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JNJ: A Little DD

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By eJerry
April 13, 2004

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Greetings,

The CAGR curves of JNJ was the topic of a recent thread. It just so happens that I purchased some JNJ prior to learning about the BMW method. I believe JNJ is a compelling purchase, and I had planned to make additional purchases, but I was pretty fuzzy about under what conditions I would make those purchases. This is what I love about the BMW method--now I know exactly what prices I'm going to be looking for and why those prices are so good.

Below is the document I prepared prior to making my initial purchase. It's based loosely on the format (not necessarily the depth) of TMF recommendations I've seen.

So, FWIW, my version of DD for JNJ----
Best regards, Jerry
________________________

Johnson & Johnson: (JNJ)
Gerald C. Hyatt March 8, 2004

Investment Summary
Health care is one of the most persistent of human needs. We never outlive our need for health care. Johnson & Johnson participates in three broad categories of health care: consumer products, pharmaceuticals, and medical devices. It provides popular and necessary, repeat purchase products, and has a substantial research department dedicated to keeping that product line up-to-date. A proven product line, a stable of new and very promising products, a well-run company that hasn't participated in the 2003 bull market makes this look like a promising investment for the next three-to-five years.

Corporate Facts
Johnson & Johnson is a health care giant. It owns over 200 companies, has 108,300 employees, has operations in 54 countries, and its products are sold in 174 countries. There are three main divisions, as mentioned above. Consumer products contributed 18% of 2002 sales. Medical devices contributed 34.7% of sales, and pharmaceuticals were responsible for the remaining 43.7% of 2002 revenues. All three divisions had higher sales than 2000, and throughout the company's history, it has had positive annual sales growth every year with the exception of 1931.

The Company enjoys a gross margin of 71%, an operating margin of 26%, and a net margin of 19%. Sales growth was 12%, earnings growth was 16%, and it increased R&D by 10% and its R&D staff by 50%. The R&D budget is highest for the Pharmaceuticals division. Return on equity was 24% and Return on invested capital was 23%. All of these, point to a large, stable, very well managed company that should be able to maintain moderate growth far into the future.

The only weaknesses that I see in the numbers are that the Foolish Flow Ratio is currently 1.26. According to TMF, large established companies should be able to keep this below 1.25. The Flow ratio is improving, though, gradually decreasing over the last three years, and the most recent quarter did show a Flow Ratio of 1.24.

The other weakness is that for 2002, free cash flow shrunk from the previous year and was less than earnings. The most recent quarter, however, shows an increasing free cash flow that is greater than earnings, so the Company is going in the right direction here as well.

The Chairman and CEO is William Weldon. His writing is clear and he seems honest. The company has raised its dividend every quarter for the past 40 quarters, and also repurchased $5-billion in stock this year (2002). Employee stock option grants are limited to 1.6% of outstanding shares, which is not excessive. All of these are characteristics of a shareholder-friendly management team.

The management style of the company is to give as much rein as possible to the operations in the field, that is, the 200 companies it owns. The goal is to maintain a strong entrepreneurial atmosphere and to let local decisions be made locally. The unifying link is provided by the Company Credo, created in 1947(?), which declares that the company is dedicated to the welfare of its customers, its employees, its communities, and its shareholders.

Its consumer products, including Band-Aid, Splenda, and Accue-Vue; are distributed to retailers. The other two segments, however, are sold through a sales force, and to wholesale distributors. The product in recent news is the CYPHER drug-coated stent, which is inserted into clogged arteries. The drug-coating increases the success rate of this procedure. It's been recently approved by the FDA, but because it costs more than non-treated stents, it has been accepted slowly. A recent study in Italy has indicated that the drug-coated stent is much more effective than standard stents, so this may motivate increased sales.

Examples of some of its primary competitors are Proctor & Gamble, in the consumer component, and Merck and Novartis in the pharmaceuticals and medical devices fields. Of those, Johnson & Johnson has the largest market cap, the most employees, the best revenue growth (ttm) and the highest net income (ttm). Only Novartis has a higher gross margin and Proctor & Gamble has higher revenue. Johnson & Johnson has the lowest PE and the lowest PEG of the group. It looks to be in a very favorable position with respect to its competitors.


Investment Thesis
When I look at the financial statement and read through the company reports, I see a picture of a profitable, well-managed, stable company in an important field that hasn't participated in the recent bull market. It stands now at about 10% off of its 52-week high.

A depressed stock price, with many well-known consumer brands, a stable of current drugs, a full pipeline of drugs on the way (many in stage III testing), and enough cash to buy small promising companies that can't afford to finish their own research, this is a compelling investment.
Valuation
I want my investments to double in 5 years, which is equivalent to a 15% annualized growth rate. At its current eps of $2.16 and an expected PE of 25 in five years, the Company will have to grow its earnings by 15% per year to meet my goal. It will have to grow earnings by 11% to match the growth of the S&P 500. Over the past three years, it has grown earnings by 15.79%, so 15% isn't an unreasonable expectation. A growth rate of at least the market rate of return, seems to be highly probable.

At the end of 2002, its PEG was 2.09, which was less than that of its industry (2.15), and of the S&P500 (2.37). Currently, the Yahoo Finance page shows a PEG of 1.38. By all respects, this seems to be undervalued at the moment. When dividends are factored in, adding another 1.78%, the hurdle is lowered even more.

Consider, as well, that Johnson & Johnson meets all of the Rule Maker requirements, with the exception of the Foolish Flow Ratio that I mentioned earlier. That would indicate that this stock should sell at a premium to the market. If I give it a small premium to the market of 33 times earnings, that would put its price at $64.80. I believe that is much closer to its value.


Time Frame
This is a long-term successful company, and could be a very long-term investment. For the near-term, it may take three-to-five years for the market to push it up to a more reasonable price. I'm not sure why this isn't participating in the current bull market, but it is definitely being overlooked. I don't think investors are going to wake up tomorrow and start buying this, so it could very well take three-to-five years and I should purchase it with that time frame in mind.


Risks
Current risks involve legal battles the Company is facing. With a consumer giant in the medical industry, liability cases are likely to be just a part of doing business. Currently, Johnson & Johnson is facing a court battle over a drug produced by a company it purchased. The jury in the case awarded monetary damages, the judge reduced those drastically, but Johnson & Johnson has a very aggressive litigation policy and is seeking complete acquittal in an appeal. The Company fights for its rights, and its capital.

It also faces ongoing patent infringement lawsuits. It has been engaged in a dispute the AMGEN that is being decided in arbitration, which significantly reduces legal costs and punitive damages. As I said above, the Company is legally aggressive, as is a requirement in the medical industry.

Johnson & Johnson does much of its business overseas, so the foreign exchange rate plays a key role in its net margins. However, at this time of a weak dollar, it was determined that taking unfavorable exchange rates into account, the Company's revenues still grew by more than 10% in 2002.

For a drug company, having plenty of drugs in the testing pipeline is a key to survivability. I glanced through the drugs in the Johnson & Johnson pipeline and I was impressed. Remember, that with a company this large, if their own pipeline begins to dry up, they can buy someone else's. This is a strategy they have used successfully in past.

Selling Criteria
Instability in the political arena could drive the price down further, but this should only bring buying opportunities, not selling. If, on the other hand, the price increases at a rate much greater than its historic rates over a short period of time, I may consider taking some profit if I have another promising place to put the proceeds.

As long as the fundamentals remain strong and the business outlook remains promising, this should be a keeper.

Conclusion
I will purchase 100 shares of this stock at the market tomorrow. There will likely be many opportunities to purchase more in the coming months.


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