Saturday, January 18, 2014

Johnson & Johnson Analysis

Johnson & Johnson is the world's biggest diversified health care company. Its roots can be traced back to a surgical dressing company founded in 1886 by brothers Robert, James, and Edward Johnson. Nearly 130 years later, the Johnson & Johnson (JNJ) family of companies includes:

  • The world's 6th largest consumer health company
  • The world's largest medical devices & diagnostics company
  • The world's 5th largest biologics company
  • The world's 8th largest pharmaceuticals company

The company is organized into 3 segments: Consumer, Pharmaceutical, and Medical Devices & Diagnostics, representing 20%, 40%, and 40% of total revenues. JNJ is a S&P500 dividend aristocrat, has paid an uninterrupted dividend since 1944, and has increased it for 51 consecutive years. Only 15 companies in the entire world have managed to raise dividends for more than 50 years each. JNJ is truly among the elite companies of the world.

Past Business Performance

I love to look at 10 year numbers, as I believe it smooths out much of the economic cycle. While JNJ's past decade has certainly had its ups and downs, particularly the recalls of the last few years, it has still managed to deliver an annual total return of 8.4%, beating its peer group by nearly 1.8% and the S&P500 by nearly 1.3%

Here are some other 10 year numbers (2003 to 2012, as 2013 FY results are not out yet)
  • Revenue growth from 41.9B to 67.2B, representing CAGR of 4.8%
  • Operating Income growth from 9.9B to 15.9B, representing CAGR of 4.9%
  • Adjusted Net Income growth from 7.2B to 14.3B, CAGR of 7.1%
  • Adjusted EPS growth from $2.40 to $5.10, CAGR of 7.8%
  • Dividend growth from $0.93 to $2.40, CAGR of 9.9%
What makes all of this even more amazing is that there were 2 recessions spanning a total of 32 months during this decade. During the most recent recession, JNJ's businesses barely saw a blip:
  • Revenues grew 4.3% from 07 to 08, and fell just 2.9% from 08 to 09
  • Net Income grew 22.4% from 07 to 08, and fell just 5.3% from 08 to 09
  • FCF per share grew from 07 thru 09
Return on Equity has averaged between 25 and 30% for much of the decade, only dipping into the high teens in 2011 and 2012 due to a large number of recalls. A similar story can be seen in the net (17-21%), operating (23-27%), and gross margins (70-72%). Simply put, JNJ's not only consistently makes profits, they do it in a consistent fashion. 

JNJ's performance is the result of several things:
  • diversified product line, making JNJ relatively immune from economic cycles
  • strong competitive advantages from scale
  • stable financial position (only $15B of debt vs $17B of cash on hand)

Current Valuations

A key determinant to future returns is the price paid. Overpaying for even the best company in the world will surely lead to mediocre returns. To illustrate this, using JNJ itself as an example, take a look at an old 2012 F.A.S.T Graph of JNJ since 1993.

  • The stock clearly went through a period of overvaluation during the late 90s, and as a result has done very little for the next decade (sounds like most equities actually...).
  • Since 2009, the stock has been cheap even when compared against the orange 15x line. 
  • Historically stock of premium businesses like JNJ have commanded a premium price, and we do see this in the blue line, which shows JNJ typically is priced at 20-21x PE.

Given the above, and that FY 2012 adjusted earnings were $5.10, we saw that JNJ's fair value should have been closer to $100 than its price of $60-70 in 2012. We also see that in a bull market like the 90s, buying JNJ any time it dips close to 20x PE (tagging the blue line) was a pretty good buy.

  • Analysts on average expect JNJ to earn ~$5.50 for FY2013. This looks like a pretty safe bet given the first 9 months of 2013 have generated $4.28 in earnings, and that Q4 2012 generated $1.19. 
  • Equity is currently priced at 17x 2013 earnings
  • Applying 20x leads to a $110 premium business fair value target

Forward Business Outlook

There are a few questions I ask when looking forward:
  • Where will the growth in revenues come from
  • What reasonable dividend growth rate can I expect
  • How much room for error do I have

While Johnson & Johnson's size and diversity helps make the company incredibly insensitive to economic cycles, it also makes it incredibly difficult to move the revenue needle. So where will the growth come from?
  • Global growth of the middle class: Health & personal care are big issues across the world. When people move into the middle class, one of the first things they want to secure is quality and trustworthy health & personal care products. JNJ's diverse product portfolio & strong brands will ensure it will make its ways into the bathrooms and medicine cabinets of citizens around the world. One example is China, where domestic products often contain harmful materials. This has led to rapid growth in demand for foreign products. JNJ has capitalized on this by building a reputable brand in China. On a recent trip back, I observed prominent retail displays for Johnson's baby products as well as Acuvue contact lenses.
  • R&D Pipeline: With any pharma company, upcoming patent cliffs and the drug pipeline are big focal points. JNJ has one of the best pipelines in the industry. JNJ's pipeline is separated into: Neuroscience, Cardiovascular and Metabolism, Immunology, Oncology, and Infectious Diseases & Vaccines.
    • Zytiga, a prostate cancer drug from the oncology pipeline, sales grew over 300% to $961 million in 2012
    • Olysio, a hepatitis C drug from the Infectious Diseases & Vaccines pipeline is a potential cash cow in the $20B hep C drug market
    • Invokana, recently approved Type 2 diabetes therapy drug from the Cardio & Metabolism pipeline is projected to generate $2.5B in sales per year.
    • Imbruvica, a potential blockbuster treatment for Mantle Cell Lymphoma, with estimates of up to $9.2B in annual sales
    • Sirukumab, a promising rheumatoid arthritis drug in the immunology pipeline
  • Acquisitions: smart acquisitions in both developed and emerging markets will help bolster JNJ's brand portfolio and drug pipelines. In the past, JNJ has not been shy about making large acquisitions. The $20B acquisition of devices maker Synthes in 2012, and the $16.6B acquisition of Pfizer's consumer healthcare division in 2006 are two of the biggest in recent history. Smaller ones include a €1.75B purchase of Dutch vaccine maker Crucell and a $1B purchase of oncology drug research company Aragon Pharmaceuticals

As JNJ's past has shown us, we can reasonably expect 4-5% revenue growth + buybacks to translate into 7-8% EPS growth. I believe based on the above, that this is a reasonable base case for the next 5-10 years as well.  This should translate into a dividend growth rate of 8% or better. This gives JNJ a combined yield + DGR score of 11. This is a very solid value for a core holding.

The potential downside for JNJ is clear. 2 of the 3 business segments are relatively stable and predictable. Pharma is the big question mark. Thus, potential growth may not materialize if some of the drugs in the pipeline do not pan out as expected. I believe in this worst case scenario, we would see flat to 2% revenue growth, which coupled with buybacks could still translate into 2-4% EPS growth. Given JNJ's current low dividend payout ratio of 47%, we could still see 5% dividend growth. That gives it a yield + DGR of 8, which is just barely okay.

While JNJ stock certainly isnt as dirt cheap as it was in 2012, during the recall scandals, it is not extremely expensive either. One could say that currently there is no premium priced into JNJ. Its like you are getting a business class seat for the price of an economy seat. I think that makes JNJ a moderate buy.

Disclosure: Long JNJ since 2007

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