Johnson & Johnson Must Remedy Weak Organic Growth

NEW YORK (TheStreet) -- I didn't win many friends after suggesting in early August that shares of Johnson & Johnson (JNJ), which were trading at around $94, were too expensive.

Not only had the health care giant (then) posted year-to-date gains of 30%, but the stock carried a price-to-earnings ratio that was (then) six points higher than rivals Abbott labs ( ABT) and Pfizer ( PFE), which didn't make sense to me.

Aside from the valuation concerns, there were also some red flags in Johnson & Johnson's operational performance. While the company's overall revenue results appeared solid, led by strong performances in the drug business, there were some noticeable weaknesses in its other segments. Yielding just 2% revenue growth in its consumer business was one example (in constant currency).

Since that article, shares of Johnson & Johnson have been down by as much as 9%. With the company due to report its third-quarter results Tuesday, I believe management needs to show not only better diversification but also meaningful improvements in organic growth, which spans beyond the Synthes acquisition.

Tuesday, The Street will be looking for Johnson & Johnson to post a profit of $1.32 per share on revenue of $17.43 million. Earnings are expected to grow almost 6% year over year, while revenue is expected to grow at a paltry 2%.

I say "paltry" because this would be less than half of the 5% growth the company posted in the July quarter -- not to mention the estimated 2% growth would be a quarter of the 8% growth the company posted in both the April and January quarters.

Clearly, the direction of the revenue trend is still a concern. However, the real question is to what extent does this impact the company's organic growth.

Johnson & Johnson bulls often disagree whenever the "organic" argument is raised. Organic growth measures a company's operational performance, while removing external factors such as acquisitions. Take, for instance, the devices business: While that segment did register a healthy 12% year-over-year revenue growth in the July quarter, on an organic basis, growth was actually less than 2% when adjusting out the contribution from Synthes.

I've said this on more than one occasion: Management was brilliant for seizing an opportunity in the Synthes deal that is now paying dividends. But just because the segmental growth numbers look impressive, in absolute terms, it doesn't mean they actually are, when digging a bit deeper.

On Tuesday, I also want to see if Johnson and Johnson becomes more balanced.

We can agree that the company has several highly regarded businesses and leads the markets in areas including orthopedics, medical devices, nutrition and drugs. However, as noted, the consumer side of the business only posted 2% year-over-year growth. By contrast, Johnson & Johnson's pharmaceutical segment posted revenue growth of almost 13% year over year. Essentially, it is the drug business, which beat the Street-estimated 4%, that has been doing all of the heavy lifting.

The Street doesn't seem to care much about these details as long as Johnson & Johnson continues to rake in the profits. Admittedly, there aren't many companies that do as well. While I do believe the company's strong drug business should keep growth going for the next several years, in my opinion it would be reckless to ignore the weak organic growth situation in not only the medical devices division but on the consumer side.

Until I see better balance between the segments and improved organic growth, I can't recommend the stock, which, even with this recent pullback, is still expensive. Should shares fall to $80, better balance or not, I just might have to reconsider.

At the time of publication, the author held no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a co-founder of StockSaints.com where he serves as CEO and editor-in-chief. After 20 years in the IT industry, including 5 years as a high school computer teacher, Saintvilus decided his second act would be as a stock analyst - bringing logic from an investor's point of view. His goal is to remove the complicated aspect of investing and present it to readers in a way that makes sense.

His background in engineering has provided him with strong analytical skills. That, along with 15 years of trading and investing, has given him the tools needed to assess equities and appraise value. Richard is a Warren Buffett disciple who bases investment decisions on the quality of a company's management, growth aspects, return on equity, and price-to-earnings ratio.

His work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets.

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