Investors are Myopic on Johnson & Johnson’s Prospects
Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors often suffer from myopia with regards to their investments. Investor myopia refers to cognitive thinking and decision making which is overly focused on recent events at the expense of longer term consequences. In the case of Johnson & Johnson (NYSE: JNJ), investors have discounted its long-term prospects on the backdrop of disappointing second quarter results. I believe that the company is undervalued as the market is not rewarding the company for its strong drug pipeline and has magnified its issues in the consumer business far ahead to the future.
Myopia Starts with Second Quarter Results
Johnson & Johnson reported last week that sales for the second quarter reached $16.5 billion, a decrease of 0.70% compared to the same period last year. This translates to net earnings and diluted earnings per share of $1.4 billion and $0.50, respectively. Excluding special items, earnings per share amounted to $1.30. This translates to an increase of 1.6% year on year.
Total one-time charges reached $2.2 billion from integration costs from the Snythes acquisition, litigations costs and research and development write downs. Although the integration costs appear a one-off charge, it will still impact its earnings in the successive quarters. The recent results also included sales of Synthes, which contributed 1.20% of worldwide sales growth. The slower than expected quarterly financial results is attributed to negative currency fluctuations. For the year, the company reduced its full year earnings guidance. It now expects earnings per share of $5 to $5.07 in 2012, lower than the previous earnings per share guidance of $5.07 to $5.17. The revision mainly reflects the negative impact of currency fluctuation, offsetting the positive impact of its Synthes acquisition.
Analysts seem to agree with management. Based on the average estimates, Johnson & Johnson is expected to earn $5.07 per share. This translates to earnings growth of 1.4% higher than prior year’s results. For the next 5 years, the company is forecasted to grow by 6.4%. Based on the recent earnings report, it seems that the company could easily beat and potentially exceed its guidance.
Details Suggests Market is Discounting JNJ’s Long-Term Prospects
In terms of breakdown, both domestic sales and international sales declined by 1.2% and 0.4%, respectively. The decline in international sales is due to negative currency impact and slower operating results. Both the consumer and medical device segments posted a decline in sales, while the pharmaceutical segment recorded a slight increase in sales.
Its consumer segment reported revenues of $3.6 billion, down by 4.6% compared to the second quarter in 2011. Domestic sales slightly declined by 1.9% year-on-year to $1.3 billion, while the international sales also posted a decline of 6% to $2.3 billion.
Its medical devices segment posted sales of $6.6 billion, a slight decline of 0.1% year-on-year. Sales in the domestic market increased by 2.9% to $3 billion, whereas the international markets declined by 2.4% to $3.6 billion. The primary drivers of its medical devices included better than expected orthopedic sales, blood glucose monitoring products, wound care products and international sales of energy products.
This segment faces several headwinds, including European austerity measures, pricing pressures and a slowdown in elective surgeries. These contributed to slower growth for the segment. Moving forward, I expect that the international business will contribute a major portion of its medical device business. Its peer, Medtronic (NYSE: MDT) reported that its international business accounted for 44% of its revenue for the quarter. Specifically, Metronic saw an increase in revenues from sales of pacemakers and heart valves.
Meanwhile, its pharmaceutical business increased 0.9% to $6.3 billion. Domestic sales declined by 4.5% to $3.1 billion due to supply problems on third party manufacturing problems. International sales grew 6.8% to $3.2 billion.
A quick look on its drug pipeline suggests that it should continue to post strong gains in the future. Its new drug launches, notably cardiovascular drug Xarelto, cancer drug Zytiga and hepatitis C drug Incivo should provide good revenue stream in the a tough operating environment. Also, it does not face any major patent losses in the near term. It has also amended its distribution agreement with Merck (NYSE: MRK), which could imply higher incremental sales.
I believe that the long-term growth rate of 6% seems conservative. Given its strong drug pipeline, it could post net income growth as much as 10% to 15%. Over the 10-year period, its net income grew as much as 20% in 2002. Its operating margins have remained stable at 25%.
This is also higher better than its peers. For example, Pfizer (NYSE: PFE) posted anemic growth rate of 2% for the last 10 years. The company has experienced several problems including competitive pressures from generic pharmaceutical companies and patent expiration. In fact, Pfizer operating margins have declined significantly from 36% to 22%. GlaxoSmithKline (NYSE: GSK) also posted a net income growth rate of 3% for the same period. GlaxoSmithKline's operating margins have improved to 28% in 2011, although it dipped significantly to 13% in 2010. Finally, Merck experienced decline in net income by 1.48% over the last 10 years while operating margins have recovered to 16%.
If you also compare the company’s current financial position to its past, it is definitely in better shape. It has free cash flow of around $11 billion and current cash position of $19 billion. This ensures that its growth expansion plans are fully funded.
Valuations: Imputing 5% Growth Rate
The stock is currently trading at 13 times 2012 earnings and carries a dividend yield of 3.55%. Over the last 5 years, the stock has traded between 13 times to 18 times earnings. This is lower than the earnings multiples of both Pfizer and Glaxo of 20 times and 14 times, respectively.
It seems that the market is imputing a 5% growth rate on Johnson & Johnson shares based on the current price levels. If we assume a 10% growth rate for the next 10 years, my back of the envelope calculations suggest an upside of 28%. The market is not convinced that it could post double digit growth as it faces headwinds such as negative currency fluctuation, supply issues and a difficult operating environment in Europe. However, this is unwarranted as its diversified business model and strong financial position will assure earnings visibility amid tough situations. Moving forward, the market will pay higher on Johnson & Johnson shares once these headwinds are gone.
jordobivona has no positions in the stocks mentioned above. The Motley Fool owns shares of GlaxoSmithKline, Johnson & Johnson, and Medtronic. Motley Fool newsletter services recommend GlaxoSmithKline, Johnson & Johnson, 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.
