Drip Portfolio Report
Monday, October 6, 1997
by Jeff Fischer (TMF Jeff@aol.com)

ALEXANDRIA, VA (Oct. 6, 1997) -- Pharmaceutical sales at this company increased 15% to $7.2 billion in 1996, while operating profits in pharmaceuticals increased 20%, to $2.4 billion. The operating margin in the division was 33%, topping the operating margin of any other healthcare company that we have considered.

The company spent over $1 billion in research and development directly related to its pharmaceuticals, or 15.2% of sales. This is among the highest of any pharmaceutical company. (Pfizer, by comparison, is expected to spend about 16% of sales on research and development this year, but all of the money won't go to the pharmaceutical division.)

The company that we're referring to doesn't rely on seven major drugs as Pfizer does, or on only one or two giant sellers, but sells more than 90 drugs, many addressing ailments that are less likely to be affected by formularies. (Formularies are restricted buying lists from HMOs that allow only certain drugs to be bought under insurance.) Twenty-six drugs offered by this company had sales of over $50 million, and nineteen had sales of over $100 million. If the company only sold drugs, or almost only, it would have higher net margins than Schering-Plough and Pfizer, probably topping 22%.

Schering-Plough and Pfizer trade at 6.3 and 6.6 times sales. If the pharmaceutical division that we're speaking about was backed out of JOHNSON & JOHNSON (NYSE: JNJ) and traded separately, it would almost certainly -- with its diversification of product, strategic partnerships, high spending on R&D, and with better margins than the competition -- trade for about six times sales in this stock market as well, or command a $43 billion market cap.

But that isn't all that this company does, of course. With a market cap of $79 billion, Johnson & Johnson also sold $8 billion in professional products in 1996, up nearly 20% from the year prior (including the Cordis acquisition), and $6.3 billion in consumer products, up more than 9% from the prior year. This extra $14.3 billion in sales was achieved with operating margins of 12.4% -- no small feat. With a leading brand name and worldwide presence, a price to sales ratio on these divisions would probably be in the 3.0 to 4.5 range (Gillette trades at 4.8 times sales). Granting the consumer and professional division of Johnson & Johnson a multiple of 3.4 times sales we get an additional $48.6 billion in market cap.

Adding the two divisions together, the implied fair value of Johnson & Johnson is nearly $92 billion, which is $13 billion above the current market cap -- representing a stock price of nearly $70 per share. The company as a whole would trade at 4.1 times trailing sales in this case. The stock currently trades at 3.1 times sales.

Though valuation isn't a major factor in our decision because we want to buy the business model and worry less about the current stock price, we still consider valuation as quite important. If you could simply buy any leading business at any price and expect to outperform the market over 20 years there would be more great investors on the planet. Or more wealthy ones, anyway. In this case, in the end, I like both the diversified business and the valuation of Johnson & Johnson better than our other choices. In the final analysis these two factors combined make Johnson & Johnson a difficult company to bypass in favor of Pfizer. Pfizer has half the sales of Johnson & Johnson but sports a larger market cap, while moving toward a business model that will depend even more greatly on pharmaceuticals -- which adds additional uncertainty for a number of reasons over the long period of time that we're considering. Also, Pfizer's sales are not expected to grow at a rate any faster than Johnson & Johnson's, and the company depends primarily on only a handful of successful drugs.

Before sounding too negative about Pfizer -- a company that I actually do want to own -- it's worthwhile to note that both Pfizer and Schering-Plough were rated as "buys" today by UBS Securities, and both stocks moved positively on the news. Even at these prices this isn't surprising. Both are great companies. I like Pfizer enough that I want to consider it further down the road as a discretionary holding in the portfolio, rather than begin with Pfizer as one of the portfolio's "core holdings." Pfizer certainly could be a foundation upon which to build a portfolio, but with its wide diversity, Johnson & Johnson fits the bill better than Pfizer.

Arguably Johnson & Johnson's pharmaceutical business, which is nearly as large as Pfizer's, is nearly as impressive (and more so in diversity), and the margins achieved in it are even stronger than Pfizer's. Also, Johnson & Johnson's R&D spent on pharmaceuticals as a percentage of sales is near equal to and probably above that of Pfizer's when you consider the many strategic agreements that Johnson & Johnson invests in with smaller companies. Either way, the two R&D amounts are at least comparable, and Johnson & Johnson's R&D spending in its pharmaceutical division has increased at a compound growth rate of 15.3% annually for the past ten years, an impressive accomplishment.

In the consumer products arena, Johnson & Johnson beats everyone hands down, and this division should see consistent and sustainable domestic and international sales growth as the world's markets continue to open. Johnson & Johnson can be a world leader in toothbrushes, contact lenses (it already is), baby power, dental floss -- all those repeat purchase items that investors should covet. Johnson & Johnson is the most able company to continually gain from the emerging markets in the consumer healthcare world -- a market that promises to grow much larger over the next two decades. (50% of the company's sales are international.) We've seen that but for Abbott Laboratories, our other considerations don't have much of a consumer division (or growth in them) to speak of.

Finally, if you're worried that the consumer product division eats into margins, consider this division separately from that of the pharmaceutical division. Companies are often worth more when broken apart, as is arguably true with Johnson & Johnson. The other companies that are mainly pharmaceutical (Schering-Plough and Pfizer) already seem to be recognized and valued as such by the market, trading at over 6 times sales. Johnson & Johnson's stock arguably holds unlocked value if investors break it apart, even only mentally.

Whatever wild turns the healthcare world takes, however HMO's fall into step, whatever drug policies are initiatied, and however the FDA rates a new drug from the company, Johnson & Johnson still has about 68% of sales coming from professional and consumer products, and the rest of sales coming from some 90 drugs, many of which treat more common ailments and are marketable to a large portion of the globe (allergy and breathing, contraceptive and digestive, antifungal and bacteria).

The company is a leader in all three of its divisions, with decent margins and growth rates in all. Best yet, all indications are that this is sustainable and capable of being improved upon. The company spent nearly $2 billion in R&D last year, putting it in the top ten of all U.S. companies in this category, and 35% of products sold last year were introduced in the last five years. For those wanting to invest in Pfizer for the growing cardiovascular market -- good idea. It's worthwhile to consider too, though, that Johnson & Johnson is the world leader in interventional cardiology sales.

Johnson & Johnson has increased sales each of the last 64 years, and net income every year for the past 35. Earnings per share has grown 15.8% annually the past ten years, and the stock, with dividends included, has returned over 22% annually over that time -- doubling the historic return of the S&P 500. Johnson & Johnson has one of the best compounded dividend growth rates as well, and currently yields about 1.5%, more than any of our other choices except for Abbott Labs, at 1.6%. Finally, the company has made 125 external alliances in the last twelve months, as its Investor Facts page shows.

Trading at 20.9 times next year's earnings estimate and 3.1 times sales, Johnson & Johnson is a company that we can begin to buy while actually feeling that we're purchasing our share of the business at a reasonable price -- which is not entirely easy to do in this market, as Warren Buffett said earlier this year. As Buffett also said, "The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries. In each case you simply want to acquire, at a sensible price, a business with excellent economics and able, honest management. Thereafter, you need only monitor whether these qualities are being preserved."

Tomorrow we'll get Randy's thoughts on healthcare.

Fool on!


                    Day   Month Year  History
        Drip:    +0.00%   0.00%  0.00% 0.00%
        S&P:     +0.00%   0.00%  0.00% 0.00%
        NASDAQ:  +0.00%   0.00%  0.00% 0.00%

        Rec'd   #    Security         In At      
       9/8/97   1      Intel         $94.69      

                        Base: $700.00
                    Expenses: $ 55.50 (Moneypaper)
                   Purchases: See above
                        Cash: $549.10
                 Total Value: $652.00 apprx.

The portfolio began with $500 on July 28, 1997, adds $100 on the 15th of every month, and the goal is to have $150,000 by August of the year 2017.