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Analyst Note 01-12-2006
Johnson & Johnson JNJ and Boston Scientific BSX are engaged in a pitched battle over medical-device maker Guidant GDT. As the bidding war intensifies, we'd like to discuss how the changing terms of the deal affect our view of J&J.
We like the J&J-Guidant combination from a strategic perspective. For the past several years, J&J's sales have been increasing at impressive double-digit rates, but growth has been fueled disproportionately by the pharmaceutical segment. J&J's operating profit from pharmaceuticals has swelled to nearly 60% of the total. The Guidant deal would boost the representation of medical devices and bring that segment's earnings contribution closer to that of pharma.
While we think a more equitable balance among J&J's lines of business is a positive, it shouldn't come at too high a cost for Guidant. J&J's latest offer values Guidant at about $68 per share. Given Guidant's quality-control problems, we think this is too high. If the deal were to go through at that price, we'd be inclined to reduce our current J&J fair value estimate of $76 per share by $2-$3. For each additional $1 billion that J&J pays, we'd probably reduce our fair value estimate by an additional $0.50 per share.
Thesis 12-23-2005
We think Johnson & Johnson is an exemplary wide-moat company. It boasts trusted brand-name products, world-class R&D and marketing capabilities, and global scale and reach. We would eagerly buy the shares at a slight discount to our fair value estimate.
We like J&J's global leadership positions in three attractive health-care business lines: pharmaceuticals, medical products, and consumer products. Each line has excellent long-term growth prospects driven by favorable demographic trends or structural shifts in the U.S. economy toward quality-of-life services. The multiline platform provides valuable diversification in the event of an adverse development in any single business line.
J&J is a model of consistency and stability. The firm has delivered 19 consecutive years of double-digit earnings increases and 42 consecutive years of dividend increases. Cash flow from operations covers the dividend nearly 3 times. J&J has an excellent record of capital allocation and generation. Returns on invested capital averaged 22% during the past five years.
A key reason for J&J's success is its decentralized management structure. The company encourages entrepreneurship among local managers to stimulate creative new product development. The pharma group includes a number of medium-sized biotech companies that J&J has been steadily acquiring since 1999. J&J generates more in sales of biotech drugs than any other large drugmaker. Sales and marketing expertise and quality manufacturing skills are important distinguishing core competencies. The company keeps a careful watch on costs, too. This shows in the steady improvement in operating margins, which have increased from 17% to an estimated 28% between 1995 and 2005.
J&J's highly respected consumer-products business boosts the company's organic growth and adds stability to cash flows. The company has a record of steady annual increases in its consumer-products market share.
J&J has been reporting some of the best numbers in the pharma group lately, and we think its long-term outlook is equally promising. A fertile pipeline of new drug candidates and medical devices should ensure robust long-term sales growth. We forecast $8 billion in free cash flow this year--an impressive 16% of sales and 4.0% of our fair value estimate.
Valuation
Our $76 fair value estimate reflects our forecast of 9% sales growth and 17% earnings growth for J&J this year, driven by robust growth in the consumer and medical-device segments. Longer term, we forecast compounded sales growth of 8% and earnings growth of about 9% over the next five years.
Our fair value estimate is subject to adjustment depending on the outcome of the battle between J&J and Boston Scientific BSX for medical-device maker Guidant GDT. We think that Guidant's quality-control problems will be costly to fix. Therefore, if the deal goes through at the latest price of $63 per share, we would be inclined to reduce our fair value estimate by $2 per share or by a larger amount if J&J increases its purchase price.
Our fair value estimate is sensitive to changes in our assumptions of sales and earnings growth. For each 1-percentage-point reduction in our five-year sales growth estimate, our fair value estimate declines by $2 per share. We also forecast about 80 basis points in operating margin improvement on J&J's huge sales base of $50 billion. If J&J is not able to improve operating margins, our fair value estimate would also decline by about $2 per share.
Risk
J&J's biggest seller, Procrit/Eprex, has been losing share to Amgen's AMGN Aranesp. Another breadwinner, Duragesic, lost patent exclusivity this year. While J&J has a strong early pipeline of new products, its late-stage pipeline is thin, and it will be challenging to make up for Duragesic's lost sales. J&J is locked in a battle with competitor Boston Scientific BSX over acquisition target Guidant GDT. Guidant has experienced numerous quality-control problems this year. We don't think J&J was aware of these problems when it negotiated the original $25 billion purchase price in December 2004. Additional product defect revaluations could badly damage the value of J&J's investment in Guidant.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Johnson & Johnson 50,656 170,701
* Merck 21,994 75,198
* Eli Lilly & Company 14,411 63,492
* Guidant 3,691 24,543
* Novartis AG ADR 28,247 135,295
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2004
Strategy
Johnson & Johnson is decentralized, with more than 200 operating companies. It has made pharmaceuticals its top priority but remains committed to its slow-growing consumer segment because its brands inspire consumer trust and provide healthy cash flow. Acquisitions are an important part of its growth strategy. Notable examples are Centocor in 1999, Alza in 2001, and Scios in 2003.
Management & Stewardship
In April 2002, Bill Weldon took the reins from Ralph Larsen, who led the company through more than a decade of double-digit growth. Weldon is only the sixth chairman in J&J's 117-year history. His ultracompetitive nature and salesmanship propelled him through the ranks at J&J, where his attitude matches the company's credo. Weldon started with J&J as a sales representative right out of college. He ran the endosurgery and pharma units before ascending to the top job. J&J's board has consistently been rated one of the best in America, and the firm regularly earns one of the top spots on Fortune's Most Admired Companies list. J&J's long-term management incentive plan is innovative: The value of the awards is not determined (or awarded) until retirement and is fully performance-driven.
Profile
Johnson & Johnson is a diversified health-care company with three divisions: pharmaceutical, medical devices and diagnostics, and consumer. Pharmaceuticals represents 47% of total revenue, and medical devices and diagnostics accounts for 36%. The remaining 17% comes from well-known consumer products like Band-Aids, Johnson's Baby Shampoo, and Tylenol.
Growth
We project 9% sales growth this year. We project compounded sales growth of about 8% through 2009. We forecast five-year earnings growth of about 9%.
Profitability
J&J is very profitable and becoming more so. We expect operating margins of 28% this year, up from 22% just five years ago. Improved product mix and cost controls should drive incremental operating margin improvements over the next five years.
Financial Health
J&J remains one of a handful of companies with a AAA credit rating, thanks to its pristine balance sheet. Cash flow from operations covers the dividend (which currently yields around 1.8%) nearly 3 times.
Analyst Note 01-12-2006
Johnson & Johnson JNJ and Boston Scientific BSX are engaged in a pitched battle over medical-device maker Guidant GDT. As the bidding war intensifies, we'd like to discuss how the changing terms of the deal affect our view of J&J.
We like the J&J-Guidant combination from a strategic perspective. For the past several years, J&J's sales have been increasing at impressive double-digit rates, but growth has been fueled disproportionately by the pharmaceutical segment. J&J's operating profit from pharmaceuticals has swelled to nearly 60% of the total. The Guidant deal would boost the representation of medical devices and bring that segment's earnings contribution closer to that of pharma.
While we think a more equitable balance among J&J's lines of business is a positive, it shouldn't come at too high a cost for Guidant. J&J's latest offer values Guidant at about $68 per share. Given Guidant's quality-control problems, we think this is too high. If the deal were to go through at that price, we'd be inclined to reduce our current J&J fair value estimate of $76 per share by $2-$3. For each additional $1 billion that J&J pays, we'd probably reduce our fair value estimate by an additional $0.50 per share.
Thesis 12-23-2005
We think Johnson & Johnson is an exemplary wide-moat company. It boasts trusted brand-name products, world-class R&D and marketing capabilities, and global scale and reach. We would eagerly buy the shares at a slight discount to our fair value estimate.
We like J&J's global leadership positions in three attractive health-care business lines: pharmaceuticals, medical products, and consumer products. Each line has excellent long-term growth prospects driven by favorable demographic trends or structural shifts in the U.S. economy toward quality-of-life services. The multiline platform provides valuable diversification in the event of an adverse development in any single business line.
J&J is a model of consistency and stability. The firm has delivered 19 consecutive years of double-digit earnings increases and 42 consecutive years of dividend increases. Cash flow from operations covers the dividend nearly 3 times. J&J has an excellent record of capital allocation and generation. Returns on invested capital averaged 22% during the past five years.
A key reason for J&J's success is its decentralized management structure. The company encourages entrepreneurship among local managers to stimulate creative new product development. The pharma group includes a number of medium-sized biotech companies that J&J has been steadily acquiring since 1999. J&J generates more in sales of biotech drugs than any other large drugmaker. Sales and marketing expertise and quality manufacturing skills are important distinguishing core competencies. The company keeps a careful watch on costs, too. This shows in the steady improvement in operating margins, which have increased from 17% to an estimated 28% between 1995 and 2005.
J&J's highly respected consumer-products business boosts the company's organic growth and adds stability to cash flows. The company has a record of steady annual increases in its consumer-products market share.
J&J has been reporting some of the best numbers in the pharma group lately, and we think its long-term outlook is equally promising. A fertile pipeline of new drug candidates and medical devices should ensure robust long-term sales growth. We forecast $8 billion in free cash flow this year--an impressive 16% of sales and 4.0% of our fair value estimate.
Valuation
Our $76 fair value estimate reflects our forecast of 9% sales growth and 17% earnings growth for J&J this year, driven by robust growth in the consumer and medical-device segments. Longer term, we forecast compounded sales growth of 8% and earnings growth of about 9% over the next five years.
Our fair value estimate is subject to adjustment depending on the outcome of the battle between J&J and Boston Scientific BSX for medical-device maker Guidant GDT. We think that Guidant's quality-control problems will be costly to fix. Therefore, if the deal goes through at the latest price of $63 per share, we would be inclined to reduce our fair value estimate by $2 per share or by a larger amount if J&J increases its purchase price.
Our fair value estimate is sensitive to changes in our assumptions of sales and earnings growth. For each 1-percentage-point reduction in our five-year sales growth estimate, our fair value estimate declines by $2 per share. We also forecast about 80 basis points in operating margin improvement on J&J's huge sales base of $50 billion. If J&J is not able to improve operating margins, our fair value estimate would also decline by about $2 per share.
Risk
J&J's biggest seller, Procrit/Eprex, has been losing share to Amgen's AMGN Aranesp. Another breadwinner, Duragesic, lost patent exclusivity this year. While J&J has a strong early pipeline of new products, its late-stage pipeline is thin, and it will be challenging to make up for Duragesic's lost sales. J&J is locked in a battle with competitor Boston Scientific BSX over acquisition target Guidant GDT. Guidant has experienced numerous quality-control problems this year. We don't think J&J was aware of these problems when it negotiated the original $25 billion purchase price in December 2004. Additional product defect revaluations could badly damage the value of J&J's investment in Guidant.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Johnson & Johnson 50,656 170,701
* Merck 21,994 75,198
* Eli Lilly & Company 14,411 63,492
* Guidant 3,691 24,543
* Novartis AG ADR 28,247 135,295
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2004
Strategy
Johnson & Johnson is decentralized, with more than 200 operating companies. It has made pharmaceuticals its top priority but remains committed to its slow-growing consumer segment because its brands inspire consumer trust and provide healthy cash flow. Acquisitions are an important part of its growth strategy. Notable examples are Centocor in 1999, Alza in 2001, and Scios in 2003.
Management & Stewardship
In April 2002, Bill Weldon took the reins from Ralph Larsen, who led the company through more than a decade of double-digit growth. Weldon is only the sixth chairman in J&J's 117-year history. His ultracompetitive nature and salesmanship propelled him through the ranks at J&J, where his attitude matches the company's credo. Weldon started with J&J as a sales representative right out of college. He ran the endosurgery and pharma units before ascending to the top job. J&J's board has consistently been rated one of the best in America, and the firm regularly earns one of the top spots on Fortune's Most Admired Companies list. J&J's long-term management incentive plan is innovative: The value of the awards is not determined (or awarded) until retirement and is fully performance-driven.
Profile
Johnson & Johnson is a diversified health-care company with three divisions: pharmaceutical, medical devices and diagnostics, and consumer. Pharmaceuticals represents 47% of total revenue, and medical devices and diagnostics accounts for 36%. The remaining 17% comes from well-known consumer products like Band-Aids, Johnson's Baby Shampoo, and Tylenol.
Growth
We project 9% sales growth this year. We project compounded sales growth of about 8% through 2009. We forecast five-year earnings growth of about 9%.
Profitability
J&J is very profitable and becoming more so. We expect operating margins of 28% this year, up from 22% just five years ago. Improved product mix and cost controls should drive incremental operating margin improvements over the next five years.
Financial Health
J&J remains one of a handful of companies with a AAA credit rating, thanks to its pristine balance sheet. Cash flow from operations covers the dividend (which currently yields around 1.8%) nearly 3 times.
