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Johnson & Johnson's Earnings Were Solid, but Questions Remain

By Motley Fool Staff - Feb 1, 2018 at 3:48PM

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This Steady Eddy dividend stock may have some work to do.

A stable long-term track record of sales growth, profitability, and dividend increases has made Johnson & Johnson (JNJ 1.13%) one of America's most-owned companies. Can this big-cap biopharma continue its winning ways? This week, management detailed its latest financial results, and while the numbers were solid, there were some things in the report that every J&J investor ought to be aware of.

In this clip from the Motley Fool's Industry Focus: Healthcare, analyst Kristine Harjes is joined by healthcare investor Todd Campbell to discuss the company's latest results and outline what shareholders should be watching from here.

A full transcript follows the video.

This video was recorded on Jan. 24, 2018.

Kristine Harjes: We have been doing intern application interviews for the past week or so here at Fool HQ, so I'm going to intro our next segment with a quick story about one of the interviews, in which the candidate asked us, "How do we avoid clickbait?" And I was like, that's a good question, because you see so much clickbait out there on the Web, people posting these outlandish headlines, and then the article totally doesn't back it up. And immediately, when I heard this question, I believe I had this interview with the candidate yesterday afternoon, I immediately thought of the headlines surrounding Johnson & Johnson's earnings, which were just reported, and they had a very shocking headline, which is that Johnson & Johnson posted a quarterly loss of $10.7 billion. This is the healthcare stalwart, Johnson & Johnson, who hasn't posted a loss in any quarter in the 21st century. So that headline right there is just absolutely fascinating, but it's not actually as scandalous as it might appear, and we're going to dig into why.

Todd Campbell: Absolutely. We're talking about one-time items. You have GAAP reporting and non-GAAP accounting, and sometimes it makes sense to look at GAAP, and sometimes it makes sense to look at non-GAAP, and this is one of those situations where it makes sense to look at non-GAAP, to focus on the adjusted GAAP that get rid of these one-time items that aren't likely to happen again.

Harjes: Yeah. The vast majority of that loss was due to a $13.6 billion provisional charge for taxes on $66 billion of foreign earnings that are going to be brought back to the United States due to the recent tax code overhaul. If you exclude that tax charge and other one-time items, earnings were a positive $4.78 billion, or $1.74 per share. So that beat Wall Street expectations.

Campbell: Yeah, they ended up beating on the top and the bottom line -- $20.2 billion in sales versus $20.1 billion estimates, $1.74 per share versus $1.72 per share. I think, you looked at this and said, the stock is up pre-market, and then it opened up, and it finished down pretty substantially for a company of its size. I think I saw it down, at one point, close to 4%. I'm not sure exactly where it closed that day. Are you, Kristine?

Harjes: No, I'm not.

Campbell: It took a little bit on the chin, though. I think that was because people were digging into the numbers a little bit and slightly disappointed with a couple of takeaways on the performance.

Harjes: Yeah. So in order to evaluate Johnson & Johnson's performance in any given quarter, you have the three main business segments to think about: the pharmaceutical segment, which is almost always the most important one to evaluate; then there's also the consumer goods segment and the medical device segment. The pharma segment was up 17% year over year to $9.68 billion. That was mostly led by a 40% increase in sales of cancer drugs like Darzalex and Zytiga and Imbruvica.

But there are a lot of moving parts here, and there are also plenty of important drugs that lost volume in sales. Remicade, for example, that's one we've been keeping our eye on forever. It's an autoimmune blockbuster. It fell about 10% because of biosimilar competition. We knew this was coming, and management actually says that's less of a decrease than they were expecting. But it will probably accelerate in 2018. Another one, Invokana in diabetes, fell 29%. That one was pretty surprising for me, at least, due to competition from Jardiance.

Campbell: There's so much competition now in the diabetes space for Invokana. In December, yet another drug that works the same way got approved. This is a very crowded market. I think people looked at Invokana and said, oh, my God, down 29%, that's more than I was thinking it would be. They looked at the fact that Remicade sales sagged more than 10% year over year. You mentioned Imbruvica. Yes, sales grew pretty substantially, but if you actually look at what Wall Street was looking for, it actually came in below those estimates. Darzalex is probably the best bright spot among the whole bunch, with sales up 82% at $371 million. Analysts were only expecting about $347 million.

The other thing, you mentioned the clickbait-y headline stuff, there's so much stuff to dig into when it comes to Johnson & Johnson. And part of the problem for investors looking at just the headline numbers is, you have to remember they also did a massive acquisition of Actelion. And that has inflated what they're reporting as far as growth. You look at 15% operational growth from pharmaceuticals. Well, get rid of all the benefit from Actelion and currency and stuff, and 4.2% growth overall in the quarter across all of its businesses. So, you're talking about low single digits rather than, if you just looked at the headline number, something like 11.5% growth.

Harjes: Yeah, absolutely. Speaking of low single digits, the consumer health segment was only up about 3.1%, and the medical device segment, just to round us out with the third and final segment, was up 11.5%. They also provided a 2018 outlook, and they are expecting revenue of $80.6 billion to $81.4 billion. That would be operational growth of about 4%, or organic growth of around 2.5-3.5%.

Campbell: Yeah, and I think that was kind of disappointing to folks, too. It marks a slowdown in organic growth from where we saw in 2017. And it's really not that much better than what inflation theoretically could be. If you look at Johnson & Johnson's stock leading up into this, it was trading pretty richly compared to itself over time. If you look at, historically, the P/E range for that company, it was up at the upper band of that. So you were pricing the shares for perfection, and instead you got solid results with some question marks. And I don't think that was the perfect recipe for this thing to continue to put in new highs, at least on day one.

Harjes: One of the big question marks moving forward, and this was extremely evidenced in the Q&A section of the earnings call is, what are they going to do with this newfound cash? They have about $12 billion that's immediately accessible from the repatriation. The way that they answered this question was to reiterate that their strategy is pretty much the same. Their No. 1 priority is going to be research and development. After that, it's going to be to raise the dividend, like they've been doing for so many years. That's what makes them a Dividend Aristocrat and a very attractive stock for so many people. After that, then they'll look at M&A, but only the right company at the right price. And then, maybe, after that, some share repurchases.

But that's clearly way down the road. No. 1 for them is absolutely going to be more research and development, in particular in the United States. For a while now, they've been borrowing money to fund their R&D efforts in the U.S. because it was cheaper to do that than to pay tax on bringing the cash back. Now, they'll be able to both fund those operations better and, hopefully also pay some of that debt down.

Campbell: Yeah. If you look at their costs last quarter, they actually started to spend a little bit more than they normally do on R&D already. There is, though -- again, you look at it and say, that's exciting, that they're going to recommit that money to R&D. But as we know from being healthcare-focused on this show, R&D investment doesn't necessarily translate into growth any time soon. A lot of these drugs in R&D programs end up failing or end up missing the mark as far as what you might hope they may deliver. The thing I thought was interesting, too, is that if you go into the Q&A section of their transcript from their fourth quarter conference call, you kind of get the impression that, yeah, dividend hikes are on the table, but they also seem pretty confident a 50% return rate is pretty solid as far as the dividend goes. So maybe, the dividend increase that people were hoping for will be a little bit smaller when it finally happens. I suppose that could be maybe weighing down a little bit of enthusiasm, too.

Harjes: I think it's their job, in these answers, to temper expectations.

Campbell: Yeah, absolutely. Whenever you have a situation -- you don't want to be involved with biotech companies that pump and dump. [laughs] You want to have them underpromise and overdeliver, absolutely.

Harjes: Yeah, and that's what you get with a stalwart like Johnson & Johnson.

Campbell: I would agree with that. I think the big question marks, the things to watch in 2018 as we go forward is, what kind of things are getting closer to the market in the pipeline? What happens with drugs like Zytiga, which is their leading prostate cancer drug? Sales were up significantly last quarter, and I think they're clocking in around a $2.8 billion run rate, but there's some patent concerns there. The company addressed it on the conference call, and they said, our patent for administration use was invalidated, but we're appealing it, and if we win our appeal, that's going to protect Zytiga through 2027. But if they lose that appeal, then theoretically, Zytiga could start facing off against the competition by the end of 2018. So then you end up with Remicade already facing off against biosimilars, and Zytiga potentially facing off against generics in 2019. So, what's going to offset that, especially when you have very low-single-digit organic growth modeled?

Harjes: Well, could be an acquisition. We don't know. But, with Johnson & Johnson, there's so much going on with that company that there will always be high points and low points. It's the total opposite from a single drug clinical-stage biotech, where you know exactly the single catalyst that you're supposed to monitor. With J&J, the way that I see it is, this company has tailwinds at its back, it has a smart management team, it has ridiculous flexibility on its balance sheet, especially now that it has more access to its cash. Even with a couple of ups and downs and bumps in the road, I do see a very bright long-term future for Johnson & Johnson.

Campbell: It's hard to imagine that this company isn't going to remain a core holding for most income investors and most large-cap mutual funds for decades.

Harjes: Yeah. If you don't think you're a J&J shareholder, you probably are.

Campbell: [laughs] Yeah, absolutely.

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