Excerpts of J&J

Led by its underappreciated pharmaceutical division, the giant health-care conglomerate may be poised to deliver mid-single-digit revenue growth and high-single-digit profit growth in the coming years after a forgettable multiyear stretch marred by persistent factory problems in its consumer division and a $2.9 billion charge related to the recall of artificial hips. With its missteps, J&J (ticker: JNJ) managed to alienate the normally patient Warren Buffett, whose Berkshire Hathaway (BRK.B) has sold nearly all of its investment in the company.

Berkshire’s holding stood at just 492,000 shares at the end of the third quarter, down from 31.4 million shares at the end of 2011 and 45 million a year earlier. The company “obviously messed up in a lot of ways in the last few years,” Buffett told CNBC earlier this year, marking a rare corporate critique by the Berkshire CEO.

While Berkshire was selling, Wall Street started warming to the J&J story. Its shares have risen to about $70 from a June low of $62. There could be further upside in the next year, to $80 or higher, assuming the company is able to build on the momentum shown in the third quarter, when organic, currency-adjusted revenue growth of 5% was its best showing in five years.

The stock has disappointed for a decade, having traded at $65 in 2002. “Revenue growth is improving in all three businesses. That leads to the potential upside for earnings per share,” says Barclays analyst C. Anthony Butler, who has called J&J “the misunderstood giant.”

He carries an Overweight rating and an $85 price target. J&J’s three businesses are pharmaceuticals, medical devices and diagnostics, and consumer. [ ], Butler has set an optimistic sum-of the-parts value of $85 on three divisions based on projected 2013 earnings. His 2013 estimate of $5.75 a share is above the consensus of $5.49 a share. His low-end, sum-of-the-parts valuation is $68, suggesting limited downside. This year’s operating profits are expected to total $5.05 to $5.10 a share. The company is valued at $195 billion, making it the largest publicly traded health-care company in the world.

“If you look at J&J like a bond, it’s very attractive,” says David King, lead manager of the Columbia Flexible Capital Income Fund. “The dividend yield is much higher than J&J’s 10-yearbond yield.” J&J’s dividend is now 3.4%, versus a roughly 2% yield on its 10-year debt. The dividend has grown at an 8% annual rate for the past five years and could rise at a similar pace in the next few years, making the stock like a bond with a rising interest rate. There obviously is no guarantee that J&J will maintain or continue to raise its dividend, but, as King notes, the company has a widely diversified business mix, limited economic sensitivity, and a 50-year history of dividend increases.

J&J trades for 13 times projected 2013 earnings, and is in line with most major drug stocks, as J&J has lost its historic premium to the sector. J&J shares are up 8% in 2012, trailing Pfizer (PFE), Abbott Laboratories (ABT), and Merck (MRK), which all are up about 15%. Detractors say J&J is a stodgy, slow-growth company that now lacks its former innovative edge, and is run by an overly conservative management team that allowed a series of costly and embarrassing quality problems to occur on its watch.

7  J&J’S CONSUMER DIVISION, which includes Tylenol, Sudafed, Band-Aid, Listerine, and Johnson’s baby products, has had 25 product recalls in the past few years, and one of its three North American plants, in Fort Washington, Pa., has been shut since 2010. That plant and two others in North America operate under a federal consent decree, as J&J seeks to satisfy regulators that its manufacturing processes are being fixed. The factory problems have led to shortages of products like children’s liquid Tylenol.

J&J hasn’t said when it expects the factory situation to be fully resolved and its production back to normal, but CFO Dominic Caruso said on the company’s conference call in October that J&J continues “to make progress” and that more products are returning to store shelves. Barclays’ Butler is assuming 5% sales growth in the division next year as product availability increases. J&J’s medical devices and diagnostics division makes a wide variety of products, including artificial knees and hips, spinal implants, Acuvue contact lenses, and many types of surgical supplies.

But the division required J&J to take a $2.9 billion charge in the fourth quarter of last year to deal with lawsuits and other expenses stemming from recalled metal artificial hips made by its DePuy subsidiary that were prone to shredding following implants. J&J also saw its former top position in coronary stents slip away, and it essentially abandoned that business, in which rival Abbott Laboratories now holds a leading position.

MANAGEMENT, WHICH DECLINED to speak to Barron’s, citing a “quiet” period before quarter-end, probably would plead guilty to conservatism. It emphasizes the dividend over share repurchases and views J&J’s Triple-A credit rating as a major asset. That Triple-A is one of the few left among major American companies; the other three are held by ExxonMobil (XOM), Microsoft (MSFT), and Automatic Data Processing (ADP). J&J has a great balance sheet with $2.9 billion of net cash on Sept. 30.

It also prefers acquisitions to share repurchases, having bought more than 50 companies in the past decade. In one of its largest deals, J&J paid $17 billion, net of cash, or about 20 times earnings, in June for Synthes, a Swiss medical-products company. That deal wasn’t outrageously priced, but many investors would have preferred to see that money go for stock buybacks. J&J also refuses to follow the industry breakup trend, which will play out in a big way at yearend with the split of Abbott Labs into two entities, one focused on medical and nutritional products like vascular stents and infant formula, and the other on branded drugs.

All this hasn’t sat well with institutional investors, who generally avoid J&J stock. It’s telling that J&J’s three largest holders are index funds. So strong is the view that J&J shares have little upside that hedge funds often short J&J against long positions in other health-care stocks in socalled pair trades. The aversion to J&J could turn into a positive because institutional investors are underweighted in the stock relative to benchmarks and might scramble to buy it if the company’s earnings growth accelerates.

8  On the Street, Goldman Sachs analyst Jami Rubin made the case for a breakup earlier this year, arguing that “evidence is building across health care that smaller, more focused companies can perform better than their diversified peers.”

Others have argued that it’s foolish for J&J not to take advantage of the current rate environment to issue debt to buy back stock. These investors point to Amgen’s (AMGN) large debt-financed buyback last December that was followed by a 50% rise in its stock. There was some thought that J&J’s new CEO, Alex Gorsky, who succeeded William Weldon in April, might shift policies, but Gorsky, a company insider and former Army captain, has made no big moves.

Replying to a question from Rubin on J&J’s third-quarter conference call in October, J&J’s CFO Caruso said, “We feel very good about having a broad-based business in health care. We think that’s the way to be positioned for where health care is going globally.” All three divisions seem to be clicking. J&J’s drug unit saw an 11.3% rise in third-quarter sales, its strongest showing in eight years. The company’s broad portfolio is led by Remicade, which targets autoimmune disorders like Crohn’s disease and is expected to generate $6 billion in sales this year.

Key areas include cancer, immunology, and infectious diseases like HIV. J&J’s patent expirations are largely behind it, allowing newer drugs to make a difference. One of its most successful new launches is Zytiga, a leading drug for advanced prostate cancer that could approach $1 billion in sales this year. J&J’s drug division amounts to a large biotech company, with complex, differentiated drugs that are tougher to copy.

Even with its missteps and stodgy management, J&J may be on the brink of an extended period of nice earnings growth. The situation could get even better if the new CEO ever reverses the company’s objection to a breakup and sizable share buybacks. Long one of the stock market’s great defensive stocks, J&J could emerge as an offensive star.