Johnson & Johnson Medical Products company in Markham, Ontario

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Shares of Johnson & Johnson (NYSE:JNJ) have continued to do well, with many moving parts taking place at the business. In the summer of 2020, I updated my thesis after a $6 billion "bolt-on" deal for Momenta, adding to its diversified growth engine.

Some Perspective

In the summer of 2020, shares of Johnson & Johnson were trading fairly stable around the $150 mark. After reporting flattish sales at $82 billion in 2019, the company posted adjusted earnings of $8.68 per share, yet GAAP earnings came in three dollars lower. The company was on track to show steady performance in 2020, originally guiding for a mid-single-digit increase in sales and earnings per share, at least ahead of the pandemic.

This resulted in a market multiple at around 16-17 times earnings as net debt of $8.4 billion was very modest given the profitability of the business. With second quarter sales down 9% that year on the back of the outbreak of the pandemic, the company cut the guidance, but soon it was evident that the company was recovering, commanding a $400 billion equity valuation at the time.

The company used some of its financial firepower to acquire Momenta Pharmaceuticals in a $6.5 billion deal to broaden its immune-mediated diseases. Given the strong balance sheet and headwinds from the talc issues apparently on the retreat, I was warming up to the shares. I ended up concluding to be a happy buyer around the $140 mark on the back of the earnings power, solid valuation and 58-year dividend track record which paid investors $4 per share at the time.

Stabilization

Fast forwarding two years in time, shares have mostly traded in a $150-$190 range, displaying little volatility, while the market at large has seen a huge boom and subsequent bust as well.

In January of this year, Johnson & Johnson reported 2021 sales to be up 13% to $93.8 billion. Adjusted earnings rose by a convincing 22% to $26.2 billion, for earnings equal to $9.80 per share. Growth was driven by all the three segments. The core pharmaceutical business grew sales 13% to $52 billion, medical devices sales rose by an impressive 17% to $27 billion as consumer health grew less than 4% to just below the $15 billion mark.

The company guided for solid growth in the mid to high single digits this year with regard to sales and earnings. Following an uninspiring first and second quarter, the company maintained the full year currency adjusted guidance. Solid momentum and strong cash flows generation made that a $5 billion buyback program was announced in September.

In October, the company announced its third quarter results as reported sales growth was minimal, following the impact of the strong dollar, as otherwise sales would have grown in the high single digits. Adjusted earnings are now seen just a couple of pennies above the $10 per share mark, with earnings otherwise having come in around seventy cents higher.

Retained earnings made that the company actually ended the third quarter with a net cash position of $2 billion. The 2.66 billion shares outstanding now command a $455 billion equity valuation at $171 per share as net cash is equal to less than a dollar per share. At this valuation, Johnson & Johnson is valued at around 5 times sales and around 17 times earnings, a turn less if we factor in the strength of the dollar.

Of course, there are some moving targets as J&J has announced before that it was looking to spin off its consumer health business, with the activities being called Kenvue going forward. This does not simply seem to be a spin-off related to optimization and focus of activities, as it allows J&J to isolate lawsuits with regard to talc products and baby powder as well.

A Big Deal

While many thought things were smooth sailing, with J&J being a predictable growth play and investors setting themselves up for the spin-off of the consumer health activities, the company surprised the market a bit with a substantial deal.

On the first day of November, J&J announced that it was looking to acquire Abiomed (ABMD) at $380 per share, valuing the business at $16.6 billion excluding the value of an earn-out contingent value right which has the potential to add 10% to the deal value. Abiomed's strength in heart, lung and kidney support technologies are complementary to the own activities of Johnson in this area and represent among the largest unmet needs, creating a long runway for growth.

Shares of Johnson & Johnson fell about a dollar on the news announcement, as a half percent move is hard to read into, with investors implicitly giving management the benefit of the doubt. Hard to believe, yet a $16.6 billion deal is only equivalent to 3-4% of the own valuation here, truly a bolt-on deal even as the dollar amount does not indicate that to be the case.

Needless to say, the near term impact will bring minor dilution as interest expenses on the deal are significant. This comes as Abiomed posts revenues at a run rate of just over a billion here. Actually, the business is already solidly profitable with operating margins posted around 20% of sales. The problem is that interest expenses on a +$16 billion deal outweigh operating earnings around 20%.

Concluding Remark

The recent deal looks a bit rich at around 15 times sales, a far higher multiple with Johnson itself trading around 5 times sales. This marks a huge premium yet is likely a strategic move with Abiomed standing at the forefront of a huge addressable market, as J&J's experience and marketing capabilities create an interesting set-up to drive and grow its franchise further.

With J&J on track to isolate potential liabilities, which makes economic sense, but can be doubted if this is really ethical, I still like J&J as a steady play. Net debt will increase to $15 billion, a minimal amount given the earnings power as earnings multiples remain in check. At these levels, the earnings yield surpasses earnings power by a point or two, while an investment allows for steady growth.

All of this makes me upbeat as I regard the company to be fairly valued, with no intention to aggressively initiate a position here while sell-offs are seen in other areas of the market.