Johnson & Johnson
Bear's Rebuttal
by Brian Graney ([email protected])

Jeff seems to think that I'm obsessed with J&J's past. He's right.

In valuing companies, Fools must look ahead and try to project the expected cash flow streams of our proposed investments. But with a company like J&J, there's just no way to overlook the fact that so much of the firm's performance four or five years out depends on its innovations in the recent past. When there is even a hint of that innovation stream damming up a bit, our future cash flow projections become that much more uncertain.

Sure, J&J is coming up with new products, as Jeff stated. But are they really the innovations the company needs to kick-start its future growth? Benecol margarine may end up being a blockbuster, but in the Finland test market it was priced 10 times higher than regular margarine and was said to "taste terrible," according to Advertising Age. And while J&J has some licensing agreements for a new class of painkillers called Cox-II inhibitors, at least one analyst expects rival Cox-II's (such as Searle's "celebrated" Celebra) will hurt J&J and possibly "eat Tylenol for lunch." More uncertainty.

Throw the changing face of the U.S. healthcare marketplace into the mix, and our valuation becomes even more murky. J&J will be competing against new profit-seeking entities, such as for-profit hospital companies and supra-regional health maintenance organizations more and more in the days ahead. Whether the company will properly adjust to this new competitive environment remains to be seen. What is known is that this added uncertainty also must be rightly discounted in the price we are willing to pay for J&J's future cash flows.

So, how should we value J&J? As fellow Fool Alex Schay recently pointed out, "The ability to accurately predict cash flows ten years out is a feat that precious few investors have been able to accomplish with any success." So, I won't even try. Instead, I'll hand the baton to Jeff, who had this to say about the collective valuations of J&J and its drug-making rivals about a year ago:

"Pharmaceutical companies are not cheap right now... If we were buying any of them outright and in bulk right now, for any time period less than five years, it would be a questionable purchase based on the rate of return that we could realistically anticipate."

I know what you're thinking... "He's digging back into the past again." But at the time, J&J was trading at 3.4 times trailing sales and had a forward P/E ratio of 20. If it was "not cheap" then, J&J certainly does not offer investors a greater margin of safety today with its shares changing hands at 4.8 times trailing sales and with a forward P/E ratio of 27.

We like to own our companies for a long, long time around here. But we also like to acquire shares of our chosen companies at attractive valuations. J&J is a tremendous performer and its impressive financial results year-in and year-out definitely warrant some kind of premium in the marketplace. But right now, that premium is pretty stiff. If J&J's valuation seemed questionable to Jeff a year ago, it certainly is too rich for my blood today, especially considering all the uncertainties mentioned above.

Dr. Brian's advice: Take two Tylenol and call me when J&J's share price is more attractive.

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