In 1886, three brothers from New Brunswick, New Jersey, started a medical products company that produced the first-ever commercial surgical dressings. In the next 30 years, innovation at the company led to the development of dental floss, first aid kits, and adhesive bandages (better known by brand name Band-Aid), along with reinvestment that pushed them into international markets (Canada in 1919 and England in 1924). Since 1924, their expansion in new product divisions and geographic regions has helped the company to secure their position as the eighth largest pharmaceutical company, sixth largest consumer health company, fifth largest biologics company, and the largest medical devices and diagnostics company in the world.
Today, the company is at risk to lose the trust and brand equity they have built over the past 125 years. Short-term production and quality issues, along with questionable business practices, have caused the share price to falter, forced management to defend the company and its practices on Capitol Hill, and led to millions in fines. Goldman Sachs (GS) has come out ahead of earnings (4/19) and suggested investors buy puts in anticipation of lowered guidance. They may very well be right; for me, I don’t participate in these games because I have seen the futility in trying to predict earnings, and would not bet (that is what you are doing) my money that they will beat/miss earnings by a penny. I’m certainly not an expert on market timing (that phrase in an oxymoron in my mind), and don’t have any concern about beating the market in a quarter or year; I am a long-term investor who likes buying shares at a discount to intrinsic value. In this analysis, I will explain why I believe Johnson & Johnson (JNJ) is a great investment for anyone who is looking to invest, and has a holding period that extends beyond 2011.
At the top of the ladder is CEO William (Bill) Weldon, who has left himself in a tough situation, with investors calling for changes – and soon (see David Chulak’s open letter to Mr. Weldon). Apparently, the board didn’t get the message, and only lowered his compensation in 2010 by 9% to $23.2 million, despite two years of revenue declines. Competitors Pfizer (PFE) and Merck & Co (MRK) each named new CEOs in the past couple of months, a move that analysts expect to be passed up on by Johnson & Johnson’s board since most of the members are buddy-buddy with Mr. Weldon; the meager 9% cut in pay is a testament to this belief. Luckily (in the view of many shareholders), Mr. Weldon will likely make the change by his own doing sooner rather than later: After 40 years with the company and 9 as CEO, it is likely that the 62 year old will call it quits after the current issues have been resolved.
Former consumer products chairwoman Colleen Goggins retired on March 1; the consumer group has now been split into separate divisions, which should allow areas like OTC to “give focused attention to quality and compliance, and the critical task of restoring McNeil Consumer Healthcare brands,” according to a statement by Johnson & Johnson. How long this “critical task” will take to be resolved is an important question to many, with an uncertain answer.
No need to waste any time: Let’s jump right into the recalls. In the past fifteen months, the company has had 50-plus product recalls, including more than 288 million items in 2010. The recalls have been widely covered by every major news source, along with the public lashing that the House Committee on Oversight and Government Reform gave Mr. Weldon in October 2010 for Johnson & Johnson’s “too cozy” relationship with the FDA, and the company’s attempt to execute a phantom recall in June 2009. Weldon’s response to date has been the allocation of more than $100 million to upgrade McNeil’s (consumer segment) plants and equipment, along with investments in quality control company-wide. He has promised that that the Pennsylvania plant will “represent the state of the art in medicine production” when it reopens, and that the company has “no higher concern than providing parents with the highest-quality products for their children.” Obviously, I’m not going to sit here and tell you that Weldon will change McNeil’s ways overnight, and all will be well soon enough. But I will present the argument for why I think the balance between risk and reward at the current valuation pessimistically extrapolates the recent issues.
Considering the company’s current position and recent results, it looks like they will need to spend a good amount of capital improving production quality, getting products back on the shelves, and advertising for brands that have fallen out of the consumer's view over past 15 months. Luckily, with Johnson & Johnson, the balance sheet is a fortress, with more than $27 billion in cash and marketable securities compared to $9 billion in long term debt as of January 2, 2011. With a current ratio of more than 2 and the honorable distinction as one of few companies sporting an AAA bond rating, Johnson & Johnson has the cash on hand and access to capital at dirt cheap interest rates (10-year notes issued in 2010 at 2.95%). If throwing cash at the problem is part of the solution, there are few companies that are in a better position than Johnson & Johnson.
Operating Results: 2010
Based on company estimates, the recalls of products manufactured at Las Piedras and Fort Washington facilities impacted 2010 sales by roughly $900 million, part of an 8.9% decline (excluding 1.2% positive currency impact) in consumer segment sales for 2010. The OTC Pharmaceuticals & Nutritionals franchise was impacted the most, with year-over-year sales declining by 19.2%. Full year sales were equal to $14.59 billion (smallest of three business segments at Johnson & Johnson), and generated an operating profit of $2.34 billion (less than 35% of results in pharmaceuticals and MD&D)
2010 Pharmaceutical sales were $22.4 billion, equal to 36.4% of the company’s total revenues, with a split of $12.5B from the United States and the remaining $9.9 billion coming from international markets. Like most multinationals, the international markets are where the growth is: In 2010, Asia-Pacific and Africa (for the whole business) sales increased 11.69%.
The Pharmaceutical segment brought in more than $7 billion in operating profits, and accounted for nearly 42% of the company’s pre-tax earnings. To say the least, pharmaceutical is an important part of Johnson & Johnson’s overall success, and will be a key part of the company’s expansion into international markets over the next decade.
In 2010, the global pharmaceutical market was worth roughly $670 billion, and (according to EvalutePharma) is expected to grow 4% per annum over the next five years. In the industry, there are some headwinds: the mix of drugs coming off patent (Johnson & Johnson has “lowest patent exposure of the major pharmaceutical companies”), and cost containment measures are creating increased competition and fights for market share. However, in the long-term view, there are significant medical needs that are unmet around the globe, along with changing demographics (boomers) in the United States, both of which are favorable for the company and the industry.
The most important segment in pharmaceuticals for Johnson & Johnson is immunology, where they are the leading company in the U.S. market. The segment is driven by the major product Remicade, which grew 7% in 2010, along with two products launched in 2009 (Simponi and Stelara) that had combined sales of $600 million. Overall, the immunology segment grew 17% in 2010.
The company is also successful in the “Long Acting Injectable Anti-Psychotics” segment, where they expanded 14% in 2010 and outpaced the overall growth of the anti-psychotic market. The company also exceeded 40% growth for two HIV products, as well as 16% operation growth in oncology.
Johnson & Johnson has seen recent success from their innovation: The company was #1 by sales for products launched in 2009 and 2010 ($844.5 million), outpacing the nearest competitor by more than 7%. This is a testament to the AAA balance sheet and a commitment of more than $20 billion to R&D in the past three years.
Two of the products that drove 2010 sales are Stelara and Simponi. Stelara, which was launched Q3 2010, treats psoriasis, a chronic autoimmune skin disease. Since the launch, the company has increased their share to 20% over the dermatology market over 15 months, with “constant growth period over period.” According to Mr. Duato, Stelara has had a similar response with dermatologists to Remicade; this is a positive sign considering that Remicade accounted for 7% of Johnson & Johnson’s total revenue in 2010. Simponi, which is a once a month injective for rheumatoid arthritis, also looks good after the launch; so far, the sales growth has been strong over the first 20 months, and it has the opportunity to become an important piece of the bottom line in the coming years.
Johnson & Johnson recently acquired Dutch vaccine maker Crucell for roughly $2.4 billion in cash, which gives the company better access to emerging markets and to vaccines, which they do not currently have a strong presence in (“building block in entry to vaccine space”). The two companies have been working together since 2009 on an influenza antibody and a flu vaccine, which should dissuade any fears among investors of a misaligned acquisition (at least in a cultural sense).
As noted previously by Paul Stoffels, the global head of Johnson & Johnson's pharmaceutical research and development, the combination provides the company with “a new platform for growth and advances our goal to deliver integrated health care solutions, with particular emphasis on prevention."
Johnson & Johnson has some up-and-coming products in the pharmaceutical segment that have the potential to significantly add to the top and bottom line over time. In 2007, 50% of sales were from products that no longer had exclusivity, or were close to losing exclusivity; the remaining 50% were split between core products and regional/legacy products. In 2010, regional/legacy products have grown as a percentage of sales (former “near exclusivity” products from 2007), and recently launched products are a sliver of the pie. The telling graph, which depicts 2014 expectations, shows that two-thirds of sales for the year will come from core products and recently launched products/compounds, suggesting a reinvigorated product portfolio, of which the foundation is being laid today. As noted by Mr. Duato, these changes “depict the transformation that you are going to see [in pharmaceuticals].”
Medical Devices & Diagnostics
The Medical Devices & Diagnostics segment achieved a 4.4% year-over-year increase in sales to $24.6 billion, driven by 3.6% and 5.0% growth in the U.S. and international markets, respectively. Operating profit increased 7.5% year over year to $8.27 billion, driven by growth at the top two brands in the segment, Depuy and Ethicon.
For the full year, sales at Johnson & Johnson came in at $61.59 billion; when we back away to the companywide level, the $900M setback from the consumer segment impacted full year sales by a paltry 1.46%. Considering the long term history, past success with adversity, and strong financial position, one would think that JNJ wouldn’t be too beat down on the street; they would be wrong. Diluted EPS for 2010 was $4.78, meaning that the company is trading at less than 11x TTM earnings as of Wednesday’s close (after backing out excess cash).
The Past Decade
Backing away from the noise and looking at the operating results seems like a reasonable way to cut through the uncertainty surrounding Johnson & Johnson. A quick look at the past 10 years (ending with 2010 to provide a realistic view that includes the current problems) should help investors to develop an idea of what lies ahead for the 125-year-old company:
|Category||2000 Result||2010 Result||10 Year CAGR|
|Dividend Per Share||$0.62||$2.11||13.03%|
The analyst should consider the environment in 2010, and what impact the recalls and the global economic situation have had on the respective accounts. The numbers over the past 125 years say something about the viability and the strengths of Johnson & Johnson that words can’t; these are a testament to the sustainable competitive advantages that JNJ has developed and sharpened over the past century.
I’m not a big proponent of forecasting 10-year earnings (again, analysts’ attempts to look a year out are enough to recognize the futility of this exercise); I prefer to use a reverse DCF, and see what the current price implies about the market’s expectation for the company’s future. In the case of Johnson & Johnson, here is the output based on Wednesday’s close ($59.60):
|Company||Johnson & Johnson (JNJ)|
|Net Cash||$18.502B (Not Included)|
|Long Term Growth Rate||3%|
|Implied 10 Year Growth Rate||3.55%|
Based on the Reverse DCF calculation, which does not include the nearly $20 billion in cash on the company’s balance sheet, Johnson & Johnson’s implied 10 year growth rate for owners earnings is only 3.55% (when using a conservative 3% long term growth rate). This compares to a 10 year CAGR in operating earnings of 9.05% from 2000-2010.
There is no doubt that Johnson & Johnson has hit a rough patch. Company-wide recalls, coupled with relative inactivity and undue praise by the board, have caused Johnson & Johnson’s stock to suffer. Problems in both the consumer segment and at Depuy (see here) suggest that the company may still have recalls in front of them, which certainly won’t please the market. However, as value investors, it is important to step back and see the bigger picture. Johnson & Johnson has a fortress balance sheet, and generates billions in free cash flow every year; if anybody has the resources and scope to recover from these issues, Johnson & Johnson would be at the top of the list. Continued international expansion will be key to long-term growth, and a focus on M&A (more than $40 billion in the past 10 years) will remain an integral part of corporate strategy. David Lewis, an analyst at Morgan Stanley (MS), has issued a note to investors suggesting a $10 billion-plus acquisition to boost growth might be in the works (with the Crucell as a starting point). If the past is any indication, then this will be an area where Johnson & Johnson continues to spend extra cash and create value for shareholders (example: 2006 buyout of Pfizer’s consumer health business for $16.6 billion).
As Mr. Weldon noted in the 2010 shareholder letter, “Trust and confidence in Johnson & Johnson and our products are fundamental to everything we do.” Some of that trust may have been lost for the time being, and some customers will never buy products from Johnson & Johnson again. However, for the large majority of consumers, the thousands of products the company produces are not a representation of Johnson & Johnson (most people probably don’t even know who the parent company is); they are stand-alone brands with their own place in consumers’ minds.
When people think mouthwash, they think Listerine, not Johnson & Johnson. The same can be said (not when they think mouthwash – hopefully) for Neosporin, Nicorette, Visine, Acuvue, K-Y, Clean & Clear and Rogaine, just to name a few.
As Warren Buffett has noted before, you pay a dear price for a cheery consensus on Wall Street. With Johnson & Johnson, you are paying a price that implies 10-year growth of less than 4% per annum for a company that has nearly tripled that growth rate over the past decade. Warren liked the way that sounded, and added more than 17 million shares to his position in early 2010, at an average price 4% above today’s close. For long-term investors, now is the time to load up on shares of Johnson & Johnson.