A Member of Pat McKeough’s Inner Circle recently requested his opinion on one of the best known consumer stocks in North America.
Johnson & Johnson gets almost half of its revenue from its pharmaceutical business. Investors can underestimate the risk of drug stocks, says Pat, due to the high costs, regulatory hurdles and fierce competition. On the other hand, the long-term outlook for the company remains positive: it trades at around 15 times forecast earnings and has raised its dividend for 55 consecutive years.
Q: Dear Pat: Johnson & Johnson seems to be a widely recommended stock. Please, may I have your analysis?
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A:JOHNSON & JOHNSON (symbol JNJ on New York; www.jnj.com) operates through three major businesses:
Pharmaceutical (47% of revenue) makes anti-infective, antipsychotic, contraceptive, dermatological and gastrointestinal drugs;
Medical devices and diagnostics (35%) sells equipment for joint reconstruction and managing circulatory diseases;
Consumer (18%) makes over-the-counter products such as Johnson’s baby-care items, Band-Aid bandages, Tylenol and Motrin painkillers, Listerine mouthwash and Neutrogena skin cream.
Johnson & Johnson’s revenue rose 4.2%, from $71.3 billion in 2013 to $74.3 billion in 2014. Revenue dropped 5.7%, to $70.1 billion in 2015 before rising 2.6% to $71.9 billion for 2016. In 2017, revenue rose again, by 6.4% to $76.5 billion.
Johnson & Johnson’s earnings per share rose 18.5%, from $4.81 in 2013 to $5.70 in 2014. Profit then slipped 3.9% to $5.48 a share in 2015 before rebounding 8.2% to $5.93 in 2016. In 2017, earnings per share were only $0.47 due to a $13.6 billion charge associated with the new U.S. tax legislation. However, excluding that charge and all other unusual items, earnings per share rose 8.5%, to $7.30 per share in 2017, from $6.73 per share in 2016.
In June 2017, Johnson & Johnson paid $30 billion in cash to acquire Actelion Ltd., a Swiss biotech company best known for its drug therapies to treat high blood pressure.
As part of the agreement, Actelion spun off its research & development business. Idorsia Ltd., now trades on the Swiss stock exchange. Johnson & Johnson has held on to 9.9% of that new firm and the former parent also has the option of buying an additional 22.1% stake.
Growth stocks: Research spending rises 16% year over year
Johnson & Johnson continues to spend heavily on research and development. In 2017, it spent $10.6 billion (13.8% of total revenue) on research. That’s up 16.0% from $9.1 billion (12.7% of total revenue) in 2016.
The company’s balance sheet is strong: its long-term debt of $30.7 billion (on December 31, 2017) is just 8% of its market cap. It also holds cash of $18.3 billion.
We’ve always felt that many investors underestimate the risk of drug stocks, and overestimate their potential. They also overlook the huge costs drugmakers face in creating a new product and gaining regulatory approval for it. Investors are just as likely to overlook the limited time that drugmakers have to recoup their investments before a patent expires or a better drug comes along.
As well, many consumers now opt for cheaper store brands over the kind of name-brand products Johnson & Johnson sells. That requires the company to spend more and more heavily on marketing.
Moreover, big acquisitions, such as Actelion, may come with hidden problems that can delay the expected benefits.
Still, the long-term outlook for Johnson & Johnson is positive. The company will probably earn $8.10 a share in 2018. The stock trades at 15.6 times that estimate. The $3.36 dividend yields 2.5%. Johnson & Johnson has increased its payout annually for the past 55 years.
Inner Circle recommendation: Johnson & Johnson is okay to hold.
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