Buy J&J and Avoid the Winner's Curse

Suppose you read this in your favorite financial daily:

"Acme was outmaneuvered by Jones & Co., a much smaller rival, for control of TargetCorp…When Jones raised its bid, Acme was left dumbfounded, unable to respond."

You'd think Acme was run by a bunch of dopes that got outsmarted, right?

This is, in fact, almost exactly how the Financial Times described the outcome of the recent bidding contest between  Boston Scientific (BSX) and  Johnson & Johnson (JNJ) for control of  Guidant . It's a striking example of how the financial media typically treat merger and acquisition deals as sporting contests in which the winners and losers are immediately known--the winners are those who make bold bets and pull the deal through in some tense late-night negotiation.

But unlike a football game won by a last-minute Hail Mary pass, the ultimate winner of a merger battle is unknown when the deal is sealed. If cost savings cannot be wrung out of the combined firm, if the target was in worse shape than anticipated, or if the acquirer simply paid too much, then the "winner" of the merger battle may actually lose out by delivering poor shareholder returns. Conversely, the "loser" winds up winning--which is exactly why I think you should ignore the breathless characterizations of the financial media and buy some J&J shares while they're cheap.

Everything Has Its Price
Sure, a J&J/Guidant combo would have been a powerhouse. And yes, few health-care companies are better than J&J at fixing the kind of manufacturing problems that Guidant has been suffering. But Johnson & Johnson hasn't created one of the world's best multidecade corporate track records by ignoring financial common sense. Everything has its price, and Guidant's simply got too high for J&J. So it did what any prudent investor would do--walked away. Far from being "unable to respond" to a higher bid for Guidant--see the quote above--J&J prudently declined to raise its bid. Big difference.

But perhaps J&J was being too tight-fisted, and the product recalls at Guidant that caused J&J to lower its bid will wind up being not that big a deal in the long run? Maybe--but consider that J&J had been poking around Guidant's operations since the initial deal was struck in December 2004, while Boston Scientific only started getting an inside look at Guidant a full year later. I think that it's a safe bet that J&J was the more knowledgeable party, and if it thought the issues at Guidant merited a lower bid, it's probably right.

What a Company
The benefit from this soap opera for investors is that the hot-money folks on Wall Street have slapped down J&J's shares to a point at which they look very, very attractive. I've always thought of J&J as a well-run health-care mutual fund, without the expense ratio. Consider that its various biotech products would make up one of the largest biotech firms in the world, or that its DePuy orthopedic devices unit would also be the second-largest company of its type if it were a stand-alone firm. Granted, about 50% of operating profits come from pharmaceuticals--but given the 36% operating margins in that division, I don't think that's something to complain about.

Wall Street thinks it is, however, and it seems like slowing growth in pharmaceuticals is one of the reasons why J&J's shares have been whacked lately. This perspective misses the forest for the trees. Sure, sales of a couple of the firm's large drugs have slowed recently as generics have taken market share (Duragesic) and competition has increased (hormonal contraceptives). But most are chugging along nicely, and J&J has a solid pipeline of new drugs coming down the pike--some of which look like they could be big winners. Overall, J&J should file 10 new drug approvals between now and the end of 2007.

The bottom line is that the drug business won't generate the kind of growth over the next five years that it did over the past five, but neither is it falling off a cliff. Overall, we think that J&J will still generate earnings growth of about 9% over the next five years, and share repurchases from the firm's burgeoning free cash flow could add a bit to the per-share earnings growth rate. Also, growth could be a good deal higher if the company's new drugs surprise on the upside.

And, of course, J&J is still J&J, converting almost 20% of sales to free cash flow, generating returns on capital of 30%, and increasing its dividend in near-lockstep with its earnings. Few companies have a more consistent track record of superior capital allocation.

What a Bargain
We think that J&J shares are worth $76, substantially above the current price. As you can see in the chart below, Johnson & Johnson is generating substantially more operating cash flow per share than it was five years ago, yet the stock has largely traded sideways. Moreover, the current price/earnings ratio of 16 is not only lower than it has been in a decade, it's also lower than the market--and I think it's an easy stretch to call J&J an above-average company. Add a 2.2% yield to the 9%-plus earnings growth rate, and you've got a decent prospective total return before taking any multiple expansion into account.

 

Finally, I like J&J because I can clearly identify why the stock is mispriced: The market thinks that J&J is worse off for not having won the Guidant bidding war, and investors seem to believe that slowing pharmaceutical growth is a long-term worry. Given that J&J would have overpaid for Guidant, and that the firm's drug pipeline looks pretty good to us, we disagree. As I've written before, my confidence in an investment thesis is stronger when I can put a finger on why I disagree with the market.