Johnson & Johnson (NYSE: JNJ) has returned more than 25% since the Rule Maker Portfolio purchased the healthcare products giant in April 2001. Truthfully, our only mistake when we bought the company was that we didn't buy more. We chose just to use our monthly $500 investment, rather than selling shares of another, perhaps underperforming, holding. Nevertheless, today we continue our Portfolio review with a look at J&J.
In addition to the favorable characteristics of the pharmaceutical industry -- which include attractive demographic trends, low Foolish Flow ratios, strong cash flows, resistance to economic change, high profit margins, barriers to entry in patent protection, and predictable revenues -- we added J&J to the Portfolio because of its long operating history and list of expanding possibilities, two critical components of Rule Maker investing.
The former gives us great insight into J&J's business. We want to invest in proven companies. Coca-Cola (NYSE: KO) has been around for more than a century and withstood great economic change. Likewise, J&J has been in business since 1885, surviving and succeeding through difficult economic and spending conditions. Hence, by operating through multiple business cycles, we have a certain amount of faith and insight into the company's business.
Here's a quick look at J&J's long history of impressive performance:
- Revenues have increased every year for the last 68 years.
- Averaged 10.6% annual sales growth for the last 100 years.
- Averaged 10.5% annual net income growth for the last 100 years.
- Cash flow from operations has nearly doubled over the last five years.
- Its dividend has increased each year of the last 38 years.
Expanding possibilities is also important because we want to invest in companies that will be bigger and strong over the next five years. Over the last 20 years, as it grew from a consumer and low-end medical products company to a high-end medical and pharmaceuticals products firm, J&J has laid a foundation that will allow it to be more relevant in the future and provide the necessary returns to double over the next five years.
For instance, at a meeting last month with analysts to discuss its medical devices group, J&J provided better-than-expected data on a new line of stents -- tubes that prop open arteries to maintain blood flow to the heart and prevent blockage -- known as Cypher. J&J sells stents through Cordis, one of 42 companies it has acquired in the past decade. The announcement was just one example of J&J's many expanding possibilities.
J&J is also a classic Rule Maker because of its diversification. With consumer products making up 24% of sales last year, medical and diagnostics 35%, and pharmaceuticals 41%, it's not too dependent on a particular product or market for future growth. In Philip Fisher's book Common Stocks and Uncommon Profits, he writes diversification can be achieved by only owning a few stocks if those companies have highly diversified product lines. J&J is one such company.
Further, diversification is noteworthy in that it makes J&J a safe haven in our Portfolio, a concept recently discussed in Motley Fool Select, our premium research product. Investors can avoid volatility by not overpaying for a stock OR by owning companies immune to economic change. With its history, growth prospects, and diversification, investors have jumped into this safe haven and bid shares up 17% un the past 12 months, while the S&P 500 fell 25%.
With 190 companies selling its products in 175 countries, this space does not permit a complete review of J&J, but our biggest concern remains growth, something management has said continues to depend on execution. J&J's drug research has had its share of late-stage failures in recent years, which in part explains why many of it top products -- including the best-seller Procrit, which came from Amgen (Nasdaq: AMGN) -- were acquired or licensed.
The company calls for pharmaceutical growth of 12% to 15% annually through 2005, achieved through new brands, the Alza acquisition, and added emphasis on top-selling drugs. For example, J&J leads the birth control market with a worldwide share of 26%, but its share in Europe is 7%, compared to 37% in the U.S. With a total market opportunity estimated to be $3.7 billion, expanding its position Europe is a solid growth opportunity.
J&J's calls for long-term growth of 10% to 11% on the top-line and 13% to 15% on the bottom-line, which begs us to ask the question: At the current price, can the stock double over the next five years? J&J closed recently at $54.99 per share and a market cap of $171 billion. With more than $5 billion in trailing 12-month free cash flow, J&J currently trades at a multiple of 30 times free cash flow, compared to the S&P 500 at 23 times.
Below are estimated Price to Free Cash Flow ratios and the growth rates required for 2x5y returns:
Projected P/FCF 35 30 25 20 FCF Growth Rate for 2x/5y 12% 15% 19% 25%
Assuming the market will still pay 30 times for J&J, which we think is reasonable given its diversification and long history of above average returns, the company needs to grow free cash flow 15% annually over the next five years for 2x5y returns. If that multiple were to come down to 25 times, however, it would need to grow free cash flow 19% annually, slightly more optimistic considering its free cash has grown 18% annually the last three years.
With a double within reach, we plan on remaining J&J shareholders for some time. Its current valuation of 30 times free cash flow is about the highest multiple we'd be willing to pay, even for a company like J&J with growing pharmaceutical and medical device businesses that give it the opportunity to become a bigger and stronger company in the future. We also love its long history and diversification, and at the current price we would not rule out adding to our position.