Johnson & Johnson's Outlook

| About: Johnson & (JNJ)

Summary

Johnson & Johnson still has AAA rated debt.

Management has raised the dividend (annually) for the last 53 years.

Johnson & Johnson shares currently yield 2.8%.

It's time to take a look at Johnson & Johnson's (NYSE:JNJ) valuation again, because I like to review all of my long-term stock holdings at least once per year. Currently, I am not holding a whole lot of value in the US stock market. At times like this, I have to sit back and let my cash build. Some of my fellow investors complain about cash losing value to inflation. I am willing to take that risk over short periods of time, especially when I don't see many great alternatives and inflation is a fairly modest 2%.

Today, I'm going to share my thoughts on Johnson & Johnson. Most of my long-term holdings, including Johnson & Johnson, share certain characteristics like brand strength and consistent earnings. Many consistent dividend-paying companies in the consumer staples space have seen their share prices increase substantially over recent years. The same goes for many utility companies, as both groups have become popular with yield-starved investors. For this reason, I've begun to unload several of the dividend companies that I bought in 2008 and 2009. Time will tell if this is a good thing, but (to borrow a song lyric) "to everything there is a season." One company I purchased during the 2008/2009 financial crisis, that I am not selling, is Johnson & Johnson. Please read my thoughts below.

Overview

Most investors are familiar with Johnson & Johnson, the New Jersey based healthcare behemoth. Since its founding in 1886, Johnson & Johnson has grown to include 128,000 worldwide employees and expand around the globe. For the last 53 years, management has raised its dividend (at least annually). The company operates in the following business segments.

  1. Consumer Products - This division manufactures and sells items like baby shampoo, skin care products, oral care products, antiseptic creams, over the counter supplements/medications, and feminine products. This division is responsible for many of Johnson & Johnson's best-known brands including: Motrin IB, Pepcid, Sudafed, Zyrtec, Neutrogena, Band-Aid, and Tylenol. This group represents 20% of Johnson & Johnson's revenue.

  2. Pharmaceuticals - This division sells various products to healthcare providers, retailers, and distributors for prescription use. These products involve treatments for various blood, heart, neurological and metabolic diseases. This group represents 45% of Johnson & Johnson's revenue.

  3. Medical Devices and Diagnostics - This division sells its products to doctors and healthcare facilities (clinics and hospitals). Think of replacement joints, pacemakers, and heart catheters, when you think of this division. This group represents 35% of Johnson & Johnson's revenue.

With that background in mind, let's take a deeper look at Johnson & Johnson. Based on a recent stock price around $108 per share range, the company boasts a dividend yield of 2.8% and a P/E (price to earnings) multiple of 19.8. The company has more cash and cash equivalents ($38+ Billion) than debt ($20 Billion). A well-capitalized company with a rock solid balance sheet, like Johnson & Johnson, is better able to ride out short-term struggles and should therefore be a more stable investment. Johnson & Johnson is also one of the few US companies that has AAA rated bonds.

Johnson & Johnson's revenue growth and earnings (on a per share basis) have generally climbed over the past 10 years. Free cash flow per share has also generally increased over the past 10 years. This is important because a growing stream of free cash flow gives a company's management more options when it comes to expanding the existing business, buying other businesses, and rewarding shareholders (with dividends and share buybacks). In the Gurufocus chart below, you will also notice that the dividend per share payout has steadily increased. With the current 53% dividend payout ratio, those dividend increases are likely to continue for years to come.

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Important Metrics

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Return-on-equity (ROE) - Johnson & Johnson has a long history of satisfactory ROE figures for investors. ROE is one of the figures I keep a close eye on, to be sure management is putting the company's resources to good use.

Operating and Net Margins - Other than an issue in 2012, Johnson & Johnson's margins have been holding in a nice range for the last 10 years. For a company of its size, and with its array of products, I think such consistent profit margins are a great sign. These ratios, in conjunction with the top and bottom line growth we discussed above, give me confidence that management will be able to pass any future price increases through without losing customers. Such is the value of a stable company, which owns several powerful brands.

Valuations

As mentioned above, Johnson and Johnson has a long history of rewarding shareholders with stock buybacks and increasing dividends. The company has spent big money on repurchasing stock each of the past 10 years, including nearly $13 billion worth in 2012 and $3.5 billion in 2013. Given the developed world's aging demographic and declining health, I think healthcare companies like Johnson & Johnson are a great place to invest for the future.

I have been a shareholder since 2008 and my only complaint is that I didn't buy more shares in 2008. My current discounted cash flow model suggests Johnson & Johnson's shares are undervalued. Earnings per share (diluted) have been growing at an annual average of almost 16% per year, over the last 10 years. For the purposes of my calculation, I assumed that growth over the next 10 years would be at half that rate (or 7.95%).

I also have become less and less comfortable extrapolating the earnings growth of companies 20 years in the future, because of the disruptions many industries face. Instead, I have begun extrapolating earnings growth out 10 years in advance, and then assuming a price to earnings ratio based on those earnings. In this case, I am assuming the earnings in 2026 will be $10.91 dollars, and based on a price to earnings ratio of 15, guesstimate the share price of Johnson & Johnson will be about $163 in 2026.

On an annualized basis, that isn't a great return, but it would be predictable, and the dividends would be nice. Keep in mind this is a guesstimate, and like Warren Buffett, I would rather be approximately right, than precisely wrong. A price to earnings ratio of 15 is fairly conservative for Johnson & Johnson. My discount rate of 5% is quite low, but I think it reasonable with global interest rates being so low.

It can take years for Mr. Market to reward shareholders of a given company, depending on the given stock market cycles at the time. Take a look at Johnson & Johnson's share price over the past 5 years, in the Yahoo Finance chart below. The price per share has increased substantially, as the company grew and prospered. Would you believe investors that bought the stock in 1999 (at $50) still had a stock trading at $50 in 2009, despite 10 years of the company growing and profiting. Having predictable companies like Johnson & Johnson in my portfolio helps me be patient and wait for stock markets to recognize what I believe to be quality investments, of course, collecting dividends all the while.

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In my opinion, Johnson & Johnson has the right mix of long-term growth and a management that is rewarding shareholders. It also has one of the strongest balance sheets in the S&P 500, which limits the company's downside risk. With all of my bullish comments, and the metrics listed above, you may be wondering why I'm not adding to my shares at these levels. My answer is simple. I believe the broad stock market is overvalued and the company's shares are even trading at a premium by their own historical standards. (See the Morningstar table below.) I will wait, and watch, for better levels. Rest assured however, that I am not selling our current holdings, and will buy again when prices come down.

Disclosure:

I am long JNJ. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by Morningstar.com, Yahoo Finance and GuruFocus.com.

Disclosure: I am/we are 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.