Johnson & Johnson (NYSE:JNJ) has had a nice climb in price over the last several years. The company has strong operating margins, low interest expenses, and a solid return on equity. What's not to like? There are a few things that make me very cautious. I'm going to break it down with the five step DuPont Analysis to shed some light on how the company is reaching those ROE figures.
JNJ had a very low effective tax rate in 2013 and in the first quarter of 2014. I would expect to see some regression to the mean. I don't think it is sustainable for the tax rate to stay that low. If JNJ could sustain such a low tax rate, they would have the best lobbyist on the planet. The first quarter benefited from low reported tax expense, the second quarter suffered from high tax expense. It may be worth taking a long term perspective and adjusting net earnings figures for the long run tax rate rather than relying on spikes tied to tax rates.
The interest burden has decreased, but liabilities have been fairly steady. The figures in my chart are net of interest income, but the majority of the change has been in the amount of expense reported. All things considered, this interest burden looks too low to me and may indicate that JNJ is not using enough debt in their capital structure. I'll dig deeper into that capital structure later.
The operating margins were trending upwards and then took a leap higher. The sudden nature of the change makes me a little nervous regarding the improvement. One way to immediately bump the operating margin is to cut R&D. They didn't do that. Here's another quick table that ties in R&D spending.
The turnover ratio has been slowly decreasing. This quarter was an improvement, but on the first half the year they are only slightly above their relatively low marks from 2013. This should be a bit of a concern to investors. The lower asset turnovers may reflect a company that is accumulating bloat rather than productive assets.
From the book values, it appears that the leverage levels are decreasing. The book value of equity is insufficient to reach a conclusion, but it provides a nice starting place. If leverage and asset turnover are actually decreasing at the same time, it could provide significant problems for JNJ. The strong operating margins are being wasted by low asset turnover and leverage ratios.
The company has been repurchasing shares every year. There's a problem with those repurchases. They aren't fast enough to keep with the dilutive effects of the options the company is providing. I wouldn't expect a huge boost in the share repurchases either. One way I look for the possibility of share repurchases is to look at a company's positions in cash, equity BV, and shares outstanding over time. The cash levels have been stagnant, but the other 2 columns are trending upwards.
To get a better look at leverage, we'll go a little more in depth. Looking at the market cap for the company at the end of each period and comparing it with the amount of liabilities, we see that the leverage is trending down quite significantly. To add value to the shareholders, management should be seeking to achieve the lowest possible WACC (Weighted Average Cost of Capital). It doesn't look like that is happening.
JNJ has seen solid growth in several categories, but the gain in price has outpaced the gains in other areas. As a result, I'm inclined to think the stock might be slightly overvalued because the company is dependent on strong operating margins. As soon as they slip, the company's low asset turnover ratio and low levels of leverage could create a problem. While low leverage can be great for handling adversity, it can be a very costly way to hold large amounts of assets because of the return expected on equity. Overall, I'm slightly bearish on the stock. For the stock to do well over several years, the company needs to do three things:
- Maintain operating margins
- Perform a WACC Analysis and modify debt exposure to take advantage of low rates
- Reduce the rapid growth of assets that are not producing sales
If they do these three things, then I would be wrong and they would be a solid investment. That's possible, no analyst is right every time. I wouldn't short the stock; I just don't think that at these multiples, and after this growth rate, that it will be likely to provide risk adjusted returns. Look for other pieces that are bearish on the stock, the lack of bears should be concerning.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from either Yahoo Finance or the SEC database. If either of these sources contained faulty information, it could be incorporated in our analysis. The analyst holds a diversified portfolio including mutual funds or index funds with long exposure to the stock.