Johnson & Johnson: Price Weakness Is Near The End

Feb. 5.14 | About: Johnson & (JNJ)

Stock price of Johnson & Johnson (NYSE:JNJ) plummeted by 8% following the announcement of below-expected 2014 guidance. I view the price weakness as a buying opportunity based on the reasons discussed below.

Valuation becomes more attractive…

Owing to the price plunge, JNJ now trades at 2015E P/E multiple of 13.8x that is at 6% discount to the same multiple of 14.7x for S&P 500 Index (see chart below).

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The fact that JNJ's consensus long-term earnings estimate of 6.5% is below the average of 8.5% for S&P 500 companies should help somewhat explain the discounted valuation. Nevertheless, the current P/E multiple discount should represent a buy signal as I believe JNJ should command a premium valuation given that 1) the 2015E P/E multiple gap has averaged at a 5% premium over the past 12 months and the current discount is almost the deepest over the horizon; 2) the stock now offers a 3.0% dividend yield, which is considerably above S&P 500 average at just 1.9%, and dividend per share has experienced an average growth rate of 7.5% since 2009, which is better than the growth for many dividend-paying stocks; and 3) JNJ is one of the largest global healthcare companies but with below-average risk owing to its diversified business lines (i.e. consumer, pharmaceutical, and medical devices).

Dividend prospects should limit downside risk…

The lower price boosted the stock's dividend yield to 3.0%, which I view as an attractive level in terms of margin of safety on the investment. I noted the following trends:

  • Management has a strong commitment to raising dividend. Since 2009, dividend per share has grown by an average annual rate of 7.5%.
  • JNJ has been a strong free cash flow generator. In the past 5 years, the company managed to generate free cash flow which is more than twice of its annual dividend payment. Given the significant cash flow capacity, it is expected that the current pace of dividend growth can be sustained going forward.
  • In the past 3 years, JNJ's dividend yield rarely exceeded 3.7% (see chart below).

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Based on the above, assuming a downside scenario where management raises the quarterly dividend twice by only 5% in May 2014 and another 5% in May 2015, which means that quarterly dividend per share would increase from the current $0.66 level to $0.73 in May 2015, but a further drop in stock price pushes the dividend yield to 3.7%. This case implies a 1-year (approximately) share price of $78.7, which is just 6.2% below the current share price at $86.6 if considering the dividend income (3%) throughout the 1-year holding period. Given Street's average 1-year target price at $100.5 is 16.0% above the current share price and the upside can potentially reach 19.0% after incorporating the dividend income, the odds ratio of 3 to 1 (i.e. return/loss) appear to be very compelling.

Upside catalysts

Looking forward, I believe JNJ should continue to deliver healthy growth owing to the following drivers:

  • The company's Q4 2013 growth primarily came from an 11.8% year-on-year growth from the Pharmaceutical segment, which was largely driven by new drugs launched recently (e.g. Zytiga and Invokana). Given the early stage and the success to date, it is expected these new drugs sales momentum will continue to build through 2014 and thus should bolster top line growth.
  • Owing to several new drug launches, JNJ's drug launch spending is expected to slow down over time. Hence, I believe the company's profitability margin should benefit from this reduced spending over a medium term and eventually would see higher EPS growth due to operating leverage.
  • In early January, JNJ announced a potential divestiture of its lower-margin Diagnostic business for $4B, which demonstrated management's commitment to exit less profitable business. I believe management would continue to pursue M&A opportunities to improve profitability and these future M&A transactions should be positive catalyst for share price. In addition, management has not mentioned about the deployment of the potential $4B proceeds. Given that JNJ already has $10B net cash, I expect management to announce a deployment plan (e.g. buyback, dividend hike, or acquisition) in near term, which should be positive to share price.

In summary, I view JNJ's risk-reward profile to be very favorable at the current price level given the discounted valuation, downside protection from dividend yield and growth, and a few catalysts ahead. A buy rating is therefore warranted.

All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.

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.