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This is Part 4 of our report on Johnson & Johnson (NYSE:JNJ). Please refer to Parts 1 through 3 of our series for more information ("Johnson & Johnson Stock Valuation - Part 1," "Johnson & Johnson Stock Valuation - Part 2," and "Johnson & Johnson Stock Valuation - Part 3").

In Part 1, we provided an overview of JNJ's business strategy, its product segments, drug pipelines, company specific issues, and our strategy to analyze the company as a whole. In Part 2, we focused on JNJ's existing products, patent expirations, and products liability issues. We analyzed how the Synthes merger and new products launched in 2011 will add to JNJ's top line. In Part 3, we analyzed JNJ's drug pipeline and discussed the likelihood of FDA approvals for JNJ's six new drug applications (NDAs).

In Part 4, we will review JNJ's previous financial reports and combine that information with our forecast to create a five-year financial projection. Our projected income statement provides estimated earnings from 2013 to 2016, and we will review ad discuss key items and assumptions used in the forecast (see Table 1, Income Statement). Using our projected earnings and free cash flow numbers, we can then derive an estimated intrinsic value for JNJ.

The 2011 financial data that we utilized for our analysis was provided by the company in its 2011 annual report (JNJ's 2011 annual report). The data for 2012 was mostly based on our own estimates, except for several items (e.g., Other Expenses) that the company has provided updated information on, disclosed in its Q2 2012 report or via news releases (JNJ's Q2 2012 release results).

Sales and Revenues

JNJ generated $65 billion sales in 2011. We assume a sustainable sales growth rate for JNJ to be 5%. This is slightly above its five-year compound annual growth rates (CAGR) of 4%, but less than its 10-year CAGR of 7.2%. This assumption is based on the fact that 7.2% annual growth appears unrealistic, while the global economy continues to slow down, but that the low five-year CAGR is also skewed by the global financial crisis and setbacks for JNJ in recent years. As these conditions improve, JNJ should be able to restore a higher growth rate.

Our growth assumptions results in base sales of approximately $68 billion in 2012. We also included an additional $4 billion sales that Synthes is expected to generate in 2012, resulting in total estimated sales of $72 billion in 2012. The new drugs awaiting FDA approval in 2012/2013 discussed in Part 3 are estimated to generate aggregate revenues of $490 million to $2.5 billion from 2013 to 2016 (see "Johnson & Johnson Stock Valuation - Part 3"). These new products will have more meaningful impact after 2013.

COGS and SGA expenses

JNJ's cost of goods sold (COGS) and selling and general administration (SGA) expenses are about 30% and 44% of net sales, respectively. We use these percentages to derive estimated COGS and SGA expenses.

Other (Income) Expenses

This income statement line item is the most variable. It includes "royalty income; gains and losses related to the sale and write-down of certain investments in equity securities held by JNJ; gains and losses on the disposal of property, plant and equipment; currency gains and losses; non-controlling interests and litigation settlements."

In 2011, JNJ reported $2.7 billion in Other Expenses. In previous years, however (2010, 2009), JNJ actually reported gains of $768 million and $526 million. JNJ's Q2 2012 report has already recorded $1,397 million in Other Expenses. Moreover, JNJ recently announced that "it will record an after-tax, non-cash special item related to in-process research and development consisting of a net charge to earnings of between $300 million and $400 million in the third quarter of 2012 related to the discontinuation of the Phase III clinical development of bapineuzumab IV in mild-to-moderate Alzheimer's disease." (See JNJ's discontinued Alzheimer's drug trials.) We include $350 million charges in the R&D write-off line.

As we discussed in Part 2, we believe that these products liabilities charges, litigation, and write-downs are simply a part of the pharmaceutical industry business model. Therefore, in our financial model we assumed $1 billion in Other Expenses to account for these unpredictable events for every year from 2013 to 2016.

Tax Rate

JNJ's effective tax rate in previous years has been 22%. However, the company indicated that in 2012 its tax rate will be increased to 24.9%.

Interest Income and Expense

Interest expenses were derived from our projected debt and interest schedules. Overall, JNJ's long-term debt balance will range from $13 billion to $14 billion, while short-term debts are expected to fall within the range of $7 billion. The average interest rate for these debts is approximately 4.08%.

Overall, JNJ has a strong balance sheet. Its debt represented 22.9% and 25.6 % of total capital (shareholders' equity and total debt) in 2010 and 2011, respectively. Over the next five years, JNJ's debt-to-total-capital ratio could decrease to as low as 19%, unless the company issues new debts for major mergers or acquisitions.

Net Income and EPS

Our income statement projects earnings from 2012 to 2016 at $11.7 billion, $13.3 billion, $14.3 billion, $15.5 billion, and $16.8 billion, respectively. With 2,792 million shares currently outstanding, earnings per share (EPS) are $4.18 (2012), $4.76 (2013), $5.13 (2014), $5.56 (2015), and $6.00 (2016).

In its Q2 2012 report, the company adjusted its earnings guidance for 2012 to $5.00-$5.07 per share (see JNJ's Q2 2012 release results). The company's guidance "excludes the impact of special items and reflects the negative impact of recent currency movements, partially offset by the positive contribution from the Synthes acquisition." If we would exclude $1.9 billion in Other Expenses, our earnings estimate is $4.68, which a P/E multiple of 15 translates to a stock price of ~$70.

Dividends and Stock Repurchases

JNJ recently announced a 7% increase in its quarterly dividend, from $0.57 to $0.61. The dividend growth rate is assumed to be 7% throughout our projected period. (Note that JNJ's 10-year dividend growth rate was 12.4% from 2001 to 2011.) JNJ also issued a stock repurchase program in 2007 to buy back $10 billion of the company's common stock, with the program completed in 2011. While JNJ has not announced whether it will pursue another such program, a review of JNJ's cash flow balance indicates that the company certainly has the capacity to do so (or increase its dividends).

Cash Flows From Operations (CFO)

According to JNJ's annual report, its cash flow from operations were $14.3 billion (2011), $16.4 billion (2010), and $16.6 billion (2009). Our projected CFO from 2012 to 2016 is $13.4 billion, $16.0 billion, $17.0 billion, $18.1 billion, and $19.3 billion, respectively. Capital expenditures were $2.3 billion to $2.8 billion, representing an average of 16% of CFO. We will use these numbers to calculate free cash flow for stock valuation (see below).

According to the company's reports as of Jan. 1, 2012, its foreign subsidiaries held cash and cash equivalents amounting to $24.5 billion, and have cumulative amounts of undistributed international earnings of $41.6 billion. The company intends to continue to reinvest its undistributed international earnings to expand its international operations.

Summary of Financial Ratios and Growth Rates

Based on previous three-year average, JNJ's gross profit margin and earnings-before-tax (EBT) margin is 69% and 24%, respectively, suggesting a profitably business model. Net profit margin of 18.8% is also high relative to other industry. The 10-year average margin trends (from 2001 to 2011) are within similar ranges. Average return on equity (ROE), return on asset (ROA), and return on invested capital (ROIC) is 21.6%, 11.5%, and 16.54%, respectively. Overall, these margins and ratios suggest high profitability of its biopharmaceutical business model.

JNJ's debt is about 24% of its capital structure. Its interest coverage ratio is 22 times in 2011 and more than 30 times in 2010 and 2009. So, the company is financially sound.

The company has cash balance of $24.5 billion in 2011. Our forecast projects that the cash balance will increase from $26 billion to $40 billion between 2012 and 2016. The cash balance suggests that JNJ has the capacity to increase dividend, stock buyback, or fund merger and acquisition.

3-yr Average (2009, 2010, 2011)

Gross profit margin

69.5%

EBT margin

24.0%

Net profit margin

18.8%

ROE

21.6%

ROA

11.5%

ROIC

16.54%

Debt/total capital

24.2%

Overall Valuation

We used three models to derive an intrinsic value for JNJ's stock.

1. Using different P/E multiples, we estimated the stock prices below. On a P/E 15, the stock's target price is $71 based on 2013 earnings.

2012

2013

2014

2015

2016

Earnings

$4.18

$4.76

$5.13

$5.56

$6.00

P/E multiples

13

$54.34

$61.88

$66.69

$72.28

$78.00

14

$58.52

$66.64

$71.82

$77.84

$84.00

15

$62.70

$71.40

$76.95

$83.40

$90.00

16

$66.88

$76.16

$82.08

$88.96

$96.00

2. Dividend Discount Model

The dividend per share for the coming year is $2.44. If we assume a dividend growth rate of 7% per year, we can derive stock values using the dividend discount model with varying required rates of return (R).

2012

2013

2014

2015

2016

Dividend

$2.44

$2.61

$2.79

$2.99

$3.20

Required rate of return

9.5%

$97.60

$104.43

$111.74

$119.56

$127.93

10.0%

$81.33

$87.03

$93.12

$99.64

$106.61

10.5%

$69.71

$74.59

$79.82

$85.40

$91.38

3. Free Cash Flow (FCF) Discount Model

The FCF discount model utilizes the free cash flows derived from the projected CFO from 2012 to 2016: $13.4 billion, $16.0 billion, $17.0 billion, $18.1 billion, and $19.3 billion. We assumed that capital expenditures are about 16% of CFO, with a growth rate of 5%. Therefore, the equity values derived from the FCF are:

r=

9.5%

$105.30

10.0%

$94.60

10.5%

$85.90

Conclusion

JNJ is a diversified biotech and pharmaceutical company with a strong balance sheet and its diversity in its business segments has provided stability to its earnings growth. The company also continues to invest in innovative products: Its drug pipeline is strong, with six NDA applications currently under review by the FDA. These new drugs and products should sustain JNJ's revenue growth for the next several years.

International sales contribute to over 50% of JNJ's revenue. The company has taken steps to mitigate risks associated with currency exposure and foreign exchange rate volatility. Under its risk management strategy, JNJ has utilized hedging and derivatives to minimize foreign currency exposure's impact on the company's financial performance as well as protecting the company's cash flow from adverse movement in foreign exchange rates.

Litigation and products liability should be considered as operating expenses in a pharmaceutical company business model, rather than one-time charge items. Other weaknesses we observed were employee pension liabilities: Employee-related obligations were about $8.3 billion in 2011. Pension and related obligations are likely to increase, as JNJ's assumption on the return on pension assets of 9% is probably too optimistic in the low growth environment. Government regulations and healthcare reform act will have impact on pharmaceutical industry. But the effect is difficult to quantify at this point.

Nonetheless, JNJ's financial data still appears strong even when factoring in these expenses. The company has strong enough cash flows from operations to issue greater dividends, repurchase stock, or pursue mergers and acquisitions. Its debt ratio is also reasonably low enough that the company could issue more debt to fund such acquisitions.

We used three different models to value JNJ's stock. The P/E multiple method suggests a price target of $71, based on projected 2013 earnings with a 15 times multiple. The values derived from both the dividend discount and free cash flow models are $81 and $94, respectively (with a 5% growth rate and 10% required rate of return assumption). At the current price level of $67-$68, JNJ stock is undervalued compared to its intrinsic values.

Table 1: JNJ Income Statement and Earnings Projection

Click to enlarge image.

JNJ Income statement

Source: Johnson & Johnson Stock Valuation - Part 4