| 2006 | 2007 | ||||||
| Price: | 65.10 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 190,418 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Johnson and Johnson is the most diversified and respected mega-cap health care company in the
As one of only six Triple A rated industrial companies in America with a pristine balance sheet, 20%+ Operating Margins, 30% ROE, minimal financial and operational leverage, strong ROCE, low capex needs, and a proven history of profitable acquisitions in addition to showing discipline in capital allocation, J&J presents a low-risk, exciting investment opportunity for investors over the next 3-5 years and more. J&J is likely to perform especially well in a slowing economic environment in the
This report will argue that J&J’s low valuation is due to several reasons. 1) Mega-cap healthcare companies usually trade in a group. They are very anti-cyclical because their earnings are not cyclical. 2) Merck and Pfizer disappointed investors because of unquantifiable and potentially large liabilities from potentially unsafe blockbuster drugs, and the threat of generic drugs and weak pipelines. Until recently, the weak performance of these two fallen giants cast a dark shadow on most pharmaceutical companies. 3) In a strong economic environment coming out of a recession, the safety, diversity, and durability of J&J’s earnings stream and dividend mattered little to investors. Out of all sectors, stable healthcare and pharmaceutical companies perform the worst during a rocketing economy. 4) Review the July 2006 writeup on GE and the August 2006 writeup on the Consumer Staples ETF for many reasons that are relevant to J&J.
Company-specific reasons include: 1) Investors believe that J&J is too big to grow at the same rate it has in the past. 2) J&J’s earnings growth of 6% in 2006 is disappointing to investors given J&J has grown earnings in the double-digits every year since 1984. 3) The market is very nervous about J&J’s specific drug pipeline. 4) J&J is perceived to be a large pharmaceutical company and “black-box” in nature. A lot of investors were burned by Merck and Pfizer and do not understand the business profile of J&J, what the risks are, and how the business is changing.
With clear evidence of housing and commodities slowing, weakness at the consumer level, the inverted yield curve, and the economic expansion into its fifth year, the time is right for J&J to come back into favor among investors as its irresistible combination of stability and solid relative earnings growth will attract investors as it has done in countless number of economic and market cycles—most recently from 1994-1998 when J&J tripled. In the past nine months, Berkshire Hathaway has accumulated stock in J&J. In August,
Business: J&J is a diverse company with the following business breakdown in order of size.
Revenue Operating Profit
Global Pharmaceutical: 40% 45%
Medical Devices and Diagnostics 35% 38%
Organic Consumer Products 18% 13%
Pfizer Consumer Products 7% 4%
Total 100% 100%
US 56%
International 44%
Misconception about J&J: J&J is too big and diverse for investors to have much of an edge analyzing the individual prospects of each business. For more information about the Company, industry, or competitors, please review J&J’s Annual Report and/or sell-side research from the 21 analysts who cover the stock.
On a company-specific level, the important thing is that J&J is the most diversified large healthcare company that exists. Although many investors know J&J makes Band-Aid and Tylenol and have a favorable image of the company due to its strong brand, a lot of investors do not understand how J&J distinguishes itself from its competitors and why the Company has a lower risk profile than its mega-cap peers Merck or Pfizer.
Many relative value investors have compared J&J to Merck and Pfizer and come to the conclusion that J&J is not a cheap stock. The logic is that if one values each J&J business based on a sum-of-the-parts analysis, the large percentage of pharmaceutical profits depress the combined multiple significantly. Merck and Pfizer trade for low multiples of earnings of 17x and 13x FY2007 estimates. The obvious question many investors ask is why should J&J trade at a significant premium? Without analyzing whether or not Merck and Pfizer are not cheap stocks, one must understand that Merck and Pfizer have very concentrated pipelines of drugs. For example, Lipitor is now 25% of Pfizer’s sales and a greater percentage of profits. The market obviously knows that Lipitor is going off patent in 2011. In addition to the Vioxx liability, Merck has three different drugs that are 10% of sales or greater including Zocor and Fosamax—both of which are going off patent within the next few years—as well as Cozaar/Hyzaar. On the other hand, J&J does not have any drugs that are greater than 6% of total sales. No customer for J&J constitutes greater than 10% of sales. After Merck spun off Medco in August 2003 and Pfizer recently sold its Consumer Healthcare Products business to J&J in June 2006, both Merck and Pfizer are increasingly pure-play pharmaceutical companies. J&J is clearly a more diversified company that by definition has a lower risk profile. Although there is always a risk of a weaker pipeline than expected, a drug being pulled off the market for health reasons, or other hard to analyze risks for most VIC members, J&J’s superior global reach, lower concentration of products, services, and drugs, as well as a lack of reliance on a few blockbuster drugs make J&J a safer investment. Since it is very unlikely that J&J will suffer a large earnings disappointment due to its diversified businesses, J&J warrants a higher multiple than most of its competitors. Morgan Stanley has published several excellent research reports illustrating the modest weakness of J&J’s pipeline and the necessary steps J&J must take to reach acceptable growth levels.
Finally, J&J is likely to make further acquisitions going forward after the $16 billion purchase of Pfizer’s Consumer Healthcare Division to further diversify its business and gain additional scale in the US and worldwide. The purchase of well-known brands including Listerine, Sudefed, Ben-Gay, Neosporin, etc. are expected to result in significant synergies for J&J and be accretive to cash earnings within three years. J&J was a loser in the high-profile bidding war for Guidant but demonstrated good discipline when it refused to pay up for the asset. It is likely plenty of rumors will likely surface about J&J being interested in various companies over the next several years including Medtronic and others. J&J’s excellent liquidity position, disciplined capital management, and history of solid integration will allow it to be a successful consolidator in the future.
Valuation
Below is a table of J&J’s valuation at key points in recent history.
Median Forward 10 Year Premium to Payout Current Dividend
Forward Earnings Treasury Treasuries Ratio Yield
P/E Yield
January 1973
“The Top of the Nifty Fifty 47.8x 2.1% 6.5% -68% 31% 0.40%
Bubble”
July 1984
“The
November 1994
""Before Goldilocks" 15.5x 6.45% 8.00% 24% 38% 2.00%
November 1999
"Bubble Valuation" 32.8x 3.05% 6.00% -49% 42% 1.00%
"July 2002
"Bear Market Bottom" 15.8x 6.33% 4.50% 41% 36% 1.90%
"June 2006
"After Pfizer Consumer
Products Acquisition" 14.8x 6.76% 5.25% 28% 39% 2.50%
October 2006 16.3x 6.13% 4.60% 33% 39% 2.30%
The discount to Treasuries is greater than the 1994 period and almost as rich as July 2002 in the midst of the Puerto Rican facility scare at the bottom of the market. Both periods proved to be excellent buying opportunities. Although J&J just reached a new 52-week recently and is more expensive than levels seen earlier in the year, the higher multiple is definitely justified by lower long-term interest rates.
Many investors believe this time is different and the pharmaceutical industry has changed for the worse. While this is probably true to some extent, J&J always performs poorly on an absolute and relative basis when the economy is overheating. From 1982-1984 and 1992-1994, J&J and most of its peers went nowhere and even declined when the economy was exiting a recession despite cheap valuations and undeniably excellent EPS growth. It is unlikely that J&J will perform as well as it did in the past because of weaker growth and increased industry risks, but it is not unreasonable to expect decent returns going forward given the valuation already incorporates many of the risks investors are concerned about.
Management Guidance: Management has guided investors to high single-digit revenue growth over the foreseeable future. With modest efficiency gains and stock buybacks, J&J management has guided investors to a 10% earnings growth rate. This growth rate is higher than the 9% growth rate in FY2006 but significantly lower than the 15% growth rate over the past 35 years. Management realizes that the pharmaceutical business has new challenges and risks. However, these estimates are that unreasonable given J&J’s strong execution in the past and decent demographic trends going forward. With a 2.3% dividend yield and management’s estimate of 10% earnings growth, J&J could generate a nominal return of 12% or more. This yield relative to Treasuries at 4.8% and inflation expectations currently around 2.2% over the long-run is quite attractive with the favorable tax environment for equities relative to cash, CDs, and Treasuries.
Price Target: J&J is currently undervalued based on intrinsic value. The diversity of J&J’s business units and the unparalleled success over all types of economic environments combined with strong free cash flow and high incremental return on invested capital is attractive. If earnings and dividends can grow 8% a year for the next 10 years, which is lower than FY2006 growth, lower than the 15% rate at which J&J grew over the last 30 years, and lower than management’s guidance, then J&J deserves a P/E multiple of 22x forward earnings based on a cost of capital of 6% - 8% and a terminal multiple of 16x. If management’s goals are met, J&J could be valued at a 27x multiple. If J&J continues to grow at 15% annually and surprises investors to the upside by maintaining its growth rate, J&J could be valued at a 37x multiple.
In three years, J&J should be valued at approximately $103 a share based on analyst estimates of $4.70 in FY2009 after the Pfizer Consumer Healthcare acquisition is integrated. Including dividends, investors could receive a return of approximately 20%-25% per year with very low risk.
Adjusted Earnings Dividends
FY2006: $3.69 $1.50
FY2007: $4.00 $1.68
FY2008: $4.35 $1.86
FY2009: $4.70 $2.05
If J&J has a lousy pipeline and/or more than one material drug treatment is proven unsafe, J&J could miss FY2009 EPS estimates by 15% and earn around $4.00 a share—which is the FY2007 estimate. Given the strong balance sheet and solid history of the company, a worst-case 13x multiple on FY2009 EPS would likely result in a $65 stock price in three years including dividends. However, this multiple and earnings are very unrealistic unless J&J has an unprecedented business disaster or if 10-Year Treasury rates accelerate to levels last seen in the early 1980s.
Options: J&J options are a lucrative way of capturing the upside in the stock price because of the low implied volatility due to low interest rates and a tight trading range recently. The price of January 2009 $60 calls is only $10.90 and the $70 calls are only $5.60 on a stock price of $65.20. If J&J’s stock appreciates to $103 by January 2009, the $60 calls and $70 calls would provide upside of 400% and 600%, respectively.
Risks
1) The strength in the economy continues. J&J continues to grow, but experiences multiple contraction or stagnation. Investors prefer riskier equities for longer than we think.
2) Interest rates go to 10% or higher and the earnings and dividend yield are not as attractive to TIPS.
3) J&J does a poor job allocating capital in the 21st century by overpaying for acquisitions and spending too much money on R&D.
4) J&J’s pipeline turns out to be much weaker than expected.
5) J&J experiences a product or drug crisis similar to Tylenol in the early 1980s or Vioxx in 2004.
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