I continue to be impressed with the strength Johnson & Johnson has been showing of late. The only fly in the ointment is that it's not a particularly well-balanced strength, as the company's drug business is really driving the improvements. As ointment-flies go, though, that's really not so bad and the company continues to see respectable performance in key categories like cardiology, orthopedics, and surgery. Johnson & Johnson isn't particularly undervalued today, but investors should nevertheless be able to expect high single-digit to low double-digit returns from this point, which is pretty compelling for investors looking for a quality long-term holding.
Strong Pharmaceuticals Lead The Way ... Again
JNJ has been leveraging its strong drug business for some time now, and this quarter was no exception. Overall company revenue rose around 6% on an adjusted organic constant-currency basis, with the drug business growing around 11% and coming in comfortably ahead of expectations. Consumer revenue was pretty on much on target (growing about 2%), while devices were slightly disappointing with sub -1% operational growth.
Within the drug business, the company's immunology franchise continues to grow nicely (up more than 13%), while the blockbuster cancer drug Zytiga continues to live up to the "blockbuster" label with 73% year-on-year growth. Diabetes drug Invokana is coming along nicely, and Xarelto is showing strong sequential growth. With 30% sequential growth in Xarelto, I think JNJ has a good shot at taking significant share in the anticoagulant space, to the chagrin of Pfizer and Bristol-Myers Squibb (Eliquis) and Boehringer Ingelheim (Pradaxa).
Devices Still Muddling Through
Analysts weren't expecting a major turnaround in JNJ's device business in just one quarter, but another disappointing quarter does highlight the ongoing challenges JNJ is facing in this business. Solid results in surgery (general surgery up more than 1%, specialty surgery up almost 7%) likely bode well for both Covidien and Bard, though I do believe JNJ may be gaining some share in this area.
Orthopaedics also did reasonably well, with roughly 1% operational growth. JNJ was a little weak relative to Biomet in recon (hips/knees), and the two companies' results support the idea that recon is back on a growth trajectory.
On a more negative note, diagnostics and diabetes remain under significant pressure. The 8% decline in diagnostics was technically disappointing, but this unit has been disappointing for so long now that it's hard to call it a surprise. Likewise, while the 11% decline in diabetes was not a major surprise, it does underline the ongoing reimbursement pressures in the diabetes testing space.
Likely To Keep On Keeping On
I don't think it's fair to say that JNJ is a company that is scared to do big things. The acquisition of Synthes was a major move, as will be the expected sale of the diagnostics business. That said, I think the company is more likely to remain focused on incremental steps toward improving its operating results.
JNJ isn't likely to make a big splash into robotics, but the company is committed to maximizing its relatively new knee platform and highlighted a new fixation and energy device at the recent American College of Surgeons meeting that should keep things interesting for Covidien and Bard. Likewise, the acquisition of Aragon Pharmaceuticals and breakthrough designations for daratumumab and ibrutinib show that the company is not resting on its laurels in the drug business.
The Bottom Line
Johnson & Johnson isn't particularly undervalued today. I expect the company to grow its revenue at a long-term rate of between 3% and 4%, while ongoing improvements in operating margin and free cash flow conversion could lead to about 3% more growth in free cash flow.
Discounting that back suggests a fair value of around $89, but keep in mind that "fair value" in this case still implies high single-digit or low double-digit returns (including the dividend yield) over the long-term. Although I prefer stocks that are trading at least 20% below their fair value, in the case of a company like JNJ I'd say it's still a decent candidate for investors looking to establish long-term positions in a health care name.
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