Johnson & Johnson: Cheaper Than You'd Think

Dec.17.13 | About: Johnson & (JNJ)

Since January 2nd, 2013, a purchase in Johnson & Johnson (NYSE:JNJ) stock would have created 35.08% in paper wealth for shareholders. For $250 billion companies, it seems almost imprudent by definition to discuss the company as a potential investment after a quick run-up like that. But I think Johnson & Johnson represents more of a fair shake for prospective shareholders than you might initially think because some of the company's current earnings power is not fully showing up in the current financial statements.

If you plug Johnson & Johnson into a typical stock screener, you will see a company that looks like it is trading in the mildly overvalued range. At a current price of $91.35 per share, it looks like the company is trading at almost 21x earnings because the company appears to be generating $4.48 in profits per share.

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But I don't think that the $4.48 per share figure adequately represents Johnson & Johnson's true current "earnings power." When you subtract the earnings impairments from the figure that are strictly one-time in nature, then as of November, the company has an earnings base of $5.50 per share. That makes a difference because that means that Johnson & Johnson's "true P/E" is closer to 16.5x earnings. From 2003 through 2007, J&J traded between 15x earnings and 18x earnings. That puts Johnson & Johnson's current valuation right in the middle of where it had been before the financial crisis and long string of recalls depressed Johnson & Johnson's valuation down towards the 12-14x earnings mark.

Of course, historical valuations are only of significance to us if we can reasonably conclude that Johnson & Johnson's future growth will be roughly analogous to the company's growth in years past. Right now, the company is growing at a 9% annual clip even though it is not readily seen in the current earnings per share figures. That is due to the fact that negative currency adjustments and costs associated with the recalls have taken that figure down to 5%, which understates the core growth of the underlying enterprise. When the one-time fees subside and the currency adjustments revert towards the mean, then some of Johnson & Johnson's earnings figures will get a nice pop without the presence of earnings impairments obscuring the earnings base of the firm.

Johnson & Johnson's base is broken down into three different parts: Consumer, Pharmaceutical, and Medical Devices. As of right now, the Medical Device segment is slowly grinding forward, 2% here, 4% there, depending on the quarter you use to make your valuation decisions. With the Consumer division, growth comes in at a steady 5-7% clip. Those are the products that get sold regardless of the economic conditions-oral care, baby care, skin care, and the things you can buy at Wal-Mart that bear the Johnson & Johnson name. And then there is the pharmaceutical division. Right now, this is where the profit growth is coming from. As of November 2013, the pharmaceutical division is making 11% more than it did in November 2012. Remicade. Velcade. Prezista. Zytiga. Stelara. It is drugs like that under the Johnson & Johnson corporate umbrella that are currently giving DGI investors the "G" in Dividend Growth.

I don't normally like to enter the realm of forward-looking P/E ratios because it necessarily takes into account things that have not happened yet, but I find it tolerable to do so when the current earnings are understated and the company in question has such a predictable business model that it does not require prophetic abilities to intelligently guess what the future may hold. In the case of Johnson & Johnson, it is quite likely that the company will be reporting profits of around $5.75 per share (give or take a dime) this time next year once the earnings impairments are largely driven from the earnings reports and the growth at the consumer and pharmaceutical divisions gets fully revealed. At the current price, we're only talking about 15-16x earnings where we will be next year. Is this cheap? No. It's fair. It's the kind of price that, if recession strikes, will make you wish that you had held off on buying. But it's also the kind of price that, absent a recession, will make you wish you bought at $91 per share when you look back on the opportunity a few years from now.

I think that, in a way, the cheap valuation for Johnson & Johnson during the financial crisis and immediate aftermath spoiled investors as they got used to starting yields over 3% and 13-14 P/E ratios with this company. But historically, Johnson & Johnson is a company that has demanded a premium. For most of the 1990s, Johnson & Johnson had a starting dividend yield in the 1% range (not a typo). It didn't creep above 2% until 2004, and it did not hit 2.8% until the financial crisis hit. The years 2009 through 2012 were the only years in the past generation in which you could regularly buy Johnson & Johnson with a starting yield in the 3% range or better. My estimate is that once the product recalls fully subside, J&J's yield will come down to the 2.5% range and trade at 19x earnings or so, perhaps making investors think that the fair price of $91 per share in 2013 wasn't such a bad deal after all.

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.