A growing number of investors seem to believe that Johnson & Johnson (JNJ) is overvalued after seeing some relatively weak financial results. The combination of a low growth rate of the financial results and a relatively high valuation is a cause for concern for many. It is correct that this combination is usually quite a bad one for a stock’s future, but I believe that Johnson & Johnson’s shares are not in any sort of danger.
Johnson & Johnson published its second quarter report on the 18th of July. A small revenue miss of $110 mln was reported, landing the revenue at $18.84 bln with a yoy growth rate at 1.9%. For many, apparently, this is an alarming growth rate for the company. But if we look at the company’s history, this is far from an oddity. Actually, the average annual growth rate of the past 9 years has been exactly 1.9%.
Overall, the company has seen this trend of a slow grower for a while now. It must also be noted that the growth rate of 1.9% last quarter was partly due to unfavorable currency impact. Without the currency headwind, revenue would have increased by 2.9% compared to the year-ago quarter. But while the currency headwind has been quite a drag on financial results in the past, I believe that it will play a very different role going forward.
Forex turning into a tailwind
Currency fluctuations have put Johnson & Johnson’s financial results under pressure in the past. But it seems like the tide is starting to turn, meaning that it will change from a headwind into a tailwind for the company.
The USD is clearly losing steam with increasingly dovish comments putting extra pressure on the dollar. Roughly 48% of the company’s revenue comes from outside of the US, meaning it has a large exposure to currency fluctuations. So, this new trend can do a lot of good for the company.
The shifted trend can especially be seen in EUR/USD. The combination of growing concerns about future US inflation, while the ECB is finally talking increasingly hawkish, is lifting pressure of the currency pair. Since the Eurozone is seeing economic improvement, I believe that it is more than likely that the ECB will start raising interest rates somewhere next year. Just the anticipation of this rate hike will send the currency pair higher. By the time that the rate hike is announced, the pair will have started to move much higher. The reason that the anticipated upward movement of this currency pair is so beneficial to Johnson & Johnson is the fact that most of the foreign earnings are derived from this economic zone.
Source: Q2 Presentation
As you can see, about 22% of the total revenue and 46% of international revenue came from the Eurozone. The rising EUR/USD will therefore be a tailwind to Johnson & Johnson’s earnings.
Growing by acquisitions
Forex is not the only reason that I believe Johnson & Johnson will see a higher growth rate for their top-line. Because management is quite dedicated in improving their financial results. One example of its efforts is the Actelion acquisition for $30 bln, boosting the company’s (potential) business.
“Through this transaction, Janssen will establish a sixth therapeutic area that will be a growth engine for us as our combined team builds on the market-leading position of Actelion’s therapies,” said Joaquin Duato, Executive Vice President and Worldwide Chairman, Pharmaceuticals, Johnson & Johnson. “Actelion’s PAH franchise, including differentiated, innovative medicines Opsumit®, Uptravi® and Tracleer®1 expands our Janssen business and provides a leading commercial position in an established area of transformational medical innovation for patients with serious illnesses and significant unmet medical needs.”
This acquisition was closed on the 16th of June. With this acquisition, Johnson & Johnson will get its hands on medicine for pulmonary arterial hypertension (PAH) as well as medicines for other serious illnesses. The PAH market could be a very successful one as there is currently no cure available yet many people suffer from this disease. 100,000 patients are diagnosed with PAH in the US and other major markets.
This transaction will result in an immediate boost for Johnson & Johnson’s top and bottom line. It is expected that the acquisition will improve both short term and long term growth rates of the top and bottom line. Adding Actelion to the company will accelerate Johnson & Johnson’s top line growth by 1% with room for more. At the same time, the acquisition will immediately add $0.35-0.40 to EPS within the first year and add 1.5-2.0% to the long-term annual growth rate. This may not seem like much to some, but for a $366 bln company with sales of well over $70 bln on an annual basis, this is very positive.
Margins are just fine
Another trend that is worrying some investors was the margin decline that was witnessed this last quarter while also seeing management indicating a less favorable development for margins in the future. The reason for the lower margins during the most recent quarter was the increase of 200 bps seen in COGS. But this was mostly due to the impact of amortization. If we exclude this impact, COGS would have only increased by 60 bps. And, this increase is mostly to blame on currency fluctuations, which I do not expect to be a problem anymore going forward.
Yet investors still seem troubled because management stated that it expects its operating margins to maintain or slightly decline going forward. Earlier, it expected to maintain the same levels or increase slightly. But I would not worry about this change of stance too much as this is merely the result of more of other income being reinvested in R&D and product launches. This will drive up costs and thus lower margins.
Now that the Actelion acquisition is complete and we are seeing favorable changes in forex, Johnson & Johnson’s outlook is definitely improving. With all these developments, management actually expects the second half of 2017 to see a significant improvement. It now expects revenue growth of 5.5-6.0%, thanks to these positive developments. And, like I mentioned earlier in the article, with the way the forex market currently looks, it could very well be so that management will top even this growth rate.
So, despite a relatively weak quarter, the company is still performing well with enough growth ahead. Its forward P/E of 17.2 might seem a bit high for a company with a market cap of $366 bln, but this is for a good reason. Johnson & Johnson has long been a safe stock that offers decent growth rates of both its dividend and its revenue. And, with a growing dividend yield that currently stands at 2.5%, I believe that this stock is a good hold. I would not recommend buying the stock as it has recently reached all-time highs. Opening a position would be wiser after a dip if investors allow for one to happen.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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