Johnson & Johnson (NYSE:JNJ) announced third-quarter earnings Oct. 18 that were a mixed bag. Sales grew 6.8%, to $16 billion, while earnings per share declined 6.5%, to $1.15 a share. On an adjusted basis, they were essentially flat. They weren’t horrible but they weren’t anything to write home about either. Investors can do better elsewhere. My advice is to sell J&J and replace it with GlaxoSmithKline (NYSE:GSK). Here’s why.
Third-Quarter Earnings
Johnson & Johnson and GSK announced Q3 earnings within eight days of each other. Let’s have a closer look to see how they compare. Including the currency exchange, J&J’s revenues grew 2.6% year-over-year compared to 3% for GSK.
However, GSK faced some difficult year-over-year comparisons. In Q3 2010, it got a boost from one-time, pandemic-related revenue. In Q3 2011, its diabetes drug Avandia saw a sharp decline in sales due to potential heart risks associated with its use, and Valtrex, its drug to treat herpes, came off patent cover. Excluding those items, GSK’s revenues increased 6%, with all three segments (pharmaceuticals, vaccines and consumer health care) producing positive gains.
On the earnings front, J&J delivered $3.4 billion in net income, which is a net margin of 21.5%, 130 basis points lower than in the third quarter last year. GSK had net earnings of $1.5 billion for a net margin of 21.1%, 140 basis points higher than the third quarter last year. Head-to-head, GSK’s third quarter was marginally better.
Rest of the World
Both companies have mature businesses in North America and Europe, so let’s start our examination with their performance in the rest of the world. J&J’s revenues in the rest of the world grew 18.7% in the third quarter and represent 31.3% of its overall sales. GSK’s grew 17% in the quarter, while its rest-of-the-world revenue accounts for 38% of sales. While J&J’s revenues grew slightly faster, GSK has a more balanced geographic mix, so I’ll call it a draw.
Comparing profits for the rest of the world is a lot more difficult because Johnson & Johnson’s press release doesn’t break down geographic operating profit, only revenues. However, GSK’s information gives a few hints. Its operating profit for the rest of the world in the third quarter for its pharmaceuticals and vaccines segment was $1.04 billion on revenue of $2.47 billion, for an operating margin of 42.1%. The consumer health-care segment’s revenue in the rest of the world was $780.46 million.
The operating margin for the entire world, including the U.S. and Europe, was 24.7%, so even though the margin’s likely higher in the rest of the world, I’ll use the same number, which comes to $192.77 million. Overall, its rest-of-the-world operating profit totals $1.23 billion on revenue of $3.25 billion, for a margin of 37.8%.
JNJ’s rest-of-the-world revenue in the third quarter was $5.01 billion. It didn’t provide operating profits by segment in the Q3 release, so I’ll use the second-quarter margins, plus a couple of percentage points for good grace. We’ll have a better idea when it releases its 10-Q in a couple of weeks.
Its overall operating profit based on its three segments’ operating margins (consumer, pharmaceuticals and medical devices) was $4.1 billion, which is very close to the actual results with an operating margin of 25.6%. That’s 510 basis points lower than GSK.
If you apply the same discount to its rest-of-the-world operating margin (37.8% less 5.1%), Johnson & Johnson’s operating profit in the quarter was $1.64 billion, leaving $2.46 billion for the U.S. and Europe on $11.0 billion in revenue. GSK is clearly outperforming J&J on a margin basis, so why the lower valuation?
Bottom Line
Why indeed? GSK’s enterprise value is 6.6 times EBITDA to J&J’s 8.5 times EBITDA, yet GSK’s margins are better. J&J has a lot more cash than GSK, but both have solid balance sheets. In terms of dividends, they both pay out more than $2 a share, but GSK’s yield is higher.
GSK has just come through a difficult period. Unlike many of its competitors, it now faces very little in the way of near-term patent expiries. With strong operating profits in Asia and the emerging markets, not to mention holding a good lead on J&J in those areas, it should continue to outperform its larger competitor.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.
