Dear Mr. Berko:

What is your opinion of Johnson & Johnson, the huge drug company whose over-the-counter division makes Band-Aids and Tylenol, whose baby products division makes Aveeno and Balmex, and whose wax division makes Turtle Wax and floor waxes? The stock still trades at $60, which is where it was after the split almost five years ago.

I’ve studied the company thoroughly and I have come to the conclusion that it is undervalued and should be bought immediately, because it has the potential to move higher very soon. Confirm that you agree and let me know as quickly as possible. If you do not agree with my conclusions, please enumerate each specific reason that causes you to disagree with my analysis.

D.S., Waukegan, Ill.

Dear D.S.:

It is possible that your thorough study of Johnson & Johnson (JNJ-$60.74) might be flawed; I didn’t know JNJ had a division that makes wax products. Or could you be thinking of S.C. Johnson & Son Inc., which makes Windex, Pledge, Ziploc, Edge, Drano, Shout, Saran Wrap and all sorts of Johnson floor waxes? And by the way, the S.C. Johnson folks do not make Turtle Wax; rather, it is made by Turtle Wax Inc., a company based in Chicago.

However, I do agree with your fine analysis of JNJ. Though I think it has potential to move much higher very soon (as many good stocks do), I doubt that it will. But I can tell you that JNJ is a super long-term investment and some of our clients have owned the stock for at least a dozen years. The company’s sales growth for the most recent quarter was 1.2 percent (lower than expected), while earnings improved by 4.5 percent, also lower than the Street’s forecast. Pharmaceutical sales fell by 2.2 percent, and consumer sales and medical device revenues grew by 3.3 percent. However, the increase in earnings could have been at least 50 percent higher but for the effects of the lower dollar. As you know, nearly 40 percent of the company’s revenues derive from overseas sales.

The share price has been lackluster since 2000, though dividends, book value, cash flow, revenues and earnings all have doubled. Those are inarguably impressive results; however, I’m a little less sanguine about the next six years.

I’m a JNJ enthusiast because its superb management has ensured that 70 percent of JNJ products hold the No. 1 or No. 2 spot in their respective markets. That’s not unimpressive. I’m a JNJ devotee because I’m told the company will file nine to 11 new drug approvals next year. That’s not unimpressive, either. I’m a JNJ aficionado because the company intends to buy back $5 billion of its common stock in the coming 12 months and has more than $15 billion in cash and securities on its balance sheet. That cash cache gives JNJ (which lost Guidant to Boston Scientific) plenty of flexibility and good affordability to make almost any acquisition it needs to make. And I’m a JNJ votary because its average five-year return on capital exceeds 30 percent, and because this year’s free cash flow could exceed 20 percent of revenues.

I believe JNJ’s growth over the coming six years will not be as vigorous as it was during the past six years. Acquisitions or mergers excepted, I think recent earnings of $3.50 per share could reach $5.45 by 2012, and the $1.50 dividend might increase to more than $2. I believe revenues can grow from $51 billion to $70 billion, that cash flow can increase by 50 percent, that book value can grow by 60 percent and, best of all, I think the stock has the potential to trade above $110 a share.

This company’s superb management, its excellent track record, its bulging coffers and its well-diversified portfolio of health-care and consumer products offer shareholders attractive, risk-adjusted total return potential. So if you’re a conservative, long-term investor, you’ve just got to love this stock. But if you think JNJ will soon have a significant upside price change, then you’re probably dumber than a partridge in a pear tree.

Please address your financial questions to Malcolm Berko, P.O. Box 1416, Boca Raton, Fla. 33429 or e-mail him at malber@adelphia.net.

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