Johnson & Johnson Remains Undervalued

Johnson & Johnson, Inc. (JNJ) currently trades at 12.5x our 2009 EPS estimate of $4.51. We believe J&J’s diverse and deep product mix, lack of cyclicality, strong financial position and consistent record of earnings growth will insulate it from a prolonged economic downturn.

We believe J&J offers investors long-term value with low risk in the form of stable earnings and a diverse product portfolio. While management’s 2009 EPS guidance implies a slight contraction from 2008, results through the first quarter were ahead of ours and consensus estimates. We also note that actual results can be highly influenced by the movement in foreign exchange rates.

In the near-term, the company’s “AAA” credit rating, large cash balance and product and geographic diversity should provide some downside protection in the event that economic conditions deteriorate further. We believe the stock remains attractively priced at these levels, and reiterate our Buy recommendation with a $70 price target. The dividend currently yields 3.5%.

Delving deeper: Pharmaceuticals Division

J&J continues to contend with generic competition, which is keeping a lid on growth of its Pharmaceutical division. Patent expirations of Risperdal (expired) and Topamax (March 2009) are key losses at the division. Remicade will also come under pressure as additional competition comes online.

Plus, the safety issues surrounding ESA’s has had a substantially negative affect on Procrit sales. While the company has a number of late-stage candidates that are expected to be commercialized in the near-term, they will not begin to make a material impact until 2010 or 2011.

Yet, despite these issues, the company continues to forge ahead with commercializing its late-stage pipeline, which should help soften the impact of recent generic competition beginning in 2010. The list of drugs recently gaining initial approval or expanded indications over the last 18 months includes Ustekinumab, Risperdal, Invega, carisbamate, Yondelis, Prezista, Intelence, Zevtera and Tapentadol.

We expect the Pharmaceutical division to post flat sales growth from 2008 through 2012.  We think a significant portion of earnings growth will likely come from cost savings, and thus earnings growth should outpace revenue growth for several years ahead.

While first quarter 2009 revenue was below estimates, EPS surprised on the upside due to management’s ability in quickly and effectively trimming costs. We expect cost-control to be a significant contributor to EPS growth going forward.

Other Divisions

The Consumer division has historically been a strong catalyst of revenue growth for J&J, and while it’s more sensitive to a softening economy, we believe it can grow sales at a 4-year CAGR of almost 4% from 2008 to 2012. The Medical Devices should also continue to be a significant contributor to J&J’s top-line and is expected to grow substantially faster than pharmaceuticals despite the recent influx of competition to the Cordis division’s products. We look for Medical Devices sales to grow at a CAGR of 5% through 2012.

The shares currently trade at 12.5x our 2009 EPS estimate of $4.51. We model EPS to grow at a 4-year CAGR of 5% through 2012. We believe the shares remain undervalued given J&J’s strong financial position and ability to post solid growth even in times of severe macroeconomic stress.

We reiterate our Buy recommendation and have established a price target of $70, yielding 24% before dividend (currently yielding 3.5%). Our price target implies a P/E multiple of 15.5x our 2009 EPS estimate of $4.51.

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