In what has become a red-hot stock market for medtech stocks, it’s the rare quality company that hasn’t taken part in the rally. As a huge player in drugs, devices and OTC consumer healthcare products, Johnson & Johnson (NYSE:JNJ) has certainly been carried along by this healthcare lovefest – the shares are up nearly 40% over the past year, and only a small handful of other large companies (Stryker (NYSE:SYK) and Roche (PINK:RHHBY), for instance) can come close to matching or exceeding Johnson & Johnson.
The curious thing about this performance is that it hasn’t accompanied strong, even financial performance. JNJ’s drug business has roared back to life, but the device business continues to struggle with a difficult environment and past mistakes, while the consumer business tries to recover from the reputation and market share damage incurred by the spate of recalls and contamination problems a few years ago.
Deals bring drugs back from the dead
From around 2004 to 2010, JNJ’s drug business was nothing to celebrate. More recently, though, deals like the acquisition of Cougar and licensing agreements with Bayer and Mitsubishi Tanabe have really started to pay off with the launches of high-profile Zytiga, Xarelto, Invokana. Paired with the ongoing success of drugs like Remicade, drugs now lead the way for J&J – organic sales were up more than 11% in the latest quarter, and drugs now account for close to half of the company’s profits.
The 3 aforementioned drugs ought to be major contributors for many years, though admittedly the SGLT-2 space (Invokana is the first such drug approved in the U.S.) is unproven. Certainly there will be competition, including Medivation’s (NSDQ:MDVN) Xtandi, and Eliquis from Pfizer (NYSE:PFE)/Bristol Myers Squibb (NYSE:BMY), but JNJ looks to be in a strong competitive position. At the same time, the company’s emerging hepatitis C and cancer portfolio (including 2 drugs that have received breakthrough designations – daratumumab and ibrutinib) holds promise even with the rampant expected competition in these markets.
Devices struggling, but maybe not as bad as it looks
Quite a bit of attention has been paid over the last year or 2 to the struggles in JNJ’s device business. The company saw the brutal competition in coronary stents with Abbott (NYSE:ABT), Boston Scientific (NYSE:BSX) and Medtronic (NYSE:MDT) and elected to punt – focusing instead on other cardiac products (including ablation) and peripheral interventions. Cardio was up 6% for the last quarter, and that’s not a terrible result given the underlying patient volume trends.
Certainly the diabetes business is in trouble now, largely due to pricing pressures tied to reimbursement. Likewise, investors have had cause to wonder and worry if Covidien (NYSE:COV), Intuitive Surgical (NSDQ:ISRG) and/or Teleflex (NYSE:TFX) are gaining too much share in the energy and surgery markets. Even so, I like the moves that the company has been making lately with the Ethicon business and I’m not convinced that management can’t stem the declines.
The big unknown is orthopedics. The integration of the Synthes deal has gone pretty well so far, but the hip and knee reconstruction markets are still touch-and-go from a volume perspective. With orthopedics now about ⅓ of the device business, generating better growth ought to be a high priority.
Diagnostics, too, is an unknown but in a much different sense. JNJ has under-invested in this business for years, losing market share across the board. Now management says they’re looking to sell or spin off the business. While skeptics will argue that this business has been badly damaged through mismanagement and neglect, I would point out that both Beckman Coulter and Dako were able to attract buyers despite their own issues with lagging competitiveness and years of under-investment.
Will consumer regain its reputation?
Perception is a tough thing to measure, which makes it hard to say just how much damage the quality control and recall issues did to JNJ’s OTC business and brands. I don’t believe that Colgate-Palmolive (NYSE:CL), Procter & Gamble (NYSE:PG), and Unilever (NYSE:UL) have, or can, shut the door on JNJ, but I do think it will take time to reclaim former glories. The necessity of rebuilding the business likely limits margin-improvement options (like restructurings), but better growth than the 3% seen lately should be possible – particularly if JNJ can start leveraging these brands into faster-growing emerging markets.
Capital will always be controversial
I do expect that there will be ongoing debates and discussions over how Johnson & Johnson will manage its capital. The company has a strong balance sheet, so it really comes down to a question of priorities more than capabilities. The zeitgeist now is one that really pressures companies to make gaudy returns of capital through dividends, special dividends, and share buybacks, and I’m actually a little surprised there hasn’t been a stronger call for JNJ to borrow and write checks to shareholders (the price performance over the last year may explain why that hasn’t happened).
I expect JNJ to keep plenty on reserve to pursue deals and partnerships as opportunities evolve. The big run-up in biotech and pharmaceuticals would make most acquisitions here pretty expensive, but there’s almost always a licensing deal to be had for the discerning Big Pharma player. So too in OTC/consumer products, where the run in consumer staples stocks has increased valuations pretty significantly over the last six to nine months.
That leaves devices, where here too there have been plenty of outperformers and valuations have moved from undervalued to fairly valued or overvalued in many cases. Could JNJ do another deal in orthopedics to flesh out its exposure to the fast-growing extremities category? How about a deal to add to its surgical tools business? Or perhaps JNJ gets exceptionally ambitious and aims for a company like Intuitive Surgical (NSDQ:ISRG) or St. Jude Medical (NYSE:STJ). I don’t see the later 2 as being particularly likely, but I do expect the company to be on the lookout for companies where they can wring out serious leverage (adding products/technology to established business units) or see meaningful above-average growth potential.
The bottom line
I suppose it’s always something between me and JNJ. I was happy to sell my shares at a profit a couple of years ago and flip the funds into Roche (which has outperformed JNJ since then), as I really didn’t like the direction the company was pursuing under former CEO Weldon. Then, around the time Gorsky was named the new CEO and for a few months afterward, there was a narrow window of opportunity where JNJ seemed undervalued. Then the stock started this 40% run – a run that has taken the stock from meaningfully undervalued to more or less fairly valued.
I expect Johnson & Johnson to grow its revenue at a long-term rate of around 4% to 5%, with free cash flow growing a bit faster (up to 6% or 7%) on ongoing improvements in free cash flow conversion. That works out to a fair value today in the high $80s – meaning that Johnson & Johnson is not overpriced or a bad stock, but rather that the stock is more or less being treated fairly by the market. As I do think there are cheaper stocks available today (many of which are pretty high-quality in their own right) and I’m a bit worried that the drug stock rally has gone too far too fast, JNJ isn’t my favorite name. Still, if Gorsky can manage this company in such a way that the consumer business recovers and the device business becomes a real contributor to growth again, the rewards to patient investors should be significant.
Disclosure – Simpson owns shares of Roche.
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at tuonela.fool@gmail.com.