Johnson & Johnson (NYSE:JNJ) is one of the biggest companies in the world, and certainly the biggest pharma on the market, with over 250 sub-companies making up its huge size. After releasing its first quarter financials, Johnson & Johnson saw its stock tumble by over 3%.

In this week's episode of Industry Focus: Healthcare, analyst Kristine Harjes is joined by Todd Campbell to discuss what went wrong (and right) for the company in the first quarter. Listen to this episode to find out what J&J's three sub-sections are and how much money they bring in, some of the most pressing concerns facing the company in the next few years, what J&J was probably thinking with its costly acquisition of Actelion last year, what kind of investor might want to buy into J&J and what kind of investor might want to pass.

A full transcript follows the video.

This video was recorded on April 19, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Kristine Harjes, and today I'll be talking healthcare with my usual partner in crime, Todd Campbell. Todd, how are you doing today?

Todd Campbell: I'm doing well. Kristine. You sound like you might have a little bit of cold.

Harjes: I know. I'm not really sure what this is. It is full-blown allergy season here in D.C., so I'm hoping it's allergies. Apologies to listeners, because I know I don't sound great.

Campbell: Hopefully you'll feel better soon.

Harjes: I hope so. Fingers crossed. Also, I apologize in advance if I end up coughing or something during this episode. I'm going to try really hard not to, I have my water next to me. We'll see how it goes.

Campbell: Excellent, all right.

Harjes: Today, we're talking about just one topic, which I feel like is kind of unusual for the Healthcare show. We usually like to pack a bunch of different things in. We're focusing on the largest pharmaceutical company in the world, which is Johnson & Johnson.

Campbell: This company is so big it almost feels like, even though we're covering one subject, we're really covering eight subjects.

Harjes: If we really want to make ourselves sound impressive, we're covering the 250-plus sub-companies in the Johnson & Johnson family of companies.

Campbell: Do they really have 250 sub-companies?

Harjes: Yeah, more than that.

Campbell: That's extraordinary. This is a company that's been around for an extremely long time. They have increased their dividend for 54 consecutive straight years. That tells you how long they've been in business, and how long they've been generating out returns that they can return back to shareholders. They just came out this past week and reported earnings for the first quarter. I think, by all measures, it was a solid quarter. It wasn't a stunner; it wasn't incredibly exciting. But that's not why investors are interested in Johnson & Johnson anyway.

Harjes: Exactly, there's a lot of stability with this company. As you mentioned, they've been around forever, since 1886. In that time, they've only had nine CEOs. So this is a very reliable company. It doesn't change quickly. It's pretty hard to make a boat that big pivot on a dime anyway. But they constantly, year in and year out, churn out pretty reliable results. Because of that, a lot of conservative, dividend-seeking investors are attracted to this stock, which, in general, has performed really well. When I was looking at earnings, I was actually a little surprised to see that the stock dropped about 3% yesterday in reaction to this earnings report. To me, there wasn't really a whole lot surprising in there. They're still on track for their own guidance that they laid out, and even though things weren't great, that was at least what I was expecting going in. This is a company that's struggling a little bit to reignite growth, but looking at it broad picture, I'm not terribly worried for the long term.

Campbell: Yeah, I think the biggest takeaway at the end of the day -- to get a little bit ahead of ourselves -- will be that there is some concern over pricing power and some of their big, top-selling drugs that may be weighing on some investors' minds. But again, you're talking about a company that's going to grow the top line 2%-4%, and the bottom line 4%-6%. If you're looking for a fast-growth company, you're going to go somewhere else. You're going to look at Celgene. But if you're looking for a steady-Eddy income producer, Johnson & Johnson is a staple, it's a core holding in many of the largest portfolios in America. I think, on balance, they reported $1.83 in earnings for the first quarter. That's very solid. It's 5.8% year over year -- that's pretty darn good.

Harjes: 7.5% when you look at it constant currency.

Campbell: Right, although I always get a little antsy about trying to X-out the effect of currency, because the reality is they are a global company and they will always be dealing with currency, sometimes headwinds, sometimes tailwinds. But yeah, from an operational perspective, it is helpful to know what's behind the growth or deceleration -- $1.83. I think the Street was looking for maybe $0.06 or $0.07 less than that, so it was a beat. There's a caveat out there. A lot of the beat, at least half of it came from a lower-than-expected tax rate. So investors shouldn't be looking at this and thinking it's an indication that this year, things are really clicking, and we're going to be able to deliver better than expected in each of the remaining quarters, because they are forecasting the tax rate will normalize over the course of the year -- $1.83 on sales of $17.8 billion. The sales were up 1.6% year over year. Again, you're not talking about a dynamo of growth, but this is a big, solid, steady-Eddy kind of company.

Harjes: Exactly. When we think about Johnson & Johnson as a healthcare company, I think it's easy to only think about it as a pharmaceutical company. But they actually are composed of three major segments. The first one is pharmaceutical. Let's go ahead and save that one for last, because it's probably the most important. The first two I think we should dive into are the consumer segments, and also the medical-device segment. The consumer segment, we'll start with that one. This is the segment of Johnson & Johnson that produces things like Band-Aid and Tylenol, the Johnson's baby products, all these brands that you see and know and hopefully love. This is generally a pretty stable, flat segment. It's not super high-growth or high-margin. Overall, it accounts for about 18% of total revenue. It looks like it is hitting a little bit of a hiccup, especially when you look at it as a global segment.

Campbell: Yeah. We saw the consumer segment deliver sales growth of 1% year over year, $3.2 billion in revenue. But if you back out acquisitions and stuff, sales didn't make any headway; they actually fell a little bit. The reason they cited for the weakness in consumer is that some companies were drawing down their inventory. If you're building up inventory, you're buying more than you need and sticking it in your warehouse. Maybe that happened in the fourth quarter, and now they're working through those inventories. That, theoretically, should be temporary. You mentioned Tylenol. Tylenol was a bright spot for them. Over-the-counter medicine or products, that's the biggest part of consumer, and sales there grew 1.4% year over year. That business is stable and solid. The acquisition tailwind they got was in beauty. That beauty market was fairly good for them. They saw sales rise 11.6% because of those acquisitions, but they also lost ground in oral, where they saw a 6% slide, and also about a 6% slide in the baby care products. Again, lots of puts and takes there. But like you said, the consumer is your cash cow, it's steady, it's not going to grow more than that plus-1, minus-1 kind of range. So I don't think there were any major real surprises there.

Harjes: I would agree with that. As usual, it's a mixed bag, like wound care was down 12%, and we're going to have some other segment like beauty that was up a bunch. Overall, though, this segment is extremely stable. They're consumer staples. Everybody knows Acuvue contact lenses. These are some of the biggest name brands there are.

Campbell: Yeah. I think investors have to realize, the consumer products are not going to be a huge source of revenue or earnings growth. It's just a steady business. Maybe there's more of an opportunity in their medical device unit, for example.

Harjes: Sure. Let's talk about that one. This one is 35% of total revenue, so, starting to be a little bit more important on a cash basis to this company.

Campbell: $6.3 billion in sales for the quarter, up 3% roughly year over year. You back out deals, and sales globally were up 1.7%, so, faster, a little bit better than consumer, larger percentage of the total overall pie. They have a lot of different businesses, part of the 250, that are operating under the medical-device umbrella. They have exposure to cardiovascular, diabetes, orthopedics. But not all of those businesses performed equally. You had some winners like cardiovascular, and you had some losers like diabetes.

Harjes: Right. This is a business segment that is very much managed by adding on small acquisitions and getting rid of low performers. It's definitely a very componentized part of the company. They had a couple of interesting acquisitions in the first quarter. For example, they bought the medical-optics subsection of [Abbott Labs], which closed on Feb. 27. This was called Abbott Medical Optics. That rounded out their eye-health offering, particularly within the surgery category of vision care. That vision-care segment was actually up the most of any segment within medical devices, and it now counts for about 13% of medical devices.

Another acquisition; I'll call out two more. The first one was Megadyne Medical Products, and the other one was Torax Medical. Basically, the way that I view this business here is that they're going to keep buying different products and companies that are profitable and can boost the places in which they already have a little bit of a footprint. When you look at Johnson & Johnson's size, they have so much distribution power, they have so many relationships with different providers of medical devices, that they're really able to take these smaller companies and leverage them and make them more valuable than they would have been as stand-alones.

Campbell: I think you make a very good point, Kristine, in that the way they're managing this company is very opportunistically. They're looking at it and saying, "Where have we delivered the growth in these particular areas, and can we sell those and take that money and buy something else that's bolt on, and kick-start growth and improve profitability that way?" They have, for example, some really good demand in cardiovascular thanks to some of their products that are used to treat atrial fibrillation. Treating a-fib through catheterization, that's basically what they're doing. It's complicated, but what they're doing is, if you have an irregular heartbeat, they'll put a catheter in to fix the part of the heart muscle that's setting off the wrong electrical signal. Anyway, more procedures are being done, and that's helping the cardiovascular side of the world.

They do have some question marks. The orthopedic part of their business is the biggest part of their medical-device sales. Hips, knees, spine. And there's been some pricing pressure there. It's a highly competitive market. It's tied a little bit to the whims and whispers of what's going on with the economy, because it does require a lot of out-of-pocket spending. So that business has some question marks. Also, there's some question marks associated with the diabetes franchise, where they make things like insulin pumps. They actually said in January that they're thinking of looking at strategic options for that business. Perhaps, by the end of the year, they make a decision about what to do with it, either they partner it or sell it off, or whatever. So there are some changes that are going to be going on over the course of the year, some things to watch within this basket. But again, an important part, and it is growing.

Harjes: If you look at overall trends, macro level, medical devices in general, you can probably expect they're going to do pretty well. As people get older, they live longer, they're going to need more of this type of surgery, for example, that this segment would address.

Campbell: Yeah, larger patient pool plays into pretty much all of Johnson & Johnson's product lines. You're talking about a 50-year megacycle. Longer living, larger global population, definitely plays into procedure volume, and that should be a net benefit or tailwind for the company.

Harjes: Exactly. The third and final segment of Johnson & Johnson, and the one that I think we would probably have the best time talking about, just because it's more along the lines of what we normally discuss, that would be the pharmaceutical segment, which is called Janssen. This one grew some 2% operationally in the first quarter. It is by far the most important part of this company. It's about 46% of total revenue. I can absolutely see it becoming over 50%, maybe even within the next year.

Campbell: Yeah, this is also a big driver of their profitability. Just by making changes in how they do manufacturing, and staying pretty tight-fisted when it comes to spending, and because of the way the mix broke out between biologics and small molecules. Biologics are usually a little bit more margin-friendly. They were able to boost margins in their pharmaceutical units by 4%, 400 basis points. That's pretty extraordinary, and pretty good. Top line, like you said, on a reported basis, the growth really wasn't that great. It was up 1%. Domestic sales were down slightly. International sales were up. There were some puts and some takes here as well. Some very strong-performing drugs, and some drugs, maybe, that investors should be keeping an eye on to see whether or not they find some footing, or see whether or not sales continue to decline.

Harjes: One drug I know we've called out a bunch in the past is Remicade, which is one of their key drugs. It's an anti-inflammatory. This is a drug that everybody has been watching because of the threat of biosimilar competition. Quick reminder: Biosimilars are basically generic versions of very complicated drugs that you can't make what would technically be called a generic for. [Merck & Co.] is partnered on this drug. When you look abroad, you see this biosimilar called Inflectra being priced at about a 15% discount to Remicade. It's a little bit concerning as an investor to think, is this going to start affecting Remicade sales in the United States as well?

Campbell: Yeah, Remicade is huge. We're talking about almost $1.7 billion just from this one drug alone last quarter.

Harjes: Yeah, this one is super-important. But it looks like maybe we don't quite have to worry about that as much, at least not yet. Management has commented that they're not seeing much impact from a Remicade biosimilar just yet.

Campbell: I think we can probably kill a whole episode talking about Remicade and the whole movement toward biosimilars. In Europe and overseas, they have a much more established biosimilar market. As a result, Remicade export volume from Johnson & Johnson is falling much more quickly than the threat is here in the United States, where it's just basically an emerging market for these biosimilars.

So overall, Remicade sales fell 6%, as I mentioned, to $1.67 billion. U.S. sales were down 2.4% to $1.18 billion, and that was following the launch of Inflectra -- this was the first full quarter of it, Q1. And I think what people have to say is, "Why were sales down if they say they don't see much of an impact?" What they were saying was, "We don't see much of an impact in prescription volume and market share." But they did say they are seeing an impact in pricing. My view is they said, "You launch that biosimilar with only a 15% discount. Guess what? This is a margin friendly drug for us; we can match that price. So, we're going to maintain our market share until you get to a point where we don't want to match it anymore."

So that might be a very big struggle for biosimilar manufacturers in the United States, where you have these very high-priced drugs, theoretically, a lot of room for the manufacturer to be able to compete more aggressively with the biosimilars when they first roll out.

Harjes: Right, especially when you consider that a doctor looking at your original drug versus the biosimilar version, I think there's a healthy amount of skepticism there among a lot of prescribers in that they'll be hesitant to switch patients, or even start new patients, on the biosimilar when they're used to the original brand-name drug.

Campbell: Yeah, it's going to come down to cost, whether or not the payers make them.

Harjes: Yeah, if the pricing is minimal, I don't see payers pushing for that, I don't see doctors pushing for it. But as you mentioned, it's a pretty nascent market.

Campbell: Yeah, and I feel like, when you look back at the regular generic market, as it started to grow in the '90s, there was a lot of hesitancy about that. Of course, now, we all know that the majority of prescriptions written are for generics. So I think there's a tremendous opportunity here. Remicade is going to face headwinds for a long time. It's just that maybe the headwinds aren't as strong initially as was feared. That's something to keep in mind. On the plus side, they did have some standout drugs. Darzalex for use in multiple myeloma is now on a $1 billion blockbuster pace after winning approval at the end of 2016 for use in the second-line setting. Imbruvica, which is a drug that they share with AbbVie, is also growing very strong. Their share of that was $409 million, up 57% in the quarter year over year.

Harjes: Right. One other standout to me in the pharmaceutical segment, something to keep an eye on, is this acquisition of Actelion, which was a company that Johnson & Johnson purchased for $30 billion. If that sounds like a lot, it is. They originally offered $26 billion, and Actelion said no. They tried $27 billion; still got a no. At one point, Sanofi was in there trying to negotiate and buy Actelion; they failed. Johnson & Johnson eventually nabs up this maker of very specific lung-disease drugs. I'm just going to go with the acronym -- PAH is the indication for the drugs that they make. They also have a couple of potential blockbusters. They have a pipeline, but interestingly, in this acquisition, the R&D unit is going to be spun off and traded independently on the Swiss stock market. Johnson & Johnson will only own 16% of that company, and they'll have the rights to buying another 16%.

But I think this deal has been met with a lot of skepticism because of the price tag and this decision where you're not really going to get as much of the upside from the pipeline that this company has. So a lot of question marks surrounding that. This was one of the very first things that was addressed during the conference call this quarter, because they're expecting the deal to close by the end of Q2. They actually updated their guidance for the year to reflect bringing Actelion in. It looks like the expected boost to revenue will be $1.3 billion this year. I'll remind you, this was for a $30 billion acquisition.

Campbell: It's an absolutely massive deal, and they paid through the nose for it. But you have to look at it from Johnson & Johnson's perspective. They have a ton of cash locked overseas that they can't bring back to the U.S. without having to be taxed on it. 

Harjes: Yeah, barring some potential theoretical tax holiday, which has been discussed, but of course, there's no guarantees there.

Campbell: Right. So, you look at it and say, "I have a chance to buy a company, Actelion, with the cash that I have locked up overseas, in a cash deal, so, not taking on debt. The cost is very low to me to do that. So I'm buying a company that not only has drugs that are on the market that are leaders in their space that are racking up a blockbuster number for me, but they're profitable." These are profitable drugs. Actelion was making money. So they're looking at this and saying, "We can do this deal at this price and still see a tailwind to our earnings in the first full year after completion of $0.35," we'll call it, somewhere in the $0.30-$0.40 range. So, 2018, we get that nice little tailwind, despite the actual cost. So it's an expensive deal, but it's still a profit-friendly deal for them.

And the argument is, across some of these large companies, if you don't have growth, if you're a big, huge company -- we talked about this a lot with [Gilead Sciences], too, and Pfizer is another one -- you have to deploy that money to buy some growth. And that's what they did. I don't fault them for that. It could end up being a win, especially if their stake in that spin off pays off over time.

Harjes: Yeah, if Gilead Sciences is any indication, the market does not like companies that just sit on cash. I personally think that's a rather short-term way of looking at it, but, we'll see if this Actelion deal pays off.

Campbell: Well, the return on cash isn't very high, though, is it, Kristine? So, you have to look at it, from a shareholder perspective, are you doing what's going to get shareholders the biggest return with the money that you're not giving me in the form of dividends or buybacks?

Harjes: Yeah, I think the tax point you make with Actelion is very spot-on. This is a company that's headquartered in Switzerland. They've already paid the foreign taxes on that money, so now they don't need to pay the repatriation taxes on $30 billion, which is substantial. Anyway, you mentioned the dividend, and that is definitely the next thing I want to talk about, because that is one huge reason why people buy this stock. Right now, they're paying out a payout ratio of about 2.5%. They are a dividend aristocrat. They have been increasing their dividend for 54 or 55 years. It's a pretty incredible amount. They're probably going to raise it again in the next two weeks, probably in the high-single-digit range, boost to this payout that they've been paying their shareholders year in and year out for a long time.

Campbell: Yeah, their payout ratio is only 53%. A few years ago, it was 70%. So they have room and flexibility, and they have plenty of cash flow coming in. This is one of those companies, to go back and come full circle on the conversation, if you're looking for growth, you're probably not going to be excited by this company. But if you're looking for a company that will be a steady-Eddy performer and give you a nice dividend every year, then yes, this is a core holding. It's not necessarily a cheap dividend stock. If you look historically over the past 10 years, it's trading at the higher end of its trailing P/E, not the lower end. But at the same time, when you talk about a company like J&J, you're not really talking about timing it based on valuation.

Harjes: Yeah, exactly, it's typically always traded for a premium. By the way, thank you for correcting me earlier -- I said payout ratio of 2.5%. I meant dividend yield. Payout ratio, as you noted, is in the mid-50s, and that's on both an earnings basis and a cash flow basis. But yeah, as we've said, probably a million times already in this episode, it's a reliable company. It's one of just two companies to have a triple-A rating from Standard & Poor's -- that's better than the U.S. government. They still have a ton of cash on the balance sheet. They have some debt, but again, "AAA"-rated balance sheet -- this is a strong company. Nothing to worry about here.

Campbell: I'm going to caveat that a little bit, Kristine, to wrap up here. There are some things that investors are going to want to watch. I have faith that Johnson & Johnson can navigate these struggles, but Remicade is still a question mark, because it accounts for a large percentage of their sales. You're going to have to watch and see how that plays out in script trends over the course of the next year. I also saw a drop-off in revenue for Zytiga, which is an important prostate-cancer drug, and Xarelto, which is an important anticoagulant. So we're going to want to watch those trends, too. Those are $2 billion-a-year-sales drugs, and we want to know whether or not they're going to find footing, or if competition is going to continue to put those sales at risk. So there are some things that investors will want to watch. But generally speaking, yeah.

Harjes: Yeah, I agree. It's not all sunshine and rainbows. But personally, I'm a shareholder. I am happy to be a shareholder. I would be happy to buy more at prices today if I had room in my portfolio for that, but it's not the right decision for me to overload even more in healthcare right now. But honestly, I think I will be holding this company for a very long time. And when I'm getting toward retirement and I look back and say, "I bought this company in my early 20s," I think I'll be OK with that decision.

Campbell: Yeah, it's kind of one of those stocks where you look at each sector and say -- it's like owning [ExxonMobil] if you're investing in energy stocks.

Harjes: Yeah, it's a classic. So hopefully this episode has helped our listeners sink their teeth a little bit more into earnings and in general what goes on with this Goliath of a company. Todd, thanks so much for dissecting it with me today!

Campbell: Happy to be here!

Harjes: As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and bearing with my voice today, and Fool on!

Kristine Harjes owns shares of Gilead Sciences and Johnson & Johnson. Todd Campbell owns shares of Celgene, Gilead Sciences, and Pfizer. The Motley Fool owns shares of and recommends Celgene, Gilead Sciences, and Johnson & Johnson. The Motley Fool owns shares of ExxonMobil and has the following options: short June 2017 $70 calls on Gilead Sciences. The Motley Fool has a disclosure policy.