Healthcare and consumer staples giant Johnson & Johnson is a core holding in both newsletter portfolios. Let’s take a deep dive into one of its key sources of growth, its ‘Pharmaceutical’ segment.
By Alexander J. Poulos and Kris Rosemann
Consistency of returns is one of the hardest goals to achieve in the investment world. Often, one of the key components when selecting equities to build a long-term portfolio is their respective durability through the ups and downs of the economic cycle (in portfolio theory their collective performance would matter). A company that is able to generate resilient returns under various conditions often has a business model with defensive characteristics and an attractive Economic Castle.
Johnson & Johnson (JNJ), the consumer healthcare behemoth and newsletter portfolio holding, fits the above definition closely. J&J’s business model is diversified throughout all aspects of healthcare ranging from well-trusted consumer products such as baby powder to medical devices and cutting-edge research culminating in branded medications. The company dates its founding to 1886 when “President Grover Cleveland dedicated the Statue of Liberty” and “Coca-Cola was invented by a pharmacist in Atlanta.” Its first annual meeting of stockholders in 1888 had only three shareholders. Let’s dig in to the most innovative area of J&J’s businesses, the ‘Pharmaceutical’ segment.
Remicade
J&J’s pharmaceutical business competes in a broad range of therapeutic classes, highlighting the breadth and depth of its research efforts. The company’s best-selling pharmaceutical product remains Remicade, a tumor necrosis (TNF) blocker predominantly used in Crohn’s Disease along with a host of other inflammatory diseases. J&J originally acquired the rights to Remicade through the acquisition of Centocor for roughly $5 billion in stock in 1999, which has proved to be a masterstroke as Remicade has been established as the gold standard for the treatment of Crohn’s Disease. Remicade posted total sales of nearly $7 billion in 2016 alone.
Though Remicade remains J&J’s top selling product, Pfizer (PFE) launched a competing treatment dubbed Inflectra in November 2016. The launch was done “at risk” as Pfizer remains confident it will invalidate the rest of the intellectual property (IP) estate that protects Remicade. We view the aggressive move by Pfizer, a well respected and deep-pocketed pharma giant, as the ushering in of the age of the biosimilar, and we expect the rise of the biosimilars will follow the same method witnessed via the loss of patent protection on small molecule products.
Many believe the complexity of the biological drug class will shield the patented product from intense pricing competition, a belief we generally view as false, and J&J believes that it will be able to maintain market share in a market that it claims is already competitive on price in other geographic segments. Time will tell. Fortunately, being the well-diversified pharma player it is, J&J is working hard to mitigate any loss from Pfizer’s entrance in this area, but we suspect the impact of Inflectra will be felt throughout 2017.
Oncology
J&J continues to pivot into the field of oncology as reimbursement levels remain robust.
The company owns a 50% stake in Imbruvica, the pace setter for the treatment of Leukemia, and sales of Imbruvica continue to ramp higher as partner AbbVie (ABBV) pushes for a more rigorous label. The expansion of Imbruvica’s treatment label is crucial for the product to reach its lofty peak annual sales estimates of $6 billion, and J&J’s portion of Imbruvica sales came in north of $1.2 billion in 2016, a significant jump over 2015’s tally. We remain excited about Imbruvica’s potential and view the product as an attractive cornerstone of J&J’s oncology division.
Still, new compounds are necessary to expand J&J’s reach in the field, and the recently approved Darzalex for the treatment of multiple myeloma may help to fill this role. The product achieved approval as fourth line monotherapy, but its true potential remains in combination with the established treatments in the field. For example, J&J is looking to pair Darzalex with Velcade in addition to dexamethasone in an effort to set up a new standard of care for the treatment of multiple myeloma, which remains an area of intense competition with multiple recent entrants into the field.
We are impressed with Darzalex thus far and feel J&J has a winning compound that should help offset potential sales erosion from the loss of patent exclusivity for Remicade. With Imbruvica and Darzalex in the fold, J&J’s ‘Oncology’ division is a force to be reckoned with.
Cardiovascular
The most prevalent name in J&J’s ‘Cardiovascular’ division is Xarelto, a factor Xa inhibitor indicated for a broad range of clotting disease states. Xarelto’s key advantage remains its once-daily dosing, which distinguishes it from its primary rival Eliquis, but Eliquis recently surpassed Xarelto in terms of market share thanks to it capturing a larger proportion of new scripts written per IMS data, a disturbing trend. J&J may have lost focus a bit, but the company has returned to focusing on positioning Xarelto as the preferred product on many formularies of late.
We expect the field to remain very competitive, and the market opportunity is enormous as the generic alternative and clear market leader Warfarin has a litany of drug-drug and drug-food interactions along with the need for more frequent lab tests. Once a reversal agent enters the market, the market share for Warfarin will shrink rapidly with Xarelto and Eliquis being the ultimate beneficiaries. Xarelto continues to power the ‘Cardiovascular’ group’s results higher with 2016 sales of nearly $2.3 billion, solidifying the product’s blockbuster status. Xarelto sales jumped over 22% in the year on a year-over-year basis, and the treatment has more growing to do before it hits peak sales, in our view.
Invokana is the second-most valuable asset in the ‘Cardiovascular’ division with 2016 sales north of $1.4 billion dollars. Invokana belongs to the subtype 2 sodium-glucose transport (SGLT-2) inhibitor used for the treatment of diabetes, a class that remains competitive with three primary players battling it out for market share. Invokana is currently the clear leader based on script data, but recent results from archrival Jardiance suggest this may change as 2017 progresses. The key for the battle in formulary position remains clinical outcomes, a notable change from previous years. Eli Lilly (LLY), the manufacturer of Jardiance, conducted a study that proved the product reduced cardiac death in patients, offering a key point of differentiation, a fact we fully expect Eli Lilly to exploit in marketing the product.
We view the recent developments in the cardiovascular division as troubling and no longer feel the unit will deliver meaningful growth over the near term. Such a trend may have already begun as J&J’s ‘Cardiovascular’ sales on an operational basis in 2016 advanced by less than 1% from 2015 levels–reported results dropped slightly due to currency headwinds–compared to more than 15% year-over-year reported sales growth in 2015. Though the decline in revenue may be gradual, we view the ‘Oncology’ division as the primary growth engine for J&J pharma moving forward.
Inflammatory Disease
Outside of Remicade, J&J owns two additional products to treat inflammatory diseases. The next most valuable franchise is Stelara, a human interleukin-12 and 23 antagonists for the treatment of a host of inflammatory conditions. The label for Stelara is progressing in a similar manner as Remicade, but Stelara’s primary area of use remains Psoriatic Arthritis even though it was recently approved for Crohn’s Disease. The product continues to ramp sales progressively higher with a sales jump of over 30% to $3.2 billion in 2016 from 2015. At first glance, the sales growth trend seems impressive, but we’ll be watching Rx trends closely.
For one, Novartis’ (NVS) Cosentyx continues to take market share for the indication of Psoriatic Arthritis. The growth of Cosentyx coupled with the recent approval of Eli Lilly’s Taltz may draw script volume away from Stelara in the coming periods. Also, the specialty inflammatory disease category remains a primary target for PBM’s looking to reign in the cost of prescription drugs while numerous products jockey for favorable formulary positioning. As a result, we expect pricing gains to be harder to come by, making volume increases a requirement for revenue growth, something we do not expect Stelara to achieve as new entrants continue eating up market share.
The final product in the division is Simponi, which belongs to the TNF class. Simponi is used to treat a bevy of inflammatory diseases such as Psoriatic Arthritis, Rheumatoid Arthritis and most notably Ulcerative Colitis. The treatment generated sales of more than $1.7 billion in 2016, a 31% gain over 2015 sales, but we expect sales of the entire TNF class to come under pressure as Inflectra, the biosimilar for Remicade, makes its presence felt.
Looking at the entire ‘Inflammatory Disease’ division as a whole, the group has its share of challenges. Remicade sales may face headwinds as Inflectra steals share, and we have a hard time envisioning either Simponi or Stelara ramping sales volume meaningfully, a necessity for growth given anticipated pricing pressures. The competitive pressures felt in the ‘Inflammatory Disease’ and ‘Cardiovascular’ divisions likely motivated management to strike a deal to utilize offshore cash to acquire additional treatments and drive growth inorganically via the acquisition of Actelion. Let’s have a look.
Actelion
J&J has shored up its ‘Cardiovascular’ division through the acquisition of Actelion, a move we view as a good strategic fit as Actelion’s product lineup revolves around treatment for Pulmonary Arterial Hypertension (PAH). However, the price tag could be considered a bit steep, though J&J plans to spin off some of Actelion’s R&D into a new company. Returns similar to those generated form the Centocor deal in the late 90’s are highly unlikely, but we wouldn’t expect every acquisition to work out as swimmingly as it did.
We view the deal more as a defensive move, a way to utilize cash trapped overseas while likely generating a positive return via a stable of approved products. The deal will inevitably impact the company’s balance sheet health, but we expect Johnson & Johnson’s robust free cash flow generation to handle any increase in debt or depletion of its cash coffers relatively easily, “J&J Boasts Below-Market Earnings Multiple; Deal with Actelion Not Concerning.”
Valuentum’s Position
J&J’s diversified business model produces an abundance of free cash flow far beyond the operational needs of the business. The company has a long and enviable track record of returning cash to shareholders via a robust dividend, and it remains near the top of our list of favorite dividend payers as it registers an impressive Dividend Cushion ratio–driven by its free cash flow coverage of cash dividend obligations and current balance sheet health—as it boasts a solid yield. We see no reason to consider reducing our exposure to Johnson & Johnson at this time, but we will continue closely monitoring developments within its innovative ‘Pharmaceutical’ segment as it continues to propel the consolidated business to new heights. It’s really hard not to like J&J.