Johnson & Johnson Ups The Dosage

Healthcare giant Johnson & Johnson (NYSE: JNJ  ) continues to prosper by virtue of its strong pharmaceutical business as the consumer and device business continue to languish. Not only does Johnson & Johnson offer a strong internal pipeline that can help maintain that momentum, the company has more than enough liquidity to acquire/license drugs if it should want to go that route. A real turnaround in devices appears to be a ways off, though, and these shares don't scream "bargain" in the meantime.

Good results, in brief
Johnson & Johnson reported better than expected results, with revenue up more than 9% as reported and closer to 10% on an organic basis. Gross margin was a tad soft (about 0.3% below expectations), but operating income rose 18% and exceeded expectations by about 10%, with a 200bp beat on operating margin driven by scant 2% growth in SG&A spending. 

Drugs lead the way...
Once again Johnson & Johnson saw its performance driven by the pharmaceutical business. Sales rose 21% and generated about 80% of the company's outperformance versus the average sell-side estimate. Remicade remains a key drug (about 20% of total drug sales) and continues to grow (up 8%), while newer drugs Olysio (up 135% qoq), Zytiga (up 42%), and Xarelto (up 91%) continue to generate strong growth.

Olysio has been enjoying a strong tailwind from demand for Gilead's Sovaldi and continues to beat expectations. Zytiga enjoys around one-third market share in castration-resistant prostate cancer , while Xarelto has staked out an impressive 60% share among novel anticoagulants.

... but devices still lag
Johnson & Johnson has had a hard time getting growth going again in the device space. This is in part a "market problem", but the company nevertheless came in a little weaker than expected. Sales were up 1% this quarter, led by Cardio (up 7%) as the company continues to enjoy the perks of market leadership in the growing catheter ablation market (electrophysiology sales were up 14%).

Orthopedic sales were up about 3% on an organic basis, with slightly better recon growth driven by solid hip and knee growth outside the U.S. (up 6% and 4%). U.S. results were less inspiring (up 4% and flat), and spine was a little disappointing. Johnson & Johnson outdid Biomet in hips (Biomet is being acquired by Zimmer, but the deal has not been cleared yet), but I'll be very interested to see how Stryker compares in knees, as Stryker has been doing quite well in hips but rather poorly in knees.

Vision was weak (down 3%) due in part to customers taking on inventory in the first quarter ahead of changes in taxes and prices. Diabetes remains weak (down 5%) as reimbursement continues to punish devices (testing strips and insulin pumps).

Surgical was surprisingly and disappointingly weak (down 1%), as management really didn't telegraph much weakness during their device analyst day in late May. Some of this weakness is due to declines in women's health (which has affected Covidien, Boston Scientific, and Bard as well to varying degrees). We won't know for sure until we see Covidien's results, but there may be some incremental share loss going on here as well, to the benefit of Covidien.

Olysio may not last, but Johnson & Johnson is committed to the pharmaceutical space
Olysio continues to surprise analysts, as this protease inhibitor is riding the coattails of Gilead's Sovaldi. While payers are reimbursing the $150,000 cost of the combo (albeit not without complaint), it will likely be difficult for Johnson & Johnson to maintain this momentum once Gilead launches its once-daily combo regimen later this year (not to mention the eventual launch of AbbVie's combo).

Outside of Olysio, the company still has a lot going on in the pipeline, including a 3-month formulation of Invega Sustenna, data on daratumumab (myeloma), sirkumab (rheumatoid arthritis), ARN-059 (prostate cancer), esketamine (depression), and guselkumab (psoriasis). Johnson & Johnson is also in a position to license or acquire as biotech valuations continue to decline, with oncology a probable target.

The bottom line
Johnson & Johnson is not strikingly cheap. A look at EV/revenue (a popular valuation methodology in med-tech) shows the stock trading at 3.75x expected 12-month revenue – a pretty healthy valuation. Though this company has a good pharmaceutical business (and a solid pipeline) and generates ample free cash flow, it's hard to work up a lot of enthusiasm about the valuation absent more momentum in the Consumer or Device businesses.

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Stephen D.

I'm an ex-Wall Street sell-side and buy-side analyst who has spent most of the last 10 years writing on a wide range of industries and investment ideas.

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9/4/2015 4:00 PM
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