Is Johnson & Johnson Really a Safety Stock?

 |  Includes: AZN, GSK, JNJ, NVS, SNY
by: Stockopedia

In a market where a lot of investors are looking for safety, Johnson & Johnson (NYSE:JNJ) has been on a lot of financial advisers' lists as a 'safety stock'; high quality, large cap, with a low valuation and a yield that beats the 2% you can get on treasury bonds.

MoneyWeek, for instance, has an interesting article which shows how the current valuation levels for J&J have usually been the bottom for the shares,- leading to potentially good gains for shareholders over the next few years. [1]

The business is well diversified. Though it's called 'big pharma', in fact only 40% of the operating profits come from pharmaceuticals, with slightly more from 'MD&D' (Medical Devices and Diagnostics), and the balance from consumer businesses [2].

The company has a highly diverse list of products. It also has very strong market positions; for instance it's the leader in major market such as coronary stents, blood screening and typing, oral rinses, and disposable contact lenses. It claims that it is either market leader or number 2 in nearly three-quarters of its markets, which qualifies it as a Buffett-style 'large moat' company. In consumer businesses, its brands include Band-Aid, Tylenol, Listerine, Sudafed, and Benadryl - a roll call of excellent brands.

It's also geographically diverse - in 2009, 50% of the business came from the US, with 16% in Asia-Pacific and Africa, and 26% in Western Europe.

What's not to like? Well, it seems that currently the company has a number of issues.

One is a major problem at one of its manufacturing plants. Fort Washington, which manufactures products for the consumer division, has had production shut down and will be renovated following concerns from the FDA. The problems are multiple - contaminated products, unclean plant, and inadequate quality control [3] . This probably won't have a massive impact on earnings - it affects at most 10% of the product base, and will probably be at most 1% dilutive, according to analysts at Wells Fargo [4] .

However, the problems at J&J have allowed generic OTC competitors to take a much higher share of the retail market - and may lead to a loss of reputation for J&J's brands, which could take a long while to recover from.

There are also, of course, issues with patent expirations and the lack of drugs in the research pipeline to make up for those which expire. That's common to all big pharma, so while it might explain undervaluation compared to the US market, it shouldn't lead to any comparative underperformance within the sector.

Now this is where J&J's diversity has really helped it. Both pharma and consumer sales were down in the first quarter of the year, but MD&D was a standout, with 8% growth, enabling the company to maintain revenue levels.

J&J is certainly cheap compared to its historical valuations - in June it traded below USD 58 for the first time in a year - but how does it compare to other pharmaceutical companies? I ran the slide rule over it compared to GSK and Astra Zeneca (NYSE:AZN), and then looked at a couple of European pharmas for good measure - Sanofi-Aventis (NYSE:SNY) and Novartis (NYSE:NVS).

J&J is sitting on 12x earnings, and pays out a yield of 3.7%. That yield guarantees it's in many US dividend income portfolios, but it's not particularly outstanding for the sector. Currently, you'll get nearly double that with Astra Zeneca, which pays over 7%, and which is cashed up and highly cash generative, though perhaps without much in the way of near term earnings growth. (But then, if you're buying any of these stocks, you're not going to be a growth investor, anyway.) Glaxosmithkline (LON:GSK) pays over 5% in dividends, Sanofi 5.1% and Novartis 4.1%. So on yield, which is one of the main attractions, J&J isn't doing all that well.

It also looks a bit overvalued, with the European and UK stocks all trading on single figure PERs - 9.4x for GSK, 8.4x for AZN, 9.7x for NOVN and just 7x for SAN. Yes, the US tends to be a higher PER market than the European markets - but even so, J&J looks a tad expensive. (Wells Fargo analysts point out that they believe J&J is about to see a period of high top and bottom line growth, though, which may give it a trump card over the undeniably rather slow-moving competition.)

Now the funny thing about that MoneyWeek article I quoted earlier is that though it's almost entirely written about J&J, in the end, that's not the investment the writer picked. Instead, it recommends a US based ETF as the way into pharma, because so many other pharmaceutical companies are so much cheaper. So obviously, my misgivings about J&J were shared by that writer. And apparently, they may be shared by a certain Mr Buffett, who has been gradually shaving his holdings over the past couple of years...


[1] MoneyWeek, 2 July 2010
J&J first quarter investor presentation, p7
Fierce Pharma Manufacturing, 29 June 2010
Wall Street Journal, 17 June 2010:

Disclosure: No positions