Johnson & Johnson (JNJ) reports third quarter earnings before the market open on Tuesday, with expectations for a gain of $1.21 per share. This would be just under the $1.24 earned in the same quarter last year, but the company has beat expectations by an average of $0.04 over the last eight quarters so there is a good chance of flat earnings over last year's comparable.
I have been bearish on the stock for a while and have expressed the opinion to a chorus of critics. I wrote of key risks in quality control and development in January, just before the stock underperformed the broader market by more than 7% over the next two months. In March, I wrote that while the company still had promise, the stock was not worth the significant risks.
After news of success in lab studies for an experimental diabetes drug, I wrote last week that the stock may have some upside and that its position as a dividend-payer makes it a good protection-play ahead of poor economic data.
A closer look at fundamentals and valuation reveals more reason to be bullish on the outlook.
Strong fundamentals and stable income
The company has a diversified revenue stream with strong demographic trends to support future growth. Pharmaceutical sales accounted for 37% of total revenue in 2011, while the Medical Devices and Diagnostics segment accounted for another 40% of revenue. The consumer division, holding strong brand names like Neutrogena and Tylenol, makes up the other 23% of company sales.
Margins are higher than peers, with an operating margin of 17.7%, higher than 85% of others in the industry. The company's return on equity of 14.3% is also higher than most of its peers, though the high dividend payout limits the amount the company can grow. With a payout ratio of 72.7%, prospects for growth are subdued to around 3.9% unless the company increases ROE through profitability or leverage. Even with share repurchases upwards of $2.5 billion a year, the company is a cash generating monster with $16.9 billion on the balance sheet and operating cash flow of $15.6 billion over the last twelve months.
Short interest is fairly high for such a large company with 6% of the 2.7 billion float shorted. That means 162 million shares, approximately 16.5 days of the average volume, must be bought at some point.
The company has increased the dividend every year by an average of 13% since 1980. Even in the turbulence of the last five years, the dividend was increased an average of 8% a year. The shares currently pay a healthy 3.6% yield, more than twice the rate on U.S. Treasuries.
Headline risk shifts to the upside
In contrast to the last few years when the headline risk was clearly to the downside with quality control and pipeline issues, the risks have turned positive lately with an accretive acquisition of Synthes to the Medical Devices segment and positive developments in the new drug pipeline.
The company has worked through many of its patent expiration issues with strong schizophrenia, lymphoma and diabetes treatments that could drive sales. The approval of the Bristol-Myers Squibb (BMY) drug Eliquis in the first quarter of next year is widely expected, and revenue losses for popular Xarelto are already priced into forecasts. Any approval denials for competitive products could provide a boost to estimates for the company's drugs.
The company's experimental diabetes drug has had some success in lab studies and could beat competitors to reach the U.S. market. The market to treat diabetes reached $39.2 billion last year and is expected to cover a third of Americans by 2050.
Only cheaper a third of the time in ten years
Earnings have suffered lately due to special items, but the adjusted price-earnings brings the valuation to just 13.4 times on a trailing basis and has only been cheaper 34% of the time over the last decade. The average and median P/E over the last ten years has been 14.2 times trailing earnings. The fact that the average and median are so close is interesting and speaks to the tightness of valuation over time for the stock. For the shares to trade at their long-term average, the price would need to rebound to around $72.00 per share or 6% higher than last week's close.
Earnings for companies in the S&P500 may turn negative this quarter for the first time since 2009. A six percent upside in price may not be what makes most investors salivate, but the dividend yield, stable earnings and a little more upside for headline risk makes Johnson & Johnson a buy ahead of earnings.