Why We Bought Johnson & Johnson

JNJ reported Q3 earnings last month. Currency headwinds hurt reported sales growth by about 8%, and the expected run off of hepatitis C products added additional pressure. Excluding these two items, JNJ’s revenue would have grown by 5.6%, in line with last quarter’s adjusted growth and not bad for a company with over $70 billion in sales last year.

There are many reasons why we like JNJ and have made it a core position in our Conservative Retirees dividend portfolio. About 70% of the company’s sales are from products that collectively hold #1 or #2 global market share positions, over half of revenue is generated overseas (rising healthcare demand in emerging markets), its product portfolio is well diversified by segment and by drug, and management runs the business conservatively, shedding non-core assets and approaching M&A opportunities cautiously.

The company’s scale and product breadth also enables it to invest $8 billion in R&D annually, which has resulted in JNJ receiving the most FDA approvals of any company since 2009 and deriving 25% of its revenue from new products introduced in the last five years.

As a result of its competitive advantages, JNJ has earned a relatively high and stable return on invested capital over the last decade:

Source: Simply Safe Dividends

JNJ’s most profitable segment, pharmaceuticals, will remain the company’s most important growth driver going forward. Excluding the impacts of foreign currency and hepatitis C, the pharma segment grew over 10% in Q3.

While generics are taking market share and regulations can always change, there are several fundamental factors that make the pharma space appear to be a good long-term bet for JNJ. The elderly population drives about a third of industry sales and should see secular growth as the average age of people increases around the world. Ground-breaking discoveries in genomics and biotech will also catalyze new drug development. FDA approvals of new molecular entities are also happening at a faster pace, with 41 approvals in 2014 (up from 27 in 2013 and 39 in 2012).

JNJ’s drug portfolio is also fairly diversified, with REMICADE representing its largest drug by far with $6.8 billion in sales last year (around 9% of JNJ’s total revenue). However, no other drug is over $3 billion in sales. With REMICADE’s European patent expiring earlier this year, biosimilars could pose a threat to this drug’s market share. Longer-term, however, JNJ believes it will file 10 new drug filings by 2019, each with the potential to reach $1 billion in annual sales. Continued innovation is needed to keep growing the pharma business, and JNJ has one of the best track records with its comprehensive R&D process.