Summary
- Johnson & Johnson beat expectations by a comfortable margin in Q3'20, driven by the device business, but investors seem concerned about the risk that the procedure recovery is stalling.
- The pause in the Phase III SARS-CoV2 vaccine trial is unwelcome news, but I don't expect the vaccine to be a major long-term driver for JNJ's earnings and cash flow.
- Johnson & Johnson has long been dogged about growth concerns, and improved R&D productivity would certainly help, but I believe the company can maintain a 3% long-term trajectory.
- Between cash flow growth, margins, and other factors, I believe Johnson & Johnson is undervalued below $160 with upside to close to $180.
I've learned to be suspicious of apparent bargains among ultra-cap companies, and there are certainly enough moving parts to Johnson & Johnson (JNJ) to fill a small library of articles. Even so, while I can understand some concerns about growth and pipeline, as well as headline risks from lawsuits, JNJ shares look surprisingly interesting in a market where a lot of drug and device stocks enjoy elevated multiples.
For the short term, I expect worries to be focused on the pause of the Phase III COVID-19 vaccine trial, headline risk, and a potentially underlying stall in procedure recoveries. I also expect some concerns about the drug pipeline and JNJ's ability to offset patent expirations with internal R&D productivity. Even with that all factored in, a prospective high-single-digit return from a reliable performer isn't something to ignore.
No Love For A Healthy Beat
Johnson & Johnson did well relative to expectations, with a 4% top-line beat and a 10% operating income beat, but the Street was unimpressed, as concerns about near-term growth prospects seemed to loom larger in investors' minds.
Revenue rose about 2% in the quarter, with management estimating a 2% to 3% headwind from COVID-19. Pharmaceuticals revenue rose 5%, beating expectations by 2%. Device revenue declined about 3%, beating by 13% on healthy recoveries in elective/non-emergent procedures. Consumer revenue rose about 3%, beating by about 3% with steady performance.
Gross margin improved 30bp from the year-ago quarter, beating expectations by three and a half points. JNJ couldn't hold on to all of this at the operating line, but flat operating income was still good for a 10% beat and 170bp of operating margin outperformance.
Given that I could probably write a 10,000-word novelette just on earnings, I'm going to pick the items that stuck out to me. That includes the 15% growth in top-earning drug Stelara and the 44% growth in Darzalex, with the sub-q formulation helping drive growth. Interventional devices showed ongoing recoveries in procedure counts, with the ortho business down just 3% as the U.S. business returned to growth (which bodes well for Stryker (NYSE:SYK), which is skewed even more to the U.S.), surgery down 7% (after a 34% drop in Q2), and electrophysiology up double digits.
Probably the worst news in the quarter was that management didn't point to month-by-month sequential improvement in procedures during the quarter. There were already fears that the recovery was stalling out, and this won't help matters. I'd definitely look to the commentary from companies like Abbott (NYSE:ABT) and Stryker for more color on this, but it is not hard to imagine that there's an unsteady balance between patients still leery of infection risk, procedures that simply cannot be delayed further, and centers that really need patient counts to improve to shore up their own financial situations.
