Healthcare conglomerate Johnson & Johnson (NYSE:JNJ) is what you might call a staple holding in many investors' portfolios. Its superior 2.5% dividend yield and 55-year streak of raising its payout has attracted a cadre of income investors, while an array of value, income, and growth investors have bought into the Johnson & Johnson thesis on the basis of its operational diversity.
J&J, as it's more commonly known, is comprised of three operating segments, each of which serves a purpose. Pharmaceuticals, which is J&J's largest segment by revenue generation, provides rapid growth and high margins. Meanwhile, medical devices provides a long-tail growth opportunity amid an aging global population, and consumer health products delivers strong pricing power and predictable cash flow.
Because it's such a popular investment holding, a lot of investors will be keeping a close eye on what the company has to say when it reports its third-quarter earnings results tomorrow morning, Oct. 17. According to Wall Street's consensus, the company is expected to report about $19.3 billion in sales, an 8% increase from the prior-year period, as well as $1.80 in EPS, which would be a nice improvement over the $1.68 in adjusted EPS reported in Q3 2016. With Johnson & Johnson having topped Wall Street's EPS consensus in each quarter over the past three years, another beat is expected by investors.
But this quarter will be about much more than a headline sales and profit figure. There are a number of questions that long-term investors are going to want answered by management. Here are three most pertinent.
1. Is the Actelion acquisition paying dividends yet?
Arguably the most important question heading into the Q3 report is whether its Actelion acquisition is beginning to pay dividends. Johnson & Johnson completed the acquisition in June, giving shareholders just a taste of what was to come from the specialty lung disease drug developer at the tail-end of the second quarter. This will be the first full quarter of ownership for J&J, and shareholders are looking for a strong performance.
Johnson & Johnson has suggested that the Actelion acquisition should boost its long-term growth rate by 1.5% to 2% annually, with the stars of this portfolio being pulmonary arterial hypertension (PAH) drugs Opsumit and Uptravi.
However, J&J paid a pretty penny to get its hands on this line of PAH drugs -- $30 billion. Prior to the closing of the acquisition, the $30 billion represented a multiple of 15 over Actelion's annual sales, and perhaps a multiple of six times the peak annual sales of its PAH therapies. That's really expensive, and it could take years for J&J to recoup what it paid to acquire Actelion.
What's more, one of the top-selling drugs in this newly acquired portfolio, Tracleer, has begun facing generic competition. While Opsumit and Uptravi are expected to pick up the slack, it's still worth noting that J&J paid $30 billion for a company whose blockbuster drug should fade over the next couple of years due to generic entrants.
There aren't any signs yet that paying a hefty premium for Actelion was a smart move, so this report should help clear things up a bit.
2. What's wrong with Invokana, if anything?
Johnson & Johnson's success in recent years is a result of the company's strong pharmaceutical pipeline and partnerships. Between 2009 and mid-2014, J&J brought 14 novel drugs to market, of which half hit blockbuster status ($1 billion or more in annual sales). One of those highly successful drugs is SGLT-2 inhibitor Invokana, a treatment for type 2 diabetes.
Invokana was the first-approved SGLT-2 inhibitor in the U.S., and that first-to-market advantage has translated into leading market share in the SGLT-2 space. Unlike DPP-4 inhibitors, which are weight- and blood pressure-neutral, SGLT-2 inhibitors have been shown to lead to weight loss and lower systolic blood pressure. These are both welcome side effects given the propensity for diabetes patients to be overweight and hypertensive.
Until about two quarters ago, Invokana had been unstoppable. Of late, it's been a train wreck. Sales of the drug fell 26.4% in the U.S. in the second quarter, and they're lower by 22% through the first six months. If we see another double-digit percentage decline in sales, especially in the U.S., investors are going to want some answers.
The way I see it, Invokana is dealing with two issues. First, there are around a half-dozen SGLT-2 inhibitors now on the market, meaning more mouths to feed, so to speak. It's possible an increase in competition has been weighing on Invokana.
The other issue is that two long-term studies showed a greater likelihood of foot and leg amputations for Invokana users compared to a placebo. Though the risk of amputation is still relatively low, and J&J's Canvas studies demonstrated a successful lowering in the composite measure of cardiovascular risk, this warning could be the source of Invokana's struggles. Look for the company to shed more light on this situation during its Q3 report or conference call.
3. What's the immediate outlook on acquisitions?
Lastly, investors are going to be very intrigued to find out what the near-term outlook is for acquisitions following the $30 billion cash deal to acquire Actelion.
Johnson & Johnson has no issue generating cash flow, with $12 billion to $16 billion in annual free cash flow being somewhat common over the past five years. Still, $30 billion flowing out of its coffers all at once is bound to alter the way J&J looks at near-term acquisitions. You'll note that J&J only increased its dividend by 5% ($0.04) in 2017, which is its smallest percentage increase this decade. That's likely due to the fact that the company is trying to rebuild its cash balance to make a run at more acquisitions.
Historically, J&J tends to acquire small- and mid-cap companies, because it prefers to have a say in the research and development process. Acquisitions of Actelion's size are very much out of the norm. Look for management to offer its take on just how aggressive the company plans to be over the course of the next 12 to 24 months on the acquisition front.