I just finished reading through Johnson & Johnson's (NYSE: JNJ) 2001 annual letter to shareholders and SEC Form 10-K. I walk away with the feeling of a teacher that's just graded a perfect A+ paper. There's nothing flashy about J&J; it's just a company that gets all the basics right. Using just the material in the 10-K and annual letter, let me show you three of J&J's attributes that make it the type of business that exemplifies what Rule Maker investing is all about.
1. Recurring revenues in a business of fundamental value to society
With $33 billion of 2001 revenue, last year marked J&J's 69th year of increased sales. It was also the 39th year of increased dividends and 17th year of double-digit earnings growth (excluding special charges). How does J&J do it? You could say management, you could say innovation, but I would look at something else, something more fundamental. Not to oversimplify, but I believe the foundation for J&J's incredible multi-decade track record is the fact that it sells repeat-purchase products that are of fundamental value to society.
J&J's business of serving human health and well-being has characteristics of both stability and growth that few other industries can match. J&J's products -- over-the-counter personal care products, prescription drugs, and medical devices -- are not only staples for life, but they also offer the potential to lengthen both the quantity and quality of life. It's a recipe for reliable long-term growth. I know, this is so obvious, but it's one of those "duh" aspects of investing that can occasionally be overlooked -- to a Fool's great detriment.
2. Strong producer of cash
If there's any one subject that we've been dogmatic about over the years here in the Rule Maker, it's the importance of cash. How gratifying it is, then, to see J&J's CEO Ralph Larsen (who just recently retired and handed over the reins to incoming CEO William Weldon) carry our cash-is-king banner in the annual letter to shareholders. Check it out:
"Free cash flow" (defined as cash remaining after making the capital expenditures required to support the growth of our business) is, in fact, one of the very best measures of how a company is performing. Its virtue is its clarity. You either generate cash or you don't. It is not subject to many varying interpretations or accounting changes. We are pleased to report that Johnson & Johnson's "free cash flow" reached an impressive $7.1 billion in 2001 -- a record -- up from $2.6 billion just five years ago and $700 million a decade ago. In short, your Company is growing in both sales and earnings and generating substantial levels of cash flow. The net result is that our balance sheet is exceptionally strong. Our excellent financial standing is demonstrated by our ability to implement the recently announced repurchase of up to $5 billion of the Company's stock while maintaining our "triple A" credit rating -- a rating few companies have achieved.
J&J's cash flow statement verifies every word of Larsen's comments. Cash flow from operations in 2001 was $8.86 billion. Out of this amount, the company spent $1.73 billion to upgrade its property, plant, and equipment. That left $7.13 billion in free cash flow. J&J was "free" to use this sum for the following beneficial measures: retiring debt ($1.15 billion), making acquisitions ($0.23 billion), issuing cash dividends ($2.05 billion), and repurchasing its own shares ($2.57 billion). Even after all these expenditures, J&J ended 2001 with $7.97 billion in cash and only $2.78 billion in debt. That's the power of a company that generates strong free cash flow.
How strong is strong, you ask? Very. J&J's free cash flow margin (FCF divided by Sales), or what we've around here called the Cash King Margin, has been rising dramatically over the past several years:
($ billion) 1999 2000 2001 Sales $28.0 $29.8 $33.0 Free Cash Flow 4.1 5.2 7.1 Cash King Margin 14.6% 17.4% 21.5%
That upward trend, while not sustainable, is a sure sign that J&J is doing all the right things to create value for shareholders.
3. Investing heavily in pharmaceuticals
J&J's strong results over the past several years have been driven by its high-margin pharmaceutical segment. This segment includes the sales of over 100 prescription drugs, 33 of which had 2001 sales greater than $50 million. All told, J&J's pharmaceutical segment accounts for 45% of the company's total revenue, up from 40% in 1999. Given the importance of this segment, it's critical that J&J management invest heavily in research and development for tomorrow's drugs. And they are. Research expense as a percent of sales for the pharmaceutical segment was 16.6% for 2001, 16.4% for 2000, and 15.7% for 1999. To see that percentage rising each year is an indication that J&J is finding no shortage of new pharmaceutical opportunities to pursue for the future.
In sum, J&J has wonderful long-term business characteristics, excellent cash-generation capabilities, and investments that promise a bright future. The only question -- and the most important question -- that remains is whether J&J's stock price fully recognizes these qualities. Next Wednesday, I'll examine J&J's first-quarter results and then assign a grade to both the business and the valuation, per our Rule Maker Rules and Rule Maker Report Card.
In the meantime, I encourage you to consider signing up for an online seminar that Bill Mann and I will be leading next month. The topic is a critical one for investors: when to sell. Through the course of email lessons and a private seminar discussion folder, Bill and I will provide you with a number of practical tools, along with plenty of examples, in order to help you know when to hold 'em and when to fold 'em. We hope you'll consider joining us. (There's a money-back guarantee if you're not satisfied, so why not give it a shot?)
And finally, our portfolio numbers. At present the Rule Maker Portfolio is valued at $29,675.82. This brings the total Compound Annual Growth Rate to -4.1%. For the year, the Rule Maker's return has been -6.8%, compared to -27.4% for the Nasdaq and -10.7% for the S&P 500. We will update the Rule Maker Portfolio manually until our automated calculations return to being something close to reality.
Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.
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