JNJ is a core holding in our Conservative Retirees dividend portfolio due to its 3% dividend yield, low business volatility, reasonable valuation, and rock solid fundamentals. The Conservative Retirees dividend portfolio contains 25 stocks with extremely safe dividends and above average dividend yields, providing steady and predictable income while preserving your capital. JNJ was added to the portfolio on 6/25/15 at a price of $99.12 (the stock closed at $99.36 on 8/18/15).
To quickly view the 25+ years of JNJ’s dividend data and 10+ years of critical fundamental data we look at to analyze the company, click here.
Business Overview
With over $70 billion in sales spread between pharmaceuticals (43% of sales, 36% operating margin – immunology, infectious diseases, neuroscience, oncology, and cardiovascular and metabolic diseases), consumer (20% of sales, 13% operating margin – baby care, oral care, skin care, OTC pharma), and medical devices (37% of sales, 20%+ operating margin – surgery, orthopedics, and consumer medical devices), JNJ is one of the largest and most diversified health care companies. International sales account for just over half of JNJ’s total sales, and the company runs a decentralized management structure with more than 265 operating companies spread across 60 countries.
Stock Performance
Over most periods of time, JNJ has kept up with or outperformed the market. The stock’s performance has been more moderate over the past year, returning just 1.5% and trailing large caps by more than 5%.
Dividend Analysis
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. JNJ’s long-term dividend and fundamental data charts can all be seen here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
JNJ scored a premier Safety Score of 99, meaning its dividend is safer than 99% of all other dividend stocks. Dividend investors need not worry about losing sleep if they own JNJ.
As seen below, JNJ has generally maintained EPS and free cash flow payout ratios between 40-60% over the past decade, suggesting there is reasonable cushion to continue paying and growing the dividend, even in the event of an unexpected decline in the business. Although we are dealing with “non-GAAP” figures, JNJ has impressively grown its adjusted earnings for over 30 consecutive years. A business doesn’t get much safer than that.
Many of JNJ’s products are fairly recession proof in nature, which helped the company limit sales and EPS declines to just 3% and 4%, respectively, in fiscal year 2009 while raising the dividend by more than 5%. As seen below, operating margins hardly budged during the recession:
High operating margins and even moderate sales growth are usually a recipe for nice free cash flow growth, and we see that is certainly the case with JNJ:
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during the recession help give us a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.
JNJ’s debt to capital ratio has oscillated between 10% and 20% over much of the past decade, maintaining a conservative amount of leverage (especially given the lower volatility of the business). With all of the free cash flow that JNJ throws off, it has built up quite a fortress on the balance sheet. As seen below, JNJ has nearly $20 billion in net debt, the equivalent of more than 7% of the company’s current market cap. The balance sheet provides a solid foundation for JNJ to continue paying and growing its dividend while investing in opportunities for growth.
Dividend Growth Score
Our Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios.
JNJ’s Growth Score is 52, meaning its dividend’s growth potential ranks about in line with the average dividend stock’s growth potential (a score of 50 is “average”).
While JNJ has raised its dividend for over 50 consecutive years, the rate of increases has gradually slowed. As seen below, JNJ’s dividend compounded at a 9% clip over the past decade but has since come down to a 6-7% growth rate.
The company’s sheer size (over $70 billion in revenue) also makes it difficult to see a future in which JNJ’s dividend can grow faster than current rates. JNJ’s sales compounded at a 3.7% annualized clip over the last five years, and sales growth seems likely to remain in the 2-5% range going forward.
Yield Score
Our Yield Score simply ranks a stock’s current dividend yield against all of the other dividend yields in the market. A score of 50 means the stock’s yield is right in the middle of the pack. A score of 100 means it has the highest yield. The Yield Score helps assess a dividend stock’s relative value.
JNJ’s Yield Score is currently 60, meaning its 3% dividend yield is higher than 60% of all other dividend stocks. For a company with great dividend safety but modest growth prospects, this appears to be reasonable.
Competitive Strengths
Few companies ever come close to growing as large as JNJ has become. Generating $70 billion in sales has numerous advantages that will keep JNJ relevant for a long time to come.
Starting at the top, JNJ’s management team is very focused on investing only in markets that the company can dominate. Today, roughly 70% of JNJ’s sales are from #1 or #2 global market share positions, and management has shown a willingness to divest underperforming or non-core parts of the business. With nearly $20 billion in net cash, management can also remain opportunistic with buybacks and M&A opportunities, especially as the biopharma industry evolves.
This approach has been a successful one and helped JNJ develop 24 brands with over $1 billion in sales (including a consumer portfolio with some of most well-known global brands – Tylenol, Motrin, etc). In addition to a wide array of successful brands, JNJ’s three operating segments are each driven by different factors, with the consumer business providing predictable cash flow to fund growth in pharmaceutical investments. This adds to JNJ’s resilience to economic cycles and helps fund innovation.
Speaking of innovation, JNJ invests over $8 billion in R&D each year. As the largest pharma company in the US, JNJ has the most FDA approvals since 2009, releasing 14 new products, but also boasts that 25% of its sales are from products launched in the past five years. With $70 billion in revenue, that means JNJ successfully commercialized $18 billion of new products in five years, more than $3 billion per year. Such results are a testament to JNJ’s innovation, R&D processes, brand strength, and scale advantages.
Pharma has been JNJ’s growth driver, and it is one of the widest-margin industries to be in. Competition is somewhat limited due to tough governmental regulations (testing and documentation requirements for FDA clearance of new drugs are only increasing) and the R&D intensity of the industry (biopharma companies invest more than 10x the amount of R&D per employee than all manufacturing industries overall). If a drug reaches final approval and is successfully commercialized, favorable patent protection allows for a nice ramp of cash flow to more than recoup R&D efforts.
While generics are taking more share and regulations can always change, there are several fundamental factors that make this space appear to be a good long-term bet for JNJ. The elderly population drives about a third of industry sales and should see secular growth as the average age of people increases around the world. Ground-breaking discoveries in genomics and biotech will also catalyze new drug development. FDA approvals of new molecular entities are also happening at a faster pace, with 41 approvals in 2014 (up from 27 in 2013 and 39 in 2012).
Perhaps one of the biggest long-term tailwinds is JNJ’s exposure to international markets (over 50% of sales). As seen below, courtesy of PWC, demand for medicines is rising rapidly in emerging markets:
Even with all of these competitive strengths, JNJ is not always invincible. One area of recent weakness is JNJ’s Hepatitis C drug Olysio, which got off to a really hot start last year (recorded over $800M in revs in Q2 2014 but only $264M in Q2 2015) but has since collapsed in the face of competing products that were approved later by Gilead and Abbvie. JNJ’s diversification helped cushion this blow, and it has a handful of drugs in the pipeline that it expects will help it grow its drug sales above the industry average for the next five years. JNJ also partnered with Achillion to try and develop a better Hepatitis C product (Hepatitis C is a huge market – potential to reach $32 billion in drug sales by 2018), but any impact from these efforts is likely several years away.
Altogether, one of the quickest ways to assess the strength of a business model is to evaluate the level and durability of a company’s return on invested capital. As seen below, JNJ has generally maintained a return on invested capital in the teens or higher for the past decade, signs of a durable and consistent business.
Looking at growth, it’s important to remember the $95 billion drop in sales the industry experienced from 2010 to 2013 due to the patent cliff of expiring blockbuster drugs. A peak of 48 drugs lost exclusivity in 2012, but only 20 did in 2013 and around 25 in 2014. JNJ weathered this storm fairly well, with sales dipping just 1% in fiscal year 2010:
Near-term growth has been impacted by weak Hepatitis C sales and unfavorable currency movements. Adjusting for the impact of Hepatitis C sales and acquisitions and divestitures, core growth was 6% last quarter (+1.7% including Hepatitis C impact).
Key Risks
Each of JNJ’s operating segments has a unique risk profile. Let’s start with the consumer business (20% of sales, 13% operating margin), which owns an assortment of well-known brands including Tylenol, Zyrtec, Band-Aid, Neutrogena, Listerine, Motrin, and Aveeno.
In 2010, JNJ’s consumer business fell into a world of trouble. Several of its plants were closed after JNJ recalled tens of millions of products, including its Tylenol and Motrin brands, in response to continued complaints about strange odors coming from the products (manufacturing issue). The company had to spend $100 million to upgrade the plant and correct the issues, but its OTC consumer business lost basically its entire market share in certain categories.
After several years of underperformance, the consumer business appears to be back on track today (organic sales up 4% YTD) and able to play the role of predictable cash cow to fuel investment in JNJ’s higher-margin pharmaceuticals segment. With its strong brands and global reach, the consumer business should continue reducing JNJ’s business volatility (provides a solid base to help offset the occasional drug patent cliff) while providing modest growth.
JNJ’s medical devices business (37% of sales, 20%+ operating margin) appears to carry a bit more risk than the consumer segment. This business has underperformed peers in recent years and carries less exposure to areas that are exhibiting higher growth rates (e.g. robotics). With ongoing consolidation among health systems and insurance providers, pricing has also come under some pressure. However, this segment is still #1 or #2 in the majority of the categories in which it competes and has ten $1 billion plus platforms.
JNJ’s most important business is its pharmaceutical segment, which has generated 30%+ operating margins in each of the past two years and been a key growth driver. This business also seems to face the most risk, in part due to its outsized contribution to company profits.
First, the nature of the pharma industry can create some volatility. Pharma companies spend years and hundreds of millions or even billions of dollars developing a drug. If the drug is one of the lucky few that gains FDA approval, the pharma company can rely on patents and IP rights to gain a nice return on the heavy R&D investment (R&D is typically 15-20% of pharma companies’ revenues) needed to bring the product to market. PWC’s chart illustrates this long cycle:
Once the patent expires, competition in form of cheaper generic drugs typically enters the market, taking share and creating price pressure. As such, a drug’s revenue follows a bell curve pattern and requires the pharma company to consistently invent new drugs to replace revenue losses due to patent expiry. Depending on the size of the drug, this is not always an easy task and pipeline disappointments can be a risk. The following chart, courtesy of Statista, highlights the revenue curve of Lipitor from 2003-2014.
JNJ’s drug portfolio is fairly diversified, with REMICADE representing its largest drug by far with $6.8 billion in sales last year (around 9% of JNJ’s total revenue). However, no other drug is over $3 billion in sales. With REMICADE’s European patent expiring earlier this year, biosimilars could pose a threat to this drug’s market share. Longer-term, however, JNJ believes it will file 10 new drug filings by 2019, each with the potential to reach $1 billion in annual sales. Continued innovation is needed to keep growing the pharma business, and JNJ has one of the best track records.
Besides patent expirations, the pharma business faces regulatory risk. Insurance companies and governments pay for the majority of drugs and, with an ever-increasing desire to take costs out of the healthcare system, seem likely to increasingly view many branded drugs as overpriced medications. Generics provide greater savings and are seeing their drug spending as a proportion of total health spending continuing to creep up. As seen below, generics are growing faster, but branded prescriptions are also expected to show steady growth in coming years. This is also a massive market – $1 trillion in size and only getting bigger.
Source: EvaluatePharma
As long as JNJ’s $8.5 billion R&D budget and drug development processes remain effective and industry regulations don’t quickly change to crimp JNJ’s juicy operating margins, this division should see continued growth, although some years might be better or worse than others due to drug timing issues. Favorable industry trends include increasing healthcare expenditures, an aging population, the rising prevalence of chronic diseases such as diabetes and obesity, reimbursement for pharmaceutical product costs, and the Affordable Care Act (it might pressure drug pricing lower, but new coverage will be provided to 25+ million currently uninsured Americans, expanding the prescription drug market).
Outside of JNJ’s operating segments, risk is also posed by the company’s international mix (over 50% of sales are outside of the US) as the US dollar continues to strengthen. While fiscal year 2015 sales growth is being impacted, currency headwinds should ultimately prove to be a short-term issue.
JNJ has also been highly acquisitive throughout its history (bought orthopedic products business Synthes for $20 billion in 2012; bought PFE’s consumer health care business for $17 billion in late 2006), investing about 30% of its free cash flow over the past decade on deals. Large acquisitions can make or break a company, but JNJ has proven to be a disciplined dealmaker – over the last 20 years, it has acquired 130 companies but only 13 of those deals were greater than a billion dollars.
It seems unlikely that JNJ would blow its excess cash on an uneconomical large deal, and the company has shown willingness to part ways with non-core or underperforming businesses (i.e. the management team doesn’t appear to have an empire builder mentality).
Product liability claims and lawsuits are another risk shareholders should be aware of, but these events are difficult to predict and JNJ’s cash pile is more than enough to cover any damages.
Valuation
With a 3% dividend yield, JNJ has a higher yield than 60% of the 2,700+ dividend stocks we monitor. However, given the company’s modest growth profile (52 Growth Score), the stock does not appear to be cheap on yield alone.
Looking at other metrics, JNJ trades at 17.5x last year’s earnings and about 16x FY15 EPS estimates; both multiples are a slight discount compared to the market but look more favorable after factoring in JNJ’s nearly $20 billion in net cash ($7 per share; “net cash adjusted” forward P/E multiple is more like 15x).
If JNJ can continue growing 3-5% organically while maintaining current profitability levels, today’s valuation seems fair and positions the stock for upper-single digit total returns going forward (3% dividend yield plus 5-8% annual EPS growth) with less volatility than many other stocks.
Conclusion
JNJ seems most appropriate for dividend investors looking for extremely safe current income from a stock that will let them sleep well at night. From the company’s disciplined capital allocation to its nearly $20 billion in net cash, JNJ will be a diversified force in health care for many years to come. The current price seems fair for a company of this quality, albeit one with a modest growth profile. For these reasons, JNJ is a core holding in our Conservative Retirees dividend portfolio.
Leave A Comment