INITIATING COVERAGE REPORT

William C. Dunkelberg Owl Fund October 16th, 2013

Johnson & Johnson

Exchange: NYSE Ticker: JNJ
Jesse A Furukawa Lead Analyst JFurukawa@theowlfund.com

RECOMMENDATION
Share Price Dividend Yield Projected Return

BUY
$89.93 3.00% %16.08 $67.80-$94.42 0.59 $ 252.0767 $241.9297

Target Price: $101.69

Jesse Worek Associate Analyst JWorek@theowlfund.com

Market Data
52 week trading range Beta Market Capitalization (billion) Enterprise Value (billion)

Robert J Kost Associate Analyst RKost@theowlfund.com

COMPANY OVERVIEW Johnson & Johnson is one of the largest healthcare companies in the world and provides human health and well-being products worldwide. JNJ operates in three business segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The Companys Consumer segment (21.5% of 2012 Revenue) offers baby care, skin care, oral care, wound care, and womens healt h products, in addition to over-the-counter and nutritional pharmaceuticals. Some major brands in the Consumer segment are Aveeno, Neutrogena, Listerine, Band-Aid, Splenda, Tylenol, and Motrin. JNJs pharmaceutical segment (37.7% of 2012 revenue) provides anti-infective, antipsychotic, contraceptive, gastrointestinal, hematology, immunology, infectious diseases, neurology, oncology, and thrombosis medications as well as vaccines. Some of the top selling drugs in Johnson and Johnsons extensive portfolio include Remicade, which treats rheumatoid arthritis, Prezista, which is used to slow the progress of HIV, and Velcade, which used in oncology. JNJs Medical Devices and Diagnostics segment (40.8% of 2012 revenue) operates in the following fields: orthopedics, surgical care, vision care, diabetes care, specialty surgery, diagnostics, cardiovascular care, and infection prevention.

Financial Data
Cash & Equivalents (billion) Debt (billion) $14.911 $14.982

Revenue (in millions)

$75,000
$70,000 $65,000 $60,000 $55,000 2008 2009 2010 2011 2012 TTM 2013 2014 Est Est

Earnings History
Earnings Date 2Q13 1Q13 4Q12 3Q12 Earnings Date Q1 Q2 Q3 Q4 FY EPS GAAP $1.33 $1.22 $0.91 $1.05 EPS 2013 (E) $1.387(A) $1.48(A) $1.321 $1.217 $5.462 Rev YoY 8.51% 8.46% 8.02% 6.54% Price 0.0% 2.12% (0.74)% 1.38% EPS 2014 (E) $1.488 $1.505 $1.431 $1.37 $5.821

Pharmaceuticals

INVESTMENT THESIS Since going over the small-molecule patent cliff, the large pharmaceuticals industry has lost exclusivity protection on billions of dollars in prescription drug sales. While Johnson and Johnson also experienced some sales decline, its revenue sources are far more diversified than its industry competitors both geographically and economically. Currently it trades at a discount to its 3-year benchmarked P/E average. Going forward, we believe multiple expansion will be driven by a few factors: increased demand for medical devices from PPACA enrollment, growth in the consumer staples segment due to exposure in emerging markets, reinvigorated growth in OTC pharmaceuticals that had been recalled and accretion of acquisitions/product launches. INDUSTRY OVERVIEW Moving forward the Pharmaceuticals industry continues to face patent expirations from many top-selling drugs, particularly from Big Pharma. Last year alone the industry faced a record $35.1 billion in patent expirations, with a 2013 projected loss of $18-20 billion. Due to such expirations, generic competition will continue to gain market share, squeezing margins. To combat such pressures the industry has enacted strategic measures including cost-savings initiatives; increased mergers and acquisitions to bring about product diversification and synergies; and higher research and development focus on biologics, which have little generic competition due to their complexity over smallmolecule drugs. Additional short-term growth will be fueled through the new coverage of up to 32 million currently uninsured Americans in 2014. In the long-term, demand will be driven by better healthcare access in emerging markets, with a low-end market estimate of $615 billion for branded drugs in an overall market of approximately $1.2 trillion.

Analyst EPS Adjusted+ Estimates

EPS Adj.
$7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 2008 2009 2010 2011 2012 2013 Est 2014 Est

Healthcare

All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports. Thus, investors should be aware of possible conflicts of interest that could affect the objectivity of this report.

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POSITIVES
o Strong pipeline of drugs including some biologics, which are a fundamentally more sustainable growth driver than smallmolecule alternatives Consistently strong cash generation since 2005 AAA Credit rating outlook according to S&P (Better 2012 marked JNJs 51st consecutive year raising its dividend Mature blue-chip conglomerate, solid defensive stock given the current economic environment Low Credit risk concentration due to geographically and financially distributed accounts receivable Hedges against global currency fluctuations Strong late-stage pipeline indicators for Immunology, Infectious Disease, and Oncology segments Reintroduction of certain OTC products that had been recalled Strong lines of communication with hospitals and other healthcare facilities. Developing holistic healthcare supply solutions While JNJ has recently levered its balance sheet to a greater extent than in the past, rates are low and these funds were used not only to return value to shareholders, but also to expand manufacturing and research facilities worldwide JNJ has decreased its General Corporate asset base by $10B in the past year while investing in almost $20B in its MDD asset base Revenue growth slowdown has bottomed out and will pick up on the pharmaceutical segments new product launches

RISKS AND ECONOMIC MOATS Risks

o Accelerated generic encroachment directly into JNJs product offerings o Medical Device excise tax resulting from PPACA regulation could adversely affect bottom line earnings o Further government shutdown could prevent the FDA from achieving enough throughput to efficiently move pharmaceuticals/medical device products to market o Weak economic activity could adversely affect revenues in Consumer segment o Product Recalls could cause an abrupt decline in sales in any segment that JNJ deals in

o o o o o o o o o o

o o

Economic Moats
o Goodwill and Brand value developed organically and through acquisitions o Economies of Scale- JNJ has a widespread supply chain that does not rely on a small concentration of firms. This prevents supply constraints from affecting sales materially. The distribution of this companies resources also allows it to efficiently reach foreign markets where it occasionally benefits from manufacturing and developing drugs on-site. o Intellectual property that is protected by legal patents and/or trademarks means that these revenues are not susceptible to sudden market share loss due to competitive entrants

Imminent Indication Approvals in US and EU

14 12 10 8 6 4 2 0 Oncology Neuroscience Immunology Infectious Cardiovascular Diseases

# of Indications in Late-Stage Registration US # of Indications in Late-Stage Registration Europe

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Segmented Peer-group Identification o o o Consumer: Colgate-Palmolive Co. (NYSE:CL), Church & Dwight Co. Inc.
(NYSE:CHD), Kimberly-Clark Corporation (NYSE:KMB), The Procter & Gamble Company (NYSE:PG)

TARGET PRICE Relative Target Multiple = 17.5x P/E NTM Forecasted EPS = $5.80 Peer Analysis Target Price = $101.69

Pharmaceuticals: Bayer AG (DB:BAYN), Bristol-Myers Squibb Company

(NYSE:BMY), Eli Lilly and Company (NYSE:LLY), and Roche Holding AG (SWX:ROG)

Medical Devices and Diagnostics: Becton, Dickinson and Company

(NYSE:BDX), CR Bard Inc. (NYSE:BCR), Stryker Corporation (NYSE:SYK), Thermo Fisher Scientific, Inc (NYSE: TMO), Zimmer Holdings, Inc. (NYSE:ZMH)

FINANCIAL ANALYSIS: Sales: In the early 2000s, JNJs revenue breakdown was more heavily weighted in the MDD segment than it is currently. In the mid 2000s though, the Consumer segment, lead by OTC Pharmaceuticals and Nutritionals, grew nearly 50% to become 23.72% of total revenues as opposed to 18.33% the year before. Since 2009 though, the Consumer segment share of sales has been trending downward in favor of the MDD segment (5.17% 3yr sales growth). The MDD segment has consistently been the most profitable over the past 6 years and as such, increasing revenue contribution from these segments would incrementally improve the margins of the whole company. Geographically, JNJ has been getting an increasing share of revenue from emerging markets like Africa, Asia and South America. All segments have experienced almost entirely positive growth in foreign markets, but these regions alone have a 5-year revenue CAGR of 9.47%. This exposure of their Consumer and MDD segments to potentially large foreign markets not only provides JNJ with growth opportunities, but also further diversifies them economically. Figure 4 is a graphic representation of this geographic breakdown over time. You can see the ASPAC, Africa and Western Hemisphere excl. US segments have been steadily growing while the sales share coming from Europe and the US has slightly declined. In our DCF model, we made considerations of product mix shift within our revenue projections. We predicted around 2.5% growth for Consumer revenues to account for the relatively flat/slightly downward trend in absolute revenue while also considering possible increases in revenue abroad. To the MDD segment, we applied a short-term growth rate of 6% to model an appropriate increase in demand for medical devices and diagnostics as more enrollments in managed care leads to increased demand for these products. We calculated the 4-year CAGR for this segment (4%) and predicted that sales would increase an additional 2% due to this increased demand. Overall, the Pharmaceutical segment was the main sales driver in our projections. We had to break down JNJs timeline of current drug expirations and integrate it with their pipeline of future drugs. We forecasted the contributions from current drugs to the end of their commercial lifecycles and projected the value contributions of future drugs by modeling out their clinical testing/approval periods and commercial lives when launched. Most of the revenue growth in this segment was driven by our projections of Remicade, a biologic drug that consists of around 9% of JNJs total sales, making it the companys single largest product in terms of revenue. Remicade has faced some biosimilar threats, mostly abroad in Europe, but JNJ has successfully appealed patent extensions in Europe and the US to February 2015 and September 2018 respectively. This combined with the notoriously difficult biosimilar development process should insulate Remicade from market-share erosion in the short-term.

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Acquisitions: Argon Pharmaceuticals Synthes Inc. Synthes Inc. acquisition was made in April 2011 and closed in June of 2012. Final transaction value was about $16B, which was made in cash and stock issuance, and included about $5B in goodwill. Management expects its product contributions in the Orthopaedic segment of MDD to amount to between $.10 and $.15 this year. This year, the company announced and closed the acquisition of Aragon Pharamceuticals Inc. for $650 million. Aragon makes therapeutic oncology medications for prostate and breast-cancer. Management considers one of the acquired secondstage molecules to be a potential best-in-class treatment for castration-resistant prostate cancer. Divested: Reach-12/18/2012 Bystolic-4/2/2012 357million, Therakos While JNJ is making more acquisitions in healthcare than most other big pharma players, they have also divested from a couple operations since 2012 including Reach Toothbrushes, Therakos, Bystolic and other unspecified targets. Therakos is a cellular therapy R&D firm sold at the beginning of 2013, the proceeds from which are undisclosed. Reach is a Consumer segment brand that was announced to be sold for cash at the end of 2012; it has yet to be closed. Bystolic is another drug segment that sold in mid-2012 for $357 million cash.

Overhead costs: Tax rate: 23.67% FY2012 R&D/Sales: 11.5% FY2012 SG&A/Sales: 31% The company has conformed to the industry trend of cost-cutting in some ways. While they have been making acquisitions and hiring more employees, they have also decreased some of their overhead costs. FY2012 effective annual tax rate was higher than usual due to increased tax burden in Q1 and Q2. This year the tax rate is on pace to be less than 20%. JNJ recognizes itself as an innovative healthcare company and as such targets an R&D margin that is typically in the 11%-12% range. This ideal has not been compromised even in the face of patent expirations and reduced sales growth because the company and the industry believe it to be a long-term success driver. The SG&A margin is lower than most pharmaceutical companies because the Consumer and MDD segments do not require as much direct marketing to healthcare professionals. JNJ has employed licensing agreements in some circumstances to offset the risk of investing in marketing activities for its drugs. In its most recent quarter, the company announced SG&A expenses that imply a margin of 30.2%. The decrease in general corporate assets should also imply a lower SG&A expense margin as there are fewer assets dedicated to these activities.

Debt/Liquidity: Total Debt/Equity: 21.51% (MRQ) Quick Ratio: 1.55 (MRQ) S&P Credit rating: AAA JNJ is a company with a strong balance sheet. It remains very liquid with historically about a 2x current ratio. While they have recently taken on some debt to buy back shares and make acquisitions, they actually had a net decrease in current ST/LT debt and overall LT borrowings from 2011 to 2012. Even disregarding their inventory as assets, the quick ratio shows us that JNJ still has sufficient current assets to cover its current liabilities.

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Margins: Operating Margin: 28.34% (S&P 500 Healthcare Sector Average: 11.59%) Margins appear 40% to be relatively EBIT Margin Segment Breakdown (6-year) 35% stable in spite of volatility in the 30% Pharmaceuticals 25% and MDD MDD segments 20% stemming from Pharmaceut15% the regulatory icals 10% environment Consumer both 5% domestically and 0% abroad. JNJs 2007 2008 2009 2010 2011 2012 superior MDD 28% 31% 33% 34% 20% 26% profitability metrics over the Pharmaceuticals 26% 31% 28% 32% 26% 24% S&P 500 Consumer 16% 17% 16% 16% 14% 12% Healthcare sector are driven by the margins in the Pharmaceuticals and Medical Devices and Diagnostics. The product mix shift into segments with these superior margins should work to expand multiples.

Shareholder returns: Dividend Yield: 2.95% -DPR jumped from around 40 to 60. DPR is superior generally ROE: 19.78% (S&P 500 Healthcare Sector Average: 18.19%) ROC: 15.86% (S&P 500 Healthcare Sector Average: 12.73%) Besides the dividend yield of about 3%, JNJ will occasionally enact share buyback plans. The last buyback plan was for 10B USD: the plan was approved in July of 2007 and finally completed by the end of 2010. This is an international company and like many international companies based in the US, it holds a significant portion of its earnings overseas. Consequently, these buybacks were not all cash, but also partial ly financed by debt. We dont see this as a problem though considering the low interest rate environment, the companys AAA credit rating and the potentially large tax burden the repatriation of those cash flows would incur. Refer to Figure 2 to see how the companys capital structure has changed over the past 5 years. It has maintained its ability to pay interest expenses while also paying down enough of its debt to reduce its debt/capital ratio significantly.

Cash Flows: Dvd P/O: 60.9% JNJ has historically had a safe dividend as it has grown every year for fifty consecutive years. While its dividend has experienced constant growth, its dividend payout ratio has typically hovered around 40% until it recently broke upward. This increase in the payout ratio can be

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attributed to the weak earnings growth in the industry over the past couple years. This ratio is as low as any of its competitors and given its history of growing its dividend, we believe that this aspect of the shareholder return is protected. While FCF have trended down the past few years

Earnings/Guidance: Since 1Q of 2003, JNJ has beat Wall Street adjusted EPS estimates every quarter except twice. The share price however, is not heavily influenced by posted earnings as one of those quarterly misses, the stock price went up slightly and the other occasion the stock dipped not even 2%. In an annual perspective, JNJs average surprise is .39% while their 5-year earnings growth is 2.96%. The MRQ, which was released Tuesday morning, beat on both top-line and bottom-line estimates. Sales were $17.575B, a 0.72% surprise and 3% increase in sales YoY; and EPS adjusted were $1.36, a 2.72% surprise, representing a 9% increase YoY. During this release, management also raised FY2013 guidance to $5.44-$5.49, a few cents above its previous estimate.

RELATIVE VALUATION: In the relative valuation, we can see that JNJ is trading at a discount to the different segments, despite having a higher gross margin than the Consumer and Medical Devices and Diagnostic segments along with highest net income margin in all three segments. Additionally, the company also has the highest projected revenue growth than its peers in every segment. Particularly noteworthy is how JNJ is expected to have positive revenue growth while the Pharmaceuticals segment is expected to have declining sales. Furthermore Johnson and Johnson is the only company in the pharmaceutical segment with a positive hiring CAGR. Large pharmaceutical companies are expected to have declining sales in the future and have started cost-cutting plans in order to maintain or increase earnings. While much of Big Pharma has been laying workers off, Johnson and Johnson has been hiring employees, which shows managements confidence in the company going forward. JNJ has a higher return on assets than the Medical Devices and Diagnostics comp group; and since the creation of these devices is machine intensive this profitability metric is especially important considering the fact that most of the companys capital assets are in this segment (~$42B). This superior performance in each segment shows the value in Johnson and Johnson and leads us to believe that it should be trading at the weighted P/E multiple of the sum-of-its-parts instead of trading at a discount.

Segment Consumer (21.5%) Pharmaceuticals (37.7%) Medical Devices and Diagnositcs (40.8%) Total Johnson & Johnson (NYSE:JNJ)

Market Cap 17865 44523 10826 73214 252077

LTM P/E 4.6 11.0 10.8 26.4 19.9

NTM P/E 3.9 7.1 6.5 17.5 16.2

Revenue Growth NTM 0.8 -0.2 1.2 1.8 5.2

LTM Gross Margin 10.3% 28.6% 25.4% 64.3% 68.8%

LTM Net Income Margin 2.3% 6.7% 5.8% 14.8% 18.4%

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APPENDIX:

Figure 1: CAPEX vs. CFO 2009-2011 (Source: JNJ 2012 10k)

Figure 2: Credit Outlook/Capital Structure for JNJ 2008-2012

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Figure 3: Change in employees from 2003-2012

Figure 4: Geographical Revenue breakdown 2007-2012

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Figure 5: Acquisition Spending of JNJ 2008-2012

Figure 6: JNJ vs. MDD comp group 3-yr P/E

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Figure 7: JNJ 1-yr P/E graph

Figure 8: JNJ/S&P Healthcare Sector 3-yr P/E

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DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward-looking statements contained within are simply the authors opinions. The writer does not own any Johnson & Johnson stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real-world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals are threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions

Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.

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