Johnson & Johnson: A Lot Of Moving Parts, But Perhaps Finally Lurching In The Right Direction

Summary:

• Johnson & Johnson shares have underperformed for years, with multiple contributing causes including upcoming generic competition for Stelara, uncertainty around talc litigation, and questions about internal growth capabilities.
• The pharmaceutical pipeline shows promise, and I like the “franchise/platform” approach in oncology, immunology, and neuroscience, but clinical and competitive risks are real.
• I’m more skeptical of management’s growth targets in MedTech, as I feel the company has often come up short versus rivals when it comes to disruptive innovation.
• Long-term revenue growth around 5%, EBITDA margins moving toward 40%, and mid-to-high-20%s FCF margins can support a fair value in the $160-$180 range.

The last couple of years have not been particularly good to Johnson & Johnson (NYSE:JNJ) stock. Although the pharmaceutical business has generally performed well, the loss of Stelara to generic competition is going to create significant headwinds for the business in the near term, and it remains to be seen if management’s target of “high mid-single-digit” growth for the MedTech business is really achievable given stiff competition across the businesses in which it operates. On top of all that, it has yet to be determined if litigants in the talc will agree to a settlement that would let JNJ put that mess to rest.

JNJ shares have not performed well since my last update, losing 15% of their value and meaningfully underperforming the broader medical device sector (+12%), not to mention rivals like Boston Scientific (BSX) (+84%), Stryker (SYK) (+58%), as well as pharma rivals like AstraZeneca (AZN) (+26%).

Johnson & Johnson shares do look undervalued, but a lot of value rests in the company’s pharmaceutical pipeline, where clinical setbacks or stronger rivals could diminish that value. Likewise, while the MedTech business looks better than it has, I’m not convinced JNJ has the toolbox to go toe to toe with some of its more dynamic rivals. I do see value-trap risk here, but in a market where there’s not much value left in med-tech, this is a name worth a look.

The Near-Term Challenges Are Sizable, But Addressable

I think at least two of the biggest negative drivers for JNJ have been concerns about upcoming generic competition for Stelara and the uncertainty around the talc litigation.

Stelara has been a major winner for JNJ, and the company will start facing generic competition outside the U.S. this year and in the U.S. next year. The business will not drop to zero overnight, but the drug was about 13% of 2023 revenue (about 11.5% of Q1’24 revenue) and I would estimate somewhere around 19% to 25% of the company’s operating profit. That’s a big hit to absorb over a relatively short period of time, and it very much carries the risk of flattening out JNJ’s growth for a couple of years.

The talc litigation issue has been hanging over the company for some time, as management has looked to a variety of avenues (including bankruptcy court) to resolve the case and limit their exposure. After a New Jersey court spiked the company’s legal strategy about a year, management has gone back to the drawing board and came up with a new offer it presented back in May. This offer would basically take the form of a consensual prepackaged bankruptcy, with JNJ setting aside $11B (in present value) to be paid out over 25 years, with $6.5B upfront and $4.5B set aside for future claimants.

This latest offer may finally get it done, and at a cost that is definitely manageable for the business (less than 2% of market cap upfront). Even with that payout, and including what the company paid for Shockwave, the capital/liquidity situation will be fine, with JNJ’s considerable cash flows (even post-Stelara) sufficient to cover further growth in the dividend.

Can Management Pivot To A Higher Sustained Growth Rate?

Management laid out its case for higher sustained growth back at its December Analyst Day, but given that the shares are now about 5% lower, I’d say the Street wasn’t exactly convinced that the strategy will generate 5% to 7% revenue growth from 2025 to 2030.

Innovative Medicine – A Sound Pipeline And Franchise Strategy, But With Commercial Risks

On the pharmaceutical side, management is targeting at least 10 assets to generate upwards of $5B in peak revenue and another 15 with $1B-plus potential. Key assets include Carvykti (CAR-T therapy for multiple myeloma, partnered with Legend Biotech (LEGN)), milvexian (anti-coagulant), nipocalimab (myasthenia gravis, Sjogren’s, lupus, and other immunology indications), Rybrevant (lung cancer), TARIS (bladder cancer), and JNJ-2113 (psoriasis).

There’s a lot of skepticism in place with Carvykti, particularly as other CAR-T therapies have struggled to gain commercial traction due at least in part to manufacturing and administration challenges. Missing first quarter estimates didn’t help that narrative, but it is still very early days.

Rybrevant looks interesting, with encouraging data from the MARIPOSA combination study with Lazertinib, but EGFR+ non-small-cell lung cancer may be too limited of a market to support JNJ’s goals and safety/tolerability could leave the door open for rivals. Likewise with TARIS, which is a silicone-based delivery device that allows continuous release of medication to the bladder. While an early-stage study (SunRISe-1) showed a compelling 83% complete response rate, CG Oncology’s (CGON) cretostimogene showed similar efficacy (75% CR) with longer duration (83% of complete responses maintained at 12 months vs 75% in SunRISe-1) and lower side-effects – namely, no Grade 3 AEs versus 8% for JNJ and a 5% discontinuation rate.

JNJ-2113 could be a winner, though, as an oral IL-23 option for psoriasis and other immunological disease like inflammatory bowel disease. JNJ-2113 (partnered with Protagonist Therapeutics (PTGX) showed nearly 70% of patients achieving PASI-75 (placebo-adjusted), below the 90% of injected drugs like Tremfya, but certainly good enough to be competitive and open the door to multiple billions of dollars of revenue if Phase III development goes well.

All in all, I like JNJ’s platform approach, with management seeking to establish durable franchises in areas like oncology, immunology, and neuroscience where there is still high unmet need and solid reimbursement. In oncology, the company could have a $25B/year franchise in multiple myeloma in 2030 (and 50%+ share) if Carvykti, Talvey, Tecvayli, and Darzalex develop as expected (Darzalex is already annualizing at over $10B in revenue).

In immunology, the company has an intriguing pipeline of oral agents targeting IL-23 (JNJ-2113 and JNJ-4804) and IL-17 (JNJ-1459), each of which could generate billions in psoriasis, IBD, Crohn’s, and ulcerative colitis.

Last and not least, JNJ is looking to double its neuroscience sales by 2030 on the backs of Spravato and Invega, while pursuing drugs like aticaprant and seltorexant for major depressive disorder and posdinemab for Alzheimer’s, both of which are large indications with inadequate current treatments.

MedTech – A Harder Sell For Me

I am more skeptical of JNJ’s plans to grow the medical device business at a long-term rate of 5% to 7%, namely because I see the company going up against a lot of well-established competitors that in many cases have shown they can out-innovate and out-execute JNJ.

In ortho, for instance, JNJ has definitely felt some pressure from Stryker and its MAKO surgical robot, and I feel as though the company has under-innovated relative to Stryker and Zimmer (ZBH) in implants for the knee and hip. Likewise, I feel like Globus (GMED) and Medtronic (MDT) have been more active in spine and trauma, particularly on the robotics side.

I do think JNJ can be a player in the emerging high-growth market of pulsed field ablation (or PFA) for atrial fibrillation, but Boston Scientific already enjoys a healthy head start here, and I think JNJ may struggle to hold more than 15% to 20% share without some clinical evidence or product development supporting differentiation (and I don’t think its strong cardiac mapping platform will be enough).

I’m also unsure of what to make of the Ottava robot platform, particularly as it won’t even hit the U.S. market until 2027 (most likely), as the company hasn’t even submitted its IDE for a human study. Intuitive Surgical (ISRG) has a big head start here (and Medtronic is also further along with its Hugo system), and while I do see natural synergies with JNJ’s leading surgical business (it has thousands of surgeon call points, and it can leverage internal tool design capabilities), this is a distant driver at best.

I am more bullish on the cardiology business, particularly after the recent acquisition of Shockwave. I like Shockwave’s opportunities in coronary and peripheral vascular disease, and there really isn’t much credible competition on the near-term horizon for a business that is already close to $1B in revenue and still growing faster than 25% a year. Likewise, I think Abiomed still has a significant growth runway (gated in part by clinical trials, but also physician familiarity/comfort), as it’s used in fewer than 5% of the procedures it could be. Last and not least, while the Laminar acquisition (a left atrial appendage closure device like BSX’s Watchman) likely won’t hit the market until 2027, LAA closure is an exciting market given the number of people who can’t tolerate long-term anti-coagulant therapy.

If there’s a “but” here, it’s that a lot of the best growth opportunities had to be bought and brought into the company. M&A is a valid way to grow and augment a business, but I’m concerned about JNJ’s ability to drive “home grown” growth, as that is typically much more capital-effective.

The Outlook

For a company of Johnson & Johnson’s size, there’s an impossible number of moving parts, but I think this covers a lot of the basics. Still, it’s tough to see how all of these drivers will play out. The patent expiration of Stelara will happen, but with the company proving that Tremfya is superior (GALAXI-2/3), maybe they can mitigate the damage by getting patients switched over to Tremfya more quickly. Maybe the talc litigation is truly near the end. Maybe those pipeline drugs will pan out as management expects, driving significant revenue in 2030-2035. Maybe the medical device business is more competitive than I give it credit for and poised to retake share and leverage faster-growing emerging markets.

I’m modeling around 4% growth from JNJ over the next three years, but closer to 5% growth over the long term, as I do expect better things from the pharmaceutical business, and while I think the MedTech segment may disappoint 5%-7% growth expectations, I think it can at least get close.

On the margin side, I’m looking for weaker EBITDA margin this year (around 34% versus almost 37% last year) and next, but with a rebound over time back into the high-30%’s, with 40% possible in around five to six years. At the free cash flow line, I expect a mid-20%’s percentage of revenue to convert into free cash flow, growing toward the high-20%’s over time and fueling around 7% FCF growth.

Discounting those cash flows back, I get a fair value of over $160, and I get more encouraging results with a growth/margin-driven EV/revenue approach that I like to use with medical technology companies. While JNJ is certainly likely to lag a company like BSX in terms of growth, I can still support a 5.25x revenue multiple on its combined margins and growth, supporting a fair value of over $180.

The Bottom Line

I clearly have mixed feelings about Johnson & Johnson, and this is by no means a clear-cut buy call with no reservations. I do think management’s targets may be too ambitious, and a lot rides on clinical trials and competitive dynamics that aren’t in management’s control. Still, I think the shares look undervalued relative to more conservative growth assumptions and I think this is a more GARP-type name for investors to consider who may not want to pay up for a stock like Boston Scientific.

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