Selling Johnson & Johnson, JNJ

I follow Warren Buffett's purchases avidly. JNJ, Johnson & Johnson, was a name he bought last year around $60 a share. I was happy to have paid about the same. Today its around $61.25.

Johnson & Johnson endured signficant bad press in 2010 with multiple recalls of a variety of products across the spectrum: Motrin, Tylenal, Arthritis drugs, Benedryl, Rolaids, Hip devices, and on and on and on. The recalls were relentless, and drove the stock down from $70 a share in 2009, to under $50 at one point. Dozens of products were recalled due to manufacturing deficiencies, as they outsource manufacturing and dealt with continued unexplained problems. This bad press seemed temporary though, and very solvable. Combined with the impact of the Healthcare Reform Act, this meant to me that the HC overhang would wear off, and that recalls would end in 2011.

So, not surprisingly, earnings for 2010 (reported today) were weak. EPS was $4.76 a share, (actually not terrible) up from $4.40 the year before on about flat sales of $61BB. The biggest problem was that sales fell 5.5% in Q4 vs Q4 2009, quite a surprise. In Q3, sales year over year were only down 0.7%, with some negative currency impacts. But generally this company has never experienced this kind of negative sales growth, ever. The CEO said, "we will continue to see near term pressure on the business for 2011." Ouch.

But overall, the problem on top of the sales declines is that guidance for 2011 was also very weak. While the Street is forecast about $5.00 in EPS in 2011, the company is guiding to $4.80, just about flat with what they did in 2010. Not terribly impressive.

One problem with giant cap companies like JNJ (with a market cap of $170BB), is that largely they are un-analyzable. They have so many segments, its almost impossible to guage where they are going. Drugs like Remicade and Prezista were strong, but then sales of Topamax and Risperdal are succombing to generic competition and falling 35% and 50% year over year.

But the tone from management on the call was heavy. "Disappointed" and "we are refocusing" and "looking for positive movement" are discouraging. Sales for 2011 are only forecast by management to be up 2-3%. They also reported that regarding the product recalls, its not even over. They anticipate that "80% of recalls are behind us." More bad press to come, more recalls.

Also surprisingly, total consumer sales were down 15%, which is comprised of down 6% internationally and down 30% in the US. Pharmaceutical sales we know are suffering as generic competition ramps up and product pipelines dry up, so I wasnt surprised that sales fell 5.5% there. But then sales of almost every category of consumer products were also falling: skin care, baby care, womens health, wound care. Very discouraging.

Finally, medical device sales were also barely flat. There just is very little to like here, and I suspect this stock will continue to languish in the $60 range, give or take $5 bucks.

It is no secret why Buffet invests. He buys companies with decent FCF yields & Returns on Equity (ROEs), with a "moat" around the business, and businesses you can understand. He would rather pay a fair price for a good company, than a good price for a fair company. On a FCF basis, the stock is reasonably cheap, with $5 in FCF per share last year. That implies an 8.2% FCF yield, and the company pays out much of this cash in the form of dividends. The div yield is 3.5%. Its why I bought it originally.

However, I now question the moat here, especially given their sales declines. Generics and non-branded OTC drug competition are clearly having a big impact. With high unemployment in the US, its cheaper to purchase non-branded over-the-counter medicines then pay full price for the branded. Everyone knows that it's all the same stuff inside. The HC reform act is also impacting sales, hurting topline by 4-5% last year. Doesnt seem that that is ending either. This could easily slip further next year, becoming a drug company like Merck or Pfizer, desperately making large acquisitions with FCF to try to buy topline growth. (they tend to make smaller acquisitions with FCF today).

So, JNJ to me is like owning a bond. I had originally pegged this one at a slight growth type multiple of 14-15x, getting me to a value $70-75 a share, with a $2.16 dividend on top. But with growth drying up, I suspect this could trade between 10 and 12x, which puts it around $50 a share on the downside, with real upside today perhaps in the mid to high 60s best case. Up $6-7 bucks, down $10 bucks. I'll pass.

Regarding what to buy, I could be wrong, but to me it looks like the market is selling JNJ and buying TEVA. TEVA is a pharmaceutical company that focuses on generics. I think its cheap, havent bought it yet, but 10x forward earnings compared to 12x for JNJ, its immediately compelling. To boot, TEVA is sporting 20-25% growth rates as the drug patent cliff continues to hit the branded research focused firms out there. JNJ will perhaps eake out 3% sales growth in 2011.