Drugs Have Moved J&J On To A New Phase

By Stephen D. Simpson, CFA | October 16, 2012 AAA

It took a while, but healthcare giant Johnson & Johnson (NYSE:JNJ) is once again delivering on its potential as a triple-threat in drugs, devices, and OTC consumer and health products. Strong growth in the drug and devices business is very much welcome, but now the question becomes whether management can lead a similar turnaround in OTC. Although J&J looks to be on the cusp of being a good buy, ongoing outperformance does seem predicated on a more well-rounded growth profile in the coming years.

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Once Again a Growth Story
J&J's revenue for the third quarter was only slightly above the average analyst's guess, but organic growth of over 5% is quite a good result in the healthcare sector today. Growth was driven solely by the company's pharmaceutical and devices businesses, where revenue increased more than 11% and 16% respectively. Although the consumer segment was a positive contributor, it did not impress with 1% adjusted revenue growth. Although the profitability numbers require a little explanation, the overall performance was solid. Gross margin did slip over 100 basis points from last year, due in part to ongoing remediation costs in the consumer business and licensing costs in the drug business. Operating income rose 9%, however, as the company did see solid SG&A leverage.

Pharma Back in Black
It has taken several years and a lot of deals (both acquisitions and in-licensing), but J&J's drug business is back to good health. Importantly, it's not just a new drug story - drugs such as Zytiga and Xarelto are certainly contributing to growth, but older drugs such as Remicade, Concerta and Stelara continue to deliver solid performances as well. Although J&J has been getting credit for this improved performance in pharmaceuticals, an argument could be made that the company is still not getting full credit for its pipeline. Like Pfizer (NYSE:PFE) and AstraZeneca (NYSE:AZN), J&J is working on oral immunology drugs, as well as looking to expand its biologics franchise. Moreover, while J&J may not deserve as much attention for its hepatitis C research as Gilead (Nasdaq:GILD) or Abbott (NYSE:ABT), it's hardly an also-ran effort.

Still Some Work to Do in Devices
In contrast to the drug business, some may see J&J's device business lacking in near-term catalysts, despite it's recent positive quarter. Some of this can be tied to macroeconomic issues outside of the company's control - relative to prescription drugs, the co-pays and deductibles for device-based interventions have gotten worse and hospitals have pushed back aggressively on device costs. That said, whatever the reason may be, management needs to focus on keeping this business on a growth track. The company's orthopedic business is looking a little better, but I have to wonder if some of this is a product of turbulence at Stryker (NYSE:SYK). Elsewhere, the surgical business seems soft relative to the recent performance of Covidien (NYSE:COV), and the performance of the diagnostics business is not impressive. Diabetes is also weak, but this is increasingly looking like an industry-wide malaise.

The Bottom Line
The good and bad of J&J is that it's never a pure-play on much of anything; it has been a while since all three business units have really been strong at the same time. In any case, J&J looks like one of the stronger pharmaceutical stories in the space right now, while the device business isn't markedly softer than most other major medical device players such as Medtronic (NYSE:MDT). The last couple of years have been below-trend for J&J. The reason that matters is that a projected free cash flow (FCF) growth rate of 7% might sound too aggressive for a company of its size, but at least 20% of that can be tied to simply getting back to historical levels of free cash flow conversion. In any case, if J&J can continue to post low-to-mid single-digit revenue growth and modest free cash flow conversion improvements, it's not hard to argue for a fair value over $80. That's not massive undervaluation, but when the dividend yield is included, I'd argue it makes this a worthwhile stock to consider for value- and income-oriented investors.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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