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Teenage Mutant Ninja Portfolio: Splinter's Rule Maker

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earlier this week, I wrote about my love for the Teenage Mutant Ninja Turtles - the four sewer-dwelling anthropomorphic turtles that fight crime with their superior ninjutsu skills. Their love for pizza is one of their uniting factors. The other is their sensei, Master Splinter.

Master Splinter is the wise giant rat sensei of the four young Ninja Turtles. Depending on the canon you follow, he is either the pet of Hamato Yoshi or Yoshi himself turned into a rat by the glowing green mutagenic ooze. Once a high-ranking member of the Japanese foot clan (or his pet), he now raises the four turtles in the sewers of New York.

Splinter is the closest thing the Turtles have to a father, and he treats them all as his sons. He’s a mentor, martial arts instructor, protector, and above all the rule maker. He often reminds the turtles of the rules of ninjutsu, regaling tales from Japan.

If Splinter had to choose a company to invest in, it would be a calm, steady, “rule maker,” that leads its industry. These are all characteristics of Master Splinter, and they are exemplified by Johnson & Johnson (NYSE: JNJ).

In The Motley Fool's Rule Breakers, Rule Makers, Fool co-founder Tom Gardner laid out the specific criteria for a “rule making” company. As the ultimate rule maker, Master Splinter will meditate on each of these for his investment choice.

Mass-Market, Repeat Purchase of Low-Priced Goods

Johnson & Johnson serves the biggest of markets – human beings that want to take care of themselves and their loved ones. Hundreds of millions use its products such as Tylenol, Band-Aid, and Neosporin every year. Additionally, these products are consumable, meaning users will need to replenish them on a regular basis.

Most Johnson & Johnson products retail for less than $10. Talk about low-priced goods that incite repeat purchases. Moreover, a lot of those products are particularly sticky. For example, the company’s baby shampoo products are the best-selling in the industry year after year.

Gross Margin

According to Tom, Rule Makers have a gross margin of at least 60%.

Johnson & Johnson far outshine the 60% benchmark with a gross margin of 73.5% over the last twelve months. However, it should be noted the industry average gross margin is actually higher at 77.4%.

  • Competitor Abbott Laboratories (NYSE: ABT) lags J&J with a gross margin of just 68.9%.
  • Merck & Co (NYSE: MRK) bests the industry average with a nice 80.7% gross margin.
  • Pfizer (NYSE: PFE) does better than all of them with a gross margin of 84.1%.

The point here is that the 60% benchmark is just a guideline. It’s going to be higher for some industries and lower for others. Considering, J&J is within striking distance of the industry average, I feel confident moving forward and checking off the box for the company.

Net-Profit Margin

Tom says Rule Makers have a net-profit margin above 10%.

J&J reported a net-profit margin of 13% over the last twelve months. This is well above the 10% benchmark. Nonetheless, Johnson & Johnson lag the industry average of 17%.

  • Abbott Labs earns a net-profit margin of 17%, right in line with the industry average over the last 12 months.
  • Merck reported similar numbers to Johnson & Johnson with 14%.
  • Pfizer has done slightly better over the last year with 16% net-profit margin.

Despite lagging the industry average, Johnson & Johnson is still well above the 10% that Tom likes to see.

Sales Growth

Top-tier Rule Makers grow their sales by 10% every year according to Tom.

Johnson & Johnson saw sales grow just 2.3% year-over-year in the last 12 months. However, in its Q3 earnings report sales grew 6.5% year-over-year with a negative impact from currency fluctuation of 4.3%. All said, operational factors improved sales 10.8%. I know the math fuzzy, and it seems like a stretch to get to 10%, but the company outperforms its competition any way you look at it.

  • Abbott Labs improved sales 2.5% year-over-year for the last 12 months. However, its sales fell 0.5% in the third quarter of 2012 year-over-year.
  • Merck only improved sales 0.5% year-over-year for the last 12 months, and saw sales fall 2.4% last quarter from the year before.
  • Pfizer drastically underperformed with sales falling 9.5% year-over-year in the last 12 months, and a whopping 18.7% drop in the most recent quarter compared to the same period a year ago.

Despite missing the benchmark for sales growth, Johnson & Johnson is besting its competition, particularly if you look at its most recent quarter. Analysts expect sales growth of 7.4% next year after a good revenue report in Q3. I’m inclined to agree.

Cash-to-Debt Ratio

Ideally, Rule Makers will have more cash than debt. The best Rule Makers have at least 1.5 times more cash than debt.

Johnson & Johnson misses this mark as well, but again, it’s important to look at it in context. Considering how inexpensive it is to borrow money today, many companies are increasing their leverage. Remember, Rule Breakers, Rule Makers was published in 2000. I believe anything close to a 1:1 ratio is good. Johnson & Johnson comes close with a 0.80 ratio of cash to debt.

  • Abbott has a dismal cash-to-debt ratio of just 0.39. (This metric along with slowing sales growth are the main reasons why I prefer J&J to Abbott.)
  • Merck holds its own with a cash-to-debt ratio of 0.88.
  • Pfizer, on the other hand, has gone overboard on debt. It sports a miniscule cash-to-debt ratio of 0.08.

It’s good to see Johnson & Johnson is taking on a responsible level of debt, and not overleveraging itself like some of the competition.

Foolish Flow Ratio

The Foolish flow ratio is a measurement of how well a company manages its inventory and cash. The lower the number the better, but the acceptable upper limit is 1.25.

Johnson & Johnson sports a Foolish flow ratio of 1.04. That’s a great ratio, and definitely comes in under the benchmark of 1.25.

  • Abbott does even better with a ratio of 0.89.
  • Merck is about in line with J&J with a foolish flow ratio of 1.08.
  • Pfizer is only slightly weaker at 1.12.

Your Familiarity and Interest

Johnson & Johnson’s brand portfolio is quite extensive and sports quite a few very well-known brand names. The company makes Tylenol, Band-Aid, Neutrogena, Neosporin, Listerine, and many other popular over-the-counter healthcare products. Chances are you’ve bought one of the company’s products in the past. Personally, there are at least four or five J&J products in my bathroom. Johnson & Johnson definitely gets the check mark for this criterion.

Putting It All Together

Johnson & Johnson missed the mark on a couple of criteria. Sales growth is slow, but I already went in depth about that and showed the company is moving in the right direction and outpaces its competition. It also carries more debt than Tom would like to see. Still the company compares favorably to competition in its cash-to-debt ratio, and it’s very inexpensive to take on a little more debt in today’s market. J&J still maintains, what I believe is, a responsible level of debt.

Overall, Master Splinter has no qualms with calling Johnson & Johnson a Rule Maker in which he would be happy to invest. 

adamlevy has no positions in the stocks mentioned above. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services recommend Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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