Going into this earnings release cycle, the growth expectations for med-tech companies like Johnson & Johnson (JNJ) were already pretty modest. Although this healthcare and consumer giant is actually doing reasonably well from a revenue perspective, operating leverage has been lacking. Though JNJ is among the long list of med-tech names that are trading below fair value, there are more compelling names to own today.
Fourth Quarter Results - Started Okay, But Got Worse
With Stryker (SYK) and St. Jude (SJM) already paving the way to relatively low expectations for the quarter, JNJ's fourth quarter performance didn't disappoint. In point of fact, 4% sales growth is actually pretty good in a market like this. Consumer sales growth was a little soft (up 2.7%), while devices/diagnostics was as expected (up 2.4%) and pharmaceuticals (up 6.6%) were actually stronger than expected.
Where JNJ seems especially challenged now, though, is in its operating performance. Gross margin slid sixty basis points, while expectations generally called for an increase. Given the higher margins of the pharmaceutical business, this is particularly disappointing.
Operating income was down 4% this quarter and lower than expected. This makes two quarters in a row now, and the nearly two point drop in operating margin was likewise disappointing for a company that should have exemplary global leverage. Were it not for the low tax rate, bottom-line earnings would have been even more disappointing.
Read-Throughs Seem To Follow The Existing Trends
There's really nothing in JNJ's earnings that suggest big changes underway in the market. Flat performance in orthopedics (Depuy) is consistent with Stryker's performance and suggests similar low growth for the likes of Zimmer (ZMH). Ethicon and Ethicon Endo-Surgery continue to show solid growth (up 7% and 6%, respectively) and that should somewhat encouraging to investors in Covidien (COV), Bard (BCR), and Becton Dickinson (BDX). Diabetes care growth of 4% seemed soft, though, but not likely a major driver for the likes of Medtronic (MDT) or Abbott (ABT).
As far as JNJ's drug business goes, the read-throughs aren't necessarily so clear. Strong sales of Remicade (up 34%, with 14% domestic growth) are certainly a positive, but it's not precisely a zero-sum game with Abbott's Humira or other drugs. Nevertheless, it's good to see the company executing so well with this business, as it may well be compensating for other operational challenges.
Growth Still About The Pipeline
JNJ's drug pipeline should be a significant engine for better results in the coming years. Xarelto, Incivo, and Zytiga should all boost results and help neutralize some patent-related sales declines. That stands in contrast to a consumer business that still needs to repair its image after an embarrassing cascade of recalls and a device/diagnostics business that seems relatively short on internal growth drivers.
The addition of Synthes is certainly going to help the orthopedics business. The deal will significantly boost the company's share in trauma and spine - two of the better-growing categories within orthopedics. Likewise, backing out of the cardiovascular stent business was a good decision as it spares the company from wasting resources trying to catch up with Abbott, Boston Scientific (BSX), and Medtronic.
Looking at the longer term, though, this has to change if JNJ is going to remain a strong dividend-growth name. JNJ's diagnostics has fallen behind in many categories due to a failure (or disinterest) to innovate and most of the interesting growth opportunities today and in recent years were bought-in by deals. There's ample room out there and plenty of growth to be had in categories like bariatric surgery, insulin pumps, and so on, but JNJ needs to start doing better with its internal R&D productivity outside of pharmaceuticals.
The Bottom Line
JNJ is not a terrible idea for a long-term conservative portfolio, but it is also not the best. It's frankly difficult to argue for buying JNJ ahead of Stryker, Medtronic, St. Jude, or Covidien. While none of these companies have JNJ's global footprint or array of businesses, they have better recent records when it comes to internal product development and management performance.
JNJ's fourth quarter earnings are a pretty good microcosm of the company today - a good pharmaceuticals business and a good international healthcare growth story, but one weighed down by poor operating performance and sluggish growth elsewhere. Luckily, even low single-digit expectations for forward free cash flow growth suggest that the stock is 10-20% undervalued, while paying a healthy dividend.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.