The Three Components of the JNJ Story
I last wrote about Johnson and Johnson in June, providing a high level overview of the company and a discussion between the Pharmaceutical, Consumer, and Medical Devices segment. As I detailed back then, Pharmaceutical was performing well for the company, but Medical Devices and Consumer had struggled and was in the midst of several management initiatives to turn around performance.
There have been several updates since my last post. Specifically, the company has provided a detailed update on the Pharmaceutical segment at its Analyst Day, reported 3Q results, and lost its patent protection on Zytiga.
Going forward, I think of the investment story as having three key components. First, there's the eroding part within Pharmaceutical, which consists primarily of Remicade and Zytiga. Second, there's the growing Pharmaceutical portion that is expected to offset the erosion with new drugs and line extensions. Key drugs here include Stelara, Tremfya, Erleada, and Esketamine. Finally, there's the third portion which consists of Johnson and Johnson's other two major segments that are in the midst of a turnaround - the Consumer and Medical Devices segments. Sentiment among investors is largely positive following 3Q results, but there remain some concerns around consensus not being low enough for next year. I'll detail the debate among these components next.
The Erosion: Remicade and Zytiga
Johnson and Johnson faces a number competitive headwinds in the coming year that have kept investors on the sidelines. As I have detailed in the past, Remicade's ongoing competition with biosimilars Inflectra and Renflexis represents a significant risk to revenue growth given JNJ's sizeable revenue from the drug (16% of 2017 Pharmaceutical revenue). Up to this point, the company has seen revenue declines, but they have been generally less severe than expected. The company has used aggressive rebating practices to protect market share vs. biosimilar manufacturers. This strategy has still led to pricing pressure and revenue declines, but the company has managed to hold onto a large share of the volume.
The debate here is on whether declines going forward will be better or worse than expected. On one hand, declines going forward contemplate continued reductions (with consensus calling for a more severe 16% decline in Remicade revenue in 2019), suggesting that investors are expecting a worsening trend even though the actual trend had continued to outperform relative to consensus. On the other hand, investors fear that ongoing biosimilar competition, regulatory and institutional pressures in support of biosimilars (including the potential for interchangeability), and regulatory backlash against rebating practices, could all conspire to lead to an even more severe decline going forward. The regulatory environment on rebating practices should be watched in particular as the political will to stop rising healthcare costs is significant, and rebating practices have been identified among politicians and regulatory bodies as a significant competitive barrier.
The other major eroding piece is Zytiga, which is expected to represent 8% of Pharmaceutical revenue in 2018, and has been growing significantly with 43% global y/y growth in the latest 3Q results. Johnson and Johnson recently lost patent protection last month on Zytiga, but investors had largely expected the news as they had received a negative ruling in the beginning of this year. Going forward, this major contributor to growth will now turn into a negative as generics from Mylan, Teva, Apotex, and Hikma are all set to enter the market. As a result, consensus calls for a ~23% decline in US Zytiga revenue in 4Q. Many of the bulls argue that this is largely priced into the stock given where current estimates are and the muted stock reaction when the company lost patent protection. Additionally, JNJ disclosed in their recent 10Q that the District Court had extended the injunction that prevented generics from entering the market. The exact timing of when the generics will enter is still uncertain, although most analysts still expect it to occur within the quarter (as evidenced by their estimates).
Other headwinds include Concerta and Velcade, both of which are expected to represent a combined 5% of Pharmaceutical sales. These drugs also face loss of exclusivity and generic competition. Finally, Invokana remains a headwind as well as its black box label has hurt revenue growth. In 3Q, Invokana saw a 28% decline, and many investors believe that efforts to remove the black box label may be too late to impact the drug materially.
The Growth: Stelara, Tremfya, Erleada Esketamine
The major offsetting piece to these losses is the company's extensive new drug launches and line extensions. The company has 14 marketed products to drive growth through share gains and over 50 line extensions. Additionally, management noted that they have up to 10 $1B+ launches/filings planned between 2017 and 2021. This extensive pipeline gives management confidence that they can grow above the expected market growth rate of 5%. Digging deeper, investors see numerous drivers, but the four I’ll focus on here are the ones I see cited most often: Stelara, Tremfya, Erleada, and Esketamine.
Stelara is a major piece of the immunology segment with an expected $5 billion in revenue this year, and management believes this will continue to grow driven by rapid uptake in Crohn's, which has so far added an incremental $1 billion in sales. Management also expects to file Stelara for ulcerative colitis in 4Q18 in the US and globally in 1Q19.
JNJ received approval for Tremfya in psoriasis in mid 2017, and initial traction has been strong. The drug is on pace to generate almost $500 million this year (according to consensus expectations), and several brokers have the drug generating over $2 billion in peak sales as penetration of biologics grow over time. In terms of line extensions, management has trials underway in psoriatic arthritis and Crohn's. The psoriatic arthritis readout is expected in 2H19.
Erleada is the first approved oral drug for non-metastatic castration-resistant prostate cancer (nmCRPC). The drug has seen strong uptake among urologists and has high payer market access (above 80%). Growth drivers include EU approval in 1Q19 in nmCRPC and a variety of other studies across the spectrum of non-metastatic and metastatic prostate cancer, including hormone-sensitive metastatic prostate cancer (TITAN trial expected to file in 2019) and castration-resistant metastatic disease (ACIS study expected to file in 2019).
Esketamine is the first new mechanism of action in major depressive disorder (MDD) in over 30 years. The market is enormous, with 300 million people globally affected by major depressive disorder, and about 1/3 that are classified as treatment resistant (TRD) if they fail 2 or more lines of therapy. The company filed for TRD in the US in September and EU in October this year, and will look to file for MDD with suicidal ideation in 2020. In general, the results have been positive and adverse events have been resolved within 90 minutes on average.
What are the pushbacks in this area among bears? The general argument (without going into any specific drug) is that JNJ's track record has been largely mixed here. While the drugs highlighted above are generally acknowledged among bears as promising, the other less-discussed drugs will be key in ensuring above-market growth. There have been a number of drugs that have been highlighted in past analyst days that did not move forward, including sirukumab and talacotuzumab. Additionally, imetelstat and lumicitabine are on hold and the company will be making a decision whether to continue the programs or stop development. Ultimately, while the number of drugs in development are impressive, investors will need to see many of the drugs successfully progress towards market entry in order to feel more comfortable about future revenue growth.
The Recovery: Medical Devices and Consumer Segment
When I last wrote about the Medical Devices and Consumer segment, management had just outlined its turnaround plan for both segments at its Investor Day.
We'll start first with Consumer. Recall that within the Consumer segment, the plan consisted of becoming more startup-like in its approach and emphasizing e-commerce as a distribution channel. Management noted that Baby and Oral Care would be the first brand relaunches using this new approach, and investors were carefully monitoring the performances of these relaunches in order to see whether the turnaround plan would work.
3Q was the first sign that management's efforts were beginning to bear fruit. In 3Q, Consumer grew 6.1% organically (or 5.4% excluding restocking of retail inventory for the Baby product), which represented a sizable acceleration from prior trend.
Within the segment, numerous brands outperformed, including the recently relaunched Baby franchise. The Baby franchise saw 4% organic growth. Excluding the benefit of restocking, the franchise was essentially flat, which still represents an acceleration from 2Q's 6% decline. Beauty led the segment with 8% growth adjusted for divestitures. Management called out strong e-commerce growth, which, as mentioned above, was a specific focus of the turnaround effort.
Next, within the Medical Devices segment, management had outlined a plan to turnaround the segment by investing heavily in the business and launching 15-20 products this year and 20-25 products next year.
Like Consumer, 3Q was the first sign that the segment was turning around. Organic revenue grew by 2.9%, representing the strongest performance since 2Q16. Specific areas of strength included Electrophysiology (up 23%+), Interventional Solutions (up 19.4%) and Vision (up 5.6%). This segment remains below the market growth, but the turnaround remains encouraging. Of particular note, management stated a willingness to make "transformative" M&A, which is stronger language than used in prior conference calls.
Overall, both the broader Consumer and Medical Devices segment showed accelerating trends in 3Q that were encouraging signs to investors. As I wrote last June, the segments are still "show-me stories", but it's now one step beyond just a plan on paper. Investors will need to see more signs of traction before turning more positive on the turnaround efforts.
Conclusion: Watch the Three Components
Investors should watch the three components highlighted above to gauge the odds that Johnson and Johnson will outperform, as they will need 1) a slower erosion from key pharma brands, 2) strong execution within its Pharmaceutical pipeline, or 3) a successful turnaround in its Medical Devices and Consumer segments.