Johnson & Johnson Still Driven By Drugs

As another solid quarter goes into the books, Johnson & Johnson (NYSE: JNJ  ) continues to be a med-tech story driven largely by the success of its drug platform. Given the growth potential of the company's platform in immunology, oncology, virology, and metabolic disease, that's not likely to change anytime soon.

Competition may not be the biggest issue for Johnson & Johnson today. While companies like Stryker (NYSE: SYK  ) and Covidien (NYSE: COV  ) are formidable in their own right, and drug companies like AstraZeneca won't just cede markets to the company, the bigger challenge for JNJ may be living up to Wall Street's enthusiasm for the company and meeting some pretty ambitious margin and free cash flow growth targets.

A Good Top Line, But Margins Disappoint
Johnson & Johnson came through on sales for this quarter, as revenue rose 5% to over $18 billion. That was good for a 2% beat relative to the average of sell-side estimates, and the underlying organic growth rate of 6% is likely to hold up well to other large health care companies this quarter.

Growth continues to be driven by the pharmaceutical business, where sales rose 12% as reported or 13% in constant currency. JNJ's immunology platform continues to be an underappreciated source of growth, with revenue climbing 22%, as oncology also had a strong 36% year-on-year increase. Device performance was far less impressive, as reported sales declined 1% and currency-adjusted sales climbed less than 2%. Consumer continues to rebound, with 3% reported growth and adjusted growth of better than 5%.

Johnson & Johnson underwhelmed on margins. Gross margin was basically flat with the year-ago level (on an adjusted basis), missing the target by about one point. The company likewise spent more on SG&A (as a percentage of sales), leading to a 6% miss on operating income and adjusted growth in the low single digits.

Ortho And Surgical Still Mixed
Based on the numbers reported by Biomet and JNJ, Stryker and Zimmer aren't going to have many excuses if their hip and knee numbers don't look solid this quarter. While the hip and knee markets seem to be turning around, particularly in the U.S., JNJ's spine business remains soft and I would expect Stryker to see some benefit from this (particularly given NuVasive's stronger than expected quarter). While it's still much to early for Stryker's acquisition of MAKO to be a market share mover, a healthier hip and knee market in the U.S. should still be constructive for the more missionary effort of pushing the RIO system.

I'm definitely curious now to see how Covidien's surgical business fared this quarter. JNJ's results were mixed, with Surgical down 2% (but up 7% sequentially) and Specialty Surgery up 4% (and up 9% sequentially), and Covidien has been seeing slower growth of late. For both JNJ and Covidien, a major driver in these businesses is the ongoing penetration of minimally invasive surgery, particularly in overseas markets where penetration still notably lags the U.S.

Drugs Likely To Be The Driver For Some Time To Come
Johnson & Johnson not only has the ongoing growth of its established drug portfolio to benefit sales, but also the ongoing growth of newer compounds like Zytiga, Xarelto, Invokana, and Imbruvica. Invokana is going to see competition from Astra's Farxiga (as well as several other SGLT-2 drugs in development), but JNJ has a decent shot of getting to $2 billion with this drug. Imbruvica has done nothing but impress in clinical trials so far, and while I wouldn't say that JNJ is going to dominate the hepatitis C space, they may fare better than expected as a number two/three player in the market.

With so many potential billion-dollar drugs relatively early in their marketing lives, I believe JNJ can look forward to a long stretch of good growth from its drug business. I also expect the company to continue reinvesting as necessary, whether through licensing agreements or acquisitions, as the returns in the pharmaceutical business favor more investment relative to the device business.

The Bottom Line
Sell-side analysts have gotten rather bold with their margin and free cash flow targets for JNJ over the next three to five years. That gives me some cause for concern that JNJ could do well operationally, but still struggle to meet or exceed overheated expectations – to that end, I find it interesting that more than one sell-side analyst has come out after the earnings call basically dismissing management's guidance as too conservative.

I'm bullish on JNJ, but my expectations are more modest. I believe that long-term free cash flow growth in the neighborhood of 6% to 7% can support a price target in the mid-$90s and double-digit total returns, but I would be careful about buying into the bullish projections for what is a very large and mature med-tech company.

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