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1. Summary

In this analysis, I am looking at JNJ as a long investment opportunity. A quick look at JNJ’s financials attracted me to the company:

- High cash flow generation

- High returns on equity and assets

- Strong Balance Sheet

- Relatively low valuation (on a cash return and P/E basis)

- History of re-distributing cash to shareholders via both dividends and share repurchases.

The analysis will first evaluate the company’s performance which in turn informs a discounted Free Cash Flow model, coupled with the determination of a reasonable margin of safety and likely intrinsic returns of the company.

2. Company Analysis 2.1 Company overview

JNJ is the largest and most diverse healthcare company in the world with sales in excess of $60Bn. The company comprises three divisions:

- Pharmaceuticals (35% of sales), boasting several industry-leading drugs and a solid late-stage product pipeline,

- Medical devices and diagnostics (35% of sales), with controlling position in many areas (orthopedics, surgical devices)

- Consumer health (30% of sales), including Tylenol – which has grown recently within JNJ as a result of the Pfizer (NYSE:PFE) consumer business acquisition in 2007.

Contrary to a number of its Pharma competitors, JNJ only faces modest patent losses, with only 3% of sales at risk in the coming couple of years. This exposure should be mitigated by new drugs coming from JNJ’s development pipelines as well as continued growth in its other business units, which are not subject to patent exposure.

JNJ has been in the news recently following a couple of product recalls as well as the “risk” linked to healthcare reform. However, at this point I do not believe those should be material to JNJ’s valuation.

Recalls: These are somewhat common in the industry but should nevertheless be monitored by any investors to make sure that those are accidents and not a sign of weakness in JNJ’s quality processes overall. While recalls may tarnish JNJ in the short term, provided they are handled correctly, they should not be a risk to JNJ’s stellar brand in the consumer and healthcare space.

Healthcare reform: while a lot of articles came out in March/April on the potential impact of the Healthcare reform, the view is now that the impact will be somewhat neutral to Pharma/Device companies with some pricing pressure somewhat mitigated by increased volume.

2.2 Profitability and Growth

JNJ’s revenue growth (6.0% over the last 5-year) coupled with some margin gains led to solid gains in cash flows, with Operating Cash Flow (“OCF”) and Free Cash Flow (“FCF”) growing at 7.4% and 9.3% respectively. While revenues dropped in 2009, OCF remained fairly constant and FCF continued to improve as Capex in 2009 and on a Trailing Twelve Month (“TTM”) basis have been about $10.7B lower than in 2007-08.

Over the last 10 years, JNJ has been an impressive cash generator with an average 20% FCF/Revenue. In addition, FCFs have been rather stable, with a standard deviation vs. regression trend line of only 9%. Earnings Per Share (“EPS”) have also exhibited a relatively stable trend, with only 2 “down years” over the last 10 years (2007 and 2009).

$ millions, except per share data

Growth Rates

2005

2006

2007

2008

2009

TTM

3-yr

5-yr

10-yr

Revenue

50,514

53,324

61,095

63,747

61,897

62,593

0.7%

6.0%

9.4%

Op. Income

13,009

13,150

13,661

15,988

15,590

15,650

6.8%

5.7%

9.9%

Net Income

10,411

11,053

10,576

12,949

12,266

13,526

7.7%

5.0%

11.6%

OCF

11,877

14,248

15,249

14,972

16,571

17,908

4.2%

7.4%

10.2%

FCF

9,245

11,510

11,939

11,906

14,206

15,648

9.1%

9.3%

11.2%

EPS

3.46

3.73

3.63

4.57

4.40

4.84

10.1%

7.1%

12.2%

Note: Growth rates calculated using log-normal regression and exclude LTM

Looking forward, I will be using a “conservative” growth rate of 6% for Free Cash Flow over the next 5 years, which is below historical performance as well as below analysts’ revenue growth consensus of 6.8%. As a starting point, I will be using the projected FCF based on a 10-year regression of $15,040M. Note that this number is lower than the current TTM performance and leaves room to accommodate JNJ’s lowered guidance for the end of the current year.

Turning to returns, JNJ’s performance has also been strong with average ROE’s and ROA’s of 26.9% and 15.0% over the last 5 years (cf. appendix). Given the stability of JNJ’s performance over time, I will be using a 25% ROE level going forward as an input to the sustainable growth rate calculation.

Based on JNJ’s strong and stable cash generation as well as its strong returns, I will consider JNJ has having a strong business moat and will be looking at “only” a 30% Margin of Safety when evaluating a potential “buy” price for shares…provided the business is in a good financial condition.

Part 2 will cover Financial health, uses of cash and valuation.

Disclosure: Long JNJ

Source: Johnson & Johnson: A Strong Company at an Attractive Price, Part 1