We are carefully monitoring three well-known household-brand consumer giants - Johnson & Johnson (JNJ), Procter & Gamble (PG), and Home Depot (HD) as they slowly inch their way up to all-time highs. The following takes a brief look at each company's valuation and fundamentals to see if the companies have the necessary tailwind to take out all-time high prints:
Johnson & Johnson
The consumer-branded healthcare giant has 3 primary divisions:
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JNJ's Consumer Division (24% of revenues, now down to 21% of total revenues with brands like Tylenol, Listerine, etc. Johnson's Baby Powder, etc.) has been an unassailable brand since - well - since the 1970's but this past decade has seen numerous product recalls thanks to manufacturing issues at McNeill, which former CEO and Chairman Bill Weedon seemed very slow to address. Really, from a casual observer's viewpoint, JNJ really trashed what was a global consumer brand and enormous customer goodwill, which is only now starting to get remedied.
The Pharmaceutical division (40% of total revenues and the largest segment) is of the most near-term interest given that it is likely one of the two major catalysts we see for the stock price over the next few years. Large-cap pharma (in general) had a very good year in 2012 as the group started to break out technically, thanks to M&A moves at firms like Abbott and Pfizer (PFE), and what looks to be strategic cost reductions and expense reductions at the majors like Merck (MRK), Pfizer and Eli Lilly (LLY). JNJ's U.S. Pharma Division had its best y/y growth in revenues in the 3rd quarter, 2012, +14% year-over-year, with some of that being the Synthes acquisition. However even if Synthes and forex are excluded from Q3 '12 results, Pharma's organic revenue growth was +9% in the quarter, the best in many years.
JNJ's Medical Device & Diagnostic Division (42% of JNJ's total revenue as of 9/30/12 mainly due to the problems in Consumer and Pharma segments) has provided steady revenue growth for JNJ, although revenue growth has slowed from high-single-digit to low-single-digits as the orthopedic device business becomes more competitive. Still JNJ's MDD Division is still #1 or #2 in terms of market share in the business and should remain a steady contributor to the portfolio.
The other potent catalyst that might take some time to develop is that JNJ's new CEO, Alex Gorsky (who also ascended to the Chairman's position recently, replacing Bill Weedon) has acknowledged that the Consumer division needs mending and repair, in terms of brand management.
There are two question we ask when we get a new CEO in for a turnaround situation:
1.) Is the brand intact?
2.)Is there sufficient cash-flow and a good balance sheet to affect the turnaround?
In JNJ's case, we think a resounding "yes" is the right answer in both situations. JNJ is a prodigious cash-flow generator, with a 3.5% dividend yield and strong free-cash-flow.
[Turnarounds do not always work as we found out when Michael Dell resumed the helm at Dell, Inc. (DELL) several years ago, even with the brand "intact" and excellent cash-flow. The stock is down about 50% since Michael took over. Sometimes, sector fundamentals and secular trends can override even the best management talent.]
At 12(x) 4-quarter-trailing cash-flow, and with a 7% free-cash-flow "yield", as well as a 13(x) p.e ratio on 2012's expected earnings per share of $5.07, even if JNJ grows at just single digits in 2013, Gorsky will have time to effect change in the Consumer Division and drive better growth, without too much downside to the stock (Analyst consensus courtesy of ThomsonReuters) for JNJ's earnings per share growth for 2012 - 2015 is 1%, 8%, 7%, and 8%, hardly reckless enthusiasm.
JNJ's all time high was $72.10 in Sept '08. See the attached chart.) We would be a buyer of breakout above $72.10 on volume or a slide back to the $62 - $65 area.
As this is being written JNJ is up about 6% - 7% year-to-date, excluding dividend.
One of the first metrics we are looking for improvement in is gross margin, which has fallen from 71% as of June '08 to 65% as of 9/30/12.
With the new CEO and assuming he gets to work fixing the Consumer division and the Pharma segment starts to reflect the improving fundamentals we see in the rest of the sector, we think JNJ is a low-risk stock for a move to the $77 - $80 range. (Our fair internal fair value estimate for JNJ is $78.)
Procter & Gamble
We made our first purchase of PG's shares since 2007 - 2008 recently, when the stock pulled back to the mid $60's, and we are slowly building a position in the name.
PG is up about 5% year-to-date, as this is being written.
The primary catalyst was Ackman's and Pershing's stake, which promptly drove CEO McDonald to initiate a $10 billion cost reduction program given PG's very high-end price points in the consumer branded segment. However, we think PG is really in the earlier stages of a longer turnaround and re-structuring of the brand.
While PG didn't make the brand management mistakes that JNJ did, the problems are somewhat similar although PG has one major issue: in a lower-cost, private-label world, the PG brands are simply too expensive.
In a note out of Deutschebank after PG's fiscal 4th quarter results in July, Deutschebank noted that "PG's portfolio is 20% overpriced with 35% higher margins" than category.
That is a tough sell these days.
You can say PG is caught between the rock of needing to grow volumes and the hard place of the brand's premium pricing already: (here are the numbers from our internal spreadsheet):
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In the 2nd column, organic volume growth has fallen to zero for the last three quarters, which isn't good news since PG is now using "price" to maintain margins, however, if you refer back to the Deutschebank note cited earlier, "price" is the issue.
Currently Marketing and SG&A (sales, general and administrative expenses) are between 30% and 31% of PG's revenues, and i think over time, PG will continue to have to pare that expense or try and improve their gross margins - one or the other has to give.
The pressure continues on CEO McDonald, and Pershing and Ackman will continue to be a pebble in the shoe until PG starts to rejuvenate organic volume growth.
Currently trading at 15(x) 4-quarter trailing cash-flow, PG isn't screamingly cheap but it never has traded that way. The power of those brands is formidable, and the brands are still intact, it is just that they are premium priced. PG's earnings growth the last 3 fiscal years has been -4%, -4% and -2% in this last year ended June 30.
Street consensus (courtesy of ThomsonReuters) is looking for +2%, +9% and +7%, the next three fiscal years for what is currently a stock with a 16(x) - 17(x) p.e ratio and a 3.5% dividend yield.
PG is a high-end consumer brand, in a cost conscious world. The first metric Id like to see start to tick higher is that organic volume and organic revenue number. Earnings should then start to follow, but it won't be easy for PG - they have a steeper hill to climb than JNJ, in our opinion.
PG's previous all-time high was $75.18 in December '07. (See attached chart.)
We were somewhat surprised to see LOW move to an all-time high this past week, before Home Depot even though HD has done a better job executing, in what can only be called a depression-like scenario for housing, between late 2006 and early 2012.
Home Depot has been well vetted in the analytical circles the last year given its year-to-date performance of +53% year-to-date, (excluding the dividend), in that most investors are now aware of the better comp's than LOW's, the substantial cash-flow and free-cash-flow generation, and HD's returning of that capital to shareholders.
There isn't much new about HD that we can talk about as a potential catalyst other than a continued recovery in the US housing stock.
We'd love to see a 10% pullback to HD to add more to the name.
In terms of candidates with potential upside, we think JNJ and PG rank a bit higher than HD at this point, although HD is now within 10% distance of its January, 2000 of $69.75.
We've been waiting for a decent pullback in HD all year (to no avail), and thus we have been forced to pick away at the stock as it has risen in price, something we aren't very comfortable doing.
Trading at 15(x) cash-flow, we still believe HD needs a better pullback and retrenchment before owning more.
Thanks to the recovery in housing that is now clearly visible and apparent, there isn't a whole lot of fundamental news that could move HD absent a sharp increase in comp's.
However, watch that all-time of $69.75 - a trade and close above this level (see the attached chart) on heavy volume would be a breakout.
In order of preference, we would rank these three mega-cap consumer brand giants this way:
We've given you the all-time high prices. Watch for breakouts on heavier volumes in these stocks. We'd prefer to buy on weakness, but a heavy-volume breakout to a new all-time high is welcome too.