.]

Zeke Ashton is the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. At time of publication, Zeke owned shares of J&J in some managed accounts. Please send your feedback to zashton@centaurcapital.com.


 

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  Ticker Company Price
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  AXP AMERICAN EXPRESS COMPANY (0.67) (2.02%) 32.50 
  KO THE COCA-COLA COMPANY 0.74 1.90% 39.74 
  NOK NOKIA CORP. (0.32) (2.27%) 13.77 
  JNJ JOHNSON & JOHNSON (2) (3.85%) 50.00 
  PFE PFIZER INC (0.44) (1.51%) 28.75 
  GD GENERAL DYNAMICS CORPORATION (0.65) (0.99%) 64.75 
  TROW PRICE T ROWE GROUP INC (0.2) (0.81%) 24.64 
  SGP SCHERING-PLOUGH CORPORATION (0.1) (0.55%) 18.05 
  COST COSTCO WHSL CORP NEW 0.14 0.49% 28.76 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 05/26/98 95 AXP 35.38 32.50  -8.14%
 02/27/98 27 KO 69.11 39.74  -42.49%
 02/15/00 250 NOK 27.21 13.77  -49.40%
 04/03/01 30 JNJ 47.28 50.00  5.75%
 02/03/98 66 PFE 27.43 28.75  4.80%
 10/24/02 25 GD 79.98 64.75  -19.04%
 02/06/98 75 TROW 34.12 24.64  -27.78%
 08/21/98 44 SGP 47.99 18.05  -62.39%
 07/24/02 41 COST 35.89 28.76  -19.87%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 05/26/98 95 AXP 3,360.87 3,087.50  -273.37 
 02/27/98 27 KO 1,865.89 1,072.98  -792.91 
 02/15/00 250 NOK 6,802.85 3,442.50  -3,360.35 
 04/03/01 30 JNJ 1,418.50 1,500.00  81.50 
 02/03/98 66 PFE 1,810.58 1,897.50  86.92 
 10/24/02 25 GD 1,999.50 1,618.75  -380.75 
 02/06/98 75 TROW 2,559.06 1,848.00  -711.06 
 08/21/98 44 SGP 2,111.70 794.20  -1,317.50 
 07/24/02 41 COST 1,471.49 1,179.16  -292.33 
Cash:11,132.36 
Total:27,572.95 


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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.