I’ve learned to be suspicious of apparent bargains among ultra-cap companies, and there are certainly enough moving parts to Johnson & Johnson (JNJ) to fill a small library of articles. Even so, while I can understand some concerns about growth and pipeline, as well as headline risks from lawsuits, JNJ shares look surprisingly interesting in a market where a lot of drug and device stocks enjoy elevated multiples.
For the short term, I expect worries to be focused on the pause of the Phase III COVID-19 vaccine trial, headline risk, and a potentially underlying stall in procedure recoveries. I also expect some concerns about the drug pipeline and JNJ’s ability to offset patent expirations with internal R&D productivity. Even with that all factored in, a prospective high-single-digit return from a reliable performer isn’t something to ignore.
No Love For A Healthy Beat
Johnson & Johnson did well relative to expectations, with a 4% top-line beat and a 10% operating income beat, but the Street was unimpressed, as concerns about near-term growth prospects seemed to loom larger in investors’ minds.
Revenue rose about 2% in the quarter, with management estimating a 2% to 3% headwind from COVID-19. Pharmaceuticals revenue rose 5%, beating expectations by 2%. Device revenue declined about 3%, beating by 13% on healthy recoveries in elective/non-emergent procedures. Consumer revenue rose about 3%, beating by about 3% with steady performance.
Gross margin improved 30bp from the year-ago quarter, beating expectations by three and a half points. JNJ couldn’t hold on to all of this at the operating line, but flat operating income was still good for a 10% beat and 170bp of operating margin outperformance.
Given that I could probably write a 10,000-word novelette just on earnings, I’m going to pick the items that stuck out to me. That includes the 15% growth in top-earning drug Stelara and the 44% growth in Darzalex, with the sub-q formulation helping drive growth. Interventional devices showed ongoing recoveries in procedure counts, with the ortho business down just 3% as the U.S. business returned to growth (which bodes well for Stryker (NYSE:SYK), which is skewed even more to the U.S.), surgery down 7% (after a 34% drop in Q2), and electrophysiology up double digits.
Probably the worst news in the quarter was that management didn’t point to month-by-month sequential improvement in procedures during the quarter. There were already fears that the recovery was stalling out, and this won’t help matters. I’d definitely look to the commentary from companies like Abbott (NYSE:ABT) and Stryker for more color on this, but it is not hard to imagine that there’s an unsteady balance between patients still leery of infection risk, procedures that simply cannot be delayed further, and centers that really need patient counts to improve to shore up their own financial situations.
A Pause In The ENSEMBLE Trial
Another piece of negative news was the announcement that the ENSEMBLE Phase III trial of JNJ’s SARS-CoV2 vaccine has been paused due to an unexpected and unexplained illness in one of the trial participants. As is typically the case, there’s no other information at this point, and investors are understandably concerned that this trial halt may stretch on, as it has for AstraZeneca (NASDAQ:AZN) in the United States.
It’s a disappointing development, particularly from a public health standpoint, but I think a little perspective is in order. JNJ was already behind Pfizer (NYSE:PFE)/BioNTech (NASDAQ:BNTX) and Moderna (NASDAQ:MRNA), and although there is a lot yet to be determined about efficacy and safety, I wouldn’t say the initial look at JNJ’s data showed stunning results. Tolerability/safety will likely have an underappreciated role in this race (particularly for elderly patients), and JNJ could still potentially stand out there, but I don’t expect this to be a major blockbuster for the company, so the financial impact of the delay isn’t particularly material to my long-term estimates.
Questions About Growth Probably Won’t Go Away
I’ve followed this company for more than 20 years and during that time it seems like there have always been worries about the company’s growth. Over that time, I’d describe JNJ as a “solid, but not spectacular” performer, with management always doing enough through internal R&D and external M&A to keep the business growing around 3% at the top line (although with meaningful year-to-year volatility).
The pivot toward pharmaceuticals has been successful, with immunology and oncology in particular performing well (oncology has grown from $1.4 billion in 2000 to about $4.5 billion in 2014 to a little under $11 billion in 2019), and the higher margins of this business boosting overall adjusted margins by about four points over the last five years. Growth in devices has been less spectacular, but has included multiple divestitures, while the consumer business continues on as a fairly reliable cash cow (apart from the talc lawsuits).
R&D productivity is increasingly important in the med-tech space, and it’s a fair question to ask with respect to Johnson & Johnson, as the company doesn’t have an exceptional record. With Remicade past its peak, Stelara’s peak in sight, and likewise for smaller contributors like Prezista and Zytiga, JNJ could use a few wins. I’m bullish about the potential of amivantamab and lazertinib in lung cancer, and cautiously bullish on JNJ’s CAR-T entry, as well as esketamine. The acquisition of Momenta (NASDAQ:MNTA) and its FcRn antibody is likewise promising, with a potential multibillion-dollar total market opportunity across a collection of individually uncommon IgG-mediated diseases.
As is often the case, the outlook is murkier on the device side. JNJ has submitted a 510(k) for its entrant into the orthopedic robot market, but the company is well behind Stryker and Zimmer Biomet (NYSE:ZBH), and there are times I question the company’s commitment to the device business, as I feel others have out-innovated the company in areas like hip/knee, trauma, spine, and electrophysiology. That said, JNJ’s strong position in endoscopy, energy, aesthetics, and endomechanical tools is worth a quite a bit and relies more on steady innovation and improvement as opposed to R&D breakthroughs.
I don’t expect JNJ to vary much from its long-term trajectory, and I’m looking for long-term revenue growth in the area of 3% a year. Of course, how much the company needs to spend to drive that growth is a valid question (the Momenta deal cost about $6.5 billion), and I won’t be surprised if there’s more pressure on management to increase its capital returns (around $15.5 billion/year on average over the last five years) as the business accelerates back to $20B/year and above in free cash flow.
I expect pharmaceuticals to continue to grow as a percentage of sales, driving both higher margins and higher FCF margins (it takes less working capital to support a drug business), with FCF margins heading toward the high-20%’s/low-30%’s over the next decade and supporting a mid-single-digit FCF growth rate.
The Bottom Line
Looking at valuation, I use a combination of methods for med-tech, including discounted cash flow and both growth-driven and margin-driven approaches. All told, I get a fair value range from about $160 to $177; even at the low end, that’s not bad for a company with JNJ’s qualities.
I do have my own concerns about JNJ’s organic growth capabilities, and I do see some risk from a potential flattening of procedure recoveries, as well as headline risk, though JNJ can easily absorb any future opioid and talc settlements. Likewise, I appreciate the concerns about patent expirations in the pharmaceutical business. All told, though, I believe the shares more than reflect these growth challenges and may be an interesting idea to consider for more GARP-oriented investors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.