Drugmakers: Our Take on Earnings

We don't expect any changes to our fair value estimate for Johnson & Johnson JNJ after the firm reported second-quarter results largely in line with our expectations (after adjusting for divestitures) and slightly ahead of consensus expectations. We continue to view the stock as fairly valued and have factored in close to $3 billion in litigation charges for the opioid and talcum powder legal cases. Further, the firm's wide moat looks intact, especially following a research and development update for its drug unit that shows many promising molecules in areas with unmet medical need that should enable strong pricing power.

In the quarter, all three of J&J's major segments posted adjusted operational growth in the low- to mid-single-digit range. While the drug unit showed leadership growth in the quarter, the relative strength of this segment wasn't as robust as seen in the past few quarters as patent losses are weighing on the division, especially for cancer drug Zytiga. Nevertheless, the drug unit was able to post 4% operational growth and we expect continued steady growth for this division over the next several years, led by recently launched oncology and immunology drugs. Also, the firm's recent pipeline update in May increased our conviction in the division and led us to increase our fair value estimate by $4 per share to $134. These pipeline assets are tracking well, and we like the focus in oncology and rare diseases, where drug pricing is strong and development timelines can be short.

Outside of the drug franchise, the smaller divisions of devices and consumer products posted 3% and 2% adjusted growth, respectively, and we expect both divisions' growth to continue to trend in this magnitude over the next several years. A potential wildcard in the device segment is in robotic development that could accelerate growth, but J&J has been relatively secretive about this initiative, leading us to project more conservative growth assumptions for these new products.

Novartis NVS reported strong second-quarter results, exceeding both our and consensus expectations, and we plan to increase our fair value estimate based on the outperformance. Margin expansion was particularly pronounced, which we partly attribute to the increasing mix shift toward specialty products and continuing leverage from the growth of cardiovascular drug Entresto, trends that should continue over the next several years. Novartis' recent launches of specialty drugs continues at a relatively strong rate, which should help drive growth and bolster the company's wide moat, as these drugs tend to have pricing power.

In the quarter, total sales increased operationally by 8%, buoyed by continued gains from immunology drug Cosentyx, Entresto, and several midsize oncology drugs as well as relatively light generic pressure. Additionally, recent launches of migraine drug Aimovig and oncology drugs Kisqali and Kymriah are also boosting overall gains. We expect continued strength of new drug launches with the recent approvals of gene therapy Zolgensma, multiple sclerosis drug Mayzent, and cancer drug Piqray. Further, ophthalmology drug Beovu (RTH258), multiple sclerosis drug ofatumumab, sickle cell drug SEG101, and asthma drug fevipiprant could all gain approval by the end of 2020. While the number of drug launches is impressive, the firm is also likely facing increasing generic pressure, with several older drugs losing patent protection over the next three years, including older multiple sclerosis drug Gilenya in early 2020 depending on legal decisions.

On the bottom line, core operating income increased 20% operationally, well ahead of sales. We expect a continuing trend toward margin expansion of close to 300 basis points over the next three years, given the high margins of the new and recently launched drugs. However, patent losses will likely limit some of the margin lift potential.

In tandem with second-quarter results that exceeded both our and consensus expectations, Bristol-Myers Squibb BMY reported mixed trial data from the important CheckMate 227 study with Opdivo and Yervoy in first-line non small cell lung cancer. In aggregate, we don't expect any major changes to our fair value estimate based on the updates, and we continue to view the firm as undervalued, with the market underappreciating the potential cash flows driven by drugs treating unmet medical needs where pricing power is high. This strong positioning also reinforces our wide moat rating for the firm.

The CheckMate 227 study reported unusual results, as Opdivo plus chemotherapy did not show statistical advantage versus chemotherapy alone, while the Opdivo plus Yervoy arm of the study showed significant benefit. While we had expected both combination therapies to work, a successful outcome for Opdivo plus Yervoy could allow for more differentiation, as this is the only data showing success for a PD-1/CTLA4 combination. This is important, given Bristol will be late to the first-line NSCLC market, following both Merck and Roche. The Opdivo plus Yervoy treatment worked for patients who don't express PDL1, a group of patients where competitive drugs have had less success. The exact amount of benefit of Bristol's drugs will be important in determining shifts in market share, and we expect the detailed data to be released at a medical conference later in the year. Overall, we continue to expect Bristol will gain close to 10% of the NSCLC market.

In the quarter, total sales grew 13% operationally, buoyed by growth from Opdivo and cardiovascular drug Eliquis. While we expect continued growth for Eliquis based on its best-in-class standing, we expect it to decline in 2020 due to increased competitive pressures in lung cancer. However, we expect Opdivo growth to reaccelerate in 2021 based on the CheckMate 227 data and additional new indications outside of lung cancer.

GlaxoSmithKline GSK reported second-quarter results that were slightly ahead of both our and consensus expectations, driven by robust vaccine sales, but we don't plan to change our fair value estimate based on the minor outperformance. We continue to view the stock as modestly undervalued, with potential long-term growth not fully factored into the share price. Strong growth in the vaccine unit, steady gains in consumer products, and the ability to mitigate generic Advair competition in the quarter helps reinforce our long-term growth outlook as well as our wide moat rating.

In the vaccine unit (20% of sales), strong demand for shingles vaccine Shingrix helped drive total vaccine sales up 23% operationally year over year. We expect continued robust demand for the vaccine, given the significant efficacy improvement over the competing shingles vaccine from Merck (97% effective versus 50%). However, supply limitations will likely weigh on global growth potential, with the majority of initial vaccine supplies likely targeting the United States, where pricing is strongest. We expect Shingrix sales to reach close to GBP 2 billion by 2020. The strong vaccine growth should help mitigate the competitive pressures in the drug segment.

The drug unit (55% of sales) posted a slight sales decline of 1% operationally, largely due to generic Advair and branded HIV competition. The lost Advair sales also created an amplified impact on the bottom line due to the drug's strong margins. While we expect these pressures to continue, the annualization of the U.S. generic Advair launch will likely occur in early 2020, and the recent launch of HIV drug Dovato should help return the drug division to growth in 2020. Longer term, we expect the new HIV drug launches of fostemsavir and cabotegravir to help drive HIV sales. Also, the firm's renewed focus on cancer development should yield important growth drivers, including expanding indications for Zejula and multiple myeloma drug GSK2857916.