Another quarter is in the books, and not all that much has changed at healthcare giant Johnson & Johnson (NYSE:JNJ). The company's drug business continues to grow exceptionally well, lifting margins along the way. Meanwhile, the recovery in the consumer business continues to be slow, as is the progress in producing better growth from the large device business. Although I've been lukewarm on JNJ's shares relative to other (better-performing) stocks in the drug and device space, the shares have done pretty well over the past year and while not cheap, aren't all that expensive for long-term holders.
 
Q2 Comes In Strong Due To Drugs
Johnson & Johnson reported that revenue grew about 10% this quarter (on an “operational” basis), with organic growth a bit below 6%. That was good for a slight (roughly 1%) outperformance relative to to expectations but all of the upside seemed to come from the pharmaceutical operations.

SEE: Positive Start To Q2 Earnings Season
 
Pharma revenue rose almost 13% on a constant currency basis, good for a 4% beat relative to sell-side expectations. The single largest drug, Remicade, continues to do well (up 10%), and the blockbuster-in-the-making Zytiga continues to grow particularly well (up 70% this quarter). 
 
In the consumer business, JNJ saw just under 2% constant currency growth, which isn't that good relative to what is expected from other drug companies like Pfizer (NYSE:PFE) or Sanofi (NYSE:SNY), nor personal care companies like Procter & Gamble (NYSE:PG) or Beiersdorf.
 
I'll go into more detail on the device business in a moment, but for now I'll just mention that the 12% reported growth (and sub-2% organic growth) were below expectations for the quarter, though it was an improvement from the first quarter.
 
Operationally, the contributions of the drug business and the improvements in the consumer business are certainly helping. Gross margin rose about a half-point from last year, and operating income rose 10%, good for a roughly 3% beat versus the average estimate. The operating margin improved 40bp, whereas the average expectation was for a slight drop.

SEE: Analyzing Operating Margins
 
Devices – Ortho Slowly Improving, But Plenty Of Weakness Elsewhere
Orthopedics is about one-third of the JNJ device business now, and fortunately this was one of the better growers in the quarter – up a bit less than 3% on an organic basis. Like Biomet, JNJ saw improvements in the recon business, with growth in both hips and knees (Biomet was weaker in knees). Spine looks weak, though, and that could be an issue for others like Medtronic (NYSE:MDT) and NuVasive (Nasdaq:NUVA). With this, I'd say investors have reason to expect better recon numbers from Zimmer (NYSE:ZMH), but perhaps not so much from Stryker (NYSE:SYK).
 
While cardio showed a decent uptick (up 5%), surgical continues to be weak (down 3%) as the company sees an ongoing shift away from mechanical toward minimally invasive, and companies like Covidien (NYSE:COV) gain some share. Diabetes continues to be a real mess (down 12% and down 23% in the U.S.), while diagnostics and vision care were also a little disappointing.
 
Drugs Will Continue Doing The Heavy Lifting
On the device side, I don't see a lot for JNJ to do but wait for operating conditions to improve and perhaps consider a few focused acquisitions to improve areas like its minimally invasive tools. The company has a decent chance of competing in the peripheral intervention and atrial fibrillation markets, and ortho should continue to show steady, if restrained improvement. Unless JNJ wishes to be bold and do an expensive deal, devices aren't going to drive growth for some time yet.
 
On the other hand, the drug business is doing well and liable to get even stronger. The company has filed for FDA approval of ibrutinib (for which it partnered with Pharmacyclics (Nasdaq:PCYC)) and expectations are for this drug to quickly become another blockbuster for JNJ in the oncology space. In addition to other oncology drug candidates, JNJ also has anti-TNF compounds in the works and the Hepatitis C (HCV) drug simeprevir filed with the FDA – a drug that is unlikely to threaten the presumed leadership roles of Gilead (Nasdaq:GILD) and AbbVie (Nasdaq:ABBV) in the emerging next-gen HCV space, but could offer some upside.

The Bottom Line
I'm still more or less lukewarm on Johnson & Johnson as an investment. Like the rest of the drug and device space, these shares have done pretty well over the past year, and the company does generate quite a bit of cash flow. That said, it will be hard for me to be really bullish on the stock unless/until growth improves in devices and consumer and/or the Street suddenly reverses course and gets too bearish on the drug business. I assume JNJ will grow its free cash flow at a long-term rate between 6% and 7% for the next decade, but I wouldn't pay more than the mid-to-high $80s for that cash flow stream right now.

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