Johnson & Johnson (JNJ) recently announced what every healthcare investor cringes at: a product defect. The company reportedly had been selling a vaginal mesh implant, which supposedly injured women, before it received regulatory approval. It now has 550 lawsuits. Most regrettably, the FDA has noted a fivefold jump in injuries, malfunctions, and deaths from prolapsed organs as a result of the vaginal mesh.
In this article, I will run you through my DCF analysis on J&J and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared with Merck & Co. (MRK) and Pfizer (PFE). I find that the company is meaningfully undervalued.
First, let's begin with an assumption about revenue. J&J finished FY2011 with $65B, which represented a 5.6% gain off of the preceding year. Analysts model only a per annum growth rate of 5.8% over the next five years, which is much too conservative in light of it being nearly 500 bps below what is expected for the S&P 500 (SPY). But, for the sake of being safe, I accept the projection.
Moving onto the cost side of the equation, there are several items to consider: operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 30.5% of revenue versus 32% for SG&A, 11.2% for R&D, and 3.9% for capex. These figures are roughly in line with historical 3-year average levels.
We then need to subtract out net increases in working capital. I expect this figure to hover around 1.5% of revenue over the next half decade or so.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8% yields a fair value figure of $88.59, implying 37.4%. If anything, this estimate is conservative since both the projected growth rate and the terminal growth rate are low. The U.S. economy overall will mature into 2.5% growth - not something that can generate soaring revenue like biotech. In any event, the stock would still not fall if the WACC is 10.2%.
All of this falls within the context of a turnaround effort:
After 2 challenging years, I am proud to say Johnson & Johnson returned to delivering sales growth in 2011, and we grew adjusted earnings for the 28th consecutive year. We continue to strengthen our platform for leadership and profitable growth through new product launches, strong pipelines and investments in key growth areas. Though we continue to face challenging macroeconomic conditions, our ongoing investments have us well positioned to grow and increase our market leadership in one of the most important and rewarding industries in the world.
From a multiples perspective, J&J is fairly attractive. It trades at 18.5x past earnings but only 11.9x forward earnings. Merck trades at a respective 18.5x and 10.1x past and forward earnings versus 19.8x and 9.3x for Pfizer. Assuming a multiple of 17x and a conservative 2012 EPS of $5.19, the rough intrinsic value of the stock is $88.23 - roughly in line with my DCF result.
Consensus estimates for Merck's EPS forecast that it will grow by 1.1% to $3.81 in 2012, decline by 1.8% in 2013, and then grow by 9.4% in 2014. Assuming a multiple of 13x and a conservative 2013 EPS of $3.66, the rough intrinsic value of the stock is $47.58. Despite having 17 potential launches under development, the firm still suffers from the brand image that it has a weak pipeline. MK-6096 is a particularly exciting catalyst, since it has demonstrated solid efficacy and maintains less exposure to generics.
Pfizer faces $1.3B worth of exclusivity losses but has solid momentum off of the fourth quarter. Top-line growth was also strong across the board with the nutrition segment leading at a 20% gain. Eliquis, tofacitinib and Xalkori all look hot. With Pfizer leading in emerging markets, it also has stellar potential to explode revenue and lock in market share. Assuming a multiple of 13.5x and a conservative 2013 EPS of $2.31, the rough intrinsic value of the stock is $31.19.
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