Johnson & Johnson Staying Healthy

Johnson & Johnson (JNJ) reported earnings this morning that beat expectations and reaffirmed JNJ as a safe harbor in this extremely volatile market. We have been fairly bullish on JNJ for some time but, as of September 27th, we have the stock rated “Greatly Undervalued”, our most bullish rating. We have long admired JNJ’s consistency in growing sales and love the way it is positioned defensively to navigate what could be a difficult investing environment. One thing that shines through in JNJ’s strong earnings is management’s ability to anticipate the future and react accordingly. In this case, JNJ anticipated a tough consumer spending market and initiated a cost cutting initiative, and earnings beat estimates largely because of these efforts.

Johnson & Johnson

Earnings came in at $3.31 billion or $1.17 per share, which beat expectations of $1.11 per share. This quarter a year ago saw earnings of $2.55 billion and $.88 cents after restructuring charges. The strong performance is not only because of cost cutting (restructuring) efforts but also because of solid growth as overall sales climbed 6.4%, 3.1% of that is attributable to favorable exchange rates. Typically, in tough economic times, luxury goods get cut out of personal budgets but JNJ brands like Band-Aid, Neutrogena, Listerine and Tylenol continue to sell well. All in all, the consumer product division increased sales by 13.1% to $4.1 billion. International sales of JNJ’s consumer products grew slightly faster (14.7%) than domestic sales (11.2%). Although, the consumer products division is the smallest of the three segments of JNJ, sales growth like that is certainly notable.

The second largest segment—medical devices—also performed well over the last three months. Despite a large decline (down 22%) in sales of heart stents due to increased market competition, the rest of its medical devices drove overall segment sales growth up 8.8%. This is strong growth from the world’s largest developer and manufacturer of medical treatment and diagnostic devices. However, the results from the company’s largest component, accounting for 44% of sales in 2007—pharmaceuticals—were less than stellar. The company faced increased competition from generics (made by TEVA) as patents expired in June for Risperdal, JNJ’s schizophrenia drug. Also, safety concerns slowed sales of Procrit, which dropped 9.2% worldwide. That being said, this poor performers were offset by strong sales for Zyrtec and Remicade and the segment as a whole nudged upward by .2%.

What does this all mean? For one, Johnson and Johnson’s quarter was a success and they even increased forecast earnings for the year from $4.45-$4.50 to $4.50-$4.53. That is a further demonstration of good leadership, and management has a proven track record of keeping ROE between 17%-21% over the last 10 years. Sales are growing, management is managing, earnings are being revised upward, and the valuation looks appealing as well. Investors should understand that valuations should be taken with a grain of salt in the short term because this market, at least right now, is reflecting mostly a crisis of confidence instead of bad underlying fundamentals. However, with that being said, JNJ’s price-to-sales has historically ranged between 3.0 and 3.9, and is currently only 2.4. Price-to-cash flow is equally enticing as it has historically ranged between 12.93 and 16.71, and price-to-cash flow is currently only 9.55. Were we to see these valuation metrics return to the lower end of their historical boundaries, we would expect a price of $74. So, for investors seeking shelter in a volatile market Johnson & Johnson is taking care of business and looks compellingly valued. As an added bonus it pays a dividend yield (which appears very safe) of nearly 3%.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

We utilize this straightforward approach to value over 5500 securities, with key emphasis given to the study of individual securities' price-to-sales, price-to-cash earnings and other historical valuation ranges. Our long term value investing methodology is powered by the teachings of Ben Graham and it has proven to be very adept at identifying stock prices that are out of line with fundamental factors.

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