Since last week, Johnson & Johnson's (NYSE: JNJ) shares are down over 5%, and are now nearly 20% off their 52-week high. For a company that's lacking nothing in terms of business momentum, this share-price decline beckons a look at the company's valuation.
To review, last time we left off with the fact that J&J has wonderful long-term business characteristics, excellent cash-generation capabilities, and promising research investments. Today, let's pick up where we left off and take the company through the Rule Maker paces, as outlined in our Rule Maker Rules. By the end of this exercise, we'll have the info we need to assign grades (A, B, C, or F) to J&J for both its business prospects and valuation. Those grades should give us a pretty good idea of how attractive an opportunity the shares are at their current perch of $53.34.
1. The company must have at least one sustainable competitive advantage. The more, the better.
J&J has patents on its 100+ prescription drugs, trademarks and mind share protecting its over-the-counter consumer brands (Tylenol, Neutrogena, and Band-Aid, to name just a few), and a whole slew of know-how when it comes to getting medical products to market around the world. In addition to these commonly known competitive advantages, J&J also stands out as a savvy acquirer. One of its medical device businesses, LifeScan, a maker of blood glucose-monitoring products, was a 1986 acquisition that cost $86 million for its then-annual sales of $22 million. Today, LifeScan has in excess of $1 billion in annual revenue.
2. The company must be dominant in its given industry.
J&J is the world's largest medical device maker, the world's fifth-largest pharmaceutical company, and 75% of its sales come from products where it has the #1 or #2 market share position. J&J may not be "dominant" per se, but it is very strong. All three of J&J's businesses -- consumer healthcare products, pharmaceuticals, and medical devices -- exist in industries that are proven in their ability to support multiple prosperous companies (like Merck, Procter & Gamble, Medtronic, Pfizer, etc.).
3. A Rule Maker has been dominant for more than a decade.
J&J has been kickin' it since 1887, making it one of the oldest major U.S. corporations. Yet even in its "old age," the company is thriving. The company has an astounding financial track record that includes 39 consecutive years of dividend increases and 17 consecutive years of double-digit earnings increases.
4. Cash King Margin in excess of 10%.
We looked at this metric last week and saw how J&J has been expanding its free cash flow profitability dramatically in recent years. For the trailing 12 months ending in March, the Cash King Margin was up to an incredible 21.7%, almost 5 percentage points higher than the prior 12 months.
5. Efficient Working Capital Management, measured by a Foolish Flow Ratio below 1.25.
One big reason for J&J's awesome free cash flow has been its tight working capital management. We can see this in the Flow Ratio, which currently stands at a respectable 1.44, down nicely from 1.78 a year ago. By holding the line on receivables and inventory, J&J has been able to squeeze cash out of its system, making it available for stock repurchases and other more productive uses. The Flow isn't quite down to the levels where we'd like it, but there's been major improvement in the past year.
6. Sales above $4 billion per year, and growing revenues at 10% plus rates.
Over the past decade, sales have grown from $12.6 billion to $33.0 billion -- a bit over 10% annually. Most interesting, though, is the fact that J&J has maintained this very pace not just for 10 years, but for 100 years. Talk about consistency. The company's 100-year average annual rate of growth is 10.6%. In recent years, the company has managed to step up the pace, with revenue growing 11.5% over the trailing 12 months.
7. Best-of-class management.
J&J's financial performance is probably the best indicator of management's quality, but if you want to look beyond the financials, I'd point to the company's credo as an important underpinning to J&J's thriving longevity. This credo, which you really should read in order to appreciate, is described in the company's 10-K as management's unifying factor. Since 1943, the one-page credo has unified J&J employees worldwide in their commitment to serve customers, fellow employees, communities, and stockholders -- in that order. Clearly, however, the stockholders have ended up being best served through service to these other key constituencies first.
8. Return On Invested Capital above 11%.
For the trailing 12 months, J&J has generated net operating profit after tax of $6 billion. You take that number divided by average invested capital of $17.9 billion, and you arrive at ROIC of 33.5%. That's a phenomenal rate of return, and it's even more phenomenal when you consider that it's up from 30.3% for fiscal 2001 and 27.4% for fiscal 2000.
9. Cash no less than 1.5 times debt.
At the end of March, J&J had $7.4 billion in cash and $2.9 billion in total debt. That's net cash of $4.5 billion, or a cash-to-debt ratio of 2.55. Excellent.
10. A reasonable purchase (or holding) price.
As you can see from criteria 1 through 9, J&J has been an absolutely phenomenal long-term performer, with recent results that are the best of the company's entire 115-year existence. Unbelievable. Even more unbelievable, I think, is that the market has let J&J slip down to a price-to-free cash flow ratio of 22.7. For such an awesome company with continued strong growth prospects, it makes no sense for J&J to sell at a discount to the market's free cash flow multiple of 26.7, a number made available by Barra. I can only guess that the market must be overly focused on J&J's P/E ratio of 27.9. Eventually, however, I think the market will take notice of and focus on J&J's cash-earnings power.
Given J&J's proven ability to grow through thick and thin, along with its rising margins and ROIC, I don't think it's unreasonable for J&J to sell at a P/FCF multiple closer to 30. That'd be roughly in line with the company's five-year average P/E multiple of 30.6. At 30 times trailing free cash flow per share of $2.35, J&J shares would trade for around $70 -- about 32% above the current price.
It's time to grade J&J using our Rule Maker Report Card. The company soundly beats eight of our nine criteria for business prospects. Even on the one criteria it missed (Flow Ratio), J&J showed impressive improvement. As far as I can tell, J&J's business momentum shows no signs of slowing. As such, for business prospects, I'm assigning J&J a grade of A-, with the "-" tacked on just for its small miss on the Flow Ratio.
As for valuation, Rule Maker Manager Bill Mann has proposed that Rule Makers would ideally be purchased for 60% of intrinsic value. This is a steep hurdle, but not an unrealistic one for patient, opportunistic investors. Currently, I think J&J is closer to 76% of intrinsic value (that is, $53.34/$70). Investors looking to buy J&J at the 60% level would need to wait for a stock price of about $42. At the current price, I'm giving J&J a grade of B. If it were to somehow fall to $42, I'd up my grade to A.
You be the judge as to whether the stock is a buy right now, or whether patience might result in a better price in the near future. In any case, I think J&J is poised to be a market beater over the next several years.
And finally, if you find this process of grading companies to be a worthwhile exercise, there's an opportunity next month that you may want to consider: Bill Mann and I are going to be leading an online seminar on selling stocks. We'll be utilizing the report card, along with a number of other practical tools, to help you develop a good strategy for all the scenarios in which selling is the right decision. If you haven't tried one of these online learning opportunities, it's really worth a shot (especially since we offer a money-back guarantee). The way it works is that we'll send you email lessons and work with you directly on private message boards. It's a very rich experience, and I hope you'll consider joining us.
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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