Justin Sullivan
Johnson & Johnson (NYSE:JNJ) (“JNJ”) has been following the overall negative trend in the market since April of this year, but all things considered, JNJ hasn’t performed badly relative to the S&P 500, large-cap pharmaceuticals, and/or large-cap med-techs over the last year, nor since my last bullish write-up on the shares about two years ago. The performance of JNJ hasn’t been spectacular, but it has shown a lot of the GARP attributes that I had expected to see.
Looking at the upcoming third quarter earnings release, I think expectations are dialed in to a point where the bias should be positive for the company and stock. The average earnings estimate has come down about 5% over the last three months, and I think this is a reasonable reflection of pressures from currency (a strong dollar), ongoing inflation, and certain market disruptions like staffing shortages in hospitals. I do expect a relatively upbeat tone, however, with more visibility on improving margins and market share growth in 2023.
If you’re looking for a get-rich-quick name, I don’t think JNJ is really ever going to be the stock for you. If you’re looking for a name that should generate returns in the neighborhood of the S&P 500 with some counter-cyclical positives, not to mention potential upside from more active management, this is still a name to consider.
Core Franchises Should Carry Johnson & Johnson Through
Although I do see a risk of higher-than-modeled forex pressures, I expect operational sales growth from JNJ in the 6% to 7% range for the upcoming third quarter – close to the current sell-side average, but a little higher than the mathematical average of 6.3%. Ex-vaccine growth should be around 1.0% to 1.5% higher than that.
MedTech should lead the way this quarter, as normalization of procedure counts (post-COVID) and share gains in several markets outpace some ongoing pressures from staffing shortages. I’m expecting something a little north of 7% for MedTech core growth, with double-digit growth in Interventional on strong electrophysiology and growing neurovascular. Ortho and surgery will probably be more lackluster, and it’s well worth watching how JNJ performs in major ortho (hips and knees) and spine relative to Stryker (SYK), Zimmer (ZBH), and others.
The Pharmaceuticals business should also outgrow the company average, though not to the same extent as MedTech. The company’s core immunology and oncology platforms should perform well, particularly with ongoing share growth from Darzalex in hematology, but I could see COVID-19 vaccine sales as a driver of variance relative to sell-side expectations. With Legend Biotech (LEGN) already announcing that the companies will be spending $500M to increase their internal lentivirus manufacturing capacity, I’d expect more questions on potential M&A targets given the market pressures on biotechs these days and management’s stated willingness to growth through strategic M&A.
Consumer will likely be the laggard, with something around 3% year-over-year core growth. Inflation and supply bottlenecks continue to be an issue for the company. I wouldn’t expect meaningful updates on the spin-off plan with this quarterly report.
JNJ Continues To Target Above-Average Growth, But Targeting Isn’t The Same As Delivering
JNJ’s newish CEO (Duato became CEO at the beginning of the year) has maintained consistent targets for JNJ to outgrow its markets and major competitors over the next five years, adjusting for the expected spinoff of the Consumer business in 2023.
Pharma
I’ve talked about the transformation of the drug business before, and I continue to be impressed at how the company has used strategic M&A and reinvestment into core science capabilities to build this business. The immunology business has almost doubled since 2013, while the oncology business has grown from a bit under $4B in 2013 to what I expect will be around $16.7B in 2022, with the company enjoying a particularly strong franchise in hematology now.
Handicapping pharma pipeline development is never easy in the best of times, but JNJ has launched over one new drug a year (on average) over the past decade, and has not only ongoing share growth opportunities in areas like hematology, but also emerging opportunities in areas like lung cancer with its Rybrevant/lazertinib combo. Given the company’s clean balance sheet and market pressures on biotechs, I’d expect JNJ to be a willing and able acquirer, but I also expect discipline with the company less likely to chase near-term revenue boosts and more likely to target opportunities to enter into intriguing science-driven platform opportunities.
MedTech
Despite the challenges and unpredictability of drug development, it’s actually the company’s MedTech business where I have more doubts. The company has put a lot of its underperformance behind it already, underperformance that I believe was driven by a lack of reinvestment and management prioritization, but there is still plenty of work to do.
While the company has done well in hip (orthopedics), I haven’t been as impressed with the company’s efforts in knee, spine, trauma, or extremity, and I think the company has been slow to recognize the importance of robotics. Management has already started moving to correct a lot of this (namely through increased M&A), but companies like Globus (GMED), Medtronic (MDT), Stryker, and Zimmer have stepped up their game in recent years. Likewise, while I think JNJ can still become a player in soft tissue robotics (where it will compete with Intuitive Surgical (ISRG), I’ve been disappointed by how long this has taken to develop.
I like management’s decision to refocus its device efforts around core portfolios in areas like oncology, cardiology, trauma, respiratory care, and stroke – these are significant drivers of mortality and areas where innovation can drive market share and attractive pricing. Neurovascular is another of those areas where I would have liked to see JNJ get more active years ago, but this remains an attractive market and I think JNJ could use internal development and M&A to build this business more quickly.
One area worth watching is the ablation market. JNJ is a market leader in ablation to treat atrial fibrillation, but the growth of pulsed field ablation could give rivals like Boston Scientific (BSX) and Medtronic a chance to grab share; I personally think Abbott (ABT) is more vulnerable than JNJ, but time will tell.
All told, while I still think there is more to prove in the MedTech business relative to the pharmaceutical business, I think JNJ is on better footing now. Not only has the company stepped up its overall R&D reinvestment in the business, but the company has started more actively targeting growth opportunities and “moonshot” R&D projects rather than just serial innovation on older and well-established but slower-growing platforms.
The Outlook
I do still have some doubts that JNJ can achieve the growth it’s targeting from MedTech, but I also think the business is performing better and management is earning a benefit of the doubt with improved execution. I also see some risk to the drug business from more aggressive government actions on drug pricing, but relative to many drug companies, I don’t see JNJ as quite as exposed to aggressive pricing. As overall risks go, then, I’m not too concerned about the longer-term outlook for JNJ.
While my long-term revenue growth forecast ends up at around 3%, some of that is driven by deceleration in the COVID-19 vaccine business (which may not decelerate as much as I fear); core growth should be above 3% and there could be upside beyond that if management can hit its targets.
With the drug business becoming a larger and larger part of the mix, I expect improving margins, with EBITDA margin growing from the low 30%’s pre-COVID-19 to around 37%-38% over the next three to four years and FCF margin climbing toward 30% over time, driving mid-single-digit FCF growth.
The Bottom Line
I continue to value large med-techs like JNJ through a combination of discounted free cash flow and EV/EBITDA and P/E methodologies driven by growth (revenue, primarily) and margins. By these approaches, JNJ continues to look undervalued to me, with a total expected long-term annualized return of around 8% and 10% to 20% upside over the next year or two.
While a potential 20% move in JNJ would qualify as significant, I think JNJ is better seen as a “slow and steady” GARP type of name that should be bought during weak markets – times like these, in other words. With a strong core business and opportunities to drive better growth through improved R&D prioritization (targeting growing/disruptive product opportunities), selective M&A, and solid execution, I think JNJ remains a good core holding prospect, even if not the most scintillating idea at any given time.
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