I have written about Johnson & Johnson (NYSE:JNJ) a number of times, beginning with a moderately bullish initiation of coverage on April 16, 2014, in Why Johnson & Johnson Can Be Prescribed For Most Investors. When I wrote that, JNJ was trading at $99.20, and I had just bought the stock. Now it is above $110. It has traded in-line with the stock market (NYSEARCA:SPY), and with a roughly similar dividend yield. So - not a bad performer, though nothing exciting.
In the past two years, JNJ has shed and added divisions. It has made clear to the Street that it will sell more divisions as needed to sustain and grow the dividend.
Soon after I bought the stock in 2014, I sold it soon around $107 to focus all my investment resources on more aggressive plays such as Gilead (NASDAQ:GILD). Since then, I have covered JNJ without a long or short position in it as I have come to consider it as a bond substitute.
In fact, a 2-year chart of JNJ overlaid with a long Treasury bond ETF (NYSEARCA:TLT) and a major utility ETF (NYSEARCA:XLU) shows them moving very closely over the entire time point. Of those three, TLT is the best performer and JNJ the worst. That's looking only at price, and TLT has slightly out-yielded JNJ as well.
So far, my thesis that JNJ is a bond substitute has been right on target; and I've been bullish on bonds, and therefore it's gratifying to see JNJ's price move in the same direction.
The main stock I was focusing on 2 years ago was Gilead, which has far outperformed both TLT and JNJ over that time frame.
Because JNJ is such a large and predictable company, it's worthwhile reviewing the big picture as I see it.
Corporate and stock overview
Even though JNJ is a relative upstart into pharmaceuticals, it has executed that transition so brilliantly that I consider it the #1 Big Pharma company, though I exclude Roche (OTCQX:RHHBY) from that as it's pretty much a biotech company via its Genentech subsidiary. So if I ever say anything relatively negative about JNJ or its stock, it's in the context that its Big Pharma competitors are mostly in my view big, lumbering dinosaurs, often corrupt, far too dependent on price increases, and generally have overpriced stocks.
JNJ's own problem is that its device and consumer product divisions have been troubled and show inadequate signs of really growing. That's why I thought the company should consider splitting into three, just as Abbott Labs (NYSE:ABT) successfully did in two stages - but I'm confident it will not happen anytime in the relevant future at JNJ. So I think we have to look at it as one large company with three divisions that have little to do with each other, even though they are all in the "healthcare" field.
Now to the business matters that not all shareholders follow.
Product exclusivity issues - what to think about
Per the latest 10-K, I'll start with challenges to Xarelto, JNJ's blockbuster anticoagulant licensed from Bayer (OTCPK:BAYRY), though anyone comprehensively interested in JNJ's numerous IP-related issues can start on page 67 with other matters.
In any case, Xarelto has a patent trial in March 2018, with a patent expiration date in December 2020. Since the first ANDAs were filed by multiple filers in October 2015, I would think that if the generic side wins the battle, there could be an at-risk launch potentially before the expected appeal. I don't know how to handicap this fight; the number of generic filers suggests they think there's something they want to be in on. Because Xarelto is so big and fast-growing, and so high-profile, I think it's worth being aware of when thinking of JNJ's growth rate beyond 2017 and certainly beyond 2018.
Another reason to mention this suit relates to my interest in a biologic agent that's awaiting FDA approval (for a BLA) this summer, namely an antidote to Xarelto and the other drugs of its class. This drug, andexanet from Portola Pharmaceuticals (NASDAQ:PTLA), should benefit from a cheap Xarelto. There's nothing like a well-known blockbuster whose use has been held back by price going generic to see unit sales rise further despite the lack of promotion. It could be a material positive for PTLA if Xarelto goes generic well ahead of schedule.
This important prostate cancer drug is protected by one patent that expires in 2027. Otherwise, the drug is open to generic competition. Zytiga is under attack two ways. One is via the usual Paragraph IV submission to the FDA related to ANDA filings. The other involves a request for the USPTO to engage in an IPR of Zytiga, with the filer, Amerigen, hoping to have the patent invalidated.
This drug for HIV/AIDS does not get a lot of attention as a stand-alone agent, but it did about $1.8 B in sales last year. Some complicated litigation has been ongoing. The best I can tell from JNJ's disclosures is that Lupin has been working hard to develop a non-infringing formulation that could allow its version to come to market well before the relevant patent's 2024 expiration.
Even though sales at $6.6B in 2015 make this JNJ's most important product by sales, it is subject to biosimilar competition in the EU and is scheduled to lose all patent protection in the US in 2018 at the latest. Pfizer (NYSE:PFE) has very recently received FDA approval to market a biosimilar to Remicade for all of Remicade's indications, not just the ones PFE studied clinically. I think the matter to watch is how quickly other biosimilars come to market in the EU, how many biosimilars get approved by the FDA and whether they all get approved for all indications, and how quickly the newer oral and subcu competitors to Remicade gain market share.
Remicade is an important contributor to the company's bottom line. Even though it's a biologic, if sales drop sharply due to biosimilars, even if their entry in the US is delayed until 2018, I think it could be a large enough problem to affect the stock.
Overall, I count about 35% of JNJ's pharma product sales as being at risk of going generic or being subject to biosimilar competition ahead of schedule, but more than half of that amount is comprised of Remicade, which is going to have at least one biosimilar competitor by 2018 at the latest. So, JNJ is not in too bad a shape regarding patent cliffs or generic suits. That's in stark contrast to its direct competitor in myeloma, Celgene (NASDAQ:CELG), and in contrast to Biogen (NASDAQ:BIIB), both of which have some significant patent issues to their lead products.
Overall, I give JNJ high marks for this important aspect of their business, but they are not magicians, and they are going to lose two important products no later than 2020 (Remicade by 2018 and Xarelto by late 2020).
Pipeline progress in Q1
Q1 and the first few weeks of April have been slow from a news standpoint. JNJ's promising Darzalex, currently a salvage agent for myeloma but one that could be moved to frontline use in several years if the R&D goes well, is making good progress with regulators. Imbruvica, its blockbuster for blood cancers (about 50%-owned), received FDA approval for frontline use in CLL. JNJ linked an R&D deal for a prostate cancer drug with Tesaro (NASDAQ:TSRO). It also canceled a Phase 3 program for a non-opioid pain drug, an antibody (fulranumab). This move was unusual and somewhat embarrassing because the Phase 3 studies were well underway and there had been no safety issues reported that induced the company to cease the trials.
Overall, pipeline action has been blah to negative this year, given that the regulatory progress with Imbruvica and Darzalex was fully expected but the discontinuation of fulranumab was not expected (and received a question from one analyst).
Now, on to a discussion of Q1 results.
J&J has another uninspiring quarter
The various presentations can be found on the website as well on the usual financial media. I'm going to begin with the bottom line, comment on that; then work downward to a brief discussion of the different corporate segments and geographies; and then to my reason for following JNJ as a non-shareholder, namely its pharma division's progress. First, the basic numbers:
Johnson & Johnson and Subsidiaries Condensed Consolidated Statement of Earnings
(Unaudited; in Millions Except Per Share Figures)
Sales to customers
Cost of products sold
Selling, marketing and administrative expenses
Research and development expense
Interest (income) expense, net
Other (income) expense, net
Earnings before provision for taxes on income
Provision for taxes on income
Net earnings per share (Diluted)
Average shares outstanding (Diluted)
Effective tax rate
So, earnings were down noticeably yoy, more than 5%. This was then financially engineered by a 360 basis point drop in the tax rate to only 18.9% as well as a 1% reduction in shares outstanding.
Pre-tax earnings as a % of sales dropped from 32.1% to 30.3%. One of the reasons for that was one of the company's periodic "restructuring" charges. Companies began introducing those "charges" perhaps 20 years ago rather than the normal and logical practice of folding them into operating costs. A restructuring charge is a meaningless term. Is a factory obsolete, meaning was it being depreciated too slowly? Were employees laid off (fired), and there were severance payments? Did the company make an efficiency move in some way, which will lead to future profits that will outweigh the upfront costs? If it's the last of those, then while all the possibilities are normal costs of running a business, then the deception is greatest because the future profits that came from spending money in Q1 will never be labeled "one time" and excluded from GAAP EPS.
So, basically it was a weak quarter. The company had to ramp up R&D as it has pipeline issues (i.e., it was under-spending a bit on R&D previously, I would think).
The drop in tax rate is of low quality, given very high tax rates in the US that to one degree or another may have to be paid, even with a "tax holiday" to repatriate funds, in order for shareholders to get any utility out of profits generated from a low-tax, often Irish, intellectual property-holding subsidiary.
Now let's look at where the trouble arose.
Only pharma supported meaningful growth in Q1
From the first table in the press release, we see this:
Johnson & Johnson and Subsidiaries Supplementary Sales Data
(Unaudited; Dollars in Millions)
Sales to customers by
segment of business
Consumer products and medical devices are both more or less dead in the water, even after forex issues. Even international pharma was quite sluggish ex-forex.
So the obvious question is how much of the 13% gain in sales in US pharma was volume versus price.
While I treat JNJ as a pharma company, consumer products plus medical devices comprise more than half the company's sales. So this weakness is material to shareholders. The company did issue some positive comments on the prospects for devices in its commentary, but overall my view is that JNJ is an underperformer in this segment.
Not shown in this article, but the next table in the press release shows that sales outside of Asia were weak across the board.
Comments on pharma
Remicade sales jumped $180 MM in the quarter, up 11% yoy. The rest of the immunology group showed growth, mostly organic given that these are strong, young products. The company is expecting no biosimilar competition to Remicade from PFE this year.
In oncology, Imbruvica sales grew $150 MM. This is going to be a big winner for years to come. Velcade for myeloma, though, lost sales, as Revlimid from Celgene continues its ascent. Darzalex is just getting going.
In CV, Xarelto grew 29%, up sharply from the 15% yoy growth realized in Q4. Since Xarelto grew 23% yoy in 2015 vs. 2014, clearly price increases in Q1 are part of JNJ's growth strategy for this product.
Invokana (plus the combo, Invokamet) for diabetes showed slowing growth in the US, from $266 MM to $297 MM. In the US in Q4 2015, Invokana sales were $348 MM. In all of 2015, Invokana sales were $1.24B, meaning its average quarterly sales last year were $310 MM. Thus, Q1 was uninspiring. Invokana is a direct competitor of Lilly's (NYSE:LLY) Jardiance, which reported a positive CV outcomes study last year. One has to wonder whether Jardiance has a current advantage over Invokana. In the conference call, the company provided a laundry list of challenges for Invokana, including prior inventory stuffing, price competition (rebates) and positioning challenges on managed care formularies. Invokana is an important product for JNJ, and this bears watching.
The company is guiding to close to $72B in sales this year. Sales in 2013 were $71B, and in 2014 they were $74B. So, the company has been going nowhere in sales. With a market cap of $306B at a stock price just above $110, this puts JNJ at a P:S of 4X, which is in-line.
I think that sales are more important than projected earnings, which are heavily massaged and are non-GAAP, whereas I focus on GAAP. I expect that earnings will "come through."
Takeaways from the conference call and concluding thoughts on the stock
The company mentioned that the slowdown in the Chinese economy was relevant, with China comprising 5% of JNJ's sales. This is an important point in thinking through where future growth is coming from. With the secular rise in biosimilars in the US and EU, the last redoubt of pharma, antibodies and related biologics, is under pressure. In addition, competition in pharma is in a cyclical uptrend, as investment dollars chase the share prices and operating results upward. So structurally, challenges in China, if more secular than cyclical (time will tell), could be problematic for JNJ and its peers.
There were questions from analysts on takeover possibilities, given JNJ's strong balance sheet as well as strong free cash flow. As a positive for investors in junior biotech, JNJ believes that biotech valuations are more reasonable than they were, whereas medical device stock prices remain unattractive to an acquirer. I expect a typically intelligent pharma acquisition strategy from JNJ.
Basically, this was an unexciting quarter for this company. With the stock trading around 20X TTM GAAP EPS, it is at a notable discount to peers in Big Pharma despite having the best balance sheet and the most famous consumer-facing name. In addition, nothing has changed my view that JNJ is the best-run Big Pharma company, and it would be nice to see the company's medical devices division turn the corner for real. Finally, the consumer products business is recovering from the disaster with Tylenol and other OTC production facilities. I expect that this will not happen again, as management is highly focused on preventing anything like this again.
With so many other large cap/mega-cap peers to JNJ trading more expensively, JNJ can be viewed through that prism as relatively undervalued, and could trade higher on that basis alone. In addition, compared to prevailing interest rates, JNJ's 2.7% dividend yield, likely to grow for years to come and maybe "forever," will attract many investors and provide little reason for the company's many long-time satisfied investors to sell.
So, steady as she goes in pharma, with a focus on the generic and biosimilar challenges that challenge JNJ's secular growth strategy as well as on the company's ability to compete more strongly in devices.
Disclosure: I am/we are long GILD,PTLA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.