Rule #1 Analysis Blitz #1: Johnson & Johnson (JNJ)

The first blog post of my Rule #1 Blitz will be on Johnson and Johnson (Ticker: JNJ), the pharmaceutical/consumer products company with which pretty much everyone on this planet is familiar.  Its more well known products include Tylenol, Band-Aid, Aveeno, Neutrogena, and Johnson's Baby products.  The company has been around for over 100 years, employs more than 100,000 people worldwide, has over 230 subsidiaries, and boast of 47 consecutive years of dividend increases.  In short, this company is no joke!

Moat
So, without further ado, let's jump into our Rule #1 analysis of JNJ (download my spreadsheet here)!  Let's first look at the moat of the company, which is the first of the 3 Ms.  As I briefly stated above, JNJ is a well known company and has a tremendous brand moat.  To evaluate its moat on a quantitative basis, we look at the Big 5s and its debt.  The Big 5s include return on invested capital (ROIC), sales or revenue growth, earnings per share (EPS) growth, book value per share (BVPS) growth, and free cash flow growth.  We want all of those numbers to be 10% or greater.

From the summary chart below, we see that ROIC, BVPS growth, and free cash flow growth are green everywhere - looks good.  A few yellow and red flags are raised in sales and EPS growth.  Let's dig a little more. We see that last year's sales and EPS actually decreased from the previous year.  The year 2009 was not exactly a stellar year for the economy; so, we'll let that go.  The 5-year average numbers look a little better, with sales growth at 5.5% and EPS growth at 9.9%.  I think EPS is just fine, but sales growth seems a little sluggish.  Going back a few more years, the 9-year average for sales growth is 8.7%, which is sufficiently close to the 10%.  The time to pay back its debt with its cash flow is 0.6 years.  Anything under 3 years is fine.  So, this looks fairly good.  I'm not overly concerned about its sales and EPS growth numbers.  We just need to be a little cautious and keep our eyes open.

Moat Score: 7 / 10

Figure 1: Rule #1 Analysis of Johnson and Johnson (JNJ)

Margin of Safety

So, JNJ's moat has a conditional pass.  The remaining 3Ms are meaning, management, and margin of safety.  Meaning and management are qualitative.  Let's continue with margin of safety.  From the figure above, under Sticker Price, you will see what the intrinsic value (or sticker price) is, as calculated by the Rule #1 methodology.  The trailing-twelve-month (ttm) EPS was $4.82.  The growth number used was the lower of the estimated EPS growth and the historical BVPS growth, which was 6.3%.  The price-to-earnings (PE) ratio used was the lower of historical PE and PE estimated from EPS growth, which was 12.6.  Using these numbers, the sticker price was calculated as $27.65.  With a margin of safety of 2, the entry price is $13.83, which is 50% of $27.65.  The share price is $63.88 (at time of writing), which is more than double that of the intrinsic value!  To be fair, we used a fairly low growth number of 6.3%.  So, I went back to my spreadsheet and played with the number a little bit.  Even if we assumed 15% growth, the entry price would still be $31.81.  This stock is waaay overpriced!  If you think about it, it makes sense.  The global economy is still in shambles, and so investors will flock to defensive stocks like J&J.  Further, J&J is a well known and established company.  It will be rare that it will be undervalued by much and go unnoticed.

I'll include a blurb about Payback Time here...at 6.4% annual EPS growth, it'll take 9.6 years for the EPS to accumulate to its present share price.  I'd say it's a little on the high side for you to consider accumulating JNJ stock.

Margin of Safety Score: 1 / 10

Management
Next up is management.  How do you know management (i.e. CEO) is good?  Most of the time, you really can't tell.  However, there are some clues that help us decide.  First and foremost, how are the financials?  Let's face it, businesses exist to make money.  If the CEO can't make money for the company, there's something wrong.  From the Moat section above, he's not doing a bad job.

Second, let's look at his personal interest in the company.  We want to see vested interest, which means stock ownership.  You can find that information on Yahoo Finance easily.  Mr. Weldon owns 259,360 shares of the company stock, approximately $16 million worth.  We can also see what his recent transactions were.  In the past couple of years, Weldon had not made a single large purchase of J&J stock.  That's not a particularly bad sign, but it's not a good one either.  If I knew the company I'm running is going to make lots of money, I'm going to put more money into the company.  His most recent transaction occurred in September, where he exercised his options to purchase 238,100 shares at $50.69, and immediately after, sold it for $58.49 on the open market.  From that transaction, he made about $2 milllion.  Maybe he needed money to buy a mansion, who knows?  But it doesn't exactly give me confidence in him.  It seems like what he did was cashing out.

Management Score: 5 / 10

Meaning
Phil Town explains that a company must have meaning to an investor if he were to invest in it.  What is exactly meant by "meaning"?  It's not simply, "I like the company", type of meaning.  Rather, one needs to understand its business on a high-level and be able to identify the various issues that surrounds the business.  For example, I own First Solar (ticker: FSLR) stock.  It has meaning to me because i) I believe in renewable energy and that it will replace oil as the world's main energy source, ii) I understand First Solar's technological and business strengths compared to other solar players (i.e. its low cost thin film technology and vertically integrated business model), and iii) I am genuinely interested in this sector such that I don't mind reading up on developments on a daily or weekly basis.  It needs to interest you so that keeping up with the latest developments is not a chore.  It should be homework that you enjoy doing!  Therefore, I can't do this analysis for you.  I don't know whether J&J has any meaning to you, but for me, I think it is too diversified of a company for the typical investor to truly understand.  Unless you've worked in the industry before and have a breadth of knowledge, it may be wise to stay away from J&J.

Now, since this is a Catholic investing blog, I wanted to make this section also ethically oriented.  Is this an ethical company?  It is likely that you have heard about the drug recalls that J&J had issued in the past year.  As a result, a number of plants were shut down temporarily and millions of bottles of medication were recalled.  Drug recalls are not uncommon in the pharmaceutical industry, but the way J&J handled the recall was less than ethical.  It was discovered that J&J had hired a contractor to secretly go into retail stores and buy up all of the problematic Motrin products.  This has been dubbed as the "phantom recall".  This action, in my opinion, is absolutely unethical.  Not only were the well-being of consumers jeopardized in the first place, J&J would not assume responsibility and issue a proper recall.

Other ethical issues include i) animal testing, ii) the Propulsid case in the 90s, where hundreds of people died as a result of taking this drug, many of whom were infants, iii) the Ortho Evra "contraceptive", which is in part an abortafacient.  And the list goes on...As I've said before, most pharmaceutical companies will likely have products that, in some way, violates our ethical standards.  I'm not saying that there is no ethical pharma company out there, but it would take a long time to sort through all of them.

Meaning Score: 3 / 10

Summary
So, let's summarize the scores...

Moat Score: 7 / 10
Margin of Safety Score: 1 / 10
Management Score: 5 / 10
Meaning Score: 3 / 10
OVERALL (not an average): 2 / 10

J&J scored badly in the Meaning and Margin of Safety areas.  I believe those two alone should deter you from investing in it.  J&J's numbers aren't bad, but cannot in anyway justify your purchase of its stock!