What company has a better credit rating than most countries, is paying a higher yield than 10-year US treasuries and probably has more cash on its balance sheet than Greece, Portugal and Spain combined?Johnson & Johnson, in spite of more than two years of revenue and margin declines, continues to have enviable amounts of cash, maintains its AAA rating, and is easily able to pay and increase its dividend—now yielding 3.5%. The trickle of recalls that started in 2009 with Tylenol products for kids turned into a flood over the next two years and damaged this venerable company. It has not killed it and there are signs of recovery. While the pace of recalls has been decelerating, problems continue to plague them. Infant Tylenol has been recalled this month due to a defect in the protective cover—it collapsed into the medication. Product defects have hit the consumer segment especially hard with more than 50 separate OTC medication recalls. Prescription medications and medical devices were not immune to problems and JNJ recalled Topramax, and Eprex, Acuvue contact lenses, Ethicon sutures and DePuy has withdrawn its metal on metal hip resurfacing product from the market. Expensive MistakesThe hip recall incurred a charge of $3 billion in the fourth quarter of 2011. In 2010, the McNeil recalls cost the business around $900 million in lost sales. While it was not broken out for 2011, lost business is estimated at $400 million. Remediation costs will continue through 2012 and are taken out of cost of goods. Fort Washington will not open until 2013. Gross margins contracted as costs related to remediation were incurred.Generally, gross margins have declined since the acquisition of the consumer segment from Pfizer in 2007. Consumer products are lower margin and they became a much larger percentage of revenue in 2007. Margins 2011 2010 2009 2008 2007 2006 2005 2004=====================================================================Gross 68.7% 69.5% 70.2% 71.0% 70.9% 75.8% 76.5% 76.1%Oper 20.0% 22.1% 22.4% 20.9% 20.4% 25.7% 26.5% 27.2%Altogether, the defective products and ongoing failure of quality control have taken a toll on the economics of the business and erased the halo effect that years of selling band aids and children’s over the counter medications gave the company.Growing by AcquisitionThe flood of recalls can trace its roots back to the JNJ acquisition of Pfizer’s consumer healthcare at the end of 2006. Under Pfizer in 2005, consumer healthcare did revenue of $3.9 billion and JNJ paid $16.6 billion. The consumer segment went from 18% of total revenue to 25%. Pfizer (NYSE:PFE) was reshaping its business into a pure pharmaceutical company – a plan that went somewhat astray when it acquired Wyeth for its portfolio of drugs and pipeline and ended up back in the consumer/nutritional business. The acquisition by JNJ was an attempt to buy some growth. Pharmaceuticals and medical devices were beginning to slow. Two drug blockbusters with a combined $6 billion in peak sales were set to see generic competition in 2009—Risperdal and Topamax. JNJ’s standard operating procedure is to grow through acquisitions and partnerships. It works well for the most part and it worked in 2007—the year of the acquisition. It will be interesting to see if Synthes, their largest acquisition in history at $21.3 billion, will give them the growth they are paying for. Synthes will close in 2012. As a medical device company, it may serve to expand margins.The trouble with the growth through consumer products is the effect on combined margins. Increasing the consumer segment, with operating margins half of medical devices and pharmaceutical, lowered JNJ’s combined margins. The consumer segment went from 18% of revenue in 2006 to 25% in 2008. Margins dropped 5%. It was a decision to add growth regardless of the effect. The plan was to cut costs in consumer by $500 to $600 million to bring margins back. The cuts short-changed the corporate quality and compliance program and that opened the Pandora’s box of seemingly endless recalls. The decentralized structure that JNJ’s acquisition strategy leads to requires the CEO to have a firm grasp on each business. JNJ has gone from 30 subsidiaries in 1982 to around 250 operating companies currently. The task of keeping tabs on all of JNJ is daunting. Cutting essential oversight personnel was a critical error. The size makes delegation a necessity and not only numbers of employees declined but also quality did as well. Reports to management did not raise red flags because those responsible for reports and briefings were not qualified for the task. With Weldon’s resignation, we can hope for resolution of these defects.Annual Growth 2011 2010 2009 2008 2007 2006 2005=====================================================================Consumer 2.0% -7.7% -1.6% 10.8% 48.30% 7.50% 9.20%Pharmaceutical 8.8% -0.6% -8.3% -1.2% 6.90% 4.20% 0.90%Medical devices 4.9% 4.4% 1.9% 6.4% 7.20% 6.20% 13.10%Revenue 5.6% -0.5% -2.9% 4.3% 14.6% 5.6% 6.7%Gross 4.4% -1.5% -3.9% 4.4% 7.2% 4.6% 7.2%Operating -2.3% -0.8% 3.1% 6.3% -4.2% 2.7% 3.2% As year-over-year comps began to apply in 2008, consolidated growth dropped back to disappointing low single-digits. When pharmaceuticals slowed from expirations in 2009, growth fell into negative numbers. Consumer could not rescue growth and by 2010, the consumer segment was under pressure as the costs of the recalls began to build. Consumer appears to have bottomed in 2010 and consolidated, gross and operating income growth were all in negative territory. There has been some recovery in 2011. Operating income growth is still negative as JNJ took a $3 billion charge for hip recalls in Q4 2011.Quarterly growth by segment 12/11 9/11 6/11 3/11================================================Consumer 1.6% 4.9% 4.0% -2.2%Pharmaceutical 6.7% 8.9% 12.2% 7.5%Medical devices 2.7% 6.1% 7.2% 3.3% Return on Invested Income When looking at a serial acquirer it is useful to check how the returns on the investments are doing. That is best done with ROIC. ROIC takes into account investments in all of the assets including working capital, property, plants and equipment and any good will and intangibles that have been paid for that do not represent tangible assets. 12/2011 12/2010 12/2009 12/2008 12/2007 12/2006========================================================ROIC 18.2% 22.2% 25.6% 22.3% 22.4% 27.0%For the numerator, we use net operating profit after adjusted taxes or NOPLAT. That is operating income after depreciation with taxes adjusted to represent cash taxes paid. ROIC dropped post-acquisition of Pfizer’s consumer segment and as integration pains subsided, it recovered. In 2011, it hit six-year lows as poor performance in pharmaceutical and medical devices combined with recall costs sent growth into negative territory WACC (cost of capital) is 8% and the spread remains widely positive. ROIC will improve as the company continues its evident recovery.Q4 2011/Annual Results HighlightsGlobal sales were $16.3 billion for Q4-- up 3.9% constant currencyU.S., sales decreased 3.4%; Europe grew 9.4% operationally; Asia-Pacific/Africa region up 7.9%. US continues to lag.Net income was $3.1 billion and EPS was $1.13, up 9.3% and 9.7% respectively (adjusted for the charge for hips).Annual revenue was $65 billion, an increase of 5.6%. Sales grew 2.8% operationally; currency added 2.8%. A weak dollar is great for international businesses.Net revenue was $13.9 billion; EPS (adjusted for the DePuy charge) was $5.00 grew 5% versus the 2010 results.ConsumerConsumer segment Q4 revenue was $3.7 billion-- up 1.6% adjusted for currency. Operational sales increased 2.7%; even U.S. sales were up 2.4%.OTC meds were still under pressure and down 2.9% due to supply constraints.Skin care (including Neutrogena) remains one of the brightest segments and was up 6.6%.PharmaceuticalsRevenue for Q4 was $6.1 billion -- up 6.7%. The loss of patent on Levaquin hit the US particularly hard revenue decreased 8.3%. Sales outside the U.S. increased 25%. Patent expiration is always painful and JNJ is through the worst of it for now.The JNJ pipeline is beginning to pay its way -- REMICADE, STELARA and SIMPONI, were up nearly 20%; growth for REMICADE was 14.3%, STELARA at over 70%, and SIMPONI 10.7%. Remicade sales were helped by JNJ winning a substantial portion of the Merck territory. VELCADE (for multiple myeloma) growth was 22.4%. PREZISTA (HIV) was up 34.2%. The pipeline and its success in turning pharma growth around has been one of Weldon’s greatest accomplishments. Growth in pharmaceuticals and a fertile pipeline critical components that will keep the JNJ business moving forward.Medical DevicesQ4 revenue was $6.5 billion –- up 2.4% operationally with a positive currency impact had a positive impact of 0.3% for a total sales increase of 2.7%; sales in U.S. were down 0.4%; outside the U.S. they were up 4.6%. Exiting the stent business impacted sales negatively. It had to be done as the JNJ stent was losing market share every quarter. Abbott with its Xience franchise has taken over as market leader in the stent businessDePuy (orthopedic implants) grew 0.3%; U.S. down 4% and the business outside the U.S. growing by 5.7%. The orthopedics business has been dismal with hip and knee implants struggling to keep even low single-digit growth. Stryker (NYSE:SYK) and Zimmer (NYSE:ZMH) have both failed to see resumption of fast-growing sales and have seen their double-digit growth fall into low single-digits. It is possible that the golden age of high ortho growth is gone and the new normal is single-digit. I would expect high single-digit rather than the current anemic growth we are seeing quarter after quarter once economic conditions improve.Overall, the picture is one of JNJ returning to growth.Weldon is LeavingJNJ has started to recover and that should go on as consumer expenses wind down, pharmaceutical pipeline products continue to grow and ortho returns to at least high single-digit growth. Consumer confidence may begin to be restored under new leadership if Alex Gorsky is capable. It’s unlikely that will happen with Weldon in charge. William Weldon will leave in April after 10 years as CEO.Dividend Discount ValueJNJ has a long history of paying dividends and increasing the payout. The recent payout ratio is at 64% and at an 8 year high. The increase in the dividend was 6% and is following a declining trend in growth of the dividend. As JNJ reaches stabilization in top line and earnings growth, the dividend growth will need to stabilize. With a company of its size, we may be seeing long-term low single-digit revenue growth ahead. A dividend growth model based on the Gordon growth model for a mature company gives a value per share of $94 if we allow 6% growth. That may be optimistic and if we take a more conservative 3% growth that allows the company to increase at near the rate of historical inflation the value drops to $41.83. The truth is likely somewhere in between and the value lies close to the current price. At a yield of 3.5% and a AAA credit rating, with prospects of much improved performance ahead, free cash in excess of $11 billion in 2011 to pay $6 billion in dividends, the dividend is safe and decent compensation for an investment. I would not count on much share price appreciation
2011 2010 2009 2008 2007 2006 2005 2004=====================================================================Gross 68.7% 69.5% 70.2% 71.0% 70.9% 75.8% 76.5% 76.1%Oper 20.0% 22.1% 22.4% 20.9% 20.4% 25.7% 26.5% 27.2%
2011 2010 2009 2008 2007 2006 2005=====================================================================Consumer 2.0% -7.7% -1.6% 10.8% 48.30% 7.50% 9.20%Pharmaceutical 8.8% -0.6% -8.3% -1.2% 6.90% 4.20% 0.90%Medical devices 4.9% 4.4% 1.9% 6.4% 7.20% 6.20% 13.10%Revenue 5.6% -0.5% -2.9% 4.3% 14.6% 5.6% 6.7%Gross 4.4% -1.5% -3.9% 4.4% 7.2% 4.6% 7.2%Operating -2.3% -0.8% 3.1% 6.3% -4.2% 2.7% 3.2%
12/11 9/11 6/11 3/11================================================Consumer 1.6% 4.9% 4.0% -2.2%Pharmaceutical 6.7% 8.9% 12.2% 7.5%Medical devices 2.7% 6.1% 7.2% 3.3%
12/2011 12/2010 12/2009 12/2008 12/2007 12/2006========================================================ROIC 18.2% 22.2% 25.6% 22.3% 22.4% 27.0%
1. Great analysis. If I'm going to look at your reports over time I'm inclined to think that it has increase about 10% in price the last year and not added to its potential. A solid bond-like investment.2. Of course I'm going to ask .... which do you like better ABT or JNJ?Hockeypop .... still recovering from ALL those wonderful links!
Excellent summary. My view is that total annual returns in the 5-10% range are likely for the next 5 years. Glad to see Weldon gone certainly, but not sure Gorsky can put the lid back on Pandora's box.sw
hi HPgotta go with JNJ--the Abbott split makes me nervous. Don't know what the split does to the dividendAs always Humirais a question mark. It will be an enormous part of the new segment--even worse than it is now. We have new biologics coming out all the time and it's just a matter of time before Humira slows due to competition. Stelara is gaining every quarter (JNJ biologic)Even though JNJ is up from the $58 lows last year, at $66 we have a lot better idea of what the future holds. Weldon is gone, McNeil is back on line in 2013, expenses for the recalls are slowing and the business segments are back in positive territory. Add the Synthes acquisition in which I think was expensive but a smart move and we look good for the next few years. At 3.2% with very little downside left in bad news stock shock, do we put our money into 1.9% 10-year treasuries or JNJ :)ps: can I nominate the board yet--
the Abbott split makes me nervous LeKitKatI sold all my ABT shares in January. First, because I had made a tidy profit on my investment and second, because I'm not fond of spin-offs.That's not to say that spin-offs are categorically good or bad, it's just that I put considerable effort into researching companies prior to investing. I was very comfortable owning ABT, but the spin-off will require a doubling of the research effort and...well...I'd rather conserve my energy. Either or both of the new entities may be wonderful investments. Time will tell. I prefer to let the dust settle and reevaluate after there's a track record to examine.I recently sold all my COP shares, too, for the same reasons.
ps: can I nominate the board yet-- 1. As long as you recognize that I'm voting for you this time -- sure.2. A smart, analytic, award-winning woman asking my opinion? Would you write something for me to DW telling her that actually happened? She won't believe it! ;-)3. Thanks for the analysis (and to others). Looks like my JNJ buy point can shift to about $63. It's my second largest individual stock holding to Berkshire. Both now seem compelling, especially with my hedging the downside with my Mungofitch disaster puts.Thank you!Hockeypop
Fortunately or unfortunately, I've held JNJ for the last 5 years giving me totally flat growth in terms of stock price, but at least I have about 15% more JNJ than I did 5 years ago due to reinvested dividends.I was at the point where I'd decided to sell JNJ- flat growth, flat price, flat everything. But with Weldon leaving, I'm hesitant. I also have some dry powder (if I didn't, I would have sold JNJ a couple weeks back) so I'm not itching to get off my 3.5% dividend just to have cash.I'm willing to wait and see how Q1-Q2 goes before I jump the gun. Unless I find something else that's a screaming buy.Thanks for the great post LeKitKat.
Thanks capI have never believed JNJ was going to make me rich with share price appreciation. It has not gone much of any place for 5 yearsActually that's not quite trueBack in 2003 or so when I first started buying stock instead of mutual funds JNJ was one of my first buys around the mid-$50's and I did think it would make me rich. After following along for the last 7 or 8 years it began to dawn on me that JNJ had some upper limit that would be difficult to cross any time soon. That has been around $70. It's just too massive to go anywhere and there is always something that is going to go wrong with a company this big. It would be a miracle if every segment was doing well at the same time.I started to think of it more like a bond than a stock. Just like there seems to be resistance at the top, as long as things are going reasonably well, the cash and the dividend keep it from falling endlessly. The perfect storm of horrible performance was pretty close this last year and yet the did not correct much.There is not a lot to lose on the bottom if JNJ keeps paying the dividend and increasing it. You of course are not guaranteed to get your investment back like a bond but do have the opportunity to wait for an upturn and could potentially sell at a profit. There is no maturity/time constraint working against youThe yield you get is a factor of where you buy and rather than set a firm price per share, I set a minimum yield I need from these bond-like stocks. With JNJ I was looking for 4%. It's not quite there today, but I am thinking of putting it in some IRAs instead of fixed income because it beats the 10-year treasury by a bunch and is probably about as safe.Look at this chart of P&G and JNJ superimposed. They track each other almost perfectly. P&G has characteristics very similar to JNJ re: bond-like features and lack of big growth potential. http://finance.yahoo.com/echarts?s=JNJ+Interactive#symbol=jn...
Back in 2003 or so when I first started buying stock instead of mutual funds JNJ was one of my first buys around the mid-$50's and I did think it would make me rich. I think you're being a little pessimistic about the potential of Johnson & Johnson's share price (with the emphasis on "potential"). In 2003, when you first bought JNJ, the average P/E was—according to Value Line—19.4. Last year the average P/E was 13.1. Like a lot of quality stocks, JNJ's P/E has contracted as the share price has, more or less, flat lined since the bursting of the tech bubble. Think Wal-Mart and Sysco, etc.For arguments sake, if you bought JNJ shares at $53.50 in 2003 and the P/E had remained constant, based on last year's reported per share earnings (Value Line again), the share price would be approximately $92.00. The annual earnings CAGR since '03 was about 7.3%. In 2003 the average dividend yield was 1.8%, now it's 3.5%.It's not so much that the company has been in the doldrums but rather that the market has continued to punish the stock for getting bid up too high in the past. At least, that's part of the picture. Another aspect is that annual earnings have slowed somewhat over the last decade and are expected to grow at around 5% a year for the next three to five years. In spite of this net profit margins have edged up slightly over the last decade and earnings growth has exceeded the growth of sales. Returns on equity and total capital have contracted slightly, but are still relatively stella. They are estimated (by Value Line) for 2011 at 21.5% and 18.5% respectively. In my book anything over 15% for return on total capital, which is, in effect ROIC, is the sign of an efficient and superior company. In JNJ's case, returns on tangible capital are substantially higher.The stock price could continue to flat line, but if earnings do grow at 5% a year in five years the stock's P/E will be flirting with single digits, at slightly under 10, at which point the dividend yield would likely be 4.8%. Could it happen? Sure, but reason suggests that it's not likely.Ben Graham suggested that a P/E of 18.5 isn't inappropriate for a company that grows its earnings at 5% a year. Graham wasn't exactly Mr. Irrational-Exuberance. Provided JNJ stays on the "slow and steady" there's more chance than not that the P/E ratio will, at some point, rise. It's very easy to think that because a stock's price has flat lined for what may seem an interminable time that it is doomed to that path forever.For what it is worth Morningstar estimates J&J's "fair value" at $77 a share, with a "consider buying" price on the stock of $61.60. Value Line estimates a share price between $100 and $85 for 2014-16, and, a P/E of 15.kelbon
Ben Graham suggested that a P/E of 18.5 isn't inappropriate for a company that grows its earnings at 5% a year. Graham wasn't exactly Mr. Irrational-Exuberance. Provided JNJ stays on the "slow and steady" there's more chance than not that the P/E ratio will, at some point, rise. It's very easy to think that because a stock's price has flat lined for what may seem an interminable time that it is doomed to that path forever.Doesn't that mean JNJ is appropriately priced right now, given its 18.6 P/E? And if that's the case, aren't there quite a few companies that are significantly undervalued out there (AAPL being the one that stands out the most clearly to me).Looking at JNJ's chart, it appears the dividend will be increased within the next quarter. The last 4 dividends were 57 cents per share, 54 cents the 4 quarters before that, and 49 cents before that. If they raise the dividend to 60-62 cents per share per quarter, the yield will be flirting with the 4% mark.
Doesn't that mean JNJ is appropriately priced right now, given its 18.6 P/E? And if that's the case, aren't there quite a few companies that are significantly undervalued out there (AAPL being the one that stands out the most clearly to me).From the horses mouth, JNJ:"The Company maintained its earnings guidance for full-year 2011 of $4.90 - $5.00 per share. The Company's guidance excludes the impact of special items."Let's split the difference and say that earnings per share are $4.95. At $65 a share that's a P/E of 13.1.Whether or not it's appropriate to exclude "special items" or not is a matter of opinion. I'm of the opinion that if, indeed, special items are really nonrecurring events then it is appropriate to exclude them for reporting and valuation purposes.kelbon
Sorry, the last post was a little behind the times.Here's some solid figures from the company.Excluding these special items in both periods, net earnings for the full-year 2011 were $13.9 billion and diluted earnings per share were $5.00, representing increases of 4.4% and 5.0%, respectively, as compared with the full year of 2010.* The Company announced earnings guidance for full-year 2012 of $5.05 to $5.15 per share, which excludes the impact of special items. This guidance reflects operational growth of approximately 3.5% to 5.5% partially offset by an estimated negative impact of currency of approximately 2.5%.If you exclude special items, the trailing P/E at $65 a share is 13 and the forward P/E, splitting the difference, is 12.7.kelbon
Ben Graham suggested that a P/E of 18.5 isn't inappropriate for a company that grows its earnings at 5% a year. Doesn't that mean JNJ is appropriately priced right now, given its 18.6 P/E?I believe Graham & Dodd used 10-year average earnings to compute the P/E to address fluctuations in earnings due to business cycles and "one-time" adjustments.
I believe Graham & Dodd used 10-year average earnings to compute the P/E to address fluctuations in earnings due to business cycles and "one-time" adjustments.The formula as described by Graham in the 1962 edition of Security Analysis, is as follows:V = EPS x (8.5 + 2g)V = Intrinsic ValueEPS = Trailing Twelve Months Earnings Per Share8.5 = P/E base for a no-growth companyg = reasonably expected 7 to 10 year growth rateWhere the expected annual growth rate “should be that expected over the next seven to ten years.” Graham’s formula took no account of prevailing interest rates.He revised his formula in 1974 to account for prevailing interest rates.kelbon
So what to make of this from his other tome?"In former times analysts and investors paid considerable attention to the average earnings over a fairly long period in the past – usually from seven to ten years. This average figure was useful for ironing out the frequent ups and downs of the business cycle, and it was thought to give a better idea of the company's earning power than the results of the latest year alone."- Ben Graham, The Intelligent Investor.http://www.hussman.net/rsi/adjustingpes.htm
So what to make of this from his other tome?This is what I make of it: Clearly, at one point, Graham thought a p/e of 18.5 for a company growing earnings, seven to ten years in the future at 5%, a year was a "fair" valuation.Secondly, Graham didn't differentiate that much between excellent companies and so-so companies. To him, if it was cheap enough regardless of lumpy earnings or business fundamentals, it was a buy. I would posit that the suggestion of using average earnings over seven to ten years would be a more appropriate, and prudent, approach if you are trying to evaluate cyclical companies that have very lumpy earnings — perhaps this is what Graham had in mind? Johnson & Johnson isn't this kind of company and has exhibited smooth and advancing earnings up until now. I would be inclined to think that if you took J&J's average earnings over the last ten years as a measure of value, you would be likely to walk away from a stock, that in my opinion, is quite attractively priced. kelbon
Hi all,V = EPS x (8.5 + 2g)V = Intrinsic ValueEPS = Trailing Twelve Months Earnings Per Share8.5 = P/E base for a no-growth companyg = reasonably expected 7 to 10 year growth rateBeing somewhat of a math geek, the above formula has become an intriguing "math problem" that I've been trying to solve for a number of years. So far, no luck. If you read Ben's explanation for the formula, it suggests that it approximates the prevailing calculations at the time which I've assumed means some sort of dcf analysis on either divis or earnings. In college I studied a whole slew of numerical approximation techniques and so something deep inside me thinks that Ben had applied one of those techniques to take the basic dcf process and simplify it into that formula - that's my theory anyway.Knowing the derivation of a formula is the key to its successful use and to knowing its limitations. Both of which would be important to know if one was really going to rely on that equation.The formula is very similar to the Gordan Growth equation which is:V = D / (k-g)for a stable grower. In it's most general form D = dividends or free cash to equity (both of which could be related back to E, earnings by some factor, say, payout or other). k is discount rate and g is the growth rate.I've tried to reconcile the two formulas using various assumptions and even playing with some infinite series approximations. The two just don't reconcile that I can figure out anyway.Anyone Geekier than me out there that might have some ideas? If so, I'd love to hear about them.As a tangent, I recently rediscoverd this formula that would seem to only apply to asset heavy industries or where book value has a real meaning:V = sqrt(22.5 * earnings per share * book value per share)Near as I can tell, It's really a weighting formula combining Ben's recommendation that an investor not pay more than 15x earnings or 1.5x book, I think. I had never used this particular formula before until recently trying it out of few names I'm somewhat familiar with. It seems to give reasonable results.Anyway, I'm always intrigued by these simple formulas for fair value just because.Rich
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