Johnson & Johnson Is Overvalued

In this article, I take a look at Johnson & Johnson (JNJ), a diversified healthcare company. We are going to evaluate it as an equity investment. In other words, we're going to examine the industry, the company's financial statements and the valuations.

Industry

Typically, healthcare companies are non-cyclical. The companies typically have stable cash flows and high dividend yields. Drug firms and medical device firms have, historically, created value for investors. Their return on invested capital has been higher than their weighted average cost of capital. The industry typically has high barriers to entry. For drug manufacturers, there is the threat of substitute products when their proprietary drugs are off patent. Initially, their customers don't have much, if any, bargaining power. And the industry typically isn't supplied with unionized labor. The suppliers of labor don't have much, if any, bargaining power.

Pharmaceuticals and medical devices are mature industries with little or no growth, industry consolidation and high barriers to entry. Industry growth is limited to replacement demand and population expansion. The companies should have brand loyalty and efficient cost structures. The industry usually avoids price wars. Companies in the industry with superior products or services are likely to gain market share and experience above-industry-average growth and profitability. However, the industry does face a potential threat from biotech.

Rating System

• Buy - Be long
• Neutral - No position
• Sell - Be short

(The ratings, research and analysis in this article should be considered as a starting point for further research.)

Johnson & Johnson - Buy (Reduce Exposure)

Financial Position and Performance

Compared to the end of the fourth quarter, cash declined 42.8 percent to $14.04 billion. Marketable securities declined 62.8 percent to $10.99 billion. Total current assets decreased 23.4 percent to $41.6 billion. Intangible assets increased 61 percent to $29.2 billion. Goodwill increased 32.7 percent to $21.41 billion. The change in total assets was 1.9 percent to $115.75 billion.

Loans and notes payable declined 9.3 percent to $6.04 billion. Accounts payable declined 10.1 percent to $5.14 billion. Accrued liabilities increased 41.8 percent to $6.53 billion. Accrued rebates, returns and promotions increased 12.2 percent to $2.96 billion. Total current liabilities increased 4.5 percent to $23.85 billion. Johnson & Johnson became less liquid during the second quarter. Total liabilities declined 2.2 percent to $55.32 billion. Johnson & Johnson remains solvent and liquid. Total shareholders' equity increased 5.9 percent to $60.43 billion.

In 2012's second quarter, sales, compared to 2011's second quarter, declined 0.7 percent to $16.48 billion. The gross profit margin remained the same at 68.8 percent of sales. There was a $2 billion other expense in 2012's second quarter. Net income declined 49.3 percent to $1.41 billion. Dividends per share were more than earnings per share. The dividend increased 7 percent compared to the year-ago quarter. The comprehensive loss was $256 million in 2012's second quarter. That compares with comprehensive earnings of $3.61 billion in 2011's second quarter.

In the first six months of 2012 earnings were high quality. Johnson & Johnson didn't generate enough cash from operations to cover cash used in investing activities. The company spent just over $17 billion on an acquisition. Further, the company spent $4.6 billion on financing activities. Most of the money spent on financing activities was on dividends and the retirement of short-term debt. The cash balance decreased by $10.5 billion.

Business segments

Consumer segment sales declined 4.6 percent in the second quarter. That follows a decline in the first quarter of 2012. Both are compared with the year-ago quarter.

Pharmaceutical sales increased 0.9 percent in the second quarter. That follows an increase of 1.2 percent in the first quarter. Both are compared with the year-ago quarter.

There was a 93.3 percent decline in sales of Levaquin/Floxin in the first quarter compared with the year-ago quarter. In the second quarter, sales declined 92.4 percent. The decline in sales was due to the loss of market exclusivity in the US. The decline in sales of Levaquin/Floxin seems to be an extreme case of a decline in sales caused by a loss of market exclusivity. However, the decline in sales highlights the risk of pharmaceutical products losing market exclusivity. Also, sales of Doxil/Caelyx declined 86.6 percent in the second quarter compared to the year-ago quarter.

Medical devices and diagnostic sales were flat in the first quarter compared with the year-ago quarter. In the second quarter, medical device sales declined 0.1 percent. Both are compared with the year-ago quarter.

Legal Risks

In terms of legal risks, Johnson & Johnson faces legal risks that management claims are immaterial over the long term. A case involving the off-label promotion of Risperdal includes civil and criminal charges levied against the company. The sum of legal risk is material, given the totality of ongoing legal proceedings. A rough estimate of the quantity of legal risk facing the firm is $2-$10B+.

Click to enlarge

Johnson & Johnson may have had tighter credit policies for customers in the third and fourth quarters of 2011. There is a spike in fourth quarter receivables turnover - which is indicative of tighter credit. In the first and second quarters of 2012, credit policies returned to normal.

Revenue and revenue-share have been increasing: the increase is considered bullish.

Book value-share flattened out recently. I would consider this a neutral indication.

Pharmaceutical sales are increasing: that's bullish for shares of Johnson & Johnson.

The price-sales valuation metric is peaking. It is possible to interpret the indicator as suggesting Johnson & Johnson is overvalued. Additionally, I'm not going to suggest shorting the stock, but I would look for a dip in the $66 to $63 zone and then a retest of the $69-$70 zone.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.