Managerial Finance Thesis

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Managerial Finance - Johnson & Johnson

Company Overview

Johnson & Johnson (NYSE: JNJ) is a global conglomerate of over 250 different companies. The company did $61.1 billion in business in 2007, broken down into three main segments. The largest segment is Pharmaceuticals, which accounted for $24.9 billion, or 41%, of revenue. Medical Devices and Diagnostics earned $21.7 billion in revenue (35%); Consumer Products earned $14.5 billion (24%). The company's operations are global in scope.

The Pharmaceuticals segment includes the firm's two largest-selling products, Risperdal and Remicade, which combined account for 11% of total revenues. Within the Consumer Products segment are the company's best-known brands, such as Johnson & Johnson, Listerine, Neutrogena and Nicorette. This segment sees almost half of its sales from outside the U.S., the highest percentage of any segment. New product launches in Consumer Products totaled almost 600 in 2007, compared with just a handful of new product launches each year in Pharmaceuticals. Pfizer Consumer Healthcare (PCH) was acquired in 2007 to help bolster the Consumer Products segment. The Medical Diagnostics and Devices segment makes JNJ the largest medical technology firm on the planet, with 80% of MD&D sales coming from businesses in the No.1 or No.2 market positions (Johnson & Johnson 2007 Annual Report).

Trend Analysis

Revenue increased by $2.652 billion in 2008, an increase of 4.34%. This represented the lowest percentage increase in revenue in the past five years. In 2007, revenue increased 14.5%; in 2006 it was 5.56% and in 2005 it was 6.68%. The past year was a challenge for many firms because of the slowing economy. Despite operating in an industry where demand is relatively inelastic, JNJ still felt the sting of the economic slowdown. Year-over-year results for Q4 show that revenues declined $775 million, or 4.8%. This indicates a trend not just towards slower sales growth but towards revenue reductions. The revenue decline is historic - the first in 75 years for JNJ. This biggest contributor was generic competition for breadwinner Risperdal, which caused a 41.4% decline in sales of that one-time powerhouse (Associated Press, 2009).

As sales overall saw strong growth in 2007, so too did segment sales. Growth was strongest in the Consumer Healthcare segment, at 48.3%. This growth was from $9.77 billion to $14.5 billion. The strong growth in this segment was the primary reason for the robust growth in overall revenues. The growth driver in 2007 was the acquisition of Pfizer Consumer Healthcare, which accounted for 40.3% growth alone. The other segments also have been on a solid upward trajectory. Pharmaceuticals grew at 6.9%, driven by a handful of strong products, including two that reached the $1 billion sales mark for the first time. Medical Devices & Diagnostics achieved growth of 7.2% in 2007, marking a strong overall growth trend. It will be interesting to see how these segments have performed in 2008, given that the company's overall revenues have slumped.

Over the past five years, JNJ's cost of revenue has increased steadily. This is expected, since the revenues have also increased steadily during that time. In 2008, the cost of revenues grew at a slower pace than did revenues, ending a two-year trend where the cost of revenues grew faster than did the revenues. Cost of revenues grew at 4.28% last year, 17.89% the year before, 7.47% in 2006 and 3.97% in 2005. Overall, the cost of revenues has increased 37.38% in the past four years, whereas revenues increased 34.6%.

Sales, General and Administrative expense has increased 32.8% in the past four years. While it is encouraging that this is slower than the rate of revenue increase, the trend in the past couple of years has been that SGA expense has increased faster than revenues. Some of this increase can be attributed to the integration of Pfizer Consumer Healthcare, as evidenced by the steep increase in SGA expense in the year of that acquisition, 2007.

Research and development expense has increased 41.7% in the past four years. The bulk of this increase occurred in fiscal 2005, which saw R&D expenses increase 20.9%. Since then, the trend has been towards slowing growth of R&D expense, to the point where in 2008 R&D expense decreased 1.3%. The acquisition of PCH has allowed for this, as has the move of several products that were in development in the mid-00s into the approval and marketing portion of the pipeline. Many of these have been in the MD&D segment, which has seen a number of key product launches in the past couple of years.

Interest expense has fluctuated in the past five years. For most of this period, JNJ was a net earner of interest, especially in 2005 and 2006. The past couple of years have seen that trend reverse, to the point where in 2008 JNJ incurred a net income expense of $74 million. This is directly attributable to a sharp increase in long-term debt over the past year.

Net Income has fluctuated over the past five years. 2005 and 2008 saw strong increases of 22.9% and 22.4% respectively. Net income leveled off more in the 2006-2007 period. On the strength of the two strong years, net income growth since 2004 has been 58.3%, which is much stronger than revenue growth. Indeed, revenue declined in 2008 but net income increased 22.4%. Further, when unusual items are removed from 2007 figures, that year also showed strong net income growth, indicating a two-year trend. The 2007 growth is expected, but the 2008 growth runs against expectations because of the lower revenues and weak economy.

Johnson & Johnson's cash position has typically been strong over the past five years. Cash grew in 2005, but declined in 2006 due to acquisitions. Cash strength recovered in 2007, which is expected due the JNJ's long-term trend towards improving their cash position. The interim 10-Q statements for 2008 reveal that over the first three quarters of the fiscal year, cash levels at JNJ continued to improve, almost to 2005 levels.

JNJ's long-term debt held relatively steady from 2004 into 2006, but increased significantly during 2007, a reflection of acquisitions and the onset of slowing business. The most recent 10-Q filings show that long-term debt increased through Q2 of 2008, but began to decrease in Q3. Whether or not this represents a reversal of the trend towards increasing leverage at JNJ remains to be seen.

Cash from operating activities has consistently improved over the past four years. From 2004-2007 it increased 37.5%, less than net income but stronger than sales over the same time period. 10-Q filings indicate that JNJ's cash flow from operations in the first three quarters of 2008 was already 32.9% higher than it was for the entire 2007, indicating a strong upward trend. Again, the improved performance in the face of a slumping economy and a declining top line indicate that JNJ has thus far been able to weather the economic downturn.

Ratio Analysis

The current Price/Earnings ratio for JNJ is 12.4, which is below both the industry and S&P averages. Traditionally, JNJ's P/E ratio exceeds both of those averages. The present P/E ratio is near the 5-year low of 12.3, whereas industry and market averages are not. In the earlier part of this decade, JNJ's P/E ratio was consistently above 25. This decline in P/E indicates that investors have less faith in JNJ's ability to maintain its growth trajectory in the coming years, relative to other firms in the market.

In terms of liquidity, JNJ is a relatively liquid company.

As of Q3, their current ratio stood at 1.61, compared to an industry average of 1.1 and a market average of 1.2. Furthermore, their quick ratio is 0.65. While this is lower than the industry and market averages (both 0.9), it still reflects a liquid company. To further verify the claim that JNJ is liquid, they have an interest coverage of 229.8 times, compared with an industry average of 127.6 and a market average of 55.0.

The debt ratio at JNJ is 47.8% as of the end of Q3. The debt-to-equity ratio is thus 0.91, which compares favorably to the market (1.05) but not to the industry (0.35). Prior to the recent increase in long-term debt, the debt-to-equity ratio was 0.79 (fiscal 2006). This indicates that while JNJ has increased its long-term debt significantly, and this has resulted in an increase in overall leverage, the increase in overall leverage is not unreasonable nor is it dramatic.

Johnson & Johnson has been able to maintain margins in line with, or slightly better than, the industry norms. The gross margin is 71.0%, compared with 71.2% for the industry on average. Typically, JNJ's gross margin is in line with the industry. In terms of net margin, JNJ has a 20.3% net margin compared with an industry average of 17.8%. This net margin outperformance of the industry is consistent with past results. Net margins for both have declined vs. their five-year averages.

JNJ has recorded a fairly consistent return on average shareholder's equity over the past several years.… [END OF PREVIEW] . . . READ MORE

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