Despite reporting significant quarterly and yearly losses in their earnings call earlier this week, Johnson & Johnson's (NYSE:JNJ) shares are rallying, and their reported growth expectations are high.

In this week's Industry Focus: Healthcare, Kristine Harjes and Todd Campbell go over the highlights of J&J's call, why their sales are so down, what trouble may be looming on the horizon, what plans Johnson & Johnson has up their sleeve, and how long-term investors should be looking at the company in light of all this news.

A full transcript follows the video.

 

This podcast was recorded on Jan. 27, 2016.

Kristine Harjes: Currency woes are nothing more than spilled milk, Johnson & Johnson reports earnings on this episode of Industry Focus.

Welcome to Industry Focus: Healthcare! I'm your host, Kristine Harjes. I'm joined via Skype, as usual, by Motley Fool healthcare contributor, Todd Campbell. Today, we're going to talk about Johnson & Johnson's earnings, and definitely not cry over said spilled milk. 

So, Johnson & Johnson, a really important company to talk about. They usually set the tone for the earnings season, especially in the healthcare sector. It's a humongous company, $280 billion in market cap, well known as being a dividend-paying stock, they're one of just three triple-A rated publicly-traded U.S. companies. Really big deal.

So, they report earnings, the stock goes up about 4%. This was on Tuesday, when they finally came out with the information. And what should we be focusing on?

Todd Campbell: As you said, Johnson & Johnson kicks off the flood ... or maybe, I shouldn't say the blizzard, given what you guys endured down in the Washington this past week in terms of snow. We'll call it "The Blizzard of EPS Reports" for the 4th quarter and full year of 2015. And investors may be looking at it and saying, "Okay, I'm looking at the headline numbers, and sales in the quarter of $17.8 billion, down 2.4%, full year sales of $70 billion down 5.7% ... " That doesn't sound that great, so why would shares be rallying?

Harjes: Yeah, and as alluded to earlier in the episode, a huge, huge part of this was currency. Johnson & Johnson lost 7.5% of growth in 2015, meaning that their full year sales actually fell by 5.7%, but should have been in the green. So, this is just the price of being a multi-national conglomerate.

Campbell: Yeah, there are two major things that impacted results. Granted, there are going to be some caveats you and I will chat about a little bit more for investors. You can't just pick and choose what you want to include. But if you look at an apples-to-apples comparison for Johnson & Johnson over the last couple years, and say, if I'm just interested in how the company is doing operationally, how is management executing, then maybe I don't want to focus so much on one-time events, say, acquisitions and divestitures, and maybe I don't want to focus too much on currency, because as a multi-national, that's par for the course. And maybe -- and this one's more of a stretch -- I don't want to focus so much on the one-time benefit of a drug that turns out to be a flash in the pan.

Harjes: Now, that last one that you mentioned, I thought that was one of the most interesting points on this call. I don't know if you've ever seen this before, I've never seen something like this before. Essentially, what happens is, Johnson & Johnson's hepatitis C drug OLYSIO just gets absolutely crushed. And they knew what was going to happen, they'd been sign-posting it. But they essentially tuck in hepatitis C revenue right in there with your 'net of' items, which are usually just going to be divestments and acquisitions. But a couple of times in this call, they're listing, "Oh, if you ignore divestments, acquisitions, and also hepatitis C ... " And I'm just sitting there like, "What? Is that cheating? Can you do that?"

Campbell: I think it would definitely be cheating if they said, "Ignore the benefit for this year, but embrace the benefit you had in 2014 from it." Yeah. Let's go on the way-back machine for the moment and explain to the listeners what we're talking about. In late 2013, two companies were in a major horse race to reinvent patient care in hepatitis C. Those two companies were Johnson & Johnson, which was developing OLYSIO, and Gilead Sciences (NASDAQ:GILD), which was developing SOVALDI. OLYSIO won FDA approval, I believe, in November of '13, and SOVALDI won it in December of '13. 

However, despite both of them being good drugs, SOVALDI ended up being the dominant drug, winning most of the market share, because, frankly, it performed better overall than OLYSIO. That being said, doctors did discover that if they took OLYSIO and combined it with SOVALDI, it worked really well in patients that had tough-to-treat hepatitis C. So, sales of OLYSIO ended up coming in in 2014 at about $2.3 billion, which was ... I don't want to call it a bonus, but it certainly wasn't all that expected that they would do that well in 2014. In 2015, those sales fell off a cliff, if you will. It was still a solid $621 million, I think. But they fell off a cliff from the $2.3 billion. So you lost a lot in sales. And the reason for that was in October, HARVONI had won approval for use in genotype 1, and HARVONI was a better option, single-tablet, less costly than trying to use the combination of OLYSIO and SOVALDI. So as a result, it became a niche-status drug. 

So, Johnson is trying to say, "Listen, that was a one-time event on the drug front. OLYSIO sales surged, then they fall. So maybe, just, don't count that when you're looking at our performance."

Harjes: It kind of makes sense. They've got this gigantic pharmaceutical subsection of the business, and they knew that this was exactly what was going to happen, and they didn't want to say, "Look at how much our pharmaceutical unit is tanking," because that's not really the case. What are some of the growth drivers here that stood out to you in the pharmaceutical unit?

Campbell: Well, investors should remember that Johnson & Johnson has three major segments. It does a lot of business in pharmaceuticals, obviously, it also does a pretty good amount of business in medical devices, and it also has a $13 billion or so a year business in consumer goods, where it sells brands like a Band-Aid and Listerine.

Harjes: Of course, that's why most people know the Johnson & Johnson name.

Campbell: Exactly. The reason that people may want to not think too much about OLYSIO, and think instead about the other drugs that Johnson & Johnson has going on, in the success they're having with these other drugs, one of my favorites of all of those drugs has got to be INVOKANA. It's a type 2 diabetes drug, it's an SGLT2 drug, which simply means that it works very differently by helping to prevent how much glucose gets reabsorbed, and therefore, it allows more to get excreted by the patient. That drug has taken off like Gang Busters.

Sales more than doubled in the past year to $1.3 billion. It's also got some other really intriguing drugs are doing well: IMBRUVICA, which is an oncology drug that they're partnering up with AbbVie on, that's now over $1 billion a year drug globally. Their share of that rose from $200 million to over $600 million last year. It's also got a drug for psoriasis called STELARA, which is dosed much less frequently than their top-selling REMICADE and other anti-TNF drugs that are used in autoimmune disease drugs. That drug saw its sales jump significantly to $2.4 – $2.5 billion last year. So, there's a lot of drugs that are doing very well for the company that investors may want to focus on instead of OLYSIO, which is basically going to continue to see its sales decline and decline, as other hepatitis C drugs come to market.

Harjes: One thing I'll add on: REMICADE has been the pivotal focus of the discussion on biosimilars, and whether or not that threat will become apparent to Johnson & Johnson. As a reminder, biosimilars are essentially generic versions of biologic drugs. So, they're a lot harder to make, they're not going to sell for as much of a discount, and they're pretty new, so we're still figuring out what exactly it means for some of these gigantic healthcare companies to face competition from newly-introduced biosimilars. Interestingly, apparently, in Canada, where there is a biosimilar out for REMICADE, they're still growing REMICADE sales. So, that's a pretty promising sign. But, of course, it's something that people are questioning in the U.S., especially as, apparently, the drug is already losing market share, which I can only assume is due to some of the other drugs in this pretty competitive space.

Campbell: Yeah, the anti-TNF market is competitive. It's also one of the best-selling markets in the world. You've got HUMIRA, which is an AbbVie drug that hauls in $14 billion a year; you've got REMICADE, which hauls in $6.8 billion-ish a year for Johnson & Johnson. And you're right, this is a major focus of biosimilar makers, because the patent on REMICADE has expired in the E.U., so you're now facing off against biosimilars in those markets that are made by companies including Hospira, which is owned by Pfizer now. And, as we go forward, investors can't ignore that 9% of Johnson & Johnson's revenue comes from REMICADE. If the U.S. patent is going to expire in 2018, what's Johnson & Johnson going to do over the next two years to make sure they don't end up losing the $4 billion or $5 billion in sales that they're collecting in the U.S. off of that drug?

Harjes: Yeah, and the tone of the call didn't really seem too concerned with it. They said, "Yeah, we're going to keep defending our patent until September 2018, and even beyond that. We don't see it as a huge threat." So, that will be for sure something to keep an eye on. But, again, years out.

In more recent news, even before they announced earnings, there was some talk of a medical device unit restructuring, and this came out ... actually, on my birthday, on January 19th. Not too long ago. This is, again, one of the pretty important three units that Johnson & Johnson has. And there's going to be a huge shake-up within it.

Campbell: If you adjust out all of the items ... currency drag, and all the other impacts that weighed down on results last year on a reported basis, medical devices still lost ground. It was the one segment that didn't do very well. That's concerning, obviously, to some, because you look at it, and there's 10,000 seniors turning 65 every day, and those seniors are going to require more hip replacements, more knee replacements, more joint surgeries. A lot of different device sales will be tied to the aging of America.

So, the company is recognizing that, and they're doing a number of different things. They're restructuring in order to come up with some cost savings, they're also doing something that's kind of interesting. They're trying to work more closely between their different segments. For example, to tie in pharmaceuticals more with medical devices. So, they're working in concert with one another to develop next-generation products, rather than working as independent.

Harjes: Which sounds like a good idea. Build those synergies and whatnot. Along with the restructuring of this whole unit, there's going to be a lot of cost-cutting. Apparently 4-6% of the workforce is going to be cut. I was actually talking to my mom on the phone last night, and she's not a huge investing follower, she listens to the podcast every once in a while, but she mentioned this to me. She was like, "Oh, what are you talking about tomorrow on the show?" I was like, "Oh, we're going to cover Johnson & Johnson earnings." And she was like, "Oh man, they're cutting 3,000 jobs!" I was like, "How did you know that?" But it's because Johnson & Johnson's a New Jersey company, that's where I'm from, that's where she lives. So, that's a big deal for a lot of people right there. You look at it from a personal standpoint, it's like, that's not good ... But from Johnson & Johnson's perspective, and from the perspective of an investor, it's supposed to save $800 million to $1 billion over the next two years.

Campbell: Yeah, and that's important, because Johnson & Johnson is forecasting that their growth over the course of the next five years is going to be greater than industry growth. So, healthcare industry is expected to grow 3-5%, they want to grow organically more than that, and they want to grow their EPS more than they're growing their organic growth. Obviously, if you want to do that, you're going to have to cut some of the costs, and make those divisions more profitable. Obviously, this is one of the ways they're doing it. Of course, that creates a whole another problem, because it means more money flowing onto their balance sheet, a balance sheet that's already pretty bloated.

Harjes: Yeah, you totally opened a can of worms there that I definitely want to dig into. We've been thinking about Johnson & Johnson's merger and acquisition, M&A activity, for a long time, because as you mentioned, they're sitting on this inflated balance sheet. They've got $18.5 billion in net cash, which means $38.5 billion in cash and marketable securities, and $20 billion of debt. They didn't act in 2015, citing that everything is too over-valued. But clearly, companies have gotten a lot cheaper at this point.

Campbell: Yeah. They're going to be selective, though. If you listen to the conference call, and I advise you to. I think every investor should try to tune in to the conference call. At least, read the transcript, scroll through it. CFO Caruso had a couple interesting things to say on that conference call about this cash stockpile. One of the things he said was, it's a higher level of cash than they typically hold. But he also went on to say that they're going to act, they will act, but they'll only act when they see the right value in the right deal at the right price with the right partner.

So, there's a lot of caveats that are going to be associated with any deals they do. And you and I talked last week or the week before about how J&J has indicated that I have a preference towards smaller bolt-on acquisitions. That's probably where they're likely to focus, especially if they can get teams that fit that mantra, if you will. The right price, the right people.

Harjes: Yeah. And I'll quote Alex Gorsky, the CEO, here: "Smaller tuck-ins are frankly more straightforward to get done." So, that's showing your hand right there. Although, immediately after he says that, he does kind of pivot to say that, "You know, we do consider bigger acquisitions ... " But it seemed to be mostly in the consumer segment that they would even think about it.

Campbell: Yeah. I think investors are going to see that there's going to be money that's going to be spent, but I wouldn't expect any deals that are going to be at such a size where it's going to impede their ability to continue to send money back to shareholders through buybacks, which have been a very important part of the company's capital spending plans, and also dividends, which, Johnson & Johnson is one of the best dividend-paying stocks in existence today.

Harjes: Absolutely. It's a 3.1% dividend, a company with a really strong history of paying such a dividend. I don't know about you, Todd, but I'm definitely personally bullish on Johnson & Johnson. Probably a good time to remind people that we might have interests in the stocks we talk about on the show, and the Motley Fool could have formal recommendations for or against them; don't to buy or sell based solely on what you hear, go read that conference call transcript. But just to wrap up, this is the closing of the 2015 books for J&J. How are you feeling about the company? Thumbs up? Thumbs down?

Campbell: I'm going to give it a thumbs up. Obviously, they've got to figure out how to replace the revenue that's going to be lost from REMICADE, but they've got some really interesting drugs that are coming through the pipeline. They've got 70 products in novel drugs that they're studying in early stages of development. They've got a recent filing that they've done for INVOKANA plus Metformin combination therapy that could be a big seller. They recently got a new drug on the market for multiple myeloma. I'm going to give it a thumbs up. I think this is a company that investors can continue to stash away for the next decade, forget just one year.

Harjes: Nice. So, speaking of looking towards the future, we're almost through January already, which is hard to believe. I just wanted to let all of our listeners know that we put something together for you guys to check out, which basically is a list of all the people you hear on Industry Focus -- or, a lot of them, anyways -- our resolutions. If you're interested in what we're doing in the new year, check out resolutions.fool.com. It's a landing page, it's got a list of articles written by names that will sound familiar to you if you're a loyal listener of the show, and we're basically just talking about our different approaches to the new year, some changes we want to make, and some advice for you guys, too, if you're looking to either overhaul your finances, or just make little tweaks.

Todd, thank you so much, as always, for all of your input. Folks, I hope you enjoy digging into Johnson & Johnson a little bit more after the show, if you're interested, or just checking out the resolutions.fool.com landing page. We will talk to you next week.

Kristine Harjes owns shares of Gilead Sciences and Johnson & Johnson. Todd Campbell owns shares of Gilead Sciences. The Motley Fool owns shares of and recommends Gilead Sciences. The Motley Fool recommends Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.