At the Cyprus Value Investor Conference, I presented Johnson & Johnson as an idea. The most diversified health care company in the world offers a conservative investor reasonable returns with an extremely low probability of loss. Before I go into the details, it is important to give you some background. This idea was for a conservative high net worth client of mine who has a high allocation in bonds and wanted some equity exposure. In general, for conservative investors, I suggest that they should only hold on to high-quality stocks.
Rule No. 1: Never Lose Money.
Rule No. 2: Never Forget Rule No.1
– Warren Buffett –
Some people find the above from Buffett funny or do not think much about it. But if you think about the types of companies Buffett has bought then we understand how and why Buffett has been so successful. Simply, high-quality businesses with a moat that are purchased at a reasonable price are unlikely to result in a loss. Such a company in my opinion is Johnson & Johnson.
The company is not only the largest health care company by market cap ($380bn) but also by sales ($82bn). It trades at 16x 2021 estimated earnings, 12,5x 2021 estimated EBITDA, and a 2,8% dividend yield. The dividend has been increased in each of the last 53 years while the company has had 36 consecutive years of adjusted operating earnings growth. 70% of revenue comes from products that have either the number 1 or 2 global market share, while 26 products have over $1 billion in annual sales. All attractive facts about this powerhouse but the following are the points I find most attractive.
Revenue Diversification
The company operates 3 main divisions: Pharmaceutical (51% of sales), Medical Devices (32% of sales), and Consumer Health (17% of sales).
This ties into the Rule No 1 thesis. JNJ not only makes drugs but also has 2 additional business which provide stability and reduce investors risk. Medical devices in general is a sticky business due to switching costs (in you’re a doctor who is used to a certain instrument and trained in it, then it is unlikely you will easily go for a competitors’ products). Due to JNJ’s size, doctors also know they will get the right support and network. Consumer Health consists of well-known over-the-counter such as Tylenol, Motrin, Benadryl, Nicorette, Imodium, Pepcid, and Sudafed, skin products like Neutrogena and Rogaine, and other known health products like Band-Aid and Listerine.
If we look across the large-cap global pharma space, there are not many companies as diversified as JNJ. The below table shows revenue segmentation as per Bloomberg. As shown, most companies focus on pharma with diversified alternatives (to JNJ) being Sanofi, GlaxoSmithKline, Bayer, and Roche. I scratched Sanofi due to its lower return on capital. Bayer was out due to Roundup litigation risk. There is a potential settlement for $10,9 billion for 95,000 cases but there are 30,000 claims that remain (“Bayer isn’t out of the Roundup Woods as 30,000 Claims Remain”). Investors could be in for a surprise depending on how big the settlements with the holdouts are. Having said that this may already be priced in, however as I outlined at the beginning of this report, we are looking at
“Rule No 1” stocks. I cut Glaxo due to all the shuffling around they are doing with their various businesses. That leaves Roche which honestly looks interesting and worth more work, but it should be noted that the majority of outstanding shares are non-voting.
Within each segment, JNJ is also diversified with the largest sub-categories being immunology (17% of pharma), surgery (12% of medical devices) and beauty (6% of consumer health).
As pharma can be volatile, I wanted to see its contribution to sales. Amongst the top 10 products we can see that 4 drugs make up for 21% of JNJ’s revenues.
Out of the top 5 drugs which essentially account for 50% of pharma, 4 of these are expected to continue to grow and contribute to sales. In 2019, Stelara, Imbruvica, Invega Sustenna, and Darzalex grew 23%, 30%, 14%, and 48% respectively, while only out-of-patent since 2016 Remicade dropped (-18%). This trend is expected to continue as projections for 2021 sales show:
Research & Development
I am not particularly worried about JNJ’s ability to bring new drugs to market due to two facts. Firstly, size matters. JNJ’s research and development expense is higher than every other pharma company except for Roche. The $11,3 billion they spent was the 7th highest among all the S&P 500 companies.
Secondly, JNJ delivers. Spending a lot of money is meaningless if not spent well. In the company’s 10-K, JNJ states what percentage of sales is attributed to new products introduced within the past 5 years. Except for 2016 and 2017 where this percentage dropped to 22%, every other year from 2010 to 2019, new products were 25% of sales.
Returns / Margins
The business has consistently generated double-digit returns on equity and capital for over a decade. The median ROE has been 25% while the median ROIC 21%. Margins are stable with a median gross margin of 69% (with 65-70% over the past decade) and a median EBITDA margin of 31%. 
Capital Allocation
Over the last decade, JNJ’s operating cash flow has been a cumulative $187 billion while the company spent $11 billion on capex, $59 billion on acquisitions, $78 billion on dividends and $48 billion on buybacks. The company has returned $126 billion to investors! If you consider the $45 billion on depreciation and amortization, net new investment is only $25 billion. During that same period, JNJ increased operating profits and EBITDA by $9 and $14 billion respectively.
Battle Tested
During its history, the company has managed to survive numerous crisis. In 1982 every bottle of Tylenol was recalled as seven people died due to tampered bottles. In 2010, 43 OTC children’s medicines were recalled as problems in manufacturing resulted in inconsistent amounts of ingredients. In 2019 baby powder was recalled which led to a decision in 2020 to discontinue its sales in the U.S. and Canada. Note that the entire Baby Care division is only 2% of total revenues, while baby powder is 0,5% of US Consumer Health sales. Finally, there is the outstanding Opioid settlement with States seeking $26.4 billion of which only $5 billion from JNJ. JNJ already set aside $4 billion as mentioned in the 3Q19 conference call while the company has $19 billion in cash and equivalents.
Valuation
I have used a variety of valuation methods and overall, the stock appears to be trading just below fair value, but I do pump up the WACC by an extra 2% for terminal values. If you keep the WACC at 6,42% throughout then the stock does trades at a significant discount to fair value. And that results, even if you assume a conservative growth rate and projected cash flow margins that are below historical (projected FCF margin of 22.4 – 26.3% vs 23.4 – 28.3% over the last 5 years). When I increase my WACC for TV by 2%, fair value is around $163 (that implies a 11x EV/EBITDA for TV). A dividend discount model with growth at 6.3% (similar to recent trends), a 3% perpetuity and 8,42% TV gives a value of $144. (Note that the current forward dividend is $4.04 vs EPS ‘20E of $7,93 and FCF LTM of $6.60). Considering the amount of coverage and information available on the company this should not come as a huge surprise (but as noted I am using conservative projections). Consider however that finding such a high-quality stock trading at even fair value these days is a surprise. More importantly, JNJ will continue to compound for many years to come. Over the last 20 years, the S&P has had an annual return of 6,2% while JNJ has returned 8,4%. That means that $1 in 2000 became $4,05 in 2020 vs only $2,31 for the S&P 500.
2021 and 2022 EPS estimates are $9,87 and $10,57 respectively. Apply a 20x multiple to $10 and you get $200 which over 2 years is a 20% annual return. Even if it takes 3 years then the result is a 13% annual return. Furthermore, any market correction is just an opportunity to increase the future return in JNJ. Let’s say we have a repeat of March 2020 and an investor adds at $110 (for an average cost of around $125) then the 3-year annual return is 17% assuming normalization of conditions. Lastly, a competent trader could even trade around the position.
COVID-19 Bonus?
The company has been working on a vaccine and just begun late-stage studies with 60,000 volunteers. This made the news but isn’t anything new as the company had discussed this. It is the 4th vaccine at this stage but could be huge if successful because unlike the other vaccines JNJ’s only needs one dose and can be stored in a fridge for longer (3 months). The company will be able to kick out 1 billion doses a year. The company has said that “The vaccine will be provided at a global not-for-profit basis for emergency pandemic use”. But that does not mean it will not seek a profit ever. Even if produced at cost initially, it could become the go-to vaccine. That would be highly profitable for JNJ as a stand-alone but also for additional indirect sales of other products. Regardless, my thesis stands, with or without the vaccine drug, but the market is not yet pricing in any vaccine success.
Conclusion
Conservative, low-risk, high-quality company that is ideal for a conservative investor forming a long-term portfolio that will outperform the index over time. A “rule no 1” stock that could surprise on the upside with a COVID-19 vaccine or some other drug. Regardless, the stock pays a consistent dividend (2,8%) which is higher than that of low-risk bonds or treasuries and is expected to continue to compound at a better than market rate for a long-time into the future.
