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Summary

  • Shares are around fair value or higher, but upside exists on catalysts for higher earnings.
  • A strong R&D budget and few major patent expirations should support sales with potential in a new marketing strategy for faster growth.
  • A renewed focus on cost management should improve margins and bottom-line results.

Shares of Johnson & Johnson (NYSE:JNJ) have outperformed the S&P 500 and the Healthcare Select Sector SPDR (NYSEARCA:XLV) with a gain of nearly 13% since the beginning of the year. Despite a higher valuation and mature market, there are several catalysts that could drive shares higher. The company has few major patent expirations approaching and an R&D budget to maintain solid growth. A renewed focus on cost management could drive margins, while a new marketing strategy could help to improve sales.

Potential for sales growth and improved margins

Few other companies in the healthcare space, or anywhere in the market, can match the size and scope of Johnson & Johnson. The $290 billion drug and consumer products company holds a strong market share in its product lines and has the R&D budget to maintain it.

The pharmaceutical division contributes 39% of total company revenue with some strong new drugs that promise to increase sales over the next few years. Medical devices account for approximately 40% of revenue with the acquisition of Synthes in 2012, contributing to strong growth in the company's orthopedics business. Consumer goods account for just over one-fifth of sales, but cover a diverse line of products with strong brand loyalty.

Sales have grown at 5% on an annual basis over the last three years, but operating income has only grown 3.5% due to increases in cost of goods and operating expenses. Management was able to decrease selling, marketing and administrative expenses by 1.2% in the first quarter and may signal better cost management ahead. Beyond the renewed focus on expense management, a recent shift in the marketing strategy could help to boost sales over the next couple of years as well.

Johnson & Johnson recently announced that it would shift its U.S. media buying from Interpublic Group (NYSE:IPG) to Omnicom Group (NYSE:OMC). The company has been with Interpublic Group for more than seven years, though has considered other marketing firms several times in the past. IPG created a special team, J3 in 2007, to retain the business and defended itself in a review with OMD and WPP in 2012.

Johnson & Johnson spent more than $1 billion on media in 2013, a fifth more than the $836 million it spent in 2012 and a significant portion of its $22 billion spent on SG&A. IPG will continue to manage the company's media planning through J3, but U.S. media buying will be handled by OMD. The marketing company has been in consideration for some time, and I suspect made a strong pitch to finally get the business. I see the change as a positive for future sales, though watch the filings for any clues on the transition.

The company spent nearly $8.2 billion on research & development in 2013, above the $7.4 billion average over the last five years. The immense scale of the company's research budget has helped it avoid the patent cliff that its peers are experiencing, and there are few major drugs coming off protection over the next several years.

Valuation

Shares of Johnson & Johnson are trading at a premium relative to peers and their own history of valuation. The stock currently trades for 19.7 times trailing earnings against an industry average of 18.8 times and its own five-year average of 16.7 times.

A continuous pipeline of new drugs, fewer patent expirations and a new marketing strategy could drive sales to the upside of expectations. Sales are expected 5% higher this year to $74.9 billion, but estimates range all the way to $75.8 billion. If the company can continue to improve margins through expense management, I think 2014 earnings could reach $5.96 per share against the consensus estimate of $5.88 per share. On this forecast and a multiple of 18.5 times, I have a target of $110.26 per share over the next year.

On a discounted cash flow approach, with an 8% growth rate in dividends and 5% terminal rate after ten years, the estimated fair value is $95.55 per share. This is slightly above the current price in the market, but not so much as to sell out of a position. Even around fair value, shares of Johnson & Johnson are attractive for those looking for a long-term holding in the healthcare sector. Strong cash flows support consistent growth in the dividend and catalysts like a renewed focus on expenses and a new marketing strategy could drive stronger growth.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.