Johnson & Johnson Back on Track
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What company has a better credit rating than most countries, is paying a higher yield than 10-year US treasuries and probably has more cash on its balance sheet than Greece, Portugal and Spain combined?
Johnson & Johnson (NYSE: JNJ), in spite of more than two years of revenue and margin declines, continues to have enviable amounts of cash, maintains its AAA rating, and is easily able to pay and increase its dividend—now yielding 3.5%.
The trickle of recalls that started in 2009 with Tylenol products for kids turned into a flood over the next two years and damaged this venerable company. It has not killed it and there are signs of recovery. While the pace of recalls has been decelerating, problems continue to plague them. Infant Tylenol has been recalled this month due to a defect in the protective cover—it collapsed into the medication.
Product defects have hit the consumer segment especially hard with more than 50 separate OTC medication recalls. Prescription medications and medical devices were not immune to problems and JNJ recalled Topamax, and Eprex, Acuvue contact lenses, Ethicon sutures and DePuy has withdrawn its metal on metal hip resurfacing product from the market.
Expensive Mistakes
The hip recall incurred a charge of $3 billion in the fourth quarter of 2011. In 2010, the McNeil recalls cost the business around $900 million in lost sales. While it was not broken out for 2011, lost business is estimated at $400 million. Remediation costs will continue through 2012 and are taken out of cost of goods sold. Fort Washington will not open until 2013. Gross margins contracted as costs related to remediation were incurred.
Generally, gross margins have declined since the acquisition of the consumer segment from Pfizer (NYSE: PFE) in 2007. Consumer products are lower margin and they became a much larger percentage of revenue in 2007.
Margins
Altogether, the defective products and ongoing failure of quality control have taken a toll on the economics of the business and erased the halo effect that years of selling band aids and children’s over the counter medications gave the company.
Growing by Acquisition
The flood of recalls can trace its roots back to the JNJ acquisition of Pfizer’s consumer healthcare at the end of 2006. Under Pfizer in 2005, consumer healthcare did revenue of $3.9 billion and JNJ paid $16.6 billion. The consumer segment went from 18% of total revenue to 25%. Pfizer was reshaping its business into a pure pharmaceutical company –- a plan that went somewhat astray when it acquired Wyeth for its portfolio of drugs and pipeline and ended up back in the consumer/nutritional business.
The acquisition by JNJ was an attempt to buy some growth. Pharmaceuticals and medical devices were beginning to slow. Two drug blockbusters with a combined $6 billion in peak sales were set to see generic competition in 2009 -- Risperdal and Topamax.
JNJ’s standard operating procedure is to grow through acquisitions and partnerships. It works well for the most part and it worked in 2007 -- the year of the acquisition. It will be interesting to see if Synthes, their largest acquisition at $21.3 billion, will give them the growth they are paying for. Synthes should close in 2012. As a medical device company, margins may see some expansion.
The trouble with the growth through consumer products is the effect on combined margins. Increasing the consmer segment, with operating margins half of medical devices and pharmaceutical, lowered JNJ's combined margins. The consumer segment went from 18% of revenue in 2006 to 25% in 2008. Margins dropped 5%. It was a decision to add growth regardless of the effect. The plan was to cut costs in consumer by $500 to $600 million to bring margins back. The cuts short-changed the corporate quality and compliance program and that opened the Pandora’s box of seemingly endless recalls.
The decentralized structure that JNJ’s acquisition strategy leads to requires the CEO to have a firm grasp on each business. JNJ has gone from 30 subsidiaries in 1982 to around 250 operating companies currently. The task of keeping tabs on all of JNJ is daunting. Cutting essential oversight personnel was a critical error. The size makes delegation a necessity and not only numbers of employees declined but also quality did as well. Reports to management did not raise red flags because those responsible for reports and briefings were not qualified for the task. With Weldon’s resignation, we can hope for resolution of these defects.
Annual Growth
As year-over-year comps began to apply in 2008, consolidated growth dropped back to disappointing low single-digits. When pharmaceuticals slowed from expirations in 2009, growth fell into negative numbers. Consumer could not rescue growth and by 2010, the consumer segment was under pressure as the costs of recalls began to build. Consumer appears to have bottomed in 2010 and consolidated gross and operating income growth were all in negative territory.
There has been some recovery in 2011. Operating income growth is still negative as JNJ took a $3 billion charge for hip recalls in Q4 2011.
Quarterly Growth by Segment
Return on Invested Income (ROIC)
When looking at a serial acquirer it is useful to check how the returns on the investments are doing. That is best done with ROIC. ROIC takes into account investments in all of the assets including working capital, property, plants and equipment and any good will and intangibles that have been paid for that do not represent tangible assets.
For the numerator, we use net operating profit after adjusted taxes or NOPLAT. That is operating income after depreciation with taxes adjusted to represent cash taxes paid.
ROIC dropped post-acquisition of Pfizer’s consumer segment and as integration pains subsided, it recovered. In 2011, it hit six-year lows as poor performance in pharmaceutical and medical devices combined with recall costs sent growth into negative territory
WACC (cost of capital) is 8% and the spread remains widely positive. ROIC will improve as the company continues its evident recovery.
The three pillars of JNJ
JNJ is three operating divisions. All three have been poor performers at one time or another over the past two years . All three show signs of revovery now
Consumer revenue increased even though the over-the counter products were still in negative territory
Pharmaceutical revenue Q4 was $6.1 billion -- up 6.7%. The loss of patent on Levaquin hit the US particularly hard. Patent expiration is always painful and JNJ is through the worst of it for now.
The JNJ pipeline is beginning to pay its way -- REMICADE, STELARA and SIMPONI, were up nearly 20%. Remicade sales were helped by JNJ winning a substantial portion of the Merck territory last year. The pipeline and its success in turning pharma growth around has been one of Weldon’s greatest accomplishments. Growth in pharmaceuticals and a fertile pipeline are critical components that will keep the JNJ business moving forward.
Medical device's Q4 revenue was $6.5 billion -- up 2.4%. Exiting the drug-coated stent business impacted sales negatively, but it had to be done as the JNJ stent was losing market share every quarter. Abbott (NYSE: ABT) with its Xience franchise has taken over as market leader in the stent business
Orthopedic implants continue to lag and DePuy grew only 0.3% --- the U.S. was down 4% and tinternational was up by 5.7%. The orthopedics business has been dismal with hip and knee implants struggling to keep even low single-digit growth. Stryker (NYSE: SYK) and Zimmer (NYSE: ZMH) have both failed to see resumption of fast-growing sales and have seen double-digit growth fall into low single-digits. It is possible that the golden age of high ortho growth is gone and the new normal is single-digit. I would expect high single-digit rather than the current anemic growth quarter after quarter once economic conditions improve.
Overall, the picture is one of JNJ returning to growth.
Weldon is Leaving
JNJ has started to recover and that should go on as consumer expenses wind down, pharmaceutical pipeline products continue to grow and ortho returns to at least high single-digit growth. Consumer confidence may begin to be restored under new leadership if Alex Gorsky is capable. It’s unlikely that will happen with Weldon in charge after the events of the past two years.. William Weldon will leave in April after 10 years as CEO.
Dividend Discount Value
JNJ has a long history of paying dividends and increasing the payout. The recent payout ratio is at 64% and at an 8 year high. The increase in the dividend was 6% and is following a declining trend in growth of the dividend. As JNJ reaches stabilization in top line and earnings growth, the dividend growth will need to stabilize. With a company of its size, we may be seeing long-term low single-digit revenue growth ahead.
A dividend growth model valuation based on the Gordon growth model for a mature company gives a value per share of $94 if we allow 6% growth. That may be optimistic and if we take a more conservative 3% growth that allows the company to increase at near the rate of historical inflation, the value drops to $41.83. The truth is likely somewhere in between and the value lies close to the current price.
At a yield of 3.5% and a AAA credit rating, with prospects of much improved performance ahead, free cash in excess of $11 billion in 2011 to pay $6 billion in dividends, the dividend is safe and is acceptable compensation for an investment. I would not count on much share price appreciation.
JNJ share price at various growth assumptions:
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