Shares of Johnson & Johnson (JNJ) can be an attractive addition for extremely risk-averse shareholders but the stock is currently slightly overpriced. A strong pipeline of drugs and no major patent expirations could lead to higher dividend increases over the next few years and the company is one of the most diversified in the healthcare sector. The company is a good long-term bet and a good holding for those fearful that the rest of the market may be ready for a correction.
• Strong cash flows over a diverse line of mature products leads to extremely low volatility in the share price, even when the rest of the market falls
• While the share buyback program is not impressive, a strong dividend policy increases cash return to shareholders
• Few competitors can match the size or diversification of the company and this should protect cash flows in the future
With a market capitalization of $284 billion, few other companies can match the size and scope of Johnson & Johnson. The company has commanding market share in both healthcare and consumer goods with the research spending to keep revenue growing at a consistent pace.
The pharmaceutical division contributes about 39% of total company revenue with some strong new drugs that promise to increase sales over the next few years. Medical devices account for approximately 40% of revenue with the acquisition of Synthes in 2012 contributing to strong growth in the company’s orthopedics business. Consumer goods account for just over one-fifth of sales with a diverse range of products.
The immense scale of research spending, almost $6 billion last year, has helped it avoid the patent cliff many of the other pharmaceutical companies are experiencing. Johnson & Johnson has few major patent losses over the next five years and a relatively healthy pipeline of development drugs.
The company has had a problem with quality control and recalls in the past but this seems largely behind them. Legal costs and a hit to reputation are always a possibility but the company is large enough to weather these problems when they arise.
Sales have grown at 5% on an annual basis over the last three years but operating income has only grown 3.5% due to increases in cost of goods and operating expenses. A rate of 3.5% is still good for a company competing in extremely mature markets like healthcare and consumer goods but cost management could be a focus over the next couple of years.
Cash held on the balance sheet decreased by more than $10 billion last year but is still nearly enough to cover current liabilities. The company has $11.5 billion in long-term debt and pays just 3.95% on its 10-year bonds. Financial leverage is rarely a problem for mature mega-cap companies like Johnson & Johnson. Without stronger prospects for growth, there is little point in increasing the percentage of debt in the capital structure even at today’s low rates.
Free cash flow has increased consistently over the last several years to $13.8 billion last year and has allowed the company to grow through acquisitions. Its purchase of Pfizer’s consumer division in 2007 gave it scale on the consumer side and the company regularly acquires drug and medical device companies for the intellectual property.
Dividends and Growth
Johnson & Johnson is a Dividend Aristocrat with 51 consecutive years of dividend increases. The shares currently pay a 2.8% yield, just under the 3.1% yield average over the last five years. The company is paying out 50% of income as dividends, under a five-year average of 54% but still a strong sign of commitment to cash returns. The company usually increases its dividend for the May payment and the fact that both the yield and payout ratio have slipped below the five-year average may imply a strong increase.
Dividends per share have increased by 7.5% over the last five years with 70 years of payments. The company spent $12.9 billion to repurchase shares in 2012 but has typically only bought back less than $4 billion. At about 1.5% of the market cap, that is not very impressive given the current environment of returning shareholder cash through massive buybacks but combined with nearly $8 billion in dividends increases the cash return to about 4% of the company.
Shares of Johnson & Johnson are trading at a premium relative to peers and their own history of valuation. The stock currently trades for 19.3 times trailing earnings against an industry average of 18.6 times and its own five-year average of 16.7 times.
The company’s AAA credit rating and beta of just 0.55 to the market helps to lower its overall cost of capital. On a strong pipeline of drugs and no major patent expirations over the near-term, the board may be able to increase dividends at a slightly faster rate. For the discounted cash flow analysis below, I estimated an annual increase in dividends per share at 8% over the next ten years with a 4.5% terminal growth rate.
On these estimates, shares of Johnson & Johnson are trading at 8% over their fair value of $92.72 per share. The estimate for terminal growth of dividends may be overly conservative given the company’s mature product lines and size. Increasing the terminal growth rate to 7.5% only increases the fair value to $94.45 per share so seems to confirm a generally expensive price.
Shares of Johnson & Johnson may still be attractive to those looking for a long-term holding that they can buy and let run. Strong cash flows support a sustainable increase in the dividend and the company’s diversification in non-cyclical sectors means that prices will not fluctuate much when the rest of the stock market falls.