Why Johnson & Johnson is a Buy
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Over the years, Johnson & Johnson (NYSE: JNJ) has contributed substantially to the global health sector through its comprehensive, research-based, and technology driven portfolio of health care products. The company’s integration in its baby care segment, pharmaceutical division, and medical devices & diagnostic sector gives it a competitive edge over rivals such as Pfizer Inc (NYSE: PFE), Novartis AG (NYSE: NVS), and Covidien plc (NYSE: COV). However, despite JNJ’s comprehensive pharmaceutical product portfolio and its status as market leader in the global medical device & diagnostic sector, the company faces stringent competition from PFE, which is the market leader in the pharmacy sector.
During FY11, JNJ registered robust growth of 5.6% in its revenue base. The main growth driver was the pharmaceutical segment, which grew by 8.8%, while the contribution from the company’s consumer and medical device segments witnessed a modest increase of 2% and 5%, respectively. On the back of JNJ’s continuous focus on R&D and innovation, we have recommended this stock as a buy as we believe that through a combination of competitive product portfolio and strong brand profile, the company will continue to hold a significant position in the health care sector.
Key Thesis Points
1. JNJ holds a significant position in the global health care sector through its continuous investments in research and development as well as its diversified portfolio of health-care products. On the back of several acquisitions of private medical device manufacturers and strategic alliances, the company is well placed and has gained market leadership in the medical devices & diagnostic sector. While the company faces stringent competition from PFE in the pharmaceutical sector, we believe that with more than 100 pharmaceutical products in its pipeline, JNJ is expected to grab market share from PFE going forward. Moreover, the company faces tough competition from corporate giants like Procter & Gamble (PG) and Unilever (UL) in its consumer segment. However, owing to JNJ’s extensive investments in research and development, the company is expected to increase the contribution of its consumer segment to its revenue base.
2. The success of health care products is intensely reliant on continuous research and development, technological advancements and innovation. During FY11, the revenue generated from the medical device & diagnostics segment contributed 40% to JNJ’s bottom line, followed by its pharmaceutical sector with 38% to the total revenue base. The consumer health care sector accounted for just 22% of revenues. The growth mainly pertains to business generated from international operations, while business generated from the US remained at the prior year’s level. We expect to witness a further expansion in JNJ’s revenues, on the back of its continuous investment in innovation and research and development, coupled with expansion of its operations in emerging markets and pending products in the pipeline, including products for diagnosing cancer, mental health disorders, diabetes, heart diseases, and HIV.
3. Despite robust growth in JNJ’s revenue base, the company’s gross margin has slightly weakened to 68.6% against FY10, while the margin is still close to industry average of 69.7%. During FY11, JNJ’s operating expenses increased by 8%. The rising operating expenses were mainly a function of increased investment in research and development, and development expenses pertaining to more than 100 products in its pipeline. Accordingly, on the back of mounting operating expenses and the rising cost of products/services, JNJ’s net income decreased by 27%, amounting to $9.6 billion USD. JNJ’s net margin also stood on the lower side at 14.7%, against the industry norm of 16%. Moreover, the company’s ROA & ROE decreased to 8.5% and 16.9% respectively against 13% and 23.6% in FY10.
Moreover, while the equity of the company stood slightly higher at $57.1 billion USD, the increase was mainly attributable to the increased retained earnings. The total borrowing of the company stood slightly higher at $19.6 billion against USD $15.7 billion USD in FY10. The increase in borrowing was mainly to support the company’s research and development expenses, and the development expenses pertaining to the products in its pipeline. As a result, JNJ’s leverage increased to 0.34x against 0.30x in 2010. In FY11, the company’s operating cash flow stood at $14.3 billion USD representing ample cushion to support its research and development as well as continuous expansion in its product portfolio.
4. Going forward, we believe JNJ will have to deal with several challenges and a range of business risks including; foreign currency fluctuations, macro-economic conditions of foreign markets, technological advancements, new patents acquired by competitors, obtaining regulatory approvals and financial distress experienced by suppliers and penetrating competitive environment, amongst other issues. While knowing JNJ’s strong focus on research and development and innovation, we believe that if any of the above risks arise, the company is well-positioned to deal with any instability in its operations.
JNJ is a growth stock with a price to book ratio of 3.13x against the industry norm of 3.29x. During FY11, the P/E ratio of the stock experienced a substantial increase and stood at 18.2x against 13x in FY10. Johnson & Johnson’s peer Novartis has a trailing PE ratio of 14.7 and yields 4.7%. The stock is expected to have a single digit PE ratio by the end of 2013. Pfizer is also attractively priced with a 2013 forward PE ratio of 9.6. The stock yields 3.9%. Covidien is another healthcare stock with attractive valuation. Its trailing PE ratio is below 13 and is expected to fall below 12 by the end of next year. Covidien’s dividend yield of 1.6% is very low compared to JNJ, Novartis, and Pfizer.
We are bullish about JNJ, Pfizer, and Novartis because of their high dividend yields. These are resilient stocks during market turmoil. We believe their downside is limited in the short run and they are great long term investments. Based on JNJ’s strong fundamentals originating from diversified product portfolio, strong brand profile, presence around the globe, lower sensitivity to the market, stringent market position, substantial cash flows, and expected PE multiplier, we value JNJ at $70 USD a share. Warren Buffett had nearly $2 billion invested in JNJ at the end of December (see Warren Buffett's top stock picks). Prem Watsa, is also bullish about the company, with a position worth nearly $400 million.
This article is written by Nawazish Mirza and edited by Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in the article. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services recommend Covidien Ltd., Johnson & Johnson, Novartis, and Pfizer. 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.