Were Johnson & Johnson's Earnings Really That Bad?

By Todd Campbell and Kristine Harjes Markets Fool.com

Johnson & Johnson (NYSE: JNJ)is one of the biggest companies in the world, and certainly the biggest pharma on the market, with over 250 sub-companies making up its huge size.After releasing its first quarter financials,Johnson & Johnson saw its stocktumble by over3%.

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In this week's episode of Industry Focus: Healthcare, analyst Kristine Harjes is joined by Todd Campbell to discuss what went wrong (and right) for the company in the first quarter.Listen to this episode to find out what J&J's three sub-sections are and how much money they bring in, some of the most pressing concerns facing the company in the next few years, what J&J was probably thinking with its costly acquisition of Actelion last year, what kind of investor might want to buy into J&J and what kind of investor might want to pass.

A full transcript follows the video.

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This video was recorded on April 19, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Kristine Harjes, andtoday I'll be talking healthcare with myusual partner in crime, Todd Campbell. Todd,how are you doing today?

Todd Campbell: I'm doing well. Kristine. You sound like you might have a little bit of cold.

Harjes: I know. I'm not really sure what this is. It is full-blown allergy season here in D.C., soI'm hoping it's allergies. Apologies to listeners,because I know I don't sound great.

Campbell: Hopefully you'llfeel better soon.

Harjes: I hope so. Fingers crossed. Also, I apologize in advanceif I end up coughing or something duringthis episode. I'm going to try really hard not to,I have my water next to me. We'll see how it goes.

Campbell: Excellent, all right.

Harjes: Today, we'retalking about just one topic, which I feel like is kind of unusual for the Healthcare show. Weusually like to pack a bunch of different things in. We'refocusing on the largest pharmaceutical company in the world,which isJohnson & Johnson.

Campbell: Thiscompany is so bigit almost feels like, even though we're covering one subject, we're really covering eight subjects.

Harjes: Ifwe really want to make ourselves sound impressive, we're covering the 250-plus sub-companies in theJohnson & Johnson family of companies.

Campbell: Do they really have 250 sub-companies?

Harjes: Yeah,more than that.

Campbell: That'sextraordinary. This is a company that's been around for anextremely long time. They have increased their dividend for 54 consecutive straight years. That tells you how long they've been in business, and how long they've beengenerating out returns that they can return back to shareholders. Theyjust came out this past week and reported earnings for the first quarter. I think, by all measures,it was a solid quarter. It wasn't a stunner; it wasn't incredibly exciting. But that's not why investors are interested inJohnson & Johnson anyway.

Harjes: Exactly,there's a lot of stability with this company. As you mentioned, they've been around forever, since 1886. In that time, they've only had nine CEOs. So this is a very reliable company. Itdoesn't change quickly. It's pretty hard to make a boat that bigpivot on a dime anyway. But theyconstantly, year in and year out, churn outpretty reliable results. Because of that,a lot of conservative, dividend-seekinginvestors are attracted to this stock, which,in general, has performed really well. WhenI was looking atearnings, I was actually a little surprised to see that the stock dropped about 3% yesterdayin reaction to this earnings report. To me,there wasn't really a whole lot surprising in there. They're stillon track for their own guidance that they laid out, andeven though things weren't great, that was at least what I was expecting going in. This is a company that'sstruggling a little bit to reignite growth, but looking at it broad picture,I'm not terribly worried for the long term.

Campbell: Yeah,I think the biggesttakeaway at the end of the day--to get a little bit ahead of ourselves -- willbe that there is some concern over pricing power and some of their big, top-selling drugs that may be weighing on some investors' minds. But again,you're talking about a company that'sgoing to grow the top line 2%-4%, andthe bottom line 4%-6%. If you're looking for a fast-growth company,you're going to go somewhere else. You'regoing to look atCelgene. Butif you're looking for a steady-Eddy income producer,Johnson & Johnson is a staple, it's a core holding in many of the largestportfolios in America. I think, on balance, theyreported $1.83 in earnings for the first quarter. That's very solid. It's 5.8% year over year -- that'spretty darn good.

Harjes: 7.5% when you look at it constant currency.

Campbell: Right,although I always get a little antsy about trying to X-out the effect ofcurrency, because the reality is they are a global companyand they will always be dealing with currency, sometimes headwinds, sometimes tailwinds. But yeah, from anoperational perspective, it is helpful to know what's behind the growth ordeceleration -- $1.83.I think the Street was looking formaybe $0.06 or $0.07 less than that, so it was a beat. There's acaveat out there. A lot of the beat,at least half of it came from a lower-than-expected tax rate. So investors shouldn't be looking at this and thinking it's an indication that this year, things are really clicking, and we'regoing to be able to deliver better than expectedin each of the remaining quarters,because they are forecasting the tax rate willnormalize over the course of the year -- $1.83 on sales of $17.8 billion. The sales were up1.6% year over year. Again, you'renot talking about a dynamo of growth, but this is a big, solid, steady-Eddykind of company.

Harjes: Exactly. When we think aboutJohnson & Johnson as a healthcare company,I think it's easy to only think about it as apharmaceutical company. But they actually arecomposed of three major segments. The first one ispharmaceutical. Let's go ahead and save that one for last,because it's probably the most important. The first twoI think we should dive into are the consumersegments, and also the medical-device segment. Theconsumer segment, we'll start with that one. This is the segment ofJohnson & Johnson that produces things likeBand-Aid and Tylenol, theJohnson's baby products,all these brands that you see and know andhopefully love. This is generally a pretty stable, flat segment. It's notsuper high-growth or high-margin. Overall, it accounts for about 18% of total revenue. It looks like it ishitting a little bit of a hiccup,especially when you look at it as a global segment.

Campbell: Yeah. We saw theconsumer segment deliver sales growth of 1% year over year, $3.2 billion in revenue. Butif you back out acquisitions and stuff, salesdidn't make any headway; they actually fell a little bit. The reason they cited for the weakness in consumer is that somecompanies were drawing down their inventory. If you'rebuilding up inventory, you're buying more than you need and sticking it in your warehouse. Maybe that happened in the fourth quarter, and now they'reworking through those inventories. That,theoretically, should be temporary. You mentionedTylenol.Tylenol was a bright spot for them. Over-the-counter medicine or products,that's the biggest part of consumer, and sales there grew 1.4% year over year. That business is stable and solid. Theacquisition tailwind they got was in beauty. That beauty market wasfairly good for them. They saw sales rise 11.6%because of those acquisitions,but they also lost ground in oral, where they saw a 6% slide, and also about a 6% slide in the baby care products. Again,lots of puts and takes there. But like you said, the consumer is your cash cow,it's steady, it's not going to grow more than that plus-1, minus-1 kind of range. So I don't think there were any major real surprises there.

Harjes: I would agree with that. As usual,it's a mixed bag, like wound care was down 12%, and we're going to have some other segment like beauty that was up a bunch. Overall, though,this segment is extremely stable. They're consumer staples. Everybody knows Acuvue contact lenses. These aresome of the biggest name brands there are.

Campbell: Yeah. I thinkinvestors have to realize, theconsumer products are not going to be a huge source of revenue orearnings growth. It's just a steady business. Maybe there's more of an opportunity in theirmedical device unit, for example.

Harjes: Sure. Let'stalk about that one. This one is 35% of total revenue, so,starting to be a little bit more important on a cash basis to this company.

Campbell: $6.3 billion in sales for the quarter, up 3%roughly year over year. You back out deals, and sales globally were up 1.7%, so, faster,a little bit better than consumer,larger percentage of the total overall pie. Theyhave a lot of different businesses, part of the 250, that are operating under themedical-device umbrella. They haveexposure to cardiovascular,diabetes, orthopedics. But not all of those businesses performed equally. You had some winners likecardiovascular, and you had some losers like diabetes.

Harjes: Right. This is a businesssegment that is very much managed by adding on small acquisitions and getting rid of low performers. It'sdefinitely a very componentizedpart of the company. They had a couple of interesting acquisitionsin the first quarter. For example, they bought themedical-optics subsection of [Abbott Labs], whichclosed on Feb. 27. This was called Abbott Medical Optics. That rounded out their eye-healthoffering, particularly within the surgery category of vision care. That vision-caresegment was actually up the most of any segmentwithin medical devices, and it now counts for about 13% ofmedical devices.

Another acquisition; I'll call out two more. The first one wasMegadyne Medical Products, andthe other one wasTorax Medical. Basically, the way that I view this business here is that they're going to keep buying different products and companies that are profitable and can boostthe places in which they already havea little bit of a footprint. When you look at Johnson & Johnson's size,they have so much distribution power,they have so many relationships with different providers of medical devices, that they'rereally able to take these smaller companies and leverage them andmake them more valuable than they would have been as stand-alones.

Campbell: I think you make a very good point, Kristine,in that the way they'remanaging this company is very opportunistically. They'relooking at it and saying, "Where have wedelivered the growth in these particular areas, andcan we sell those and take that money and buy something else that's bolt on, and kick-start growth andimprove profitability that way?" They have, for example, some really gooddemand in cardiovascular thanks tosome of their products that are usedto treat atrial fibrillation. Treating a-fib throughcatheterization,that's basically what they're doing. It's complicated, butwhat they're doing is,if you have an irregular heartbeat, they'llput a catheter in to fix the part of the heartmuscle that's setting off the wrongelectrical signal.Anyway,more procedures are being done, andthat's helping the cardiovascularside of the world.

They do have some question marks. Theorthopedic part of their businessis the biggest part of their medical-device sales. Hips, knees, spine. And there's been some pricing pressure there. It's ahighly competitive market. It's tied a little bit to the whims and whispers ofwhat's going on with the economy,because it does require a lot of out-of-pocket spending. So that business has some question marks. Also, there's some question marksassociated with the diabetes franchise, wherethey make things likeinsulin pumps. They actually saidin January that they're thinking of looking atstrategic options for that business. Perhaps, by the end of the year,they make a decision about what to do with it, either they partner it or sell it off, orwhatever. So there are some changesthat are going to be going on over the course of the year, some things to watch within this basket. But again, an important part, and it is growing.

Harjes: Ifyou look at overall trends,macro level,medical devices in general,you can probably expect they're going to do pretty well. As people get older, they live longer,they're going to need more ofthis type of surgery,for example, that this segment would address.

Campbell: Yeah,larger patient pool plays into pretty much all ofJohnson & Johnson's product lines. You're talking about a 50-year megacycle. Longer living, larger global population,definitely plays intoprocedure volume, and that should be a netbenefit or tailwind for the company.

Harjes: Exactly. The third and final segment ofJohnson & Johnson, and the one thatI think we would probably have the best time talking about,just because it's more along the lines of what wenormally discuss, that would be the pharmaceutical segment,which is calledJanssen. This one grew some 2% operationally in the first quarter. It isby far the most important part of this company. It's about 46% of total revenue. I can absolutely see itbecoming over 50%,maybe even within the next year.

Campbell: Yeah,this is also a big driverof their profitability. Just bymaking changes inhow they do manufacturing, and stayingpretty tight-fisted when it comes to spending, andbecause of the way the mix broke outbetween biologicsand small molecules. Biologics are usuallya little bit more margin-friendly. They were able to boost marginsin their pharmaceutical units by 4%, 400basis points. That's pretty extraordinary,and pretty good. Top line, like you said, on a reported basis, the growth reallywasn't that great. It was up 1%. Domestic sales were down slightly. International sales were up. There were some puts and some takes here as well. Some very strong-performing drugs, and some drugs, maybe, thatinvestors should be keeping an eye onto see whether or not they find some footing, or see whether or not sales continue to decline.

Harjes: One drug I know we've called out a bunch in the past isRemicade, which isone of their key drugs. It's an anti-inflammatory. This is a drug thateverybody has been watching because of the threat ofbiosimilar competition. Quick reminder: Biosimilars are basicallygeneric versions of very complicated drugs that you can't make what wouldtechnically be called a generic for. [Merck & Co.]is partnered on this drug. When you look abroad, you see thisbiosimilar called Inflectra being priced at about a 15%discount to Remicade. It'sa little bit concerning as an investor to think, is this going to start affecting Remicade salesin the United States as well?

Campbell: Yeah,Remicade is huge. We're talking about almost $1.7 billionjust from this one drug alone last quarter.

Harjes: Yeah, this one is super-important. But it looks like maybe we don't quite have to worry about that as much, at least not yet. Management has commented that they're not seeing much impact from aRemicade biosimilar just yet.

Campbell: I think we canprobably kill a whole episode talking aboutRemicade and the whole movement towardbiosimilars. In Europe and overseas,they have a much more establishedbiosimilar market. As a result,Remicade export volume fromJohnson & Johnson is falling much more quickly than the threat is here in theUnited States, where it's just basically an emerging market for these biosimilars.

So overall, Remicade sales fell 6%,as I mentioned, to $1.67 billion. U.S. sales were down 2.4% to $1.18 billion, and that was following the launch of Inflectra -- this was the first full quarter of it, Q1. AndI think what people have to say is, "Why were sales downif they say they don't see much of an impact?" What they were saying was, "We don't see much of an impact inprescription volume and market share." But they did say they are seeing animpact in pricing. My view is they said, "Youlaunch that biosimilar with only a 15% discount. Guess what? This is a margin friendly drug for us; we can match that price. So, we'regoing to maintain our market shareuntil you get to a point wherewe don't want to match it anymore."

So that might be a very big struggle forbiosimilar manufacturers in the United States, whereyou have these very high-priced drugs,theoretically, a lot of room for the manufacturerto be able to compete more aggressively with the biosimilars when they first roll out.

Harjes: Right,especially when you consider that a doctorlooking at your original drug versus the biosimilar version,I think there's a healthy amount of skepticism there amonga lot of prescribers in that they'll behesitant to switch patients, or even start new patients, on thebiosimilar when they're used to the original brand-name drug.

Campbell: Yeah,it's going to come down to cost, whether or not the payers make them.

Harjes: Yeah,if the pricing is minimal, I don't see payers pushing for that,I don't see doctors pushing for it. But as you mentioned, it's a pretty nascent market.

Campbell: Yeah,and I feel like, when you look backat the regular generic market,as it started to grow in the '90s,there was a lot of hesitancy about that. Of course, now, we all know that themajority of prescriptions written are for generics. So I think there's a tremendous opportunity here. Remicade is going to face headwinds for a long time. It's just that maybe the headwinds aren't as strong initially as was feared. That'ssomething to keep in mind. On the plus side, they did have some standout drugs. Darzalexfor use in multiple myeloma is now on a $1 billion blockbuster pace after winning approval at the end of 2016 for use in the second-line setting. Imbruvica,which is a drug that they share withAbbVie, is also growing very strong. Their share of that was $409 million, up 57% in the quarter year over year.

Harjes: Right. Oneother standout to mein the pharmaceutical segment,something to keep an eye on, is this acquisition ofActelion,which was a company thatJohnson & Johnson purchased for $30 billion. If that sounds like a lot, it is. Theyoriginally offered $26 billion, and Actelion said no. They tried $27 billion; still got a no. At one point,Sanofiwasin there trying to negotiate and buy Actelion; they failed.Johnson & Johnson eventually nabs up this maker ofvery specific lung-disease drugs. I'm just going to go with the acronym -- PAH is theindication for the drugs that they make.They also have a couple of potential blockbusters. Theyhave a pipeline, but interestingly, in this acquisition, the R&D unit is going to be spun off and traded independently on theSwiss stock market. Johnson & Johnson will only own 16%of that company, and they'll have the rights to buying another 16%.

ButI think this deal has been met with a lot of skepticism because of the price tag and thisdecision where you're not really going to getas much of the upside from the pipeline that this company has. So a lot of question marks surrounding that. This wasone of the very first things that was addressed during the conference call this quarter,because they're expecting the deal to closeby the end of Q2. Theyactually updated their guidance for the year to reflect bringing Actelion in. Itlooks like the expected boost to revenue will be $1.3 billion this year. I'll remind you, this was for a $30 billion acquisition.

Campbell: It's anabsolutely massive deal,and they paid through the nose for it. Butyou have to look at it from Johnson & Johnson's perspective. They have a ton of cash locked overseas that they can't bring back to the U.S. without having to be taxed on it.

Harjes: Yeah, barring somepotential theoretical tax holiday,which has been discussed,but of course, there's no guarantees there.

Campbell: Right. So, you look at it and say, "I have a chance to buy a company, Actelion, withthe cash that I have locked up overseas, in a cash deal, so, not taking on debt. The cost is very low to me to do that. So I'mbuying a company thatnot only has drugs that are on the market that are leadersin their space that are racking up a blockbuster number for me, but they'reprofitable." These are profitable drugs. Actelion was making money. So they're looking at this and saying, "We can do this deal at this price and still see a tailwind to our earnings in the first full year after completion of$0.35," we'll call it, somewhere in the $0.30-$0.40 range. So, 2018, we get that nice little tailwind, despite the actual cost. So it's an expensive deal, but it's still a profit-friendly deal for them.

Andthe argument is, across some of theselarge companies, if you don't have growth, if you're a big, huge company --we talked about this a lot with [Gilead Sciences], too, andPfizeris another one -- you have to deploy that money to buy some growth. And that's what they did.I don't fault them for that. It could end up being a win,especially if their stake in that spin off pays off over time.

Harjes: Yeah,if Gilead Sciences is any indication,the market does not like companies that just sit on cash.I personally think that's a rather short-term way of looking at it, but, we'll see if this Actelion deal pays off.

Campbell: Well, thereturn on cash isn't very high, though, is it, Kristine? So,you have to look at it,from a shareholder perspective, are you doingwhat's going to get shareholders the biggest returnwith the moneythat you're not giving me in the form of dividends or buybacks?

Harjes: Yeah, I think the tax point you make with Actelion is very spot-on. This is acompany that's headquartered in Switzerland. They've already paid the foreign taxes on that money, so now theydon't need to pay the repatriation taxes on $30 billion, which issubstantial. Anyway, you mentioned the dividend, andthat is definitely the next thing I want to talk about, because that is one huge reason why people buy this stock. Right now, they're paying out apayout ratio of about 2.5%. They are a dividend aristocrat. They have been increasing their dividend for 54 or 55 years. It's apretty incredible amount. They'reprobably going to raise it again in the next two weeks,probably in the high-single-digit range, boost to this payout that they've beenpaying their shareholders year in and year out for a long time.

Campbell: Yeah, their payout ratio is only 53%. A few years ago, it was 70%. So they have room and flexibility, and they have plenty of cash flow coming in. This is one of those companies, togo back and come full circle on the conversation, if you'relooking for growth, you're probably notgoing to be excited by this company. Butif you're looking for a company that will be a steady-Eddy performer and give you anice dividend every year, then yes, this is a core holding. It'snot necessarily a cheap dividend stock. If you lookhistorically over the past 10 years, it'strading at the higher end of its trailing P/E, not the lower end. Butat the same time,when you talk about a company like J&J, you're not really talking about timing it based on valuation.

Harjes: Yeah,exactly, it'stypically always traded for a premium. By the way,thank you for correcting me earlier -- I said payout ratio of 2.5%. I meant dividend yield. Payout ratio, as you noted, is in the mid-50s, and that's on both an earnings basis and a cash flow basis. But yeah, as we've said, probably a million times already in this episode, it's a reliable company. It's one of just two companies to have a triple-A rating fromStandard & Poor's -- that'sbetter than the U.S. government. Theystill have a ton of cash on the balance sheet. They have some debt, but again, "AAA"-rated balance sheet -- this is a strong company. Nothing to worry about here.

Campbell: I'm going to caveat that a little bit, Kristine, to wrap up here. There are some things thatinvestors are going to want to watch.I have faith that Johnson & Johnson can navigate these struggles, butRemicade is still a question mark, because itaccounts for a large percentage of their sales. You'regoing to have to watch and see how that plays out in script trendsover the course of the next year. I also saw a drop-off in revenue forZytiga, which is animportant prostate-cancer drug, andXarelto, which is animportant anticoagulant. So we'regoing to want to watch those trends, too. Those are $2 billion-a-year-sales drugs,and we want to know whether or not they're going to find footing, or ifcompetition is going to continue to put those sales at risk. So there are some things thatinvestors will want to watch. But generally speaking, yeah.

Harjes: Yeah,I agree. It's not all sunshine and rainbows. But personally, I'm a shareholder. I am happy to be a shareholder. I would be happy to buy more at prices today if I had room in my portfolio for that,but it's not the right decision for me to overloadeven more in healthcare right now. But honestly, I think I will be holding this company for a very long time. And whenI'm gettingtoward retirement and I look back and say, "Ibought this company in my early 20s,"I think I'll be OK with that decision.

Campbell: Yeah, it's kind of one of those stocks whereyou look at each sector and say --it's like owning [ExxonMobil]if you're investing in energy stocks.

Harjes: Yeah,it's a classic. So hopefully this episode has helped our listeners sink their teetha little bit more into earnings and in generalwhat goes on with this Goliath of a company. Todd, thanks so much fordissecting it with me today!

Campbell: Happy to be here!

Harjes: Asalways, people on the program may haveinterests in the stocks that they talk about, andThe Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and bearing with my voice today, and Fool on!

Kristine Harjes owns shares of Gilead Sciences and Johnson & Johnson. Todd Campbell owns shares of Celgene, Gilead Sciences, and Pfizer. The Motley Fool owns shares of and recommends Celgene, Gilead Sciences, and Johnson & Johnson. The Motley Fool owns shares of ExxonMobil and has the following options: short June 2017 $70 calls on Gilead Sciences. The Motley Fool has a disclosure policy.