With the Synthes acquisition done and Zytiga on the market, I don't think Johnson & Johnson (JNJ) investors should expect too much additional flash in 2013. That may not be such a bad thing, though, as this is a pretty good company that would benefit from some serious "back to basics" operational improvements. J&J is also looking like a relative bargain, with good growth in pharmaceuticals and opportunity for improved results in the device business.
Q4 Results Not As Good When You Go Deeper
JNJ's fiscal fourth quarter results had some bright spots, but some problem areas as well. Revenue rose more than 9% as reported, with organic growth more on the order of 4%, driven by 7% growth in the pharmaceuticals business. Devices and consumer were both considerably softer, each up about 1%.
Gross margin declined about 135bp from last year, and even if an inventory step-up charge is adjusted out (about 130bp), the performance relative to last year and sell-side estimates of 67.6% still is not great. Operating earnings rose about 8% as reported, missing targets in large part due to the gross margin miss, but also somewhat higher SG&A and R&D expenses. All in all, while the company reported an EPS beat versus consensus, about $0.15 per share came from "below the line" items, and the company actually logged an operating miss.
Pharmaceuticals - New Products Ramping Well, But Momentum May Trail Off
Drugs continue to be the growth driver for JNJ, and this remains a remarkably well-diversified company by Big Pharma standards. Only one drug makes up more than 10% of sales (Remicade), and it's still growing (up 5% this quarter). The company also continues to do well with new drugs in oncology, as Velcade revenue rose 43% this quarter and Zytiga rose 74%. Investors will no doubt by closely following the head-to-head between JNJ and Medivation (MDVN) in prostate cancer in 2013, and just as a frame of reference JNJ's Zytiga sales are already three times those of Dendreon (DNDN).
If there is a risk here, it may be in analyst/investor boredom. Yes, they will both closely watch the ongoing Zytiga launch and the ongoing performance of drugs like Stelara, as well as the FDA's decision on SGLT-2 drug canagliflozin, but the cupboard is somewhat bare in terms of exciting, thesis-changing near-term clinical data. As a result, if Zytiga, Velcade or Stelara stumble, the stock may suffer.
Devices - Ortho Good (For A Change), But What Else?
Total device and diagnostics revenue came up a little short this quarter, but it wasn't the fault of orthopedics. Absent the Synthes deal, JNJ saw more than 3% organic growth, with good growth (5%) in core recon. This makes MAKO Surgical's (MAKO) recent disappointments all the more troublesome, and both raises the bar and optimism for 2013 prospects at other players like Stryker (SYK) and Zimmer (ZMH).
For the good news, though, there is still plenty of weakness. Surgery was disappointing, and it will be interesting to see if results from Covidien (COV) and Bard (BCR) confirm the market weakness or highlight share loss for JNJ. Likewise, a 4% decline in diabetes care (led by an 11% drop in the U.S.) was another disappointment from a business that has been disappointing for some time now.
Last and not least are cardio and diagnostics. Cardio was down 6% overall, but Biosense Webster was up about 14% - highlighting both the company's strength in atrial fibrillation (though we should see what St. Jude Medical (STJ) and Medtronic (MDT) have to say) and its weakness in peripheral vascular care (again, stay tuned for results from rivals like Covidien and Bard).
With diagnostics, not only were sales down 4%, but it looks like management is tossing in the towel - announcing that they are looking at divesting the business either through a sale or spin-off. Honestly, this has been long coming - the company has seriously under-invested in this unit and has allowed rivals both large (Abbott (ABT)) and small (Bio-Rad (BIO)) to gain significant ground.
Consumer Still Has Work To Do
The company's consumer business may be the best example of where better execution is needed. Sales ticked up a bit here, but were still somewhat disappointing. While the legacy of past recalls is still relevant, I have to wonder whether JNJ isn't also seeing store brand/private label substitution.
JNJ continues to make a slow recovery from the repeated quality control scandals that rocked the company, but there's a lot of work left to be done - as highlighted by the fact that some retailers are essentially rationing JNJ products like Tylenol among their stores to keep it on the shelves. Forget major new product launches or ad campaigns - just getting back to before-crisis operations will be a big help here.
Where JNJ Grows From Here
I expect the drug business to continue to drive JNJ's growth in 2013. While there are signs of life in key device markets like ortho, I think it's too soon to assume that other businesses like surgery, cardiology, and diabetes can post big intrayear turnarounds.
Longer term, I continue to see JNJ as a consistent 3%-4% grower, as new product opportunities like renal denervation and atrial fibrillation help offset some of the growth challenges presented by the sheer size of this enterprise. I do believe JNJ could, and will, contemplate some one-off deals in the med-tech space, but I'd be surprised if management looked to another major deal as opposed to refining and improving its execution. All of that said, I'd be curious to know if management has contemplated a run at St. Jude Medical (given that many believe they'd consider acquiring Boston Scientific (BSX)) .
On the margin side, I likewise believe that JNJ can regain prior 20%+ levels of free cash flow margin simply from better execution. Garnering more revenue from high-margin drugs will help, but so too will fixing the ongoing problems in the consumer business and perhaps tightening up the device operations as well (including jettisoning the diagnostics business). That said, this quarter highlights that the progress back to prior levels of margins and free cash flow production won't always be smooth.
All told, I believe that JNJ can still post free cash flow growth in the neighborhood of 5-7% over the long term, with more and more of that surplus cash flowing back to shareholders in the form of dividends and buybacks.
The Bottom Line
With new management in place, I'm increasingly positive on JNJ. I like the company's balanced array of businesses, and I see worthwhile and meaningful changes for not only organic top-line growth, but also internal margin/profit improvements. My expectation of 6% cash flow growth leads me to a fair value target of about $86.
Normally, that would mean that JNJ offers too little appreciation for me to strongly suggest others buy it. What's more, this quarter's disappointment is a bit too reminiscent of the Weldon era for me to be completely comfortable. That said, I do think these shares hold solid appeal for long-term investors, and management deserves a bit more time to prove that it can effectively communicate with the Street and drive results in line with expectations.