JNJ reported Q3 earnings last month. Currency headwinds hurt reported sales growth by about 8%, and the expected run off of hepatitis C products added additional pressure. Excluding these two items, JNJ’s revenue would have grown by 5.6%, in line with last quarter’s adjusted growth and not bad for a company with over $70 billion in sales last year.
There are many reasons why we like JNJ and have made it a core position in our Conservative Retirees dividend portfolio. About 70% of the company’s sales are from products that collectively hold #1 or #2 global market share positions, over half of revenue is generated overseas (rising healthcare demand in emerging markets), its product portfolio is well diversified by segment and by drug, and management runs the business conservatively, shedding non-core assets and approaching M&A opportunities cautiously.
The company’s scale and product breadth also enables it to invest $8 billion in R&D annually, which has resulted in JNJ receiving the most FDA approvals of any company since 2009 and deriving 25% of its revenue from new products introduced in the last five years.
As a result of its competitive advantages, JNJ has earned a relatively high and stable return on invested capital over the last decade:
Source: Simply Safe Dividends
JNJ’s most profitable segment, pharmaceuticals, will remain the company’s most important growth driver going forward. Excluding the impacts of foreign currency and hepatitis C, the pharma segment grew over 10% in Q3.
While generics are taking market share and regulations can always change, there are several fundamental factors that make the pharma 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).
JNJ’s drug portfolio is also 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 with its comprehensive R&D process.
Pharmaceutical manufacturing is one of the most profitable industries in the world. Last year, JNJ’s pharma business earned 36% operating margins. However, it is a notoriously difficult business to get started in. According to the Office of Health economics, it now costs upwards of $2 billion and 10 years of time to launch a drug compared to about $200 million in the 1970s. Spending on R&D often reaches close to 20% of sales for pharma companies, and there are no guarantees that the drug pipeline will develop as expected.
To this point, the Pharmaceutical Research and Manufacturers of America organization has noted that only two out of every 10 marketed drugs actually generate enough in sales to at least cover their R&D costs. Increased safety concerns and government regulations add further challenge to competing successfully in this industry.
With development of blockbuster drugs slowing, an increased amount of competition from lower-margin generic products, and rising R&D costs, industry profitability has been driven by trimming costs, M&A consolidation, and R&D productivity initiatives. We believe JNJ’s financial strength, decentralized management structure, $8 billion R&D budget, and proven R&D process position it well to succeed in the pharma industry going forward.
Outside of pharma, which generated 43% of sales and over half of profits last year, the company’s stable consumer business (20% of sales, 13% operating margin) continued showing improvement in Q3 and is benefiting from new product launches. This business is a cash cow that helps JNJ finance its pharma R&D and acquisitions, and we would expect it to remain stable with low growth.
Perhaps the most newsworthy item from Q3 was the company’s decision to repurchase $10 billion of its shares over the next year or so. JNJ had over $20 billion in net cash at the end of the quarter, and some investors were growing impatient with its lack of deployment on potential acquisitions.
We think the buyback plan leaves JNJ with plenty of financial flexibility to pursue deals and appears to have been a low risk move. With JNJ’s debt historically being issued at a premium of just 65 to 70 basis points over 30-year Treasury bonds, which yield about 3% today, the company’s after-tax cost of debt is pretty similar to the dividend payment (3% dividend yield) those repurchased shares would have otherwise received. The stock also trades at about 15x earnings, net of excess cash on the balance sheet – an ostensibly fair price to pay.
Perhaps this was also a signal of further discipline by the management team, which is a conservative group that approaches M&A with caution. JNJ has 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. We expect the company to be rewarded by the market when it ultimately makes its next deal, and given the run biotech stocks have had, patience seems prudent.
As seen below, JNJ’s overall business has been very consistent and stable. Sales have compounded at about a 4% annualized rate over the last five years, and revenue dropped by just 3% during the recession. Earnings and free cash flow per share compounded at more than 5% per year over this same timeframe, providing nice support for dividend growth. The company’s breadth and depth of products across health care make this a predictable and solid business.
Source: Simply Safe Dividends
While foreign exchange headwinds and increased hepatitis C competition are causing the biggest headwinds to JNJ’s business today, the biggest long-term risks, in our opinion, are drug pipeline disappointments and price pressure across several of the company’s segments. For now, JNJ appears to be on track to meet its targeted 10 new drug filings by 2019, each with potential to achieve $1 billion or more in annual sales. While generic drugs and price-sensitive health insurance providers continue to put a lid on industry profitability, we believe it will still be more profitable than the last five years as it continues recovering from the patent cliff and enjoys pricing power for drugs that demonstrate high rates of efficacy and help lower the overall system’s healthcare costs.
Within its other businesses, medical devices and consumer products, continued innovation will be the key to combat pricing pressure. New products, brands, and technologies will help JNJ maintain its lead across most categories, and the company has a great track record of innovation (25% of sales are from products released within the last five years). Rising access to healthcare in emerging markets and aging demographics also help offset some of these potential pressures.
Let’s take a look at the safety and growth potential of JNJ’s dividend.
Dividend Analysis
Over the last 12 months, JNJ’s dividend has consumed 55% of the company’s “as reported” net income and 44% of its free cash flow. These levels are fairly consistent with the company’s long-term payout ratios, seen below:
Source: Simply Safe Dividends
Even after JNJ repurchases $10 billion of its shares (financed with debt), the company will still have close to $40 billion in cash and marketable securities on hand compared to book debt (after the full repurchase plan) of less than $30 billion, resulting in an extremely healthy net debt position of about $10 billion. The business has also generated free cash flow in each of the last 10 years, including nearly $20 billion recorded last fiscal year. The company’s dividend is about as safe as they come and scores a 92 Dividend Safety Score under our rating system.
From a dividend growth perspective, JNJ has raised its dividend for more than 50 consecutive years. The company is one of the strongest in the list of S&P 500 Dividend Aristocrats and appears well positioned for continued mid-single digit dividend growth going forward (JNJ’s dividend compounded by 9% per year over the last decade). The company most recently raised its quarterly dividend by 7% per share earlier this year.
Valuation
JNJ trades at about 16.5x forward earnings but closer to a 14-15x multiple after adjusting for the company’s net cash. While foreign currency fluctuations, hepatitis C competition, and investors’ impatience for an acquisition or more significant deployment of the company’s cash pile have served as headwinds, we believe JNJ’s long-term growth potential of 4-6% per year, 3% dividend yield, and very reasonable earnings multiple make it an appealing “buy and hold forever” investment today.
Conclusion
For dividend investors living off dividends in retirement, JNJ remains a solid company that has great potential to continue growing its dividend faster than the rate of inflation for years to come. The company’s scale, product breadth, cash flow generation, R&D budget, and geographic diversification seem likely to keep the company relevant for decades to come. These are the types of dividend stocks we like to own for the long haul and enjoy the predictable income growth they give us each year.
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