Johnson & Johnson (JNJ) was formed in 1886. Over the past one-hundred and twenty-five years, it has produced an enviable record of growth and profitability and has grown into a diversified global giant with three main operating segments: consumer products, pharmaceuticals, and medical devices and diagnostics. 2009 sales were $61.9 billion with operating profits of $16.6 billion. JNJ is one of only four companies that have an AAA credit rating – the others are ADP, Exxon and Microsoft.
Operating profits have tripled over the past decade but the stock price has made relatively little progress given its high multiple at the beginning of the decade. This has caught the attention of numerous value investors who have taken large positions in the stock. Major holders include Warren Buffett, Prem Watsa, Donald Yacktman and Tweedy Browne. As a frame of reference, Buffett’s basis in the stock is just over $60.00 per share.
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JNJ has grown operating earnings at a CAGR of 5.5%, 8.5% and 9.6% over the past 5, 10 and 15 year periods, respectively. Although growth has slowed in the United States and Europe over the past five years owing to the recession, sales in the Asia-Pacific, Africa region have grown at 11.2% and sales in the Western Hemisphere, excluding the U.S., have grown at an accelerating 14.8%. This growth in developing regions bodes well for JNJ and should provide a long-term growth platform. JNJ should also benefit from an aging population and above-GDP levels of growth in the healthcare sector, although increased regulation may have a dampening effect in the U.S.
Here is the basic historical data and growth rates over the past 5, 10, and 15-year periods.
Leading pharmaceuticals companies have also experienced margin compression because of investor concerns over patent expirations. These concerns may prove to be overblown in the long-term as, according to Morningstar analyst Damien Conover, CFA, JNJ has, “Nine potential blockbusters in late-stage development or recently approved.” Of course, handicapping pharmaceutical blockbusters is a tricky business, even if you have considerable industry expertise. Nevertheless, JNJ has a superlative track record of innovation and spends approximately $7 billion annually on research & development.
Unlike other leading pharmaceutical companies, JNJ is well diversified with over $10 billion in operating profits coming from its two non-pharmaceutical divisions, consumer products and medical devices & diagnostics. There is evidence that JNJ operates with a strong durable competitive advantage: per Value Line, return on equity over the past ten years has ranged between 24.3% and 30.1%, with almost no leverage.
Since 2000 through 2009, JNJ added $31.8 billion in equity while growing after-tax profits by $8.1 billion for a strong 25.5% return. This is even more noteworthy because the acquisition of Pfizer’s Consumer Healthcare business in 2006 resulted in $6.6 billion in goodwill and $8.9 billion in intangible assets.
The next step is to attempt to value JNJ. Following Seth Klarman, I’m going to look at JNJ in a couple different ways and subject these valuations to sensitivity analyses. Today, I’ll be doing a simple discounted cash flow. In the next installment, I’m going to do an exercise suggested by Warren Buffett. Buffett, who is a big fan of Value Line, has said that what he is trying to do when he values a business is determine what Value Line will look like in ten years. In my judgment, Buffett would only perform this exercise with businesses where he has a high level of certainty about their future earnings.
Discounted Cash Flow Analysis (DCF)
This approach is the theoretical framework followed by Buffett who derived it from the economist John Burr Williams. The discounted cash flow of a business comprises its intrinsic value. Here’s what Buffett says about it in the Berkshire Hathaway Owner’s Manual.
“Let’s start with intrinsic value, an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.
The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures. That is one reason we never give you our estimates of intrinsic value. What our annual reports do supply, though, are the facts that we ourselves use to calculate this value.”
To the best of my knowledge, it is not known precisely how Buffett performs this calculation. Charlie Munger has said that he has never seen Buffett perform a discounted cash flow computation.
Some prominent value investors, such as Bruce Greenwald of Columbia University, object to the use of discounted cash flow analyses because of the large portion of total earnings that is contained in the terminal portion of the calculation, which attempts to capture earnings in the very long term. They argue that this simply cannot be done with sufficient precision to make it useful.
At least two approaches are used to deal with this objection. First, only use very conservative assumptions and second only perform this calculation with companies that have superior earnings visibility into the distant future. An example of this type of company is Coca-Cola: a hundred-year plus track record, evident durable competitive advantages, and growth prospects far into the future (Coca-Cola accounts for less than 3% of worldwide beverage consumption). I believe JNJ’s track record, economics and future prospects put it in this category.
How Longleaf Partners Does It
In the first DCF, I’m going to follow the general approach used by Mason Hawkin’s partner Staley Cates at Longleaf Partners as disclosed in an email exchange between Cates and an investor.
According to Cates, Longleaf projects 8 years worth of free cash flows, which I understand to equate to Buffett’s “owner earnings”: reported earnings plus depreciation and other non-cash charges less capital expenditures. For JNJ, I’ll use reported earnings as, historically, depreciation and cap-ex have been roughly equal.
To be conservative, Cates also uses a terminal multiple that assumes no growth after year 8. The no-growth terminal multiple is tied to the discount rate used. For example, if you use a 10% discount rate, a no-growth terminal value is 10x. (Value = Earnings / Discount Rate.) If you use a 7% discount rate, the no-growth terminal value jumps to 14x.
In the example, I assume book value per share of $21.60 (Value Line’s estimate for 2010) and a 23.5% ROE which produces year 1 earnings of $5.08 (consensus estimates for 2011 per Marketwatch are $5.07).
Following its historical practice, I assume that JNJ will payout 70% of its earnings in the form of dividends and share repurchases, which will produce a growth in equity and earnings of approximately 7% (ROE of 23.5% x 30% of earnings reinvested = 7%). (Since 2000 through 2009, JNJ added $31.8 billion in equity and produced $89.7 billion in net profits. From this you can see that approximately 30% of profits were reinvested in the business in the form of equity.)
Also, for the record and to be conservative, 23.5% is the lowest ROE earned in the past decade.
Using a 7% discount rate produces an intrinsic value of $105 per share which would imply a 43% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $71 per share, which would imply a 15% discount at a share price of $60. The 7% discount rate is lower than many analysts would use but is closer to Buffett’s approach.
Here’s the data.
Buffett favors using the interest rate on long-term government bonds as his discount rate, and he has said that he will use a slightly higher rate when these rates are particularly low. He believes it is mistaken to compensate for risk by using a higher discount rate. Instead he limits himself to only investing in situations where he is highly certain and has a margin of safety.
In the second two examples, I use the same two discount rates, but, instead of using a no-growth terminal multiple, I project earnings out 10 years and assume that, after year 10, earnings will grow in perpetuity at 3%. In this case, using a 7% discount rate produces an intrinsic value of $167 per share which would imply a 64% discount at a share price of $60. Using a 10% discount rate produces an intrinsic value of $91 per share, which would imply a 34% discount at a share price of $60.
Here’s the data (use the second tab “7% Growth 3% Terminal Growth” at the top of the page)
Of interest is that all four models produce an intrinsic value for JNJ that is higher than its current share price – in some cases, materially so.
In addition to being undervalued, JNJ looks to be in a position to grow intrinsic value in the mid to high single digit range, while simultaneously paying a generous dividend (currently over 3%) and buying back shares. The result should be a satisfactory total return.
In the next installment, following Buffett, I’ll attempt to project what JNJ’s Value Line sheet will look like in ten years.
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