Why Johnson & Johnson Moved From 'Buy' To 'Hold'

| About: Johnson & (JNJ)
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Johnson & Johnson's valuation has inched upwards towards 18x earnings, usually a high for the company in normal economic times.

The company's buyback program has a negligible effect on improving earnings per share.

J&J investors are now limited to the growth of the business to fuel returns, with buybacks and P/E expansion unable to provide investors added support.

Man, wouldn't it be nice to go back in time two years and load up on Johnson & Johnson (NYSE:JNJ) shares in the $60-$65 range when everyone was ragging on the company's sustained series of product recalls? With shares now marching toward the eye-catching $100 mark (shares surged $2.18 to close at $97.38), it can be a good time to stop and reassess whether the price of the stock is starting to get a little ahead of its expected growth rate.

Right now, Johnson & Johnson is pumping out $5.52 in profits while trading at $97.38 per share, for a P/E ratio of 17.64x earnings. A quick reference point: the last time the company traded at that valuation for a sustained period of time was June 2004, and Johnson & Johnson has returned 8.24% annually since that time. Over that time period, though, Johnson & Johnson managed to grow earnings per share at a 9% clip.

That might be a little bit higher than what we should expect from J&J over the next five to ten years. The big growth at Johnson & Johnson is coming from the pharmaceutical side, where you see sales growth in the vicinity of 5-6% per year turn into earnings growth in the 10-13% range. The Synthes acquisition is helping the medical division grow at a 8%-9% pace, but it looks like it is going to be the consumer division that will slow Johnson & Johnson's earnings per share growth a bit. The consumer division usually only grows at 4%-6% per year, but it is the company's highest-quality division and is the most recession resistant (profits increased on the consumer side throughout the worst of 2009). The catch, though, is that it acts as an anchor of sorts in good economic times.

The company's buyback program has a minimal impact on shareholder returns as the company only reduces the share count by about 30 million shares per year. That is almost meaningless considering that the company has 2.82 billion shares outstanding. It typically takes about two years or so to reduce the company's share count by 1%, making Johnson & Johnson's buyback program essentially a negligible factor in predicting future earnings per share growth.

When you try and predict what your total returns with an investment will be, there are three things you try to account for: favorable changes in valuation, the core earnings rate of the company, and any buybacks that might reduce the share count so that the earnings per share figure can receive a boost.

If you pay $97-$98 for Johnson & Johnson stock today, you are essentially foreclosing the possibility that you will be the beneficiary of favorable changes in valuation. The only time Johnson & Johnson has traded at or above 20x earnings came during the dotcom boom years and the immediate aftermath. The highest valuation that the stock held consistently in the post-dotcom period was 19.4x earnings in 2003. And when you strip out the artificial lows of the financial crisis, you will see that Johnson & Johnson is a company that typically trades in the 15-18x earnings range. If you pay 17.64x earnings for the stock today, your implicit declaration is this: "I am OK receiving total returns that mimic the earnings per share growth rate of the company, as I won't realistically be benefiting from a rising P/E multiple."

That leaves us with two factors left to judge: the core earnings rate of the company, and the buybacks. Well, I already mentioned that the buybacks for Johnson & Johnson are essentially negligible. That means Johnson & Johnson shareholders will receive total returns that echo the core earnings growth rate of the business. This year, profits are expected to grow from $5.52 to $5.88 for an earnings growth rate of 6.5%.

Over the medium term, that will figure will probably inch upwards toward 8% because Synthes will get fully integrated into the medical division in a way that will amplify growth and realize cost savings, and the pharmaceutical division will maintain its high growth of 10-13% to offset the 4-6% figures in the consumer division.

The current price of Johnson & Johnson stock offers no margin of safety in terms of the stock price. You can't really rely on a rising P/E ratio to be a component of your total returns at these levels. And neither do you get much in the way of buybacks. If you are contemplating a Johnson & Johnson investment today, it's largely a question of whether you'd be satisfied with achieving 8% total annual returns in a high-quality way. The year 2004 was rather analogous to where Johnson & Johnson's valuation is now, and those shareholders received total returns approximating 8% as well. If you are someone that insists on 10% (or more) total returns with your investment, then you should probably hold off on purchasing shares until you see the $85-$90 range so you can benefit from a bit of P/E expansion to give you that extra bit of total return.

Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.