J&J's business has faced a number of challenges during 2011, ranging from ongoing over-the-counter (OTC) product recalls and remediation efforts in its Consumer business, to the exit from its stent business in its Medical Device segment, and recurring generic competition in Pharmaceuticals. This is in addition to the tough macro environment that all of the large pharmaceutical companies face from the costs associated with healthcare reform in the US and pricing pressures from austerity measures throughout Europe. J&J has shown the flexibility to be able to skillfully manage its financial results in recent quarters and the third quarter was no exception. Overall, J&J's earnings were three-cents above consensus forecasts at $1.24 a share, representing a modest 0.8% year-over-year (YoY) increase. The company also delivered $16.0 billion in quarterly sales for 6.8% YoY growth, but this was helped by a 4.2 percentage point contribution from favorable currency movements. As a result of this performance, management moved the lower-end of its prior earnings guidance five-cents higher and narrowed its full-year guidance range to $4.95 to $5.00 per share, representing 4% to 5% YoY growth. This is expected to lead to some modest upside from the current $4.96 consensus estimate for 2011.

This company's earnings performance was particularly surprising this quarter because of the increasing pressures on margins and profitability that J&J's business has encountered. Specifically, J&J's gross margin deteriorated with higher manufacturing and compliance costs in its Consumer business that are required as part of its operation under an FDA consent decree. The hit from the first quarter of generic erosion for its large Levaquin product line and the recent addition of its acquired Crucell business further hurt gross profitability in its Pharma business. The company's SG&A spending also rose sharply, outpacing sales growth on a YoY basis, due to promotional activity behind several recent pharma product launches and user fees associated with US healthcare reform. The company was able to hold its R&D spending steady on a YoY basis, and enjoyed a slightly higher contribution from other income, due to recent divestments. The net result was a YoY decline in the operating margin and income, despite healthy top-line growth in the quarter. By excluding $316 million in the mark-to-market adjustment of a currency option and costs related to the acquisition of Synthes, which represented 9-cents a share, the company was able to deliver its $1.24 adjusted earnings figure.

All three of the company's business segments provided positive contributions to sales growth in the quarter, with foreign exchange contributing about one-half of the 16.4% growth recorded internationally. The international performance was also helped by the additional overseas territories for Remicade and Simponi gained from its arbitration settlement with Merck, and more than offset its 3.7% sales decline in the US market. The weakness in the US market was due to Consumer business, which remains hampered by recalled OTC products that remain off the market, and the domestic Pharmaceutical business, which suffered from generic competition to its large Levaquin and Concerta brands. Management expects the majority of its consumer brands to return to the market and recapture share in 2012, while newly launched and recently approved products support an improving outlook for its Pharma business. New product contributions were recorded by psoriasis treatment Stelara, its next-generation anti-TNF agent Simponi, long-acting anti-psychotic Invega Sustenna, and Zytiga for prostate cancer. In addition, recently approved products like Xarelto for the prevention of deep vein thrombosis, Incivio for hepatitis C, and Nucycnta ER for pain are also expected to support the longer-term growth of its pharma business, as well as the overall company.

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