With the Synthes merger in hand, a new CEO in charge, and a rejuvenated pharmaceutical business, Johnson & Johnson (JNJ) is perhaps in the best shape it has been in in quite some time. By no means is this a flawless story, particularly as the device business seems to need some real work, but it looks as if the company has more going for it than against it at this point.
Forex Weighs Down Revenue
Operationally, Johnson & Johnson had a decent quarter. Foreign exchange did impact the top line and lead to a below-expectations performance, but the underlying core performance was largely fine.
Revenue fell almost 1% as reported, with constant currency growth of 3.5% and organic growth more on the order of 2%. Forex seemed to weigh heaviest on the pharmaceutical and consumer businesses, though underlying "operating" revenue rose 5.1% and 0.6%, respectively. Devices were a mixed bag; overall operating growth of 3.4% was pretty much as expected, but the orthopedics business was quite strong and there was broad-based weakness across the other device/diagnostics categories.
Margins were mixed as well. Gross margin was soft -- down more than half a point from last year and about 20 basis points short of expectation. The company cut back SG&A and R&D spending more than expected, though, so operating income rose 4% and the company did fine at the per-share earnings level.
Drugs Still the Story
I know I talk a lot about the pharmaceutical business at Johnson & Johnson, but it's with good reason -- the company has really turned around its fortunes here, and pharmaceuticals remain a great global growth opportunity. 2011 was a good year, as the company saw launches for Zytiga, Xarelto, Edurant, and Incivo. So far, 2012 is not looking half bad either. Remicade may be greying a bit, but it still grew 13% this quarter, while Stelara's 46% growth is an encouraging number for a drug that hasn't quite lived up to expectations.
Looking ahead, Xarelto seems to be closing in an Pradaxa at a good clip, while the FDA's Complete Response Letter to Bristol-Myers Squibb (BMY) and Pfizer (PFE) on Eliquis buys it a bit more breathing room. Medivation's (MDVN) enzalutmamide may steal a little of Zytiga's thunder, but data and filings on canagliflozin, bapineuzumab, and TMC435, as well as the acquisition of potential heart failure drug COR-1, give investors plenty to watch.
What Ails Devices?
Johnson & Johnson's performance in the devices and diagnostics space is more of a concern. Orthopedics did well this time around, lending confidence not only to the benefits of acquiring the high-margin Synthes business, but also the thesis that Biomet's guidance was sound and companies like Johnson & Johnson, Stryker (SYK), and Zimmer (ZMH) can look forward to a rebound later this year.
Elsewhere, though, it's hard to be comfortable with the business. The diagnostics business seems to be slipping further and further behind Abbott (ABT), Siemens (SI), and Roche (OTCQX:RHHBY), and this quarter's performance in surgery has me wondering if the company is losing more share to a resurgent Covidien (COV) and perhaps Bard (BCR) as well (especially since patient volumes were positive in the second quarter).
Renal denervation could offer some spark to the device business, but Medtronic (MDT) and St. Jude (STJ) seem to have a substantial head start. All in all, then, it's worth asking if more deals may be an option -- particularly since Johnson & Johnson's clever arrangement of the Synthes deal brought more accretion than expected and the new medical device industry tax could make it harder for smaller companies to compete. The trouble is those companies that would immediately add growth -- Edwards Lifesciences (EW), Intuitive Surgical (ISRG), Cepheid (CPHD), or perhaps Illumina (ILMN) -- would not come cheap.
The Bottom Line
I'm not inclined to worry much about this quarter's gross margin performance, and I am encouraged at the underlying performance in both the drug business and the orthopedics segment. Moreover, I like the unexpected spark of creativity that went into how Johnson & Johnson structured its deal for Synthes.
The issues with the device business (and the sluggish market environment for the OTC consumer space) do concern me, but not enough to ignore the numbers. Midsingle-digit free cash flow growth can support a fair value above $80 for these shares, which is a solid return when combined with the dividend yield. Some of that performance rests on turning around the device business, but Johnson & Johnson looks like a worthwhile name for conservative investors looking for healthcare exposure.