Strong New Drug Launches Offset Generic Competition in J&J's 3Q

 Johnson & Johnson (JNJ) reported third-quarter results that largely matched our expectations, and we don't expect any changes to our fair value estimate. Total sales increased 3% operationally versus the prior-year period as new product launches offset generic competition to anti-infection drug Levaquin and continued manufacturing problems in the consumer over-the-counter business. Earnings per share grew only 1% year over year as increased selling and marketing costs caused earnings to grow more slowly than sales. J&J increased the bottom end of its 2011 EPS guidance range by 3%, taking the target to $1.95-$2.00, which we expect the company to meet.

In the pharmaceutical division, drug sales increased operationally 5% versus the prior-year period. New product launches are offsetting generic competition primarily to Levaquin, which lost exclusivity in June. With three key approvals in 2011 already, J&J is well positioned to replenish its portfolio of branded drugs. The Edurant approval for HIV, Zytiga approval for prostate cancer, and Incivo approval for hepatitis C add three new potential blockbusters for the company. Also, despite a mixed Food and Drug Administration panel in September (9-2 positive vote, but FDA documents recommended against approval), Xarelto still holds blockbuster potential. We expect these new products will more than offset J&J's limited patent exposure over the next five years.

Turning to devices, sales increased 2% operationally year over year as the decision to exit the drug-coated stent market and tepid procedure volume in the United States are slowing overall growth. We expect continued moderate growth in this segment until the worldwide economy improves, which should drive increased medical utilization and increased demand for J&J's devices. Additionally, the acquisition of Synthes should close in 2012, which should reinvigorate growth in the device segment as Synthes' trauma products remain in high demand, especially in emerging markets.

In the consumer division, sales increased 1% operationally versus the prior-year period as manufacturing problems continue to weigh on OTC sales. While we expect continue weakness in this division over the next couple of quarters, we expect steady growth will return in the second half of 2012 when consumer OTC manufacturing should fully come back on line. With a consent decree signed with the FDA regarding troubled consumer plants in Las Piedras, Puerto Rico, Fort Washington, Pa., and Lancaster, Pa., we believe the company is reaching an inflection point in quality production. Further, based on consumer surveys, most of the company's key products have taken only minor hits to their brand names, which should enable J&J to return the OTC drugs to market share levels that are only slightly lower than prerecall levels once manufacturing is back on line and direct-to-consumer advertising begins.

Earnings per share increased at a slower rate than total sales as the company increased marketing support behind key drug launches and spent more on remediation efforts for its consumer manufacturing plants. As a percentage of total sales, manufacturing and marketing costs increased more than 200 basis points year over year. We expect this trend will begin to reverse in 2012 as new drug launches reach critical mass and costs for fixing consumer plants begin to decelerate.

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