JOHNSON & JOHNSON, INC. (NYSE: JNJ) March 8, 2011 Winter JNJ.pdf · JOHNSON & JOHNSON, INC. (NYSE:...

JOHNSON & JOHNSON, INC. (NYSE: JNJ) March 8, 2011

Investment Thesis Johnson & Johnson appears slightly undervalued based on fundamentals and multiple valuations. The uncertainty surrounding the implementation or modification of “health care reform” warrants a cautious approach to the sector and Johnson & Johnson, however. We believe a HOLD rating is justified given Johnson & Johnson’s global diversification of sales, late stage drug pipeline, current demographics and current dividend yield.

Investment Summary Growth Catalysts Risk Factors

Deep Pharmaceutical Pipeline

Aging Demographics

Strategic Acquisitions/Partnerships

Emerging Markets

Unfavorable FDA Rulings

Health Care Reform Uncertainty

Patent Expirations

Pricing Pressures

1 YR Chart

Current Recommendation HOLD Price $60.40 Target Price $68.00 Projected Return 12.6% SIM Position 3.9% Sector Health Care Industry Pharmaceutical Analyst Todd D. Yaross [email protected] 614.499.4340

Summary Financial 52-Week High

$66.20

52-Week Low $56.86 Shares Outstanding (mil) 2,788.8B Market Capitalization ($mil) $163.8B Dividend Yield (%) 3.6% Beta .58 Trailing P/E 12.7 Forward P/E 12.8

EPS/Revenue Data and Projections 2010 2011(e) 2012(e) Revenue 61,587 64,122 65,847 EPS 4.78 4.97 5.25 Estimate

High - 4.90 5.29 Low - 4.80 4.93

Johnson & Johnson, Inc. focuses on the research and development, manufacture and sale of pharmaceutical, medical, and consumer related healthcare products. Johnson & Johnson is an international diversified health care company that operates as 3 separate business segments: Consumer, Pharmaceutical, and Medical Devices & Diagnostics. For the full year 2010, these segments contributed 24%, 36% and 40% respectively to the company’s top line revenue.


Table of Contents Company Analysis ........................................................................................................................................ 3

Corporate Strategy ........................................................................................................................... 3

Segment Analysis ......................................................................................................................................... 5

Consumer ......................................................................................................................................... 5

Medical Devices ............................................................................................................................... 5

Pharmaceutical ................................................................................................................................ 7

Sector Outlook ................................................................................................................................... 7

Regulatory Risk ................................................................................................................................ 7

Demographics .................................................................................................................................. 8

Financial Analysis ......................................................................................................................................... 9

Profitability Analysis......................................................................................................................... 9

Liquidity Analysis .............................................................................................................................. 9

Income Statement Projections ...................................................................................................... 10

Valuation Analysis ...................................................................................................................................... 10

Equity Valuation: Absolute Ratio Valuation Model ....................................................................... 10

Equity Valuation: Discounted Cash Flow Model ............................................................................ 11

Sum of Parts Analysis ..................................................................................................................... 12

Investment Thesis ...................................................................................................................................... 12

Catalysts ......................................................................................................................................... 12

Risks ............................................................................................................................................... 12

Summary ..................................................................................................................................................... 13

Recommendation ........................................................................................................................... 13


Company Overview

Johnson & Johnson, Inc. (sometimes referred to as Johnson & Johnson or the company) is a diversified

health care company engaged in the research, development, manufacture and sale of a diverse array of

medical, pharmaceutical and consumer related products internationally. Johnson & Johnson employs

approximately 114,000 employees through its holding company as well as its 250 operating subsidiaries.

Johnson & Johnson operates internationally through three distinct business segments: Consumer,

Pharmaceutical and Medical Devices and Diagnostics (MD&D). A detailed analysis of each business

segment is presented below.

Corporate Strategy

Johnson & Johnson is a rare breed of companies that can be considered a defensive growth company.

The company follows a 4-pronged growth strategy: it places a significant emphasis on maintaining brand

equity in the Consumer segment; it invests substantial resources in research and development (R&D)

activities in the Pharmaceutical and MD&D segments; it participates in strategic partnerships and

acquisitions; and, it penetrates emerging growth markets. The company’s iconic brands in the Consumer

segment serve as an anchor and position the company for success in declining and expanding economic

cycles. On the other end of the spectrum, however, is the company’s tremendous innovation in the

Pharmaceutical and MD&D segments. Johnson & Johnson invests a significant amount of capital on

R&D, which has resulted in a promising pipeline of drugs and medical devices and will serve as a catalyst

for growth. Another key element of the company’s growth strategy is international expansion.

Research & Development: Johnson & Johnson invests a significant portion of its resources in R&D

activities. These R&D expenditures relate to the development of new products, the improvement of

existing products, technical support of existing products and compliance with governmental regulations

for the protection of consumers and patients. The company has demonstrated a commitment to

investing in R&D with the aim of delivering high quality and innovative products. Johnson & Johnson

invested $6.8 billion, or 11.1% of sales, on R&D

in 2010.i

Johnson & Johnson’s emphasis on R&D has

enabled it to capture a leadership position

relative to its competitors. New products

introduced within the past five years accounted

for approximately 25% of 2010 sales.ii Further,

Johnson & Johnson leads the pharmaceutical

industry in U.S. sales generated from 2009-10

product launches. Figure 1 shows sales from

2009 and 2010 product launches through

Rank Company Sales

1 Johnson & Johnson 844.5m 2 Pfizer 762.7m 3 Sanofi‐Aventis 345.9m 4 Novartis 322.0m 5 Takeda 307.3m 6 Cephalon 296.9m 7 Galderma Labs 249.8m 8 Novo Nordisk 226.8m 9 Genzyme Corp 179.7m

10 GlaxoSmithKline 179.4m Source: IMS Health, National Sales Perspectives, Dec 2010

Figure 1


December 2010. Continued investment in R&D will solidify the company’s position as a market leader

and will assist in the development of new and additional products, which will enable the company to

sustain continued growth.

Strategic Acquisitions and Partnerships: In addition to its organic growth generated from brand equity

and innovation, Johnson & Johnson continues to pursue strategic acquisitions and partnerships. Such

strategic ventures increase the company’s revenue, diversify its product lines and enhance its existing

drug portfolio and pipeline. In 2010, Johnson & Johnson acquired certain businesses for approximately

$1,269 million.iii Figure 2 presents a summary of the company’s key strategic acquisitions and

partnerships it entered into during 2009 and 2010. Such transactions boosted the company’s

substantive capabilities and product offerings and will assist with future growth.

Figure 2

Company Acquired Business Summary Acclarent, Inc. Dedicated to designing, developing and commercializing devices that

address conditions affecting the ear, nose and throat.

Crucell N.V. Global biopharmaceutical company focused on the research & development, production and marketing of vaccines and antibodies against infectious disease worldwide.

Micrus Endovascular Corporation

Global developer and manufacturer of minimally invasive devices for hemorrhagic and ischemic stroke.

RespiVert Ltd. Focused on developing small-molecule, inhaled therapies for the treatment of pulmonary diseases.

Mentor Corporation Leading supplier of medical products for the global aesthetics market.

Cougar Biotechnology, Inc. Development stage biopharmaceutical company with a specific focus on oncology.

Finsbury Ortohpaedics Limited Manufacturer and global distributor of orthopaedic implants.

Gloster Europe Developer of innovative disinfection processes and technologies to prevent healthcare-acquired infections.

Elan’s Alzehimer’s Immunotherapy Program

Joint venture with Elan to develop treatments for alzheimers.

Source: Johnson & Johnson 2010 10-K

International Exposure: Consolidated worldwide sales in 2010 were $61.6 billion, a decrease of .5%.

Interestingly, Johnson & Johnson’s U.S. sales were $29.5 billion in 2010, a decrease of 4.7% while

international sales increased 3.6% to $32.1 billion.

The company recently made significant attempts

to penetrate certain international markets.

Figure 3 shows the increasing proportion of

international sales to Johnson & Johnson’s total

sales. In 2010, international sales accounted for

52% of total sales. International


expansion and the penetration of emerging markets such as Brazil, India and China offer an important

growth opportunity for Johnson & Johnson. Countries across the globe are facing the same issues that

the U.S. is facing relative to an uninsured population. Such factors are actually favorable for the

company internationally. Sales in Brazil, India, Russia and China increased 14% in 2010.iv In Brazil, over

the last 5 years, private medical insurance has increased by 60%, covering approximately 30% of the

populationv. In India, private insurance coverage is expected to increase from 35 million in 2010 to 220

million by 2015.vi In China, about 90% of the Chinese population (over 1.2 billion) is now covered by

some form of the country’s medical insurance system.vii These particular emerging markets hold huge

potential for Johnson & Johnson because they are all subject to the same demographic trends and each

trying to bring more of their respective populations into its respective healthcare coverage. As the

emerging markets evolve and the population covered by medical insurance increases in such markets,

Johnson & Johnson will be well positioned to capture a significant share of the expanding markets.

Segment Analysis

Johnson & Johnson’s total sales in 2010 were

$61.6 billion. 2010 sales by segment are

presented in Figure 4.

Consumer Segment

The Consumer segment sells a broad range of

personal care products used for baby care, skin

care, oral care, wound care and the women’s

health care fields, as well as nutritional and

over-the-counter pharmaceutical products. These products are marketed and sold to the general public

through retailers and distributors. A key advantage Johnson & Johnson enjoys in its Consumer segment

is brand equity due to its iconic brands. Major brands include Aveeno, Clean & Clear, Neutrogena,

Tylenol, Band Aid and Johnson’s Baby line of products, to name a few.

The Consumer segment sales decreased overall 7.7% from 2009 to $14.6 billion. Segment sales in the

U.S. decreased 19.3% year over year, whereas International segment sales increased 1.2% year over

year. The Consumer segment was hurt by several significant over the counter (OTC) product recalls in

the U.S. and the prolonged shutdown of a major manufacturing plant. Product recalls impacted the total

year sales by approximately $900 million.

Pharmaceutical Segment

The Pharmaceutical segment offers a diverse range of products covering a wide array of therapeutic

areas including anti-infective, antipsychotic, cardiovascular, contraceptive, dermatology,

gastrointestinal, hematology, immunology, neurology, oncology, pain management, urology and

24%

36%

40%

Sales by SegmentFigure 4

Consumer

Pharmaceutical

Medical Devices


virology. The pharmaceutical products are distributed directly to retailers, wholesalers and health care

professionals for prescription use.

Pharmaceutical segment sales in 2010 were $22.4 billion, a decrease of .6% from 2009. U.S.

pharmaceutical sales decreased 4.0% year over year while International sales increased 4.2% year over

year. The decrease in U.S sales is largely attributed to two factors: the erosion of market share due to

generic competition for certain drugs and the implementation of certain aspects of the health care

reform laws passed in March (sales were reduced by approximately $400 million as a result of

U.S. health care reform legislation).viii Additional pressure on the pharmaceutical segment is expected

in 2011 as market exclusivity for Levaquin (6% of pharmaceutical sales) expires in 2011 and a generic

version of Concerta (5.8% of pharmaceutical sales) is set to come to market beginning May 1, 2011. By

way of example, in March of 2009, Topamax lost basic patent protection and market exclusivity and

became subject to generic competition in the United States and later in the year in international

markets. Sales of Topamax declined by 53.3% and 57.9% in 2010 and 2009, respectively.

Although patent expirations and the attendant generic competition will erode market share for certain

products, Johnson & Johnson’s Pharmaceutical segment is poised for growth based on a few strategic

advantages: the company continues to see significant advancements in its deep pipeline of drugs;

double digit growth in emerging markets; and continued momentum in recently launched products.

Figure 5 presents selected pharmaceuticals in late stage (Phase III and final approval) U.S. and E.U.

development or registration and potential filings. Successful approval and commercialization of any of

the drugs should provide a top line boost to revenues.

Figure 5: Late Stage Pipeline

Approved 2009 In Registration Planned Filings 2011‐201

INVEGA® SUSTENNA™ (Neuroscience)

Abiraterone Acetate (Oncology)

Bapineuzumab IV (Neuroscience)

PRILIGY™ (E.U.) (Sexual health)

Rivaroxaban (Cardiovascular & Metabolism)

Canagliflozin (Cardiovascular & Metabolism)

SIMPONI™ (Immunology)

Telaprevir (E.U.) (Infectious Disease)

CNTO 136 (Immunology)

STELARA™ (Immunology)

TMC 278 (Infectious Disease)

DACOGEN™ (E.U.) (Oncology)

Fulranumab (Neuroscience)

Siltuximab (CNTO 328) (Oncology)




Medical Devices and Diagnostics Segment

Johnson & Johnson is the world’s largest medical devices and diagnostics business. The MD&D segment

sells a broad range of wound care and minimally invasive surgical products, including orthopaedics and

diagnostics which are distributed to wholesalers, hospitals and retailers to be used principally in the

professional medical fields. MD&D products include Biosense Webster’s electrophysiology products;

Cordis’ circulatory disease management products; DePuy’s orthopaedic joint reconstruction, spinal care,

neurological and sports medicine products; Ethicon’s surgical care products; Ethicon Endo-Surgery’s

minimally invasive surgical products and advanced sterilization products; LifeScan’s blood glucose

monitoring and insulin delivery products; Ortho-Clinical Diagnostics’ professional diagnostic products

and Vistakon’s disposable contact lenses.

MD&D sales were $24.6 billion in 2010, representing an increase of 4.4% over the prior year. U.S. sales

were $11.4 billion, an increase of 3.6% over the prior year. International sales were $13.2 billion, an

increase of 5.0% over the prior year.ix

Sector Outlook

Regulatory Risk: Health Care Reform and the FDA The Health Care sector is not as correlated to

economic indicators or data points as the other S&P Sectors. That said, the sector is not immune to

external factors. 2010 was an historic year in the U.S. from a regulatory perspective. The Patient

Protection and Affordable Care Act passed in March 2010. The sector experienced volatility following

the Act’s passage and will continue to see investor sentiment fluctuate as the market attempts to

predict whether the Act will be implemented in its current form or whether it will be repealed or

modified. Consequently, the sector will likely continue to experience volatility over the near-term.

The Patient Protection and Affordable Care Act (more commonly referred to as health care reform)

included an increase in the minimum Medicare rebate rate from 15.1% to 23.1%. Johnson & Johnson

saw a fully year impact to sales as a result of the increased Medicare rebate rate of approximately $400

million.x The 2011 full year impact to sales is estimated to be between $400 and $500 million.xi

Additionally, in 2011, companies that sell branded prescription drugs to certain U.S. government

programs will pay an annual fee based on an allocation of the company’s market share of total branded

prescription drug sales from the prior year. The company estimates that the annual fee from the sales

related to branded prescription drugs will be approximately $150 - $200 million in 2011. Commencing in

2013, a 2.3% excise tax will be imposed on the sale of certain medical devices. A complete analysis of

the health care reform law is beyond the scope of this equity report. This summary is intended to

demonstrate that the law will have an adverse effect, at least initially, on the Pharmaceutical and MD&D

segments. Gradually, however, the reform could have a benefit on the sector resulting from the

expansion of the market, with new coverage to an estimated 40 million Americans.

Hidden behind the well-publicized regulatory wrangling in the U.S. legislature related to health care

reform, the FDA has quietly increased its regulatory strain on the sector generally and the


pharmaceutical industry specifically. The FDA approved only 21 new drugs in 2010, down from 25 in

2009 and 24 in 2008.xii Although it is not entirely clear what is underlying the FDA’s reluctance to issue

patents, the new normal appears to be a reticence to grant patent protection – this is not all that

surprising given a tenet of the health care reform law is to bring down the cost of prescriptions. This

trend is troubling alone. When coupled with the discretion shown to generics, however, the outlook

appears much more ominous for established pharmaceutical firms. The FDA has recently encouraged

generic drug firms to file Abbreviated New Drug Applications seeking to market generic forms of

patented pharmaceutical products prior to expiration of the applicable patents covering those products.

Such an application requires the patent holder to defend the viability of the applicable patent in court.

If the patent holder is not successful in defending the resulting lawsuits, generic versions of the product

at issue will be introduced, resulting in very substantial market share and revenue losses. These issues

will be amplified in the coming years because the pharmaceutical industry is facing a patent cliff with

estimated losses of $80 billion of sales attributed to expiring patents through 2014.

Demographics

Although I anticipate near-term volatility due to

the aforementioned risks the sector faces, the

long-term view of the sector remains positive

supported by aging demographics and upward

trends in discretionary spending. The aging

global population is more likely to use medical

coverage/products and is expected to support

sustained sector growth. Figure 6 shows the

global population growth over the past 50 years

and the projected growth over the next 50 years:

the number of older persons (over 60) globally is

expected to triple over the next 50 years.

Figure6 Another factor supporting the growth of the sector is an increasingly positive economic outlook. The strengthening economy should result in increased employment and thus boost demand for employer-sponsored health plans. The corollary is that the improving economy should also trigger a rise in discretionary spending, resulting in industry growth due to an increased number of persons seeking healthcare coverage and the related benefits that are associated with coverage, such as prescription pharmaceutical products and medical devices. Underlying the discretionary spending (and incidentally also underlying health care reform) is the continued growth in health care expenditures as a percentage of GDP. Growth in National Health Expenditures (NHE) is anticipated to average an annual growth rate of 6.3% for 2009 through 2019, reaching 19.3%.xiii


Financial Analysis

Profitability Analysis

Johnson & Johnson’s profitability analysis suggests the firm compares favorably to its competitors.

Notably, large pharmaceutical companies have recently experienced margin compression because of

market concerns related to patent expirations. Even in light of this fact, Johnson & Johnson boasts the

second highest operating margin and strong gross and net margins. The company also has the highest

return on assets, suggesting a high degree of management effectiveness. A high return on equity is a

good measure of profitability as it reflects the company’s profits from each dollar of company assets.

JNJ PFE MRK NVS MDT GSK ABT

Gross Margin 73.6 79.9 68.7 78.5 81.1 80.6 65.8 Operating Margin 25.8 24.7 4.4 23.7 31.4 15.7 17.3 Net Margin 21.2 26.3 22.9 24.5 23.0 10.1 18.5 ROE 24.3 23.2 26.8 20.6 25.6 29.6 28.7 ROA 18.3 5.2 11.3 10.7 15.3 6.8 10.2 Figure 7: Comparison of Johnson & Johnson peers based on profitability metrics.

Analysis of Segment Operating Profit

Unlike several of its competitors, Johnson & Johnson is well diversified with 63% in operating profits coming from its two non-pharmaceutical segments, Consumer and MD&D. Figure 8 details operating profits by segment for the prior 3 year period. Consumer segment operating profit decreased 5.4% from 2009 as a result of lower sales and higher costs attributed to product recalls. Operating profit for the Consumer

segment in 2009 decreased 7.4% from 2008. Both Pharmaceutical and MD&D saw increases in operating profit in 2010. The Pharmaceutical segment operating profit increased 10.5% in 2010, recovering from a decrease in 2009 of 15.7%, which was largely attributed to restructuring charges incurred. MD&D operating profit increased 7.5% in 2010, after an increase in 2009 of 6.5%. The MD&D increases in operating profit are expected to continue based on manufacturing efficiencies and diversified product mixes. This is a positive sign for the company given that revenues from the MD&D segment accounted for 40% of 2010 revenues. Liquidity Analysis

To determine Johnson & Johnson’s liquidity position relative to its peers, we analyzed four factors: the

Current Ratio; the Quick Ratio; the percentage of long-term debt to total assets, a measurement of a

company’s leverage, calculated as the company's debt divided by its total capital (debt and equity); and,

the ratio of total assets to total equity, a measure of financial leverage and long-term solvency. Figure 9

shows that Johnson and Johnson compares favorably on all metrics. The company’s strong current ratio


and quick ratio suggest sufficient liquidity. These metrics also verify the company’s strong cash position

as shown in the discounted cash flow model presented below.

Figure 9.


Current Ratio 2.5 2.2 1.6 1.1 1.7 1.3 1.3 Quick Ratio 1.9 1.6 1.0 .7 1.2 1.0 .7 %LT Debt: Total Assts 13.8 30.8 20.2 18.5 32.5 62.5 35.9 Assets: Equity 1.8 2.2 2.0 1.8 1.9 4.5 2.5

Income statement projections

Selected financial data for Johnson & Johnson is presented in Appendix A. We estimate top line

revenue growth of 4% in 2011 versus 5% guidance provided by the company.

Valuation Analysis

We conducted an Absolute Ratio Valuation Model, Discounted Cash Flow Model and a Sum of Parts

Analysis to determine a target price for Johnson & Johnson.

Equity Valuation: Absolute Ratio Valuation Model

We believe the absolute ratio valuation model using multiples for Johnson & Johnson is an appropriate

metric using target multiples just under the historic means. The Absolute Ratio Valuation Model

presented in Figure 9 implies a target price of $68.83, representing a 14% upside to the share price as of

March 7, 2011. Figure 10 shows Johnson & Johnson’s current equity multiples compared against certain

of its competitors. Based on the multiples comparison, Johnson & Johnson is trading on average slightly

higher than its peers suggesting the stock is overvalued relative to its competitors.

Figure 9: Absolute multiples valuation over 10 years.

High Low Median Current Target Multiple

Target Metric

Target Price

P/Forward Earnings 29.3 11.1 16.8 12.8 13.5 4.90 $66.15 P/S 6.1 2.2 3.8 2.7 3 23.6 $70.8 P/B 8.6 2.9 5.1 2.9 3.5 20.09 $70.35 P/EBITDA 20.39 6.94 12.19 8.45 11 6.39 $70.29 P/CF 27.0 9.0 15.8 10.5 13 5.11 $66.55 Target $68.83 Source: Thompson Baseline


Figure 10: Comparative multiples against competitors.


P/Forward Earnings 12.8 8.8 9.0 10.7 11.1 10.3 10.6 P/S 2.7 2.3 2.2 3.0 2.7 2.3 2.1 P/B 2.9 1.8 1.8 2.0 2.5 6.5 3.5 EV/Sales 2.6 2.6 2.4 3.3 3.1 2.6 2.5 EV/EBITDA 7.9 6.9 5.1 9.0 8.5 10.0 7.9 Source: Thompson Baseline

Equity Valuation: Discounted Cash Flow Model

A discounted cash flow (DCF) valuation is presented in detail as Appendix B. The DCF analysis suggests

that Johnson & Johnson is currently trading at a discount relative to its intrinsic enterprise value. The

DCF model implies an intrinsic value of $68.09 per share. This implied value represents an upside of

12.6% over the closing price on March 7, 2011 and, perhaps more importantly, an upside of 13% relative

to SIM’s cost basis in its shares of Johnson & Johnson ($60.33 as estimated from the 3/5/11 Daily

Performance Analysis).

The DCF model is extremely sensitive to modifications to the terminal growth rate and the discount rate.

In conducting our DCF analysis, we applied a discount rate of 10.5% and a terminal growth rate of 4%.

We applied a discount rate of 10.5% for two primary reasons: the uncertainty within the pharmaceutical

segment relative to the FDA approval process (or lack thereof) and the uncertainty surrounding health

care reform. Although we see Johnson & Johnson as a defensive stock that could trend below the 10%

discount rate applied to the general market, after careful evaluation of the foregoing factors, we believe

it is prudent to assign a slightly higher discount rate to Johnson & Johnson’s expected future cash flows.

We also considered several factors in selecting the appropriate terminal growth rate to apply. With

respect to the terminal growth rate, we considered inflation projections for fiscal year 2011 as a

baseline inflation indicator, aging demographics and the increasing global population. Based on the

foregoing factors, we believe the demand for Johnson & Johnson’s products imply a terminal growth

rate of 4%.

As discussed above, altering either the discount rate or terminal growth rate will provide a range of

implied share prices. The sensitivity analysis presented as Figure 11 demonstrates the range of share

values based on the differing combinations, which also provides a second level of expectations based on

external factors.

Figure 11: Sensitivity Analysis

10 10.5 11

3.5 $70.08 $65.10 $60.79

4 $73.70 $68.09 $63.28

4.5 $79.63 $73.06 $67.50


Sum of parts analysis

Johnson & Johnson’s operating structure lends itself to a sum of parts analysis. As seen in Figure 12, the

target price under this analysis is $66.65, which represents 10% upside from the share price as of March

7, 2011.

Sales per P/S Target P/S Target multiple x

Segments Segment Ratio Pfizer Merck Novartis Medtronic Stryker Abbot GlaxosmithclineMultiple Sales/Segment

Pharmaceutical 22396 2.3 4.7 2.7 2.2 2.2 3 67188

Consumer 14590 4.7 2.2 3 43770

MD&D 24601 2.7 3.44 2.2 2.2 3 73803

TOTAL 61587 2.7 184761

Date of price 3/7/2011

Current Stock Price 60.4

# of diluted shares 2788.80

Target Price 66.25

% return to target 9.69%

Competitors P/S ratios

Equity Valuation: Final Target Price

Our final target price for Johnson & Johnson is $68.00, 12.6% above the closing price of $60.40 on March

7, 2011.

Investment Thesis

Johnson & Johnson appears slightly undervalued based on fundamental and multiples valuations;

however, the uncertainty surrounding the implementation or modification of “health care reform”

warrants a cautious approach to the sector and the stock. Although the positive fundamentals are

offset by the negative factors referenced above, we believe a HOLD rating is justified given Johnson &

Johnson’s diversification of sales worldwide, late stage drug pipeline, current demographics and current

dividend yield.

Catalysts

- Diversified sales base, both internationally and across segment lines

- Strategic acquisitions to continue diversification and boost top line revenues

- Continued R&D investment has led to a promising late stage pharmaceutical pipeline with many

candidates for approval and commercialization

- Continued demographic trends provide for an expanding market in need of health care products

and services

Risks

- Challenges to existing patents; introductions of generic versions of key pharmaceutical products

- Pricing pressures, reduced reimbursement rates and austerity measures related to a prolonged

global economic downturn


- Health care changes in the U.S. and other countries resulting in the continued consolidation

among health care providers, trends toward managed care and health care cost containment, the

shift towards governments becoming the primary payers of health care expenses

- Challenges in securing obtaining regulatory approvals to gain and maintain market approval of

products

Summary

We have established a HOLD rating, with a target price for Johnson & Johnson of $68.00, 12.6% above

the closing price on March 7, 2011. Johnson and Johnson is a classic defensive stock with tremendous

prospects for growth due to its existing platforms in major emerging markets, aging global populations

and ever-increasing expenditures on healthcare as a percentage of gross domestic product. Although

Johnson & Johnson is attractive based on fundamental and multiples valuations, we believe increased

regulation combined with regulatory uncertainty and a stringent FDA approval process may have a

stifling effect domestically. Thus, we believe it is prudent to maintain an established position in Johnson

& Johnson while the affects health care reform work their way through the sector.


APPENDIX A: Selected Financial Data

JNJ

FY FY FY FY FY FY FY FY

(millions) 2012E 2011E 2010 2009 2008 2007 2006 2005

Sales to customers 65847.268 64121.5962 61587 61897 63747 61095 53324 50514

Cost of products sold 18447 18511 17751 15057 14010

Gross profit 43450 45236 43344 38267 36504

Selling, marketing and administrative expenses 19801 21490 20451 17433 17211

Research expense 0 0 0 6986 7577 7680 7125 6462

Purchased in-process research and development (Note 20) 0 181 807 559 362

Interest income -90 -361 -452 -829 -487

Interest expense, net of portion capitalized (Note 4) 451 435 296 63 54

Other (income) expense, net -526 -1015 534 -671 -214

Restructuring (Note 22) 1073 0 745 0 0

Total 27695 28307 30061 23680 23388

Earnings before provision for taxes on income 18345.387 17371.4489 16947 15755 16929 13283 14587 13116

Provision for taxes on income (Note 8) 4035.9851 3821.71876 3613 3489 3980 2707 3534 3056

Net Earnings 14309.402 13549.7302 13334 12266 12949 10576 11053 10060

Diluted net earnings per share (Notes 1 and 15) 5.2511565 4.97237804 4.78 4.39783443 4.566582 3.63349 3.73 3.35

Consensus 5.35 4.97

Guidance 4.80 - 4.90

Diluted average shares outstanding (Notes 1 and 15) 2725 2725 2725 2789.1 2835.6 2910.7 2961 3002.985

Accounts Receivable 10403.868 10131.2122 9607.572 9646 9719 9444 8712 7010

% of sales 0.158 0.158 0.156 0.15583954 0.152462 0.154579 0.163379 0.138773

Inventories 5399.476 5257.97089 5050.134 5180 5052 5110 4889 3959

% of sales 0.082 0.082 0.082 0.08368742 0.079251 0.08364 0.091685 0.078374

Accounts Payable 6584.7268 6412.15962 6158.7 5541 7503 6909 5691 4315

% of sales 0.1 0.1 0.1 0.08951969 0.1177 0.113086 0.106725 0.085422

Change in Working Capital -241.5941 -478.017468 785.994 -2017 377 265 -1256

Sales Growth 0.0269125 0.04115473 -0.00500832 -0.029021 0.043408 0.145732 0.055628

Gross Profit to Sales 0.70197263 0.709618 0.709452 0.717632 0.722651

Chg YoY -0.0076451 0.000165 -0.008179 -0.005019

Selling, marketing and administrative to Sales 0.31990242 0.337114 0.334741 0.326926 0.340717

Chg YoY -0.0172115 0.002373 0.007815 -0.013791

Depectiation & Amoritzation 2963.1271 2885.47183 2771.415 2774 2832 2777 2177 2093

Depreciation & Amortization to Sales 0.045 0.045 0.045 0.04481639 0.044426 0.045454 0.040826 0.041434

Additions to Property, Plant and Equipment 2765.5853 2693.10704 2463.48 2365 3066 2942 2666 2632

Additions to Property, Plant and Equipment to Sales 0.042 0.042 0.04 0.03820864 0.048096 0.048155 0.049996 0.052104

Operating Profit 18345.387 17371.4489 16947 15755 16929 13283 14587 13116

Operating Profit to Sales 0.2786051 0.27091417 0.27517171 0.25453576 0.265565 0.217416 0.273554 0.259651

Chg YoY 0.007691 -0.00425754 0.02063595 -0.0110297 0.04815 -0.056139 0.013903


APPENDIX B: Discounted Cash Flow Model

Terminal Discount Rate = 10.5%

Terminal FCF Growth = 4.0%

Year 2010 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E

Revenue 61,587 64,122 65,847 68,152 70,537 73,006 75,561 78,584 81,727 84,996 88,396

% Growth 4.1% 2.7% 3.5% 3.5% 3.5% 3.5% 4.0% 4.0% 4.0% 4.0%

Operating Profit 16,947 17,371 18,345 19,083 19,750 20,442 21,157 21,218 22,066 22,099 22,983

Operating Margin 27.5% 27.1% 27.9% 28.0% 28.0% 28.0% 28.0% 27.0% 27.0% 26.0% 26.0%

Taxes 3,613 3,822 4,036 4,198 4,345 4,497 4,655 4,668 4,855 4,862 5,056

Tax Rate 21.3% 22.0% 22.0% 22.0% 22.0% 22.0% 22.0% 22.0% 22.0% 22.0% 22.0%

Net Income 13,334 13,550 14,309 14,884 15,405 15,945 16,503 16,550 17,212 17,237 17,927

% Growth 1.6% 5.6% 4.0% 3.5% 3.5% 3.5% 0.3% 4.0% 0.1% 4.0%

Add Depreciation/Amort 2,938 2,874 2,951 3,054 3,161 3,272 3,386 3,443 3,581 3,724 3,873

% of Sales 4.8% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.4% 4.4% 4.4% 4.4%

Plus/(minus) Changes WC 786 (478) (242) (250) (259) (268) (277) (288) (300) (312) (324)

% of Sales 1.3% -0.7% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4% -0.4%

Subtract Additions to PPE 2,383 2,693 2,766 2,862 3,033 3,139 3,249 3,458 3,596 3,740 3,889

Additions to PPE % of sales 3.9% 4.2% 4.2% 4.2% 4.3% 4.3% 4.3% 4.4% 4.4% 4.4% 4.4%

Free Cash Flow 14,674 13,252 14,253 14,826 15,275 15,809 16,363 16,247 16,897 16,910 17,586

% Growth -9.7% 7.6% 4.0% 3.0% 3.5% 3.5% -0.7% 4.0% 0.1% 4.0%

NPV of Cash Flows 86,048 45%

NPV of terminal value 103,674 55% Terminal Value 281,378

Projected Equity Value 189,721 100%

Free Cash Flow Yield 8.71% Free Cash Yield 6.25%

Current P/E 12.6 12.4 11.8 Terminal P/E 15.7

Projected P/E 14.2 14.0 13.3

Current EV/EBITDA 8.4 8.3 7.8 Terminal EV/EBITDA 10.4

Projected EV/EBITDA 9.5 9.3 8.8

Shares Outstanding 2,789

Current Price 60.40$

Implied equity value/share 68.03$

Upside/(Downside) to DCF 12.6%

Debt 14,541

Cash 15,810

Cash/share 5.67


Appendix C: Source List

i Johnson & Johnson 2010 10-K ii Johnson & Johnson 2010 10-K

iii Johnson & Johnson 2010 10-K

iv Zacks Investment Research

v “Healthcare Brazil,”UBS March 9, 2009

vi India Pharma 2015, http://www.mckinsey.com/locations/india/mckinseyonindia/pdf/India_Pharma_2015.pdf

vii China Ministry of Health public statements

viii Johnson & Johnson 2010 10-K

ix Johnson & Johnson 2010 10-K

x Johnson & Johnson 2010 10-K

xi Johnson & Johnson 2010 10-K

xii http://www.accessdata.fda.gov/scripts/cder/drugsatfda/

xiii Health Spending Projections Through 2019: The Recession’s Impact Continues, Health Affairs, March 2010

(www.healthaffairs.org)

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