Johnson & Johnson Can't Rely Just on Pharma

Health care giant Johnson & Johnson (NYSE: JNJ  ) recently delivered a mixed set of quarterly results that produced more questions than answers. It's hard to be too critical of a company that beats estimates and raises full-year guidance, but there are a few considerations to ponder.

Yet again, the stand-out performer in the quarter was its pharmaceutical division. However, the underlying performance in its consumer and medical devices and diagnostics divisions contained some warning signs. Moreover, whenever pharmaceutical stocks are analyzed the usual approach is to estimate the future value of its pipeline, rather than focus on current earnings. The market should do the same here.

Pharma (40.1% of sales) stands out
While it's pleasing to see an increase in revenues of $523 million (3.1%), the pharma division contributed $634 million of that figure. Ultimately, pharma offset a reduction of $141 million in medical devices and diagnostics revenues and a paltry $30 million gain from consumer products. In other words, the non-pharma divisions (60.5% of revenues) saw their revenues fall by $111 million on a combined basis.

The pharma division is rapidly expanding sales of some of its newer drugs like Stelara (psoriasis), Xarelto (anti-coagulant), Zytiga (castration-resistant prostate cancer), and Invega Sustenna (anti-psychotic). In fact, these drugs contributed $572 million of the $634 million in increased sales in the pharma segment.

Going forward, Johnson & Johnson has high hopes of developing sales of Invokana (type 2 diabetes) although it may face competition in future for its leading treatment Remicade (rheumatoid arthritis). Naturally, it will vigorously defend its Remicade patents, especially given that the therapy represents 24% of its pharma sales.

Consumer products (20.5% of sales)
Operational sales actually rose 2% (and 4% excluding divestitures), but currency effects reduced reported growth to just 0.8%. In addition, this is the year that Johnson & Johnson planned to reintroduce 75% of the consumer brands that were affected by product quality issues. Indeed, two of the affected brands, Tylenol and Motrin (painkillers), were cited as "positive contributors" in the quarter. While their contribution is an obvious plus, it suggests that the underlying performance within consumer products is weak.

There was even some discussion of consumers trading down to store brands. Frankly, this wouldn't be a surprise because the likes of CVS and Walgreen (NYSE: CVS  ) have been aggressively expanding their in-store brand sales. Moreover, the drug stores are likely to keep pushing generic versions of pharma companies' over-the-counter (OTC) and prescription drugs.

Ultimately, growth in the consumer segment will rely on emerging markets, as the U.S. mass market consumer remains challenged by a weak economy.

Medical devices & diagnostics (39.4% of sales)
Orthopedics make up a third of the division's revenues, and unfortunately they only grew 1.1% operationally in the quarter. Despite the long-term growth prospects coming from aging population, there is a note of caution going forward. On the conference call, the management cited pricing competition primarily in the trauma segment in the U.S. In addition, pricing in U.S. orthopedics remains an issue as pricing declines of 3%, 1.5% and 4% were declared for hips, knees and spine solutions, respectively.

Incidentally, this is pretty much in line with what Zimmer (NYSE: ZMH  ) said in its last results. Zimmer saw pricing down 1.3% in the second quarter. Knee pricing declined 1.4% with hip pricing down 2.1%. In a foretaste of what Johnson & Johnson would say, Zimmer had outlined on its conference call: "Competitive pressures, most notably in the United States, slowed our Trauma growth for the quarter, but were mitigated by the company's consistently strong performance in overseas markets."

The worry is that more intensive price competition will extend beyond the trauma market and increase pricing headwinds in the U.S. orthopedics market for all the leading players.

Elsewhere, its eye-care numbers were somewhat disappointing with US growth of only 1.9%, and international operational growth at 4.9%. Contact lens specialist Cooper Companies (NYSE: COO  ) sees the global lens market growing at 4%-6% this year, but for the second quarter running it recorded only 4% growth. Given that Johnson & Johnson' s overall operational growth was only 3.9%, it's reasonable to worry that Cooper's growth might continue at the low end of its targeted range.

The bottom line
The pharma division is firing on all cylinders, and looks set to continue in future quarters. However, there are some warning signs in the other divisions. It's unreasonable to expect all its divisions to be performing well at the same time, but the trend of pharma outperforming has been here for nearly a year now.Much depends on the future pipeline.

All told, the stock looks close to fair value. A forward P/E of around 16.6 times earnings isn't especially cheap for a stock forecast to grow earnings at 6%-7% rate over the next few years. The current dividend yield of 2.9% will attract income seekers, but otherwise the stock looks pretty fairly valued at $91.

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