Wednesday, July 31, 2013

Johnson & Johnson Looks Fairly Valued

Investors in health-care giant Johnson & Johnson (NYSE: JNJ) have been rewarded with a 30% share price rise in the last year. The health-care giant remains a go-to choice for investors seeking a relatively recession-proof stock with a decent dividend. However, investors need to ask themselves a few questions about its recent results: Can this share price run continue?  Does Johnson & Johnson still provide compelling value?  And what are the key takeaways for the healthcare industry from these results?

Johnson & Johnson delivers

The argument for buying Johnson & Johnson is based on the fact that its three big near-term factors depend on how its management performs, rather than purely on the economy. This means that the stock can appreciate even in a weak economy.

First, Johnson & Johnson has been trying reintroduce a number of over-the-counter (OTC) products that were taken off the U.S. market due to production issues. Second, its pharmaceutical division has several new drugs with which it can develop sales. Finally, the successful integration of orthopedic company Synthes in its medical devices and diagnostics division will create earnings growth in a weak medical spending environment.

A checklist of these three factors would conclude that the company is well on track.

The company's plan to reintroduce 75% of those lost consumer brands by the end of 2013 was confirmed in its recent second-quarter results.  U.S. OTC sales were up 17.4% in the quarter, and although they only currently compose 7.9% of total consumer sales, the marginal increases in sales and profits will make an impact in future quarters.

Furthermore, its pharmaceutical division has delivered strong performance, with a 12.9% rise in constant-currency sales in the quarter. The standout performers within pharmaceuticals included newer drugs like Stelara (psoriasis), Incivo (hepatitis C), Xarelto (anti-coagulant), Invega Sustenna (anti-psychotic) and Zytiga (castration-resistant prostate cancer), all of which recorded sales growth at around 50% or more in the quarter.  In addition, its biggest drug, Remicade (rheumatoid arthritis), which contributes nearly 24% of its pharmaceutical sales, saw sales rise an impressive 10.3% in the quarter.

Lastly, the Synthes acquisition is working well. Indeed, J&J's overall growth in the medical devices and diagnostics sector was 12% in constant currency, largely thanks to Synthes.  Excluding the acquisition, the division would have reported sales growth of just 0.5%. It’s clear that the acquisition is helping Johnson & Johnson generate growth within a difficult part of the health-care industry.

It’s all in the price

The problem for investors wanting to buy in is that the market now seems to have priced these three factors into the share price. Compare Johnson & Johnson's price-to-cash flow multiple with its price chart:

JNJ Price to Cash Flow TTM data by YCharts

The stock hasn’t traded on a price-to-cash flow multiple of around 20 since 2005-2007. A cursory glance at the chart would reveal that the share price struggled to appreciate in that period. On the basis that it currently trades on that valuation, I would argue that much of the good news is already priced into the stock. Furthermore, analysts have earnings growing in only the mid-single digits for the next two years, and I’m not sure I’m keen to pay 24.5 times earnings for that kind of growth profile.

Winners and losers from Johnson & Johnson’s results

It’s always fascinating to read between the lines of Johnson & Johnson’s results and pick out indicators for other companies’ prospects. On the positive side, investors in eye-care specialist Cooper (NYSE: COO) will be interested to hear that Johnson & Johnson recorded 5.4% operational growth in its worldwide vision care business, and specifically cited daily lenses as an area of growth.

This indicates strength within the eye-care market, and should be good news for Cooper Companies, since one of its key aims in 2013 is to increase its one-day modality sales. Cooper’s one-day lenses generate three to five times more profit than its monthly lenses. Moreover, it is more of a pure-play on the increasing popularity in one-day lenses, because it doesn't sell lens-care solutions.

On the other hand, two losers from this report could be medical device company Covidien (NYSE: COV) and radiation oncology specialist Varian Medical Systems (NYSE: VAR).

Covidien has generated much of its growth in recent years from surgical device appliances within its energy and endo-mechanical divisions. Indeed, it’s a leader in the minimally invasive surgery market. Covidien’s supporters (and I’m one of them) will always point out that its solutions are relatively low-ticket, and they demonstrate a tangible way for hospitals to reduce costs via achieving better patient outcomes.

On the other hand, Covidien is still exposed to the volume of surgical procedures in medical centers, and in its conference call, Johnson & Johnson outlined that hospital and surgical procedures are flat to negative.

Turning to Varian Medical Systems, this company definitely is a high-ticket solution provider, and could suffer disproportionately if there is a buyer’s strike in the hospital and medical center market. There is a SWOT analysis of the company in an article linked here which outlines its prospects for 2013. Johnson & Johnson talked of the negative impact of macroeconomic conditions on its medical device sales, and robotic surgery appliance manufacturer Intuitive Surgical (another high-ticket solution provider) has already disappointed in this earnings season.

Moreover, in its conference call, Johnson & Johnson described the hospital capital expenditures market as being in recession for 10 to 12 consecutive quarters. All of these events are signs that Varian may find its customers more reluctant to spend in 2013.

The bottom line

Johnson & Johnson has pretty much priced in most of the good news, and it’s hard to see how the stock can appreciate much from here. The stock has had a great run, but now it’s time to wait for a pullback.