In Johnson & Johnson’s (JNJ) third-quarter report, released October 13, reported results weren’t all that rosy for the Dividend Growth Newsletter portfolio holding. Revenue and adjusted earnings per share fell 7.4% and 7.5%, respectively, compared to the third quarter of 2014, as domestic sales decreased 0.6% in the quarter and international sales dropped 15.7% on a comparable basis. It’s not something that we were very pleased to see, but for a variety of reasons, reported results don’t quite tell the whole story.
For one, on an operational basis, which excludes foreign exchange and a number of other items, Johnson & Johnson’s quarterly results were much more encouraging. Foreign currency exchange rates had a negative impact of 8.2 percentage points on reported results, as sales grew 0.8% on an operational basis. Excluding the impact of acquisitions, divestitures and hepatitis C sales, operational revenue performance was much better in the quarter, advancing 5.6% compared to the year-ago period. Excluding those same factors, domestic sales leapt 7.7% and international sales advanced 3.8% on a year-over-year basis. On an operational basis, adjusted earnings per share even nudged higher on a year-over-year basis.
Thanks in part to the strong performance in the quarter, management raised the lower bound of its adjusted earnings per share guidance for the full year of 2015. The healthcare giant now expects to report adjusted earnings per share in the range of $6.15-$6.20 for the year, compared to previous guidance of $6.10-$6.20. Importantly, the increase of the lower end of management’s guidance range for earnings is due to operational improvements in the business, which comes despite research and development spending growing by 160 basis points in the quarter on a year-over-year basis, to 12.6% of sales. Buybacks to the tune of a new $10 billion repurchase program will only sweeten the pot. Internals at J&J generally remain robust, in our view.
Though Johnson & Johnson’s Consumer division is its smallest division, it was the strongest performer for the company in the third quarter. Sales grew 3.1% in the division on an operational basis compared to the year-ago period. Domestic sales in the division had an outstanding three months, growing nearly 9%. New product launches, strong growth in domestic over-the-counter painkillers, domestic allergy medicine inventory builds, and outstanding performance in feminine protection products were key growth drivers in the quarter for the division. The only segment within the Consumer division to record a loss on an operational basis was the Wound Care/ Other segment, where comparative results were hurt by the recent divestiture of an international cholesterol treatment. The divestiture of the SPLENDA low calorie sweetener brand in the quarter completed the divestiture of products within the firm’s nutritionals business.
J&J’s Pharmaceutical division sales took a hit in the third quarter of 2015 largely due to the increase of competitive products in the hepatitis C market. Worldwide sales of the firm’s hepatitis C treatment cascaded nearly 89% on an operational basis, leading overall Pharmaceutical sales down 0.3% on an operational basis from the year-ago period. The impact was most notably felt in its US operations, where sales fell 4.5% on a year-over-year basis. Excluding the impact of acquisitions, divestitures, hepatitis C sales, and on an operational basis, sales grew approximately 10% in the third quarter compared to the same period in 2014, however. Competing cures from Gilead (GILD) and AbbVie (ABBV) have effectively shut out opportunities in the hepatitis C market.
J&J’s pharmaceutical pipeline is as strong as ever, in our view. The company is planning to file 10 new molecular entities (NMEs) between now and 2019 that individually have the potential to generate $1 billion in sales annually, a cumulative $10 billion opportunity. For perspective, the firm’s portfolio currently consists of 3 core brands that individually generate $1 billion or more in sales annually, and it has 7 other in-market products that individually have $1 billion annual sales trajectories in 2015. The only segment within J&J’s Pharmaceutical division to realize operational sales growth less that 3% in the third quarter of 2015 was its infectious diseases segment, which experienced a sales decline of nearly 40% compared to the year-ago period, but this was due almost entirely to competition in the hepatitis C market. J&J is a pharmaceutical powerhouse, and this is not going to change anytime soon.
Image source: Johnson & Johnson Pharmaceutical Business Review
In the third quarter, J&J’s Medical Devices division fared better than its Pharmaceutical division, growing sales nearly 1% on an operational basis. Domestic sales were stronger than international sales, growing by 2% and 0.1% on an operational basis, respectively. Though the completion of the $2 billion divestiture of its Cordis diagnostics business slightly impacted results in the quarter, it has had a material impact on comparative results through the first nine months of 2015. Strong performance in the cardiovascular and vision care segments helped offset weakness in diabetes care and orthopedics.
Management believes it has both organic and inorganic opportunities to return its Medical Devices division to significant growth. Through internal innovation and from products in development, fueled by increased R&D spending, the firm has opportunities in the energy and infection-prevention markets. Originating from ongoing internal innovation, but also requiring externally sourced advances to a degree, are additional opportunities in the spine and trauma markets. Management has also left the possibility for incremental M&A activity on the table, but given the scale of Johnson & Johnson’s business, adding a few points of growth would amount to a significant acquisition, something that would not likely spring up overnight.
Though J&J’s reported results have suffered immensely from currency headwinds, operational performance is sound, and management remains confident in the ability of its Pharmaceutical and Medical Devices divisions to drive future growth. J&J’s financial flexibility may be one of its most attractive attributes, however. As of the end of the third quarter, a $20 billion debt load was overshadowed by $37 billion in cash and marketable securities. Such flexibility has paved the way for a significant share buyback program as it leaves the door open for value-creating M&A activity. The loss of revenue from its hepatitis C treatment has impacted J&J in the past year, but the healthcare giant’s robust Pharmaceutical pipeline may soon be churning out enough products to ease investor concerns.
J&J remains a core holding in the Dividend Growth Newsletter portfolio. The company’s solid 3%+ dividend yield is backed by 2.4 Dividend Cushion ratio, and we won’t be parting with shares anytime soon.