Analysis: JNJ

Tuesday morning, before the opening bell, Johnson & Johnson (JNJ) reported a top and bottom-line beat with its fourth-quarter results. Revenues of $20.39 billion (up 1.0% year over year) beat the consensus of $20.17 billion, and adjusted earnings per share of $1.97 (up 8% year over year) exceeded the consensus by $0.02.

"Johnson & Johnson delivered another year of strong operational sales growth of 6.3% and achieved our 35th consecutive year of adjusted operational earnings growth at 9.8% in 2018. This can be attributed to accelerated underlying sales performance across each of our businesses, where we also leveraged our scale across the enterprise to improve margins," said Alex Gorsky, Chairman and CEO in the press release. "Looking ahead, the strength of our broad-based business and disciplined approach to portfolio management positions us to continue to fuel investments in innovation that enable us to capitalize on strategic opportunities and deliver strong performance over the long-term."

Although the total sales growth in the quarter looks tepid, remember that about half of the company's sales come from outside the United States, and therefore, currency and the strength of the U.S. dollar carry a large impact. When we begin to strip out such impacts, in total for the quarter, sales on an operational basis increased 3.3% as currency had a negative impact of 2.3%. And when excluding the net impact of acquisitions and divestitures, operational sales growth was 5.3% worldwide, driven by a 2.6% increase in the United States and an 8.3% increase outside the U.S. As such, we think the results suggest healthy trends at the company and solid performance in aggregate. This view is backed by a full-year 2018 where Worldwide Consumer Sales and Pharmaceuticals grew above their respective market rates.

Before getting into the segments, management announced its full-year 2019 guidance in the release, and we believe that is the main driver behind the stock's early down trading. They expect sales to be in the range of $80.4 billion to $81.2 billion (below consensus of $82.57 billion), reflecting adjusted operational growth in the range of 2.0% to 3.0%. Furthermore, adjusted EPS for full-year 2019 is expected to be in the range of $8.50 to 8.65 (consensus $8.60), reflecting expected operation growth in the range of 5.7% to 7.6%. Included in guidance is an approximate $3 billion impact on some of its pharmaceutical products related to biosimilar and generics (likely Zytiga), which are both general challenges faced by many in the industry.

Despite these pressures, management expressed confidence in their ability to drive growth into the future through their marketed portfolio and near-term pipeline. In Consumer, management expects to grow slightly above the market rate, continue to build their e-commerce and digital capabilities with focus on both global and local markets, while also expand margins. In Medical Devices, it appears that the momentum built over the last two quarters is expected to continue into 2019 as management said they expect to "accelerate growth through improved execution and enhance the flow and value of innovation, which includes the progression of digital platforms," and they expressed their commitment to improving Orthopedics. Lastly, remember that any weakness in the dollar would represent a significant tailwind for JNJ.

Worldwide Consumer

Worldwide Consumer sales came in at $3.536 billion, which was in line with the consensus. On a reported basis, year over year, sales were relatively unchanged, but from an operational perspective, which excludes translational currency, sales increased by 3.3%. Breaking down operational growth one step further to exclude acquisition and divestitures (organic), worldwide sales advanced 3.8%, driven by a 5.5% rise in the U.S. and a 2.8% increase outside the U.S.

Johnson & Johnson continues to see strong share gains in the e-commerce channel, helping the company achieve strong double-digit growth across all regions. Meanwhile, Beauty posted strong results with sales increasing 4.5% (when adjusted for the impact of the Nizoral divesiture) on strength in Aveeno and Neutrogena in the U.S. and the expansion of the Vogue portfolio outside the U.S.

Worldwide Pharmaceutical

Worldwide Pharmaceutical sales were $10.19 billion, edging the consensus of about $10.02 billion. On a reported basis, year over year, sales increased 5.3%, but grew 7.2% on an operational basis, which excludes the impact of translational currency. Breaking down the operational results one step further to exclude acquisition and divestiture (organic), worldwide sales increased 7.2%, driven by a 2.8% rise in the U.S. and 13.7% growth outside the U.S. The sluggishness in U.S. sales was mainly attributed to the impact of generic competition for Zytiga, which management said had a roughly 100 basis point impact on U.S. growth to go along with increased discounts for Xarelto. Still, the company had seven key products deliver double-digit sales growth during the quarter, keeping the division's above-market growth rate intact.

Most notably, sales in the oncology portfolio rose about 25% on continued strength in Darzalex (60% sales increase globally with share gains in the U.S. and EU). As for Zytiga, growth slowed to about 6% ($786 million in sales, below consensus of $885 million) as the 27% increase outside the U.S was partially offset by the roughly 13% decline in the U.S. due to generics. Immunology sales increased 9.7% off strong performance in Stelara ($1.44 million in sales vs. $1.355 consensus) for which market share increased in the U.S. However, continued erosion of Remicade due to discounts and biosimilars remains a headwind (though sales of $1.238 million slightly beat the $1.217 consensus).

On esketamine, a pipeline therapeutic drug we have high expectations for in the future due to its potential for treatment-resistant depression, management remained excited for its approval and a product launch in this year.

Worldwide Medical Devices

Worldwide Medical devices sales came in at $6.668 billion, slightly below the consensus of $6.716 billion consensus. The Devices sales figure, year over year, represented a decline of 4.4% on a reported basis and a drop of 2.2% on an operational basis which excludes the impact of translational currency. But that is not the full story. Excluding the net impact of acquisitions and divestitures on an operational basis (organic), worldwide sales increased 3.3%, driven by a 1.0% increase in the U.S. and 5.4% growth outside the U.S.. That 3.3% organic growth is an acceleration from the third quarter 2018 rate of 2.9%, and thus, provides validation to management's plan to improve the business.

Interventional Solutions delivered another strong performance in the fourth quarter, increasing sales 12.2% on an operational basis with notable strength in electrophysiology, which grew more than 14% worldwide. Within Surgery's 3.8% operational sales increase, Advance Surgery saw strong growth of 5.7% globally, led by biosurgery growth of over 9% and a 5.5% sales increase in energy. In all, management was very pleased with surgery's results. Meanwhile, Orthopedics sales declined by 0.5% on an operational basis. Although management noted how this business has lagged market growth, they did highlight how it has delivered four straight quarters of sequential improvement.

As for some other operational highlights, the company ended the year with $19.7 billion in cash, up from $18.3 billion a year ago. Net debt ended the year at approximately $11 billion, which consists of the roughly $20 billion in cash and $31 billion of debt. Free cash flow also increased from 2017 to 2018, growing to $18.6 billion from $17.8 billion. As for the $5 billion share repurchase program, which was announced in mid-December in the wake of the stock's huge selloff related to the talc story by Reuters, $0.9 billion has been spent thus far for a completion rate of about 20%. The pristine balance sheet, the strong cash flows, and management's willingness to aggressively buy back its own stock when they see a discount are a few reasons why we have felt that the talc litigation is well contained from a financial perspective and likely offering a long-term buying opportunity.

Overall, we believe the quarter demonstrated a continuation of solid trends that we expect will carry into 2019. Although critics will point to a tepid 2019 outlook, we contend that management is typically conservative with their forecasts and the sell-side consensus was likely too high to begin with. Meanwhile, the company has put together a track record of solid execution, evidenced by above market growth in two key areas (Consumer and Pharmaceuticals despite near-term pressures) with consistent improvements to Medical Devices-- just as they said they would. Despite this, we still see a stock down roughly $20, or 13% since the mid-December talc report, even though it looks well-contained at this point. Therefore, we view shares trading at just 15x the midpoint of management's 2019 adjusted earnings per share outlook as inexpensive and attractive, and we reiterate our One rating.