We are amazed that Johnson & Johnson's shares (JNJ) have increased by 7% since the middle August and have significantly outperformed the S&P 500 during that time. We are even more surprised that it was within $0.02 of its 2008 all-time highs on October 18. Our surprise is due to the fact that it has seen its growth picture deteriorate while Bill Weldon was its CEO, and that it has lost its most due to its $44B acquisition spree over the last six-and-a-half years.
We are not surprised that Berkshire Hathaway (BRK.A, BRK.B) has pared back its stake by nearly two-thirds since Q1 2012. Berkshire still holds 10.3M shares of JNJ and well-known value investor Ken Fisher of Fisher Asset Management also owns 10.7M shares of JNJ. In short, we can see that Johnson & Johnson has come down with a mild case of sclerotic stagnation and the cause of this illness is the $44B acquisition spree executed by JNJ's deal-crazed former CEO Bill Weldon.
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Source: Morningstar Direct
We now see JNJ pursuing the $100M acquisition of Shanghai Elsker, a Chinese baby-care product maker. Even though it's a tiny little bolt-on acquisition, we think that the company should not bother with any more deals until it can start generating improved levels of adjusted organic growth. We haven't heard anything else about the deal since our August report.
We think that with its $44B worth of acquisitions, JNJ had $4.57 in EPS in 2008 and it is expecting to generate adjusted EPS of $5.06 in 2012, according to consensus estimates. This represents an unremarkable 2.58% compounded annual growth rate during the 2008-2012 time period. We see JNJ as a big, hulking ship that is lost at sea and is way off course with regards to reaching its destination. The good news for JNJ is that it is too big to fail, but the bad news is that it is too big to succeed.
In the first half of 2012, JNJ had generated flat growth relative to H1 2011 levels and this continued into the third quarter. JNJ's Q3 2012 operating revenues increased by 6.5% versus Q3 2011 levels due to its $20B blockbuster acquisition of Synthes. Negative currency headwinds (-4.3%) ended up partially absorbing JNJ's Q3 operating revenue growth and even with the aid of the Synthes deal, JNJ's revenue increased by a meager 1.8% year-over year for YTD 2012 versus YTD 2011 levels.
Johnson & Johnson had $930M in Non-recurring expenses that the company excluded as adjustments to Net Income and these included the expensing of $679M of merger-related in-process research and development, $116M in DePuy Hip related costs and $135M of Synthes integration costs and intangible asset adjustments.
Considering that Johnson & Johnson recently traded within $0.02 of its four-year high, we think that it is still too early to establish a long position in this company and investors should not panic themselves into buying shares simply because "Warren and Ken are shareholders" and "the shares have gone up".
Even with adding back non-recurring charges to its 2012 "adjusted EPS results" for Q2 2012 and YTD 2012, Johnson & Johnson's adjusted EPS only grew by 0.8% year-over-year in Q2 2012 versus Q2 2011 levels and 1% growth in YTD 2012 versus YTD 2011 levels.
Johnson & Johnson earned $4.57 EPS in 2008 and, according to consensus estimates, is expected to earn $5.08 EPS in 2012. This represents a compounded annual growth rate of 2.62% in this four-year period. At least JNJ's compounded annual return on its shares during this period was comparable to the S&P 500 and Berkshire Hathaway, though we normally expect both Berkshire and JNJ to greatly outperform the S&P 500 over extended time periods.
Source: Morningstar Direct (06/30/2006 to 10/19/2012)
In conclusion, we can see why Berkshire sold nearly two-thirds of its stake in Johnson & Johnson. Despite the fact that well-known value investor Ken Fisher of Fisher Asset Management also owns over 10M shares like Berkshire, we believe that Johnson and Johnson has a while to go before it is cured of its sclerotic stagnation. We believe that it will take time for Alex Gorsky and his management team to right the ship, especially with Bill Weldon continuing to serve as Non-Executive Chairman.
We would like to see the company bring its focus away from acquisitions and towards organic growth. While we continue to expect the company to continue to boost its dividend and buy back shares, we believe that dividend growth will decelerate. With regards to our own portfolio, we prefer Teva Pharmaceuticals (TEVA), since it has a lower PE and higher expected EPS growth.
Additional disclosure: This article was written by an analyst at Saibus Research. Neither I nor Saibus Research have received compensation directly or indirectly for expressing the recommendation in this article (other than from Seeking Alpha). We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.