Johnson & Johnson Still Offers Good Upside in 2013

The investment thesis for Johnson & Johnson (NYSE: JNJ) has long been that of a cheaply rated company whose medium term prospects are mainly about execution. This is attractive because it gives a nice balance of secular growth to a portfolio while paying a nice yield. Okay, its growth prospects are no higher than single digits but in an environment of miserly bond yields JNJ offers bond-like security with GDP+ growth prospects. A compelling proposition and the recent results did little to dispel this idea. Indeed, the restructuring plans are exactly what the stock needs to take it higher.
As ever with a diversified company of this size, not everything will be firing on all cylinders at the same time. These results were no different.

Consumer Products (21% of Sales)

Yet again the consumer products division gave disappointing numbers with declining US sales being offset by international sales growth in order to reach a paltry .9% rise on an operational basis.
With that said there was some positive underlying news in these results and investors shouldn’t be too disheartened.

• Baby care sales appear to have stabilized in the US and operational growth in the key international markets was a healthy 3.5%.
• Oral care growth in international markets was an impressive 6.6% and even though the US was down 4.6% investors need to recall that Colgate-Palmolive (NYSE: CL) has really expanded into mouthwash in the US this year. It’s natural for JNJ to lose some share against such a formidable and focused competitor but JNJ’s international performance with the new Listerine products was good.  CL stockholders need to consider this because EM is really what is driving growth at their company. Is JNJ taking back market share?
• Skin care remains a problematic category and JNJ is subject to intense competition while women’s health recorded weak performance in the US offset by strong international growth.

The real ongoing story is with OTC/Nutritionals, which make up 32% of consumer product sales and 6.6% of the total company sales. US sales declined 3.8% while international sales rose 5.7%.  JNJ has suffered over the last few years with product recalls and manufacturing issues and it is here that it will likely see some upside in 2013. Management intends to get ‘75% of the brands’ back to the market over the course of 2013. The exact timing is subject to the usual caveats but nevertheless it does represent a growth opportunity for JNJ and brands like Tylenol have strong market resonance.

Pharmaceuticals (37% of sales)

This is the real turnaround story at JNJ and a combination of new drug launches plus clinical success has seen strong performance this year. Worldwide operational sales were up 8.5% in the quarter. Some highlights include:

• Remicade (rheumatoid arthritis) represents 23% of total pharma sales and was up another 5.5% in the quarter. It belongs to a class of TNF Blocker drugs that represent the fastest growing segment of RA treatment. Sales are likely to carry on expanding strongly but there is a possible longer term concern here. Pfizer (NYSE: PFE) has had a JAK Kinase inhibitor (tafocitinib) recently approved and some rheumatologists believe that if it can demonstrate efficacy, safety and cost effectiveness then this class of drugs (and there are plenty of them in development) could replace TNF blockers like Remicade as a second line treatment.
• Elsewhere in immunology Stelara (psoriasis) was up 30% worldwide and Simponi grew nearly 55% on an operational basis.
• Neuroscience results were better than the headline figures suggest. Concerta (attention deficit disorder) is facing generic competition but I note that combined sales of Invega and Invega Sustenna  (schizophrenia) are now above the declining sales of its older antipsychotic Risperdal. So while neuroscience looks tough for JNJ in 2013 the underlying trends are not as bad.
• The real star was oncology with Velcade (multiple myeloma) and Zytiga (prostate cancer) combined seeing sales rise 51%. Together they were responsible for all the growth in the oncology segment.

In a sense JNJ is demonstrating its real strength as a big pharma company with plenty of marketing muscle. New product sales have been very impressive and it looks likely to continue this trend into 2013 even if Concerta is going to be hit with increased generic competition.

Medical Devices & Diagnostics (42% of Sales)

There are four interesting stories here:

• Successful integration of Synthes and ongoing growth in orthopaedics
• JNJ announced it is evaluating options for its Diagnostics division.
• International specialty surgical sales were up 9.5%, and this is a good sign for a company like Covidien, which is focused on growing surgical revenues in emerging markets. Indeed, JNJ’s results are a welcome positive because others in the sector have been a bit weaker lately.
• Worldwide vision care operational sales were up 6.4%, and this is ahead of the kind of industry growth rates that Cooper Companies (NYSE: COO) talked about recently. Cooper is better placed in the faster growing segments of the vision care market so if JNJ can report this kind of extra-industry growth then Cooper may surprise on the upside

The Bottom Line

Although the full year EPS guidance ($5.35-5.45) was a bit lighter than the consensus at $5.49, JNJ usually tends to be a bit conservative. Moreover, no one really can say for sure how quickly the McNeil consumer products will get back on the market or if the diagnostics division will be divested. The good news is that these positive drivers look to be in place so it looks like a matter of when, not if.

As an investment proposition JNJ still represents a stock generating 6%+ free cash flow yield with solid high single digit earnings prospects and some upside from successful execution. Throw in the 3.3% dividend yield and it really is a better proposition than a long dated government bond. It is well worth balancing the risk end of your portfolio by holding it.