Johnson & Johnson's Hidden Source Of Value

| About: Johnson & (JNJ)

This article is part of an ongoing series that highlights specific companies that are on sale. It helps me to document my thought processes when I add to my holdings or initiate new positions. Please provide your feedback in the comments section below.

Johnson & Johnson (NYSE:JNJ) is currently offering investors an opportunity to buy portions of the company at under $92/share. The stock has been drifting for the past few months since reaching its 52-week high, but has been ramping up these past couple of weeks and may provide a good entry point. Right now, JNJ is only a couple of percent off the 52-week high, hit three months ago at $93.71 per ownership interest. This few month pullback and recent ramp provides long-term investors with a good opportunity to initiate a position. Essentially, JNJ has earned a whole quarter's worth of profit and repurchased an entire quarter's worth of shares, yet the price is the same as it was a quarter ago.

Johnson & Johnson has a business model that is simple and sustainable. They provide healthcare products for the world in three segments, Consumer, Pharmaceutical, and Medical Devices & Diagnostics. If there's one thing that everyone will need in their lives, it's healthcare in one form or another. JNJ meets these needs across the spectrum of healthcare. In fact, most consumers probably don't know the name Johnson & Johnson, but they might be familiar with some of their products such as Band-Aid, Splenda, or Tylenol. According to the 2012 Annual Report, revenue grew 3.4 percent year over year, which is no small feat for a $260+ billion market cap company.

Despite the growth, I believe that JNJ trades at a discount to its true valuation. JNJ currently trades at 20 times ttm earnings, but under 16 times projected next year earnings. EPS is expected to grow over 6% next year and continue to grow over 6% annually for the next five years. It also trades at only 14 times free cash flow. Johnson & Johnson reported over $15 billion in operating cash flow for 2012. JNJ beat their earnings estimate by 9% when they reported on October 15th. Their revenue even rose 3% year over year. They also raised their forward guidance. Despite all of this, the stock price is at the same place that it was three months ago, before the earnings beat. I believe that the market will realize all of this in the next few weeks as we navigate through earnings season and this will be the catalyst that will propel JNJ's stock higher. In the meantime, I am content to accumulate shares at this perceived discount.

Also, JNJ is a cannibal! JNJ has been buying back its own stock at a pace that affects the bottom line. When JNJ acquired Synthes, it issued stock to pay for it, which explains the large jump a year ago, but Johnson & Johnson kept retiring shares since then. According to its most recent earnings release, JNJ has over 63 million shares less than it had a year ago, more than a 2% buyback over that year. As the Synthes acquisition (and other initiatives) becomes more accretive to shareholders, free cash flow will increase, allowing for more shares to be retired.

With JNJ buying so much of their outstanding shares, let's look at how that will affect earnings. Analysts were expecting a consensus EPS of $1.32 for this most recent earnings release and consensus for revenue was $17.41 billion. With JNJ's large share buyback activity, it wouldn't have to make more in total earnings to affect the bottom-line EPS. JNJ actually had a positive earnings surprise and raised its forward guidance. I believe that this is the catalyst that will cause JNJ's stock to break into new highs and close substantially higher at the end of 2013.

JNJ also has a solid yield. You literally get paid to wait. JNJ has a current yield of 2.9%. During the financial crisis, JNJ did not cut its dividend. In fact, it raised the dividend. AT&T is a Dividend Champion and has raised its dividend every year for 51 years. JNJ is both a buyback king and a dividend king!

Combined with their strong and increasing free cash flow and share buyback activity, it seems clear that JNJ has the liquidity to continue funding and increasing its dividend. JNJ is sitting on about $9 per share of cash. That is enough cash on the books to cover three years of dividends at the current rate. JNJ also has low debt, with a debt/equity ratio of only 0.22. JNJ earns a ROE of 20% on gross margins of almost 70%, which is very strong. As sales growth and increasing FCF is used to buyback shares, its financial position will only become stronger. I believe that Johnson & Johnson is one of the strongest companies out there, which is also evidenced by its AAA credit rating.

As always, this article represents my opinions at the time of writing. You should do your own due diligence before making any decisions. However, I believe that Johnson & Johnson represents a quality company that is trading hands at a discount.

Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.