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In this article, I take a look at Johnson & Johnson (JNJ), a diversified healthcare company. Further, I take a look at Merck (MRK), and Abbott Laboratories (ABT), two drug manufactures. All three companies may offer investors profit potential.

We'll use the management effectiveness ratios (return on equity, return on assets, return on investment), book value-share, price-sales, price-book value, etc... to evaluate Johnson & Johnson, Merck and Abbott Laboratories. Additionally, macro-economic indicators are provided at the end of the article. As part of investment analysis, analysts should consider both the company fundamentals and the macro-economic landscape.

The macro-economic picture in the U.S. is deteriorating. In Europe the economy is contracting. European officials are working towards recapitalizing the banks in Spain. Also, European officials are investigating pro-economic growth policies that would reduce the sovereign risks the region is facing. Until pro-growth policies are implemented and Spain's banks are recapitalized, sovereign risks remain.

Further, there is a chance that housing prices in the United Kingdom and France will decline. Unlike US housing prices, home prices in the UK and France did not decline substantially during the Great Recession. Income may not have grown enough to sustain the current level of housing prices. Therefore, it is possible that the global financial system could face risks stemming from a decline in home values in two of the world's largest economies.

Rating System

  • Buy - Be long
  • Neutral - No position
  • Sell - Be short

(The ratings, research and analysis in this article should be considered as a starting point for further research.)

Johnson & Johnson -- Buy

Investment Thesis

Given the macro-economic risks stemming from the monetary and fiscal policies in the US and European Union, investors should be positioned defensively. Johnson & Johnson has limited exposure to the economic cycle - thus the company is a defensive investment.

Given the recent increase in price-sales, price-book value and the common equity share price of Johnson & Johnson, investors should decrease exposure.

The enterprise does face legal risks, and some of its business segments could be adversely impacted by economic headwinds. Additionally, there are counter-party credit risks stemming from the crisis in Europe, and market forces could cause sales of some products to materially decline.

Company vs. Industry [TTM]

  • Return on Assets: 9.01 vs. 5.74
  • Return on Investment: 11.28 vs. 8.93
  • Return on Equity: 16.67 vs. 13.06

(The management effectiveness ratios are courtesy of Reuters.)

Price Forecast
BaselineAlternative BaselineAdverse
2012$60$58$72
2013$53$51$67
2014$56$54$60

In the baseline scenario, the holding period's rate of return is roughly 21 percent over the next year and a half. In the alternative baseline scenario, the hold period's rate of return is roughly 24 percent over the next year and a half. The adverse scenario suggests a holding period's rate of return of roughly 10.5 percent, but occurs in 2014. The current price used for estimates is $67. The return assumptions do not include dividend payments, as skillful investors may be able to negate the costs of dividends.

Valuation

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Pharmaceutical sales, a major portion of Johnson & Johnson's revenue, has been flat over the past year after increasing at the end of 2010.

Book value-share increased as book value increased and shares declined. There was a substantial increase in cash and decrease in marketable securities during the last reporting period; current assets increased. Accounts payable declined and contributed to a decline in current liabilities during the last quarter.

A decline in short-term liabilities was offset by an increase in long-term liabilities as long-term debt increased and short-term debt decreased. Current assets are more than twice as large as current liabilities.

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The price of the common equity shares of Johnson & Johnson have traded between $60 and $65 for the last year. The $60 level should hold as support as long as strains in financial markets from Europe don't intensify and the U.S. economy continues to grow. In the event that macro-economic risks materialize, shares of Johnson & Johnson could trade as low as $50. Although, Johnson & Johnson revenue is not highly correlated with economic growth.

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Price-sales is reflective of limited revenue-share growth and common equity share price volatility.

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Book value increased and common equity shares outstanding marginally declined, as the common equity share price remained relatively stable.

Financial Health

During the first quarter of 2012 and 2011, earnings quality was low. Cash flow from investing was greater than cash flow from operating activities during the first quarter of 2012 as the company generated cash from the sale of investments.

It is interesting that Johnson & Johnson generates so much cash from investing activities; cash from investing was a major portion of cash generated in the first quarters of 2011 and 2012. Investing supports the company's long-term cash balance growth. Typically, operating activity is the main driver of cash balance growth.

The company is carrying roughly $20 billion of debt; roughly $13 billion is long-term debt, and $1.5 billion is due in 2013. The company faces financial obligation risks.

Legal Risks

In terms of legal risks, Johnson & Johnson faces legal risks that management claims are immaterial over the long term. A case involving the off-label promotion of Risperdal includes civil and criminal charges levied against the company. The sum of legal risk is material given the totality of ongoing legal proceedings. A rough estimate of the quantity of legal risk facing the firm is $2-$10B+.

Business segments

Consumer segment sales in the first quarter of 2012 declined compared with the year-ago quarter. A decline in sales of "women's health" products was the largest declining segment on a percentage basis; "baby care" was the next largest decliner.

Pharmaceutical sales increased 1.2 percent compared with the year-ago quarter. Gains in immunology and oncology sales were offset by declines in infectious diseases and neuroscience sales.

There was a 93.3 percent decline in sales of Levaquin / Floxin in the current quarter compared with the year-ago quarter. The decline in sales is due to loss of market exclusivity in the US. The decline in sales of Levaquin / Floxin seems to be an extreme case of a decline in sales caused by a loss of market exclusivity. However, the decline in sales highlights the risk of pharmaceutical products losing market exclusivity.

Medical devices and diagnostic sales were flat in the first quarter compared with the year-ago quarter.

Counter-party credit risk

Johnson & Johnson has roughly $2B-$3B of credit exposure to Greece, Italy, Portugal and Spain, according to the company's financial statements. The exposure to the southern European region seems to be well managed. In a worst-case scenario, losses from uncollected accounts receivable stemming from Southern Europe could total over $1B. How material losses from the region will be is uncertain. The impact on sales of deteriorating economic conditions in Europe is a risk for Johnson & Johnson investors, and the outcome is still highly uncertain.

Economic and market forces

With regard to economic and market forces, Johnson & Johnson has been able to keep the rate of increase in the prices consumers pay for healthcare products below the U.S. inflation rate or Consumer Price Index [CPI].

An increasingly hostile environment to intellectual property continues to threaten the company's operations. Should competitors gain the ability to market generic drug versions of Johnson & Johnson products prior to patent expiration, Johnson & Johnson would report a material decline in sales.

Merck -- Sell

Investment Thesis

Given the current lack of business diversification and the valuation, a short position in Merck is recommended at this time. The loss of patent protection for Singulair further heightens anxiety about the future of the enterprise. Should valuation metrics decline to levels reflective of Merck's future operations, I may recommend the accumulation of common equity shares.

Additionally, credit risk stemming from Europe and the loss of patent protection for Singulair may result in Merck reporting a loss from operations.

Company vs. Industry

  • Return on Assets : 6.71 vs. 5.74
  • Return on Investment : 8.14 vs. 8.93
  • Return on Equity : 12.73 vs. 13.06

(The management effectiveness ratios courtesy of Reuters.)

Enterprise Operations

More important than earnings is the quality of earnings and Merck's earnings are high quality. Additionally, the company generates enough cash from operations to cover its investing and financing activities.

As part of the 2008 global restructuring program, Merck has reduced costs, increased efficiency, and enhanced competitiveness. The restructuring program is mostly complete. Further, gross margin should expand in the coming years.

Credit Risks

As of March 31, 2012, the enterprise had $1.7B of exposure to Greece, Italy, Ireland and Portugal through terms of credit extended as part of business operations.

Legal Risks

There is potential liability from court cases involving Vioxx and ENHANCE. Potential losses from Vioxx litigation are currently inestimable, and could materially adversely impact the company's financial position, income, and cash flow.

Additionally, Merck faces litigation stemming from other products that may adversely impact the firm's financial position, income, and cash flow.

Patent Risks

Between 2012 and 2013 Merck is expected to lose almost all of its revenue from the drug Singulair as the patent expires. Singulair is one of Merck's best selling drugs. Merck stands to lose roughly $4B-$5B in annual sales.

Competitors

Merck competes with Abbott Labs , Amgen (AMGN), Astra Zeneca (AZN), Bristol-Myers Squibb (BMY), GlaxoSmithKline (GSK), Johnson & Johnson , Novartis (NVS), and Pfizer (PFE).

Price Forecast
BaselineAlternative BaselineAdverse
2012$35$33$46
2013$27$25$41
2014$30$29$35

In the baseline scenario, the holding period's rate of return is roughly 34 percent over the next year and a half. In the alternative baseline scenario, the hold period's rate of return is roughly 39 percent over the next year and a half. The adverse scenario suggests a holding period's rate of return of roughly 14.6 percent, but occurs in 2014. The current priced used for estimates is $41. The return assumptions do not include dividend payments as skillful investors may be able to negate the costs of dividends.

Valuation

Book value-share declined from Q1 2010-Q1 2011 and started rising. Recently, cash and cash equivalents increased as current assets increased compared to the year-ago quarter. However, total assets were relatively flat compared to the year-ago quarter. The company is carrying roughly $15 billion in long-term debt.

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Common equity shares of Merck are rising and may be near a peak. Currently, shares of Merck are in the second intermediate rally off the 2009 low. The minimum implied measure move following the consolidation of 2010-2011 is $40. Currently shares are trading at $41.75. Shares are trading above the rising 50-day simple moving average; the trend is towards higher prices.

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Price-sales is rising and may be near a peak. Revenue increased in the first quarter of 2012 compared to the year-ago quarter. The firm was able to manage operating costs effectively and operating margin increased. Compared to the year-ago quarter, dividend per share increased to $0.42.

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Price-book value is rising and may be near a peak. Book value declined and shares of common equity increased in price. On a relative valuation basis, Merck is overvalued as price-book value has risen from 1.50-2.25; a 50 percent increase in the valuation metric.

Abbott Laboratories -- Sell

Investment Thesis

The share price of Abbott Laboratories should decline with the broader market as the U.S. economy faces a recession. Investors should position themselves net short.

Company vs. Industry [TTM]

  • Return on Assets: 8.23 vs. 5.74
  • Return on Investment: 11.36 vs. 8.93
  • Return on Equity: 20.39 vs. 13.06

Enterprise Operations

Net sales increased 4.5 percent in the first of 2012 compared to the year-ago quarter while cost of products sold decreased. Operating costs and expenses increased 1.8 percent compared to the year-ago quarter. In other words, the operating margin expanded in the first quarter of 2012 compared to the year-ago quarter. Earnings before taxes increased 4.2 percent compared to the year-ago quarter.

More important than earnings is the quality of earnings and Abbott's earnings are high quality. However, the company didn't generate enough cash from operations to cover its investing activities. Further, the firm issued $1.4B of short-term debt in the first quarter of 2012.

Total current assets increased 7.7 percent in the first quarter of 2012 compared to the fourth quarter of 2011. The increase is mostly because of an increase in short-term investments.

Net sales of proprietary pharmaceutical products, the firm's largest operating segment, increased 7.1 percent in the first quarter of 2012 compared to the year-ago quarter while operating earnings increased 14.6 percent.

Working capital increased from $8.3B at December 31, 2011 to $8.8B at March 31, 2012. The increase in cash was primarily due to higher cash generated from operating activities.

Legislative Issues

The changes to the Medicaid rebate rate will continue to have a negative impact on the gross profit margin of the Proprietary Pharmaceutical Products segment.

Legal Proceedings

While legal proceedings may have a material impact on 2012 cash flow, long-term the company isn't currently facing material risk from legal proceedings.

Price Forecast
BaselineAlternative BaselineAdverse
2012$55$52$70
2013$45$42$60
2014$48$47$50

In the baseline scenario, the holding period's rate of return is roughly 31 percent over the next year and a half. In the alternative baseline scenario, the hold period's rate of return is roughly 35 percent over the next year and a half. The adverse scenario suggests a holding period's rate of return of roughly 23 percent, but occurs in 2014. The current priced used for estimates is $65. The return assumptions do not include dividend payments as skillful investors may be able to negate the costs of dividends.

Valuation

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Book value-shares declined in the second half of 2011.

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Shares of Abbott Laboratories are trading above the rising 50-day simple moving average; the trend is up. Given the wave structure, we should see a corrective wave begin in the coming months. The corrective wave could be a sharp decline; as oppose to a sideways corrective wave. Further, given the time taken for shares to trade from $42 to $65, the corrective wave should occur this year.

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Price-sales is increasing; although the valuation metric has been relatively flat since April of 2011.

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Price-book value has increased since the end of the third quarter of 2011.

Macro Environment

GDP Forecast

BaselineAlternative BaselineAdverse
2012+2.3+1.8+1.8
2013-0.5-1.5+1.5
2014+2.4+1.6-0.5

In the baseline scenario, I see growth continuing through 2012 with a recession in 2013, and growth resuming in 2014. Under the alternative baseline scenario, growth this year is slower than the baseline scenario, and the recession in 2013 is deeper. In the adverse scenario the recession occurs in 2014. Under the baseline and alternative baseline scenarios, US equities are in a bear market during 2012 and/or 2013.

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ISM non-manufacturing PMI is declining; the index is expected to continue to decline in the coming months.

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Non-farm employment change is declining; the pace of job growth is expected to continue to slow. Eventually, job growth will turn negative.

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CB consumer confidence is increasing; the index is expected to decline in the coming months.

European Union flash manufacturing PMI is declining; the index is expected to increase in the coming months.

European Union flash services PMI is declining; the index is expected to increase in the coming months.

Disclaimer: This article is not meant to establish or continue an investment advisory relationship. Before investing, readers should consult their financial advisor. Christopher Grosvenor does not know your financial situation and ability to bare risk and thus his opinions may not be suitable for all investors.

Source: Valuations Of Johnson & Johnson, Merck And Abbott Laboratories