Are These Dow Stocks Foretelling Trouble Ahead?

So far in this series of commentaries on the Dow Jones Industrial Average component stocks that are in each S&P 500 sector, we have looked at telecommunications, financial, consumer discretionary, and consumer staples. We now turn our attention to Dow stocks in the S&P 500 health care sector: Johnson & Johnson (NYSE: JNJ  ) , Merck (NYSE: MRK  ) , Pfizer (NYSE: PFE  ) , and UnitedHealth Group (NYSE: UNH  ) .

Company

Year to Date Gain/Loss

Dividend Yield

Total Return YTD

Price/Earnings Ratio LTM

Earnings Quality Score

Johnson & Johnson

5.33%

3.52%

8.85%

22.03

D

Merck

18.18%

3.71%

21.89%

20.67

C

Pfizer

13.59%

3.53%

17.12%

18.76

C

UnitedHealth

9.32%

1.51%

10.83%

11.39

D

Total Average

11.60%

3.07%

14.67%

18.21

C-/D+

Sources: S&P Capital IQ, The Motley Fool.

Note the earnings quality scores: In the past, my research has incorporated a Motley Fool Earnings Quality Score that taps into a database that ranks individual stocks. The database designates an A through F weekly ranking, based on price, cash flow, revenue, and relative strength, among other things. Stocks with poor earnings quality tend to underperform, so we look for trends that might predict future outcomes.

Johnson & Johnson
For its latest quarter, Johnson & Johnson reported lower revenue and earnings year over year. The tables below provide revenue by region and segment.

Region

Sales % +/-YoY

Operational % +/- YoY

Currency Impact % +/- YoY

U.S.

(1.2%)

--

--

Europe

(8.3%)

1.6%

(9.9%)

Western Hemisphere

12%

22.4%

(10.4%)

Asia-Pacific and Africa

5.2%

7.7%

(2.5%)

Source: Johnson & Johnson's SEC 10-Q filing; Western Hemisphere excludes the U.S.

Segment

Sales % +/-YoY

Operational % +/- YoY

Currency Impact % +/- YoY

Consumer

(4.6%)

0.6%

(5.2%)

Pharmaceutical

0.9%

5.1%

(4.2%)

Medical Devices

(0.1%)

3.4%

(3.5%)

Source: Johnson & Johnson's SEC 10-Q filing.

Apart from declining revenue, JNJ's margins show stable trends year over year. The net profit margin, however, declined to 9% from 17% last year. The 31% tax rate versus 19% for 2011 affected this margin.

JNJ's gross profit was down 2% year over year, pre-tax income was down 41%, and the per-share earnings before adjustments, at $0.50, was down 50%. On a positive note, operating cash flow was near its highest point in two years at $4.73 billion, and free cash flow was the highest in several quarters.

JNJ's major issue affecting earnings quality is inventory: Inventory levels are the highest in two years. Inventory as a percentage of revenue jumped from 39% to 47%, and days in inventory also increased from 115 days to 137 days. The ratio of finished goods to raw materials now stands at 343%.

JNJ's numbers and trend data don't validate its P/E ratio. However, JNJ is considered a defensive play. With its 3.5% dividend yield, JNJ is a hold.

Merck
Merck's return year to date is slightly above its trailing P/E, which makes an investment in this venerable pharmaceutical company a decent play. Merck's revenue trend is up slightly, as revenue increased 1% year over year. The company's costs as a percentage of revenue have been stable, and gross, operating, and net profit margins are healthy at 67%, 25%, and 15%, respectively. As with JNJ, inventory issues are Merck's biggest headache. Days in inventory are high at 142 days, and inventory as a percentage of revenue is at 51%, although there is no trend with it. The finished goods to raw materials ratio is at 43%, which is also more manageable than JNJ's 343%. Despite sluggish inventory turns affecting earnings quality, Merck stands out as a solid performer based on fundamental analysis.

Pfizer
Pfizer reported lower revenue, down 9% year over year, to $15.06 billion, but costs and margins as a percentage of revenue held steady. The low cost of goods sold at 18% accounts for higher gross and operating margins of 82% and 36%, respectively. Pfizer's net profit margin, at 22%, was up from last year's 16%. While the gross profit declined 8%, the operating and net income each rose 25%, and earnings were up 32% from last year. Receivables are one of Pfizer's ailments, at 86% of revenue. Again, inventory is a painful issue here. Days in inventory are at 235 days, and the finished goods to raw materials ratio is a whopping 324%.

PFE Days Inventory Outstanding Chart

PFE Days Inventory Outstanding data by YCharts.

Pfizer has aggressively reduced its float to boost earnings per share. Pfizer spent $6.21 billion on 399 million shares in the last 12 months. Pfizer could spend more time on working down inventory than on buying back shares -- and shareholders would feel better.

UnitedHealth
UNH is the Dow's newest component stock, but basically is an insurance company unlike its Dow siblings. Year-over-year quarterly revenue was up 8% to $27.27 billion, and earnings rose 9% to $1.27 a share, but this company can more easily raise prices to meet rising health care costs. Despite moderately rising operating and net profit income of 5% and 6%, respectively, UNH's earnings quality suffers from cash flow issues.

UNH Accounts Payable Chart

UNH Accounts Payable data by YCharts.

The operating cash flow margin equals 10%, but not reflected in the chart is that while days sales outstanding are at 12 days, days payable outstanding are at 102 days, which equals 90 days of short-term financing. Also, payables are at 82% of revenue, and are $3.8 billion higher than receivables, which is an unsustainable source of cash flow generation.

UNH Long Term Debt Chart

UNH Long Term Debt data by YCharts.

UNH apparently also has used long-term debt to finance share reductions, artificially propping up earnings. Because of this and with its payables (i.e., health care costs) out of control, I'd be cautious here.

Foolish bottom line
This group's rising inventories and health care costs will hamper margins as inventory is worked off and global consumer demand declines globally. Foolish readers should base investment decisions on earnings quality.

If you want gains outside of health care, the Dow is loaded with companies with solid dividend payouts and sustainable business models built for the long haul. The three stocks in The Motley Fool's free report "The 3 Dow Stocks Dividend Investors Need" all have an X factor that makes them stand out from their illustrious Dow peers. Click here now to get your free copy today.

Fool contributor John Del Vecchio is co-advisor to Motley Fool Alpha and co-manager of the Active Bear ETF (NYSE: HDGE  ) and co-author of What's Behind the Numbers?. You may follow him on Twitter @johnfdelvecchio. He does not own any shares in the companies mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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