This is the second part of my analysis of JNJ as an investment opportunity. The first part can be found on GuruFocus or on my blog Margin of Safety Investing, in the Company analysis section.
JNJ’s working capital management is conservative, with a current ratio of 2.3x as of the last quarter. This is however on the higher end of JNJ”s historical position which has been over time moving between 1.5x and 2.3x. However, even at 1.5x liquidity should not be an issue for JNJ which carries about $12B in cash on its balance sheet. In addition, current assets excluding cash more than cover current liabilities.
Overall the cash conversion cycle is fairly short, at 29 days as of the latest 10-K – in line with the average over the last 10 years.
Debt
JNJ carries $11.6Bn of debt, c.40% of which in the form of short term debt. While the short term debt could be an issue in case of a market disruption, JNJ has ample cash to refinance and – following its recent bond offering – will probably reduce its short term debt exposure in the coming quarters.
Overall, JNJ’s debt level is very low with Total Debt being below Free Cash Flow – JNJ could repay its debt entirely from cash flow within less than a year! – and interest coverage is very high.
In addition, pension does not appear to present a major risk with a potential underfunding of $2Bn which seems manageable given JNJ’s cash and debt positions.
JNJ’s strong credit position (AAA bond rating!) is also reflected in JNJ’s Altman z-score of 5.2. Looking at the different drivers of the Piotroski score, JNJ also scores highly and only misses a ‘perfect score’ of 9 due to a declining gross margin (from 71% to 70%!) and declining asset turnover (from .69x to .68x)!
In conclusion, JNJ is in a strong liquidity and cash position, having the ability to cover the refinancing of its short term debt from cash as well as repay its entire debt from Free Cash Flow in less than a year if management ever wanted to. Given this low balance sheet risk profile I will keep my working assumption of a 30% margin of safety and will use a 10% cost of capital for the company (5% hurdle rate if T-bonds trade at less than 5% + 5% equity premium)
JNJ has a long history of paying and increasing dividends. Over the last 5 years, it has returned $7.99 per share to stock holders and increased its dividends per share at a rate of close to 11% p.a. while maintaining a payout ratio in the 35%-45% range.
JNJ’s use of retained earnings is satisfactory as the company has been able to gain good returns from re-investing in the business: On a 5-year basis, JNJ retained $11.80 per share and increased its EPS by $1.56 or a 13.2% return. On a 10-year basis the return has been 15.3%.
Based on these trends, I will be using the current yield of 3.5% and projecting dividends to grow in line with revenues (cf. return section below)
Buybacks
In addition to dividends, JNJ has regularly purchased its stock back, retiring about 2% of its stocks per year over the last 5 years. JNJ current share repurchase plan (from 2007) still has in excess of $1.1Bn approved for net share repurchases.
- 2010 Free Cash Flow of $15,040M (cf. Profitability and Growth section above)
- Growth for next 5 years: 6% (cf. above), declining to 5% years 6-10 and then 4% years 11-20
- Cost of capital: 10%
- Perpetual growth of 2% to calculate terminal value in year 20
This leads to a DCF value of $228.5Bn for the company, before accounting for net debt. Using a 30% margin of safety on this valuation leads to a per share entry price of $57, to which I am subtracting JNJ’s net debt position of ($6.1Bn –net cash position) leading to a price threshold for investment of slightly over $59.
I believe this evaluation of JNJ’s value to be conservative, given a lower than current FCF starting position, a forecast growth rate of about 2/3rds of historical FCF growth rate and below analyst growth consensus. Moreover FCF have in the past exhibited a low level of volatility and stability, with only two year over year declines over the last 10 years. Subtracting one “standard deviation” to Free Cash Flows throughout the period would change my forecast value after margin of safety to $54.
JNJ share price is currently changing hands at $57.5, which I believe provides an opportunity to invest in the company. However in addition to knowing that I can invest with a reasonable margin of safety – providing protection and potential upside – I also like to know that the company’s “intrinsic returns” will be satisfactory.
JNJ’s current dividend yield is 3.5% and its estimated ‘sustainable growth rate (using a payout ratio of 40% and an ROE of 25%) is 15%. However to be consistent with previous hypothesis, I will us a 6% growth rate in company cash flow as well as dividends per share. As JNJ does not grow to its maximum sustainable rate, the company thus generates excess cash ($1.69/share) which it can use to buyback share – up to 2.9% (=$1.69/current price of $57.5) – or reduce net debt.
Adding these returns together leads us to a total intrinsic return of 12.4% (yield of 3.5% + 6% growth + 2.9% buybacks) which I see as being quite rich for a company of this quality and risk profile.
Disclosure: I own JNJ shares and will be adding more to my personal portfolio
2.3 Financial Health
LiquidityJNJ’s working capital management is conservative, with a current ratio of 2.3x as of the last quarter. This is however on the higher end of JNJ”s historical position which has been over time moving between 1.5x and 2.3x. However, even at 1.5x liquidity should not be an issue for JNJ which carries about $12B in cash on its balance sheet. In addition, current assets excluding cash more than cover current liabilities.
Overall the cash conversion cycle is fairly short, at 29 days as of the latest 10-K – in line with the average over the last 10 years.
Debt
| $ millions, except per share data | ||||||
| 2005 | 2006 | 2007 | 2008 | 2009 | TTM | |
| Total Debt / Equity | 0.1 | 0.2 | 0.2 | 0.3 | 0.3 | 0.1 |
| ST % of Total Debt | 25% | 69% | 26% | 31% | 43% | 38% |
| Total Debt / FCF | 0.3 | 0.6 | 0.8 | 1.0 | 1.0 | 0.8 |
| Op. Income / Interest | 240.9 | 208.7 | 46.2 | 36.8 | 34.6 | 35.2 |
JNJ carries $11.6Bn of debt, c.40% of which in the form of short term debt. While the short term debt could be an issue in case of a market disruption, JNJ has ample cash to refinance and – following its recent bond offering – will probably reduce its short term debt exposure in the coming quarters.
Overall, JNJ’s debt level is very low with Total Debt being below Free Cash Flow – JNJ could repay its debt entirely from cash flow within less than a year! – and interest coverage is very high.
In addition, pension does not appear to present a major risk with a potential underfunding of $2Bn which seems manageable given JNJ’s cash and debt positions.
JNJ’s strong credit position (AAA bond rating!) is also reflected in JNJ’s Altman z-score of 5.2. Looking at the different drivers of the Piotroski score, JNJ also scores highly and only misses a ‘perfect score’ of 9 due to a declining gross margin (from 71% to 70%!) and declining asset turnover (from .69x to .68x)!
In conclusion, JNJ is in a strong liquidity and cash position, having the ability to cover the refinancing of its short term debt from cash as well as repay its entire debt from Free Cash Flow in less than a year if management ever wanted to. Given this low balance sheet risk profile I will keep my working assumption of a 30% margin of safety and will use a 10% cost of capital for the company (5% hurdle rate if T-bonds trade at less than 5% + 5% equity premium)
2.4 Historic use of cash
DividendsJNJ has a long history of paying and increasing dividends. Over the last 5 years, it has returned $7.99 per share to stock holders and increased its dividends per share at a rate of close to 11% p.a. while maintaining a payout ratio in the 35%-45% range.
JNJ’s use of retained earnings is satisfactory as the company has been able to gain good returns from re-investing in the business: On a 5-year basis, JNJ retained $11.80 per share and increased its EPS by $1.56 or a 13.2% return. On a 10-year basis the return has been 15.3%.
Based on these trends, I will be using the current yield of 3.5% and projecting dividends to grow in line with revenues (cf. return section below)
| $ millions, except per share data | Growth Rates | ||||||||||||
| 2005 | 2006 | 2007 | 2008 | 2009 | TTM | 3-yr | 5-yr | 10-yr | |||||
| Dividends | 3793 | 4267 | 4670 | 5024 | 5327 | 5543 | 6.8% | 8.8% | 13.8% | ||||
| Dividends per Share | 1.26 | 1.44 | 1.60 | 1.77 | 1.91 | 1.98 | 9.2% | 10.9% | 14.4% | ||||
| Diluted EPS | 3.46 | 3.73 | 3.63 | 4.57 | 4.40 | 4.84 | 10.1% | 7.1% | 12.2% | ||||
| Payout Ratio | 36% | 39% | 44% | 39% | 43% | 41% | |||||||
| Retained earnings per Share | 2.20 | 2.29 | 2.03 | 2.80 | 2.49 | 2.86 | |||||||
| Diluted Shares (M) | 3009 | 2963 | 2913 | 2836 | 2789 | 2796 | -2.2% | -1.9% | -0.6% | ||||
| Note: Growth rates calculated using log-normal regression and exclude LTM | |||||||||||||
Buybacks
In addition to dividends, JNJ has regularly purchased its stock back, retiring about 2% of its stocks per year over the last 5 years. JNJ current share repurchase plan (from 2007) still has in excess of $1.1Bn approved for net share repurchases.
3 Valuation
3.1 DCF
To evaluate the value of the company I am relying on a discounting cash flow calculation with the following assumptions:- 2010 Free Cash Flow of $15,040M (cf. Profitability and Growth section above)
- Growth for next 5 years: 6% (cf. above), declining to 5% years 6-10 and then 4% years 11-20
- Cost of capital: 10%
- Perpetual growth of 2% to calculate terminal value in year 20
This leads to a DCF value of $228.5Bn for the company, before accounting for net debt. Using a 30% margin of safety on this valuation leads to a per share entry price of $57, to which I am subtracting JNJ’s net debt position of ($6.1Bn –net cash position) leading to a price threshold for investment of slightly over $59.
I believe this evaluation of JNJ’s value to be conservative, given a lower than current FCF starting position, a forecast growth rate of about 2/3rds of historical FCF growth rate and below analyst growth consensus. Moreover FCF have in the past exhibited a low level of volatility and stability, with only two year over year declines over the last 10 years. Subtracting one “standard deviation” to Free Cash Flows throughout the period would change my forecast value after margin of safety to $54.
JNJ share price is currently changing hands at $57.5, which I believe provides an opportunity to invest in the company. However in addition to knowing that I can invest with a reasonable margin of safety – providing protection and potential upside – I also like to know that the company’s “intrinsic returns” will be satisfactory.
3.2 Expected returns
In addition to a potential re-valuation of the company’s multiple, its returns for an investor will be driven by: dividend yield, growth and share buybacks / improvement in cash position.JNJ’s current dividend yield is 3.5% and its estimated ‘sustainable growth rate (using a payout ratio of 40% and an ROE of 25%) is 15%. However to be consistent with previous hypothesis, I will us a 6% growth rate in company cash flow as well as dividends per share. As JNJ does not grow to its maximum sustainable rate, the company thus generates excess cash ($1.69/share) which it can use to buyback share – up to 2.9% (=$1.69/current price of $57.5) – or reduce net debt.
Adding these returns together leads us to a total intrinsic return of 12.4% (yield of 3.5% + 6% growth + 2.9% buybacks) which I see as being quite rich for a company of this quality and risk profile.
4 Conclusion
Despite the current noise around the company, I believe that JNJ has proven in the past that it is a strong company that has been able to grow steadily and provide outstanding returns for its shareholder. Based on my evaluation of a “safe” entry price and likely intrinsic returns for the company I am planning on investing into JNJ’s stock.Disclosure: I own JNJ shares and will be adding more to my personal portfolio
