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Johnson & Johnson Is Becoming a Far Riskier Investment

By Sean Williams - Feb 3, 2017 at 11:08AM

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J&J's reliance on pharmaceutical sales is growing rapidly, which could be a double-edged sword.

CEO Alex Gorsky standing in front of large Johnson & Johnson logo.

CEO Alex Gorsky. Image source: Johnson & Johnson.

By all accounts, healthcare conglomerate Johnson & Johnson (JNJ -1.10%) is one of the steadiest, safest stocks that long-term investors can buy. The health giant has increased its dividend for 54 consecutive years, putting it among the elite of Dividend Aristocrats (companies that have raised their payouts for at least 25 straight years). Also, until the quick rise and fall of hepatitis C drug Olysio, Johnson & Johnson had a better than three-decade-long streak of increasing its adjusted earnings per share on a year-over-year basis.

What makes Johnson & Johnson so successful is its structural setup and operational diversity. It's comprised of more than 250 subsidiaries, which makes acquiring new companies and divesting slower growth assets almost seamless.

Furthermore, its three operating segments each provide a piece of the puzzle to make things whole. The consumer health products division offers the slowest growth rate but some of the most predictable cash flow and pricing power. The medical devices unit has been bothered by a slower growth rate of late, but an expected increase in the senior population in the U.S. and abroad should expand its opportunity in hip, knee, and spine procedures in the decades to come. Finally, the pharmaceutical segment brings much of J&J's growth potential and gross margin to the table.

Johnson & Johnson's stock is up more than 10,000% since Jan. 1970 on account of these cohesive factors working together, and long-term investors certainly aren't complaining about those results.

However, Johnson & Johnson is also arguably riskier now as an investment than at any point over the last decade (or beyond). Let's have a closer look at the company's full-year earnings breakdown and I'll explain why.

Street sign suggesting risk ahead.

Image source: Getty Images.

Johnson & Johnson is becoming a riskier investment

For the full-year, J&J reported $71.9 billion in sales, a 3.9% increase on an operating basis when currency moves are excluded. That seems just fine on the surface, but dig a bit deeper and you'll notice something that could be, for some investors, a bit troubling.

Whereas J&J has historically had a pretty even distribution of revenue from its three core segments, pharmaceutical revenue totaled $33.5 billion of its $71.9 billion in 2016. In other words, pharmaceutical sales comprised 46.6% of Johnson & Johnson's revenue last year -- and this figure may only grow.

Last week, Johnson & Johnson announced that it was acquiring Swiss drug developer Actelion (NASDAQOTH: ALIOF) in a $30 billion deal. The acquisition allows J&J to get its hands on Actelion's product portfolio full of pulmonary arterial hypertension (PAH) drugs. Specifically, the deal brings Opsumit and Uptravi into J&J's portfolio. Both drugs have been touted as having peak sales potential of $2 billion per year. By the end of 2017, assuming the transaction closes, J&J's reliance on pharmaceutical sales could land anywhere between 47% and 49% of full-year sales.

Increasingly larger stacks of pills sitting on money.

Image source: Getty Images.

J&J's reliance on pharma is a double-edged sword

On one hand, pharmaceutical sales have been J&J's primary source of growth, margin, and pricing power for years. But, leaning so heavily on pharmaceuticals also comes with risks.

To begin with, branded drugs only have a finite period of patent protection. Eventually, all branded therapies lose their exclusivity and are potentially exposed to generic competition. Johnson & Johnson, along with other drugmakers, also has to be concerned with biosimilar competition now entering the fray. J&J's top-selling drug Remicade is currently facing competition from Inflectra, a biosimilar drug developed by Celltrion that's licensed and marketed by Pfizer at a 15% discount to Remicade's list price. This roughly $7 billion drug works out to nearly 10% of J&J's revenue by itself, and any adverse sales impact from biosimilars is going to hurt. 

Relying more heavily on pharma sales also exposes Johnson & Johnson to possible drug-pricing reform risks. J&J recently announced that it was going to proactively publish its drug price increases in mid-February to allow the public and regulators a better understanding of why it prices drugs the way it does. However, President Trump has also vowed to reduce the cost of prescription drugs in the U.S., meaning more of J&J's revenue stream is at risk if drug-pricing restrictions are somehow put in place.

Without a lot of innovation, J&J could struggle to keep its pharma growth engine going given the patent and pricing risks it could face.

The word "innovation" written on a chalkboard.

Image source: Pixabay.

Thankfully, innovation isn't a concern

The good news is that, for now at least, Johnson & Johnson has a long line of pharmaceutical innovations that can help stave off some of those aforementioned generic/biosimilar threats and pricing concerns.

In 2015, Johnson & Johnson announced plans to file new drug applications with the Food and Drug Administration for 10 new blockbusters (drugs capable of at least $1 billion in annual sales) by 2019. J&J has already brought multiple myeloma drug Darzalex to market, which could be on its way to topping $1 billion in sales by 2018. J&J's pipeline full of specialty therapeutics should allow it to counteract the effect of generic drugs and biosimilars.

Additionally, J&J has business development at its disposal. Johnson & Johnson is known to make acquisitions from time to time, though it typically favors smaller and midsized companies, as opposed to giants like Actelion. Adding approved products and pipeline innovation could help J&J stem its risks -- and it's easy to do with J&J regularly generating between $12 billion and $16 billion in annual free cash flow.

For now, it's probably not worth changing your investing thesis just because J&J is more reliant on pharmaceutical sales. However, it is worth keeping in the back of your mind that J&J's once-pristine operational diversity isn't so perfect anymore, which could leave it a little more exposed to drug-based risks than it has been at any point in the past decade or more.

Sean Williams has no position in any stocks mentioned. The Motley Fool recommends Johnson and Johnson. The Motley Fool has a disclosure policy.

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