Johnson & Johnson (NYSE:JNJ)

Strong management, good price at this time

Good valuation at this point post-recalls

Good value after Tylenol recall

- strong brand
- good dividends
- consistent & growing free cash flow
- OTC product recall issues should be in past

W.Buffett is back

Great company, solid dividend. Great addition to any port.

Dividend yield is high. The company has a big moat and good ratios like ROE and operational margins. EPS growth every year.

1 SUMMARY
In this analysis, I am looking at JNJ as a long investment opportunity. A quick look at JNJ’s financials attracted me to the company:
? High cash flow generation
? High returns on equity and assets
? Strong Balance Sheet
? Relatively low valuation (on a cash return and P/E basis)
? History of re-distributing cash to shareholders via both dividends and share repurchases.

The analysis will first evaluate the company’s performance which in turns informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.

2 COMPANY ANALYSIS
2.1 Company overview
JNJ is the largest and most diverse healthcare company in the world with sales in excess of $60Bn. The company comprises three divisions:
? Pharmaceuticals (35% of sales), boasting several industry-leading drugs and a solid late-stage product pipeline,
? Medical devices and diagnostics (35% of sales), with controlling position in many areas (orthopedics, surgical devices)
? Consumer health (30% of sales), including Tylenol – which has grown recently within JNJ as a result of the Pfizer consumer business acquisition in 2007.

Contrary to a number of its Pharma competitors, JNJ only faces modest patent losses, with only 3% of sales at risk in the coming couple of years. This exposure should be mitigated by new drugs coming from JNJ’s development pipelines as well as continued growth in its other business units, which are not subject to patent exposure.

JNJ has been in the news recently following a couple of product recalls as well as the “risk” linked to healthcare reform. However at this point I do not believe those should be material to JNJ’s valuation
Recalls: These are somewhat common in the industry but should nevertheless be monitored by any investors to make sure that those are accidents and not a sign of weakness in JNJ’s quality processes overall. While recalls may tarnish JNJ in the short term and provided they are handled correctly, they should not be a risk to JNJ’s stellar brand in the consumer and healthcare space.
Healthcare reform: while a lot of articles came out in March/April on the potential impact of the Healthcare reform, the view is now that the impact will be somewhat neutral to Pharma/Device companies with some pricing pressure somewhat mitigated by increased volume.

2.2 Profitability and Growth
JNJ’s revenue growth (6.0% over the last 5-year) coupled with some margin gains led to solid gains in cash flows, with Operating Cash Flow (“OCF”) and Free Cash Flow (“FCF”) growing at 7.4% and 9.3% respectively. While revenues dropped in 2009, OCF remained fairly constant and FCF continued to improve as Capex in 2009 and on a Trailing Twelve Month (“TTM”) basis have been about $10.7B lower than in 2007-08.

Over the last 10 years, JNJ has been an impressive cash generator with an average 20% FCF/Revenue. In addition, FCF’s have been rather stable, with a standard deviation vs. regression trend line of only 9%. Earnings Per Share (“EPS”) have also exhibited a relatively stable trend, with only 2 “down years” over the last 10 years (2007 and 2009).

$ millions, except per share data Growth Rates
2005 2006 2007 2008 2009 TTM 3-yr 5-yr 10-yr
Revenue 50,514 53,324 61,095 63,747 61,897 62,593 0.7% 6.0% 9.4%
Op. Income 13,009 13,150 13,661 15,988 15,590 15,650 6.8% 5.7% 9.9%
Net Income 10,411 11,053 10,576 12,949 12,266 13,526 7.7% 5.0% 11.6%
OCF 11,877 14,248 15,249 14,972 16,571 17,908 4.2% 7.4% 10.2%
FCF 9,245 11,510 11,939 11,906 14,206 15,648 9.1% 9.3% 11.2%
EPS 3.46 3.73 3.63 4.57 4.40 4.84 10.1% 7.1% 12.2%
Note: Growth rates calculated using log-normal regression and exclude LTM

Looking forward, I will be using a “conservative” growth rate of 6% for Free Cash Flow over the next 5 years, which is below historical performance as well as below analysts’ revenue growth consensus of 6.8%. As a starting point for 2010, I will be using the projected FCF based on a 10-year regression of $15,040M. Note that this number is lower than the current TTM performance and leaves room to accommodate JNJ’s lowered guidance for the end of the current year.

Turning to returns, JNJ’s performance has also been strong with average ROE’s and ROA’s of 26.9% and 15.0% over the last 5 years (cf. appendix). Given the stability of JNJ’s performance over time, I will be using a 25% ROE level going forward as an input to the sustainable growth rate calculation.

Based on JNJ’s strong and stable cash generation as well as its strong returns, I will consider JNJ has having a strong business moat and will be looking at “only” a 30% Margin of Safety when evaluating a potential “buy” price for shares…provided the business is in a good financial condition.

2.3 Financial Health
Liquidity
JNJ’s working capital management is conservative, with a current ratio of 2.3x as of the last quarter. This is however on the higher end of JNJ”s historical position which has been over time moving between 1.5x and 2.3x. However, even at 1.5x liquidity should not be an issue for JNJ which carries about $12B in cash on its balance sheet. In addition, current assets excluding cash more than cover current liabilities.

Overall the cash conversion cycle is fairly short, at 29 days as of the latest 10-K – in line with the average over the last 10 years.

Debt

$ millions, except per share data
2005 2006 2007 2008 2009 TTM
Total Debt / Equity 0.1 0.2 0.2 0.3 0.3 0.1
ST % of Total Debt 25% 69% 26% 31% 43% 38%
Total Debt / FCF 0.3 0.6 0.8 1.0 1.0 0.8
Op. Income / Interest 240.9 208.7 46.2 36.8 34.6 35.2

JNJ carries $11.6Bn of debt, c.40% of which in the form of short term debt. While the short term debt could be an issue in case of a market disruption, JNJ has ample cash to refinance and – following its recent bond offering – will probably reduce its short term debt exposure in the coming quarters.

Overall, JNJ’s debt level is very low with Total Debt being below Free Cash Flow – JNJ could repay its debt entirely from cash flow within less than a year! – and interest coverage is very high.

In addition, pension does not appear to present a major risk with a potential underfunding of $2Bn which seems manageable given JNJ’s cash and debt positions.

JNJ’s strong credit position (AAA bond rating!) is also reflected in JNJ’s Altman z-score of 5.2. Looking at the different drivers of the Piotroski score, JNJ also scores highly and only misses a ‘perfect score’ of 9 due to a declining gross margin (from 71% to 70%!) and declining asset turnover (from .69x to .68x)!

In conclusion, JNJ is in a strong liquidity and cash position, having the ability to cover the refinancing of its short term debt from cash as well as repay its entire debt from Free Cash Flow in less than a year if management ever wanted to. Given this low balance sheet risk profile I will keep my working assumption of a 30% margin of safety and will use a 10% cost of capital for the company (5% hurdle rate if T-bonds trade at less than 5% + 5% equity premium)

2.4 Historic use of cash
Dividends

JNJ has a long history of paying and increasing dividends. Over the last 5 years, it has returned $7.99 per share to stock holders and increased its dividends per share at a rate of close to 11% p.a. while maintaining a payout ratio in the 35%-45% range.

JNJ’s use of retained earnings is satisfactory as the company has been able to gain good returns from re-investing in the business: On a 5-year basis, JNJ retained $11.80 per share and increased its EPS by $1.56 or a 13.2% return. On a 10-year basis the return has been 15.3%.

Based on these trends, I will be using the current yield of 3.5% and projecting dividends to grow in line with revenues (cf. return section below)

$ millions, except per share data Growth Rates
2005 2006 2007 2008 2009 TTM 3-yr 5-yr 10-yr
Dividends 3793 4267 4670 5024 5327 5543 6.8% 8.8% 13.8%
Dividends per Share 1.26 1.44 1.60 1.77 1.91 1.98 9.2% 10.9% 14.4%
Diluted EPS 3.46 3.73 3.63 4.57 4.40 4.84 10.1% 7.1% 12.2%
Payout Ratio 36% 39% 44% 39% 43% 41%
Retained earnings per Share 2.20 2.29 2.03 2.80 2.49 2.86
Diluted Shares (M) 3009 2963 2913 2836 2789 2796 -2.2% -1.9% -0.6%
Note: Growth rates calculated using log-normal regression and exclude LTM

Buybacks
In addition to dividends, JNJ has regularly purchased its stock back, retiring about 2% of its stocks per year over the last 5 years. JNJ current share repurchase plan (from 2007) still has in excess of $1.1Bn approved for net share repurchases.

3 VALUATION
3.1 DCF
To evaluate the value of the company I am relying on a discounting cash flow calculation with the following assumptions:
? 2010 Free Cash Flow of $15,040M (cf. Profitability and Growth section above)
? Growth for next 5 years: 6% (cf. above), declining to 5% years 6-10 and then 4% years 11-20
? Cost of capital: 10%
? Perpetual growth of 2% to calculate terminal value in year 20

This leads to a DCF value of $228.5Bn for the company, before accounting for net debt. Using a 30% margin of safety on this valuation leads to a per share entry price of $57, to which I am subtracting JNJ’s net debt position of ($6.1Bn –net cash position) leading to a price threshold for investment of slightly over $59.

I believe this evaluation of JNJ’s value to be conservative, given a lower than current FCF starting position, a forecast growth rate of about 2/3rds of historical FCF growth rate and below analyst growth consensus. Moreover FCF have in the past exhibited a low level of volatility and stability, with only two year over year declines over the last 10 years. Subtracting one “standard deviation” to Free Cash Flows throughout the period would change my forecast value after margin of safety to $54.

JNJ share price is currently changing hands at $57.5, which I believe provides an opportunity to invest in the company. However in addition to knowing that I can invest with a reaso

Dividend Aristocrat. Bought in RL at 57.50.

Old people watch jeopardy. Johnson and Johnson pretty much destroy the commercial time during that program, thus old people buy this stuff. Clearly Trebek is part of a conspiracy to get this stuff bought.

cosmetics and drugs

Stock has a long history of steady and dependable growth. Additionally, health care is the sector with the greatest chance for the largest growth over the near future.

Healthcare is almost always a sure bet. Specially with solid track record like JNJ

Great company experiencing a few problems that are not a reason to worry as long as the company returns to its history of transparent concern for doing the right thing.

Valuation

Added 10/15/09

Original pitch from "11 O'Clock Stock" series.

http://www.fool.com/investing/general/2010/09/16/todays-buy-opportunity-apple.aspx

To see more about the series, watch this video from co-founder Tom Gardner:

http://www.fool.com/investing/general/2010/07/22/introducing-11-oclock-stock.aspx

Dividend

valuation, dividend, diversification, earnings growth