Tuesday, April 15, 2008

Johnson & Johnson Overview

Let's begin with a ten year operation history for Johnson & Johnson:


The company has a long history of double digit growth, with sales growing annually over the last 10 years at 10.5%, and operating income at an even faster 11.95%. It generates tons of free cash flow that is really "free". It has a great position in the worldwide health market, meaning it can benefit from the falling US dollar. Finally, it is a 4 trillion dollar per year industry which is bound to keep growing.

But can we show it is cheap? I think you can if you look at the breakdown of their businesses:
(*these are operating incomes)

There are three segments: Consumer, Medical Devices, and Pharmaceutical. The first two are solid businesses with great brands. For example, the Consumer brands include Band-Aid, Listerine, Neutrogena, Aveeno, and Nicorette. And 80% of the Medical Division's products are number 1 or 2 in their markets. These are also stable and consistently growing businesses:

Then you have the Pharmaceutical business, with 2007 Operating Income of $6.5 billion. My understanding is this industry has been heavily discounted because analysts have become nervous about expiring patents and the limited possibilities for new breakthrough drugs. Now, I don't claim to have any insight or expertise with regards to their actual drug pipeline. But I do know that of the company's 2007 Research & Development expenses of $7.7 billion, $5.3 billion was for the Pharmaceuticals segment. So, if you applied a rich multiple to the company's Consumer and Medical divisions, and then assume that the Pharmaceutical business stopped research and was simply "ran-off", then you can likely justify Johnson and Johnson's current price. ( 185 billion) And their Pharmaceutical business, with its large resources and the abundance of human capital in its employees, is likely worth much more than a "run-off" type scenario.

5 comments:

Vivek said...

"So, if you applied a rich multiple to the company's Consumer and Medical divisions, and then assume that the Pharmaceutical business stopped research and was simply "ran-off", then you can likely justify Johnson and Johnson's current price. ( 185 billion)"

Could you explain this in detail please? I lost you on this point..

Ilan said...

It is not clear management would just 'run off' the pharma division.. they may continue to invest in R&D, which may actually destroy shareholder value if the pipeline is not replenished..

Nnejad said...

Hi Vivek, what I meant was you could just cut off all research expenses today, and run the existing pharma business until patents expire and there is nothing left. (Similar to when an insurer enters into "run-off", and stops existing new business and winds up its remaining claims.)

I was looking at this as a sort of worst case scenario proxy. Johnson and Johnson employs over a hundred thousand people who are highly educated and skilled. They can collaborate and bounce off ideas with each other, helping them build their "human capital". A dollar invested in such an enterprise should be able to utilize this to generate positive returns. So a run-off situation to me seems very pessimistic.

Of course, it could cut both ways. Someone else can argue that their size has lead to bureaucracy and is ruining the company. Ilan is right ; the VERY worst case scenario would be for them to continue investing in research and coming up with nothing, destroying shareholder value in the process. Perhaps understanding how research dollars are granted/spent along the process would help in understanding how likely that is. I'll ask a relative of mine to see if he can provide any insight on the matter.

Home Theater said...
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TV Digital said...
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