There was modest investor disappointment with Johnson & Johnson’s (JNJ) second quarter results reported on July 19, 2011. The stock closed down $0.37 to $66.72 while the market increased sharply. This was due to disenchantment of some investors with the company's modest operational sales and earnings growth. With foreign currency effects and a lower tax rate being responsible for much of the EPS growth, some investors were disappointed. I disagree with this reaction. I think that JNJ is mainly about an acceleration in future sales and earnings that will be led by the strong new product flow in pharmaceuticals. I continue to recommend purchase of the stock.
My favorable analysis for JNJ is partially based on putting the effects of the pharmaceutical patent cliff behind them and resolving the OTC/ Nutritional manufacturing issue. However, far more important is my belief that new pharmaceutical products will lead to a strong increase in sales of that business and result in acceleration in operational sales growth of 10+% in 2012. Please bear in mind that these estimates are before the effects of currency which can have a big impact. Favorable foreign currency effects added 5.7% to second quarter sales growth. Who knows what the effect will be next year.
The four key new pharmaceutical products that I am most enthusiastic about are: (1) the HCV product Incivo (telepravir) licensed from Vertex for most international markets, (2) Xytiga (abiraterone) for prostate cancer, (3) Xarelto (rivaroxaban) an oral anti-coagulant and (4) TMC 435, possibly the most promising next generation HCV drug. JNJ is just in the very early stages of launching this new product flow while it is in the late stages of exiting the patent cliff and OTC/ Nutritional manufacturing problems that are putting a drag on current sales.
Overview of 2Q, 2011
Worldwide sales in the second quarter were $16.6 billion. The operational sales growth on a worldwide basis was 2.6%. However, favorable foreign currency effects of 5.7% increased the reported growth in sales to 8.3%. There were three major impediments to sales growth: the patent expiration on Levaquin reduced global sales by 3.0%, rebates caused by heath care reform led to an additional $75 million reduction of sales or 0.5% (more for earnings) and I estimate that the issues with OTC/ Nutritionals manufacturing further reduced operational sales growth by 1.1%. I think that the Levaquin and manufacturing issues will be in the rear view mirror by early next year and consider the current operational sales growth rate of currently marketed products to be about 7.5%.
JNJ and large pharmaceutical companies consistently have charges and credits due to restructurings, acquisition related expenses, legal charges etc. that affect reported earnings. In order to give investors a sense of what the earnings growth from operations actually is, they report GAAP earnings and then adjust them for non-recurring, non-operational items. As reported, net earnings decreased from $3.4 billion in last year’s second quarter to $2.8 billion this year. After adjusting for non-operational charges, net earnings were $3.5 billion, up 4.9% from last year’s similarly adjusted earnings. Similarly adjusted EPS were $1.28 in 2Q, 2011, up 5.8%. However, the tax rate in the quarter was lower than expected at 19.6% and this had an unexpected positive impact on EPS. If the tax rate had come in at the previous guidance level, EPS would have been reduced by $0.04 per share to $1.24 which would have been an increase of just 2.5%.
Sales and Earnings Guidance for 2011
The company is offering guidance for an increase in operational sales of 2.5% to 3.5% for the year, which of course ignores the effect of foreign currency. If currency exchange rates for the remainder of 2011 were to stay at current levels (the euro at approximately $1.42) then the sales growth rate would be positively impacted by approximately 3% for the year resulting in reported sales growth of 5.5% to 6.5%. This is consistent with previous guidance.
In terms of EPS, the company continues to guide investors to look for EPS of $4.74 and $4.84 per share excluding the impact of special items and assuming the same average exchange rates for 2011 as was seen in 2010. This is consistent with previous guidance. The company said that it would offset the favorable impact on earnings of the lower expected tax rate with investment spending. However, if currency exchange rates for the balance of 2011 were to remain at current levels, it would result in a favorable impact of $0.16 per share and result in reported EPS of $4.90 to $5.00 for a growth rate of approximately 3% to 5%. This is also consistent with previous guidance.
Update on OTC/ Nutritionals Manufacturing
McNeil continues to re-site production to other facilities and is making steady progress on the manufacturing validation of re-sited products. Most of the key products will be reintroduced in late 2011 and 2012. It is almost a certainty that the company will have lost some of the sales base it had before the problems. However, the year over year comparisons from a lower base should become positive.
Disclosure: I am long JNJ.