Can Johnson & Johnson Hold Its Momentum?


Shares of Johnson & Johnson have climbed 16% over the past five months and as of this writing, the stock is making new 52-week highs. The health care giant appears rejuvenated, much of which can be dated back to when J&J completed its acquisition of Synthes. But this deal hasn't completely eradicated concerns about the company's long term prospects, and more specifically, that J&J is sometimes considered "too big."

Likewise, although the company recently posted good fiscal fourth-quarter results, there were also some opportunities for improvement. Consequently, it's become progressively more difficult to consider shares of J&J a better value over rivals such as Pfizer and Covidien . J&J has to prove that it can maintain its momentum and/or improve in some key areas to calm investors' nerves.

Doing much better, but...
The company has nursed its medical device business back to better health. However, it hasn't been easy, given the rash of product recalls that has affected the company by as much as $3 billion in charges for a faulty hip replacement device. However, with the recent beat on revenue estimates, there are signs that better days might be ahead.

Despite another special charge related to the hips device, the company posted an 8% increase in global revenue for the fourth quarter, which was fueled by rebounding sales of prescription drugs and demand for its medical devices. It's worth noting here, however, that the strong 13.7% growth in medical devices was boosted by the impact of the Synthes acquisition. When excluding Synthes, sales were up roughly 1%, including a 2.2% decline in the U.S.

Is J&J truly back to growth?
Bears would argue that J&J is not truly back to "organic" growth, given the recent boosts from Synthes. Still, the company deserves credit for seeing a growth opportunity in Synthes that it otherwise might never have had. Today, the Synthes acquisition has bolstered Johnson & Johnson's position as a dominant player in orthopedic devices for trauma patients . Likewise, Synthes was able to strengthen J&J's overall orthopedic and spinal care businesses, which are now contributing to the bottom line. It's also important to note that the reported numbers were good, but far from breathtaking -- at least not from an operational perspective.

Although J&J showed some progress, Q4 gross margin declined roughly 135 basis points. This comes on the heels of a 100 basis-point decline in Q3. Management did say, however, that the impact to margins was due to an inventory step-up charge related to Synthes, which increased the cost of goods sold by 140 basis points. The step-up charge has been treated as a special item. But even on an adjusted basis, the margin was still unimpressive considering there was also a decline in the third quarter.

Nevertheless, J&J managed to grow operating earnings 8% as reported. Likewise, fourth-quarter net income arrived at $2.6 billion, or $0.91 per share. While earnings arrived significantly above the $218 million J&J earned last year, as noted, the Q4 2012 results included a $3 billion charge. However, when removing special items fourth-quarter earnings arrived at $1.19 per share -- topping Street estimates of $1.17.

Opportunities for improvement
As noted above, margins are still a glaring issue. Granted, the impact from the Synthes deal helped the device business. But are there more catalysts from this point forward? And I don't think macro-related concerns are still valid if J&J underperforms -- at least not when compared to Covidien, which seems to outperform J&J in areas like surgical.

However, it's not all bad. J&J is well-diversified and continues to perform well in drugs. The company's drug Remicade impressively accounts for more than 10% of the company's revenue. What's more, its new cancer drug, Zytiga, which posted 74% revenue growth in the fourth quarter, continues to gain incredible traction -- outselling Remicade by $13 million.

However, as my Foolish colleague Maxx Chatsko pointed out, Zytiga also has to deal with plenty of competition from the likes of Medivation, which has an oral medication drug of its own. Nevertheless, I do expect drugs to continue to be J&J's biggest driver in 2013 and beyond. And based on management's improved guidance, the company feels that way as well.

What of the stock?
As noted above, while J&J is resting near 52-week highs, the recent run in the shares have taken its P/E to above 20, where it is now trading higher than Pfizer's P/E of 14. This may signal that investors believe J&J will continue to outperform its peers for the next several quarters. But this is by no means a flawless company; if management can get margins going again, while improving the medical devices business, I don't see any reasons why J&J can't continue to rise. But those are two big "if"s.

Is bigger really better?
Involved in everything from baby powder to biotech, Johnson & Johnson's critics are convinced that the company is spread way too thin. If you want to know if J&J is nothing but a bloated corporate whale -- or a well-diversified giant that's perfect for your portfolio -- check out The Fool's new premium report outlining the Johnson & Johnson story in terms that any investor can understand. Claim your copy by clicking here now.

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Fool contributor Richard Saintvilus has no position in any stocks mentioned. The Motley Fool recommends Covidien and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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