If you're going to have a "messy" quarter, you probably couldn't do it much better than Johnson & Johnson (NYSE:JNJ) did in the first quarter. Devices and Consumer continue to log disappointing results, but the higher-margin Pharma business is more than making up the difference. Priced for total annual returns in the mid-to-high single digits, Johnson & Johnson isn't the cheapest health care play these days, but it remains a good all-weather pick with one of the best-growing large drug franchises.
Johnson & Johnson did pretty well on balance
Johnson & Johnson's quarter wasn't perfect all the way down the line, but investors are likely to forgive it given that the overall growth and margin performance was better than expected.
Revenue rose more than 5% on a constant currency basis, coming in just a bit better than expected. Pharma once again led the way with an impressive 12% revenue growth performance, exceeding expectations by more than 5%. Devices (MD&D) disappointed again, not missing by much but still only growing about 2%. Consumer also missed sell-side targets with a greater than half-point decline in sales.
The strong outperformance of the drug business led to better-than-expected margins. Gross margin improved by 1.6 percentage points. Better still, Johnson & Johnson underspent on operating expenses, leading to 14% operating income growth and a nearly 10% beat.
Pharma's beat may be harder to sustain
The "but" in the pharma beat this quarter is that a lot of it came from surprisingly strong sales of Olysio – the company's new hepatitis C drug. Sales of this drug in this one quarter exceeded many analysts' estimate for the entire year. While Olysio is part of an effective combo with Gilead's Sovaldi, the introduction later this year of Gilead's own single-pill combo is likely to limit further upside for Olysio and it is probable that this quarter included meaningful stocking orders.
On more positive notes, Zytiga continues to grow exceptionally well, with sales up 49% this quarter (and annualizing to over $2 billion/year). Stelara, too, continues to grow quite well with sales up 32% this quarter.
Disappointing results in devices
It may prove to be the case that the ACA ("Obamacare") and poor weather weighed on Johnson & Johnson's results this quarter, but the device business continues to struggle. Cardio was the bright spot with 7% growth and 15% growth at Biosense – suggesting share gains from St. Jude Medical (NYSE:STJ). With St. Jude reporting on Wednesday, investors won't have long to wait to see these two companies are faring in the battle for the rapidly growing a-fib market.
Surgical was up just 2%, with the company noting weakness in urology and women's health. This performance adds a bit of context to Intuitive Surgical's recent warning, arguing that it's not just concerns about device reliability, cost/benefit, and so on for surgical robots. Johnson & Johnson's results likely presage some weakness for Bard, but I do not believe that is necessarily true for Covidien (UNKNOWN:COV.DL) as well, where Covidien is likely continuing to gain share in energy devices and from a conversion from mechanical to minimally invasive techniques.
Orthopedics concerns me more, with sales up about 3%. Hip revenue rose 2% and knees rose 3%, both of which lagged Biomet's recent results (up 4% and 9%, respectively). I do not see why Biomet would be any less affected by weather or the ACA than Johnson & Johnson and I'm a little concerned that the company is going to get leapfrogged by Stryker and Zimmer in the short term.
A lot of options remain
Johnson & Johnson has a pretty solid drug pipeline, with promising candidates in immunology and oncology. The company does seem a little under-powered in oncology immunotherapy, but these are very early days. Given the sharp pullback in biotech recently, I do have to wonder if Johnson & Johnson might consider some selective shopping opportunities. Oncology would be a natural target and I wouldn't be shocked if the company considered some rare disease opportunities. I do also wonder about the long-term strategy in virology – the company's hepatitis C assets don't appear all that competitive to Gilead (which may well get 60% to 70% of the market in North America), and there are not a lot of obvious acquisition targets that would improve the situation.
I also believe the company could consider some options in the device space. It looks like the company is doing fine against St. Jude on its own, but adding to growth areas of orthopedics (extremities) could make sense. While there don't appear to be a large number of obvious targets that would help the surgical business, I would note that Stryker has made a series of deals that, taken together, could prove meaningful down the road.
The bottom line
To the extent that I have any problem with Johnson & Johnson, it's only that the company's device business needs more TLC and the stock's popularity doesn't leave a lot of obvious upside. On the basis of long-term revenue and FCF growth assumptions of 3% and 6%, I believe the shares are priced to return around 6% to 8% a year. That's not a bad return from a quality company.