A Knocking Opportunity Answered
We believe Johnson & Johnson (NYSE:JNJ) is making all the right moves, and at the right time. Its healthy balance sheet, cash horde and consistent cash flow generation has empowered the company to exploit significant opportunities created by the worldwide recession. Through numerous small strategic acquisitions and opportunistic partnerships, Johnson & Johnson is beefing up its already strong pharmaceutical segment.
Expanding Pharmaceutical Segment
Representing appropriately 39% of revenues, the pharmaceutical segment is J&J's largest and perhaps most important business unit. Generic competition sales have recently slowed growth considerably, but Johnson & Johnson is aggressively meeting the challenge. With an already promising pipeline of numerous compounds in high growth markets and many in late stages of development, the company is well positioned to mitigate the generic threat to future growth. Furthermore, its recent acquisitions and alliances should greatly enhance their biopharma pipeline into major growth areas. For example, the recent deal with Elans’ Alzheimer’s program gives J&J access to the third largest market relative to cost of treatment behind only cardiovascular disease and cancer. A recent deal with Crucell NV brings monoclonal antibodies and vaccines, both very attractive growth markets.
Growing Medical Devices and Diagnostic Segment
Johnson & Johnson’s diversified businesses are all poised to exploit the demographic opportunities of the world’s aging population. The Medical Devices and Diagnostic Segment is the second largest of their three business segments and represents 36% of revenues. This segment is expected to grow even faster than Pharmaceuticals. Despite strong competition, Johnson & Johnson is firmly established with highly regarded offerings in minimally invasive surgical products, wound care, orthopedics, diagnostics and both bare metal and drug eluting stents.
Consumer Products: Strong Brands in Demand
The company's consumer products segment represents 25% of sales and has been a stalwart through these trying economic times. From baby lotion to Band-Aids to Neutrogena skin care, Listerine mouth wash, Visine eye care and an endless list of leading brands, Johnson & Johnson consumer products follow us throughout our lives. Even in a recession, people want and need to feel good. It’s safe to say that Johnson & Johnson consumer products have been used by people throughout every corner of the world.
High Dividend, Stable Business Model, Low Valuation
To call Johnson & Johnson a diversified company is a gross understatement. The company operates over 250 companies around the world. They are known as a highly innovative company that spent almost 12% of 2008 sales on Research & Development. Committed to internal growth, Johnson & Johnson also pursues strategic acquisitions and normally engage in a strong share buyback program. They have recently slowed down these buybacks, however, in favor of attractive acquisition deals. Nevertheless, the company remains committed to the program long term. It currently offers a very attractive dividend yield with a legacy and commitment of raising it. Last but not least, Johnson & Johnson currently is priced at a historically low valuation.
Historical Valuation at a Glance
In Figure 1 below, we examine how Johnson & Johnson has been historically valued by the market. We chose this period because the period from 1995 to the spring of 2000 has been dubbed the infamous “irrational exuberance” period. Notice how the monthly closing stock price was above the earnings justified value line (green line with white triangles). By the beginning of 2006 (red arrow) Johnson & Johnson’s stock price came to its value driven PE ratio of 16.3. This valuation calculation is a modified version of Ben Graham’s formula for value. Most importantly, the price stayed at this level until September of 2008 before prices fell, for the first and only time since 1995, below the value line.
There are other important historical facts to be gleaned from Figure 1. On the graph, the green line with white triangles represents PE ratio of 16.3. Therefore, the current blended PE ratio of 13.5 and dividend yield of 3.1% (purple circle) indicate a lower than normal valuation. Debt at only 16% of capital testifies to the strength of their balance sheet.
The Importance of Valuation
Notice in Figure 1 that Johnson & Johnson’s stock price (black line) was touching the value line (green line white triangles) at the beginning of the period. The five year period of 1995 through 1999 represents the “irrational exuberance period” of overvalued stock values. From the high and low prices listed at the top of the chart you can see that overvaluation led to flat pricing and poor returns from 1999 to 2009 (orange arrows), even though earnings were strong.
Performance Based on Earnings and Valuation
In Figure 2 below, we illustrate the performance that Johnson & Johnson generated for shareholders based on Figure 1. Capital appreciation was slightly less than the compounded rate of earnings growth as stock prices started in value in 1995 and ended undervalued in 2009.
Overvaluation Hurts Shareholder Returns
In Figure 3, we illustrate how overvaluation can impact performance even when operating results are strong. At the beginning of calendar year 2000, Johnson & Johnson was overvalued with a PE ratio of approximately 27 against a Graham Dodd modified value PE of 16.6.
In Figure 4, we show how performance was impacted by overvaluation. Note that the dividend yield at the beginnings of 2000 was only 1.3% versus today’s yield of over 3%. This low starting dividend yield indicates a high starting valuation. Even though dividends grew each year, the company's contribution was less than normal due to high valuation. Capital appreciation was also hurt.
Today’s Low Valuation Means?
In conclusion, Johnson & Johnson is a blue chip stalwart that trades at a discount to its historical valuation. Therefore its dividend today is higher than you would normally acquire it at, and its growth is expected to continue at an 8-10% rate. If high valuation caused returns to be lower than operating results warranted in the past, then what will current low valuation means to future returns? We believe they should be enhanced. Moreover, a lower valuation implies lower risk as well. We believe Johnson & Johnson represents a very attractive, high quality investment for prudent long-term investors.
Disclosure: Long JNJ at time of writing.