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Johnson & Johnson: A Dividend Fit For A King


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Written by Mark Roussin

Big Ticket Fund
Managers

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Johnson & Johnson (JNJ) has long been a dividend company investors turned to for steady income and reliability.

As of late, however, the company has been under intense pressure from investors due to a recent Reuters article alleging the company knew about asbestos that lurked within their baby powder products. This comes on the heels of the company recently re-launching their Johnson Baby products line in Q3 to focus more on natural products and fewer chemicals with the hopes of gaining the attention of Millennial parents.

The Pharmaceuticals segment of the business continues to perform well off a strong 2018 and maintains a loaded pipeline moving forward, which will help fund the growing dividend.

As investors have turned their back on this once darling company, we want to take advantage as we believe the selling to be overblown.

Source: JNJ Investor Relations

JNJ Continues To Perform, But Guides Towards A Slowdown In ‘19

When thinking of dividend growth staples for any Dividend Growth Investing (DGI) portfolio, one of the first companies that comes to mind for most investors is Johnson & Johnson. JNJ has been one of the most well-respected, well-managed, and consistent companies for decades now.

Results

Johnson & Johnson recently reported their Q4 and Full-Year earnings that beat analyst expectations on both the bottom and top line. Here is a quick look at EPS and revenue metrics compared with expectations:

  • EPS: Reported $1.97 per share compared to $1.95 expected
  • Revenue: Reported $20.4 billion compared to $20.2 billion expected

Let’s take a look at the most recent quarterly earnings results for the company:

JNJ Q4 2018 YOY Change
Revenue $20,3941.0%
US Sales $10,6291.5%
Int’l Sales $9,7650.4%
Segment Sales:
Consumer Sales $3,536 0.1%
Pharmaceutical Sales $10,1905.3%
Medical Device Sales $6,668 4.4%
Gross Margin % 65.9% 170bps
Net Income $5,37212.5%
Adj EPS $1.9713.2%

Chart created by author

Here are the 2018 annual results for the company at a high level:

 JNJ 2018YOY Change
Revenue $81,5816.7%
     US Sales $41,8845.1%
     Int’l Sales $39,6978.5%
Segment Sales:  
     Consumer Sales $13,8531.8%
     Pharmaceutical Sales $40,73412.4%
     Medical Device Sales $26,9941.5%
Gross Margin %66.8%1bps
Net Income $22,31511.4%
Adj EPS $8.1812.1%

Chart created by author

As you can see above, JNJ saw another good quarter led by their stout pharmaceutical segment that rose 5.3% during the quarter and 12.4% on the year. This is the company’s most important segment, as it accounts for 50% of the company’s total sales.

Quarterly top line results were nothing special this past quarter, but we did like what we saw in terms of EPS growth, which was assisted by the company’s $5 billion stock repurchase plan. To easily visualize how the company breaks out sales, here is a look at the percentage of sales for each of the three reportable segments:

Source: Chart created by author

Pharmaceuticals lead the way

As you can see in the chart above, pharmaceuticals accounts for the majority of sales, so when that segment performs well the company tends to do well.

The pharmaceutical segment has been growing at a strong clip, as the segment accounted for only 39% of sales in 2013. It has grown 45% in that same period (~8.4% per year) on the back of top drugs getting more international approvals and expanding their labels to other conditions.

While key drugs will face increasing competition from generics and biosimilars, the company appears to have a strong pipeline with which to continue its growth. There’s a lot to like regarding the pharmaceutical segment’s performance and a lot to look forward to.

Guidance

In addition to reporting their Q4 results, the company released their 2019 guidance, which was in-line in terms of EPS, but its sales forecast fell short of analyst expectations.

Analysts had expected EPS of $8.60 per share and revenue of $82.69B for 2019. The company’s guidance came in at EPS of $8.50 to $8.65 with a revenue range of $80.4 billion to $81.2 billion. This has been a continued theme for many companies as they introduce 2019 guidance, with the benefits of the tax adjustments wearing off, a strong US Dollar, and a general slowdown in the economy starting to take shape.

In the company’s Q4 earnings call, CEO Alex Gorsky, explained part of their guided slowdown in sales would be related to biosimilars, which could account for up to $3 billion in sales lost in the new year. He also alluded to the fact that the strong dollar has played an important role in slower earnings the past few quarters and looking forward.

Overall, the company had another quality year with growth in every segment, but the guidance slowdown combined with the talc issue, discussed below, is what has investors worried most right now.

Baby Care Plan Of Attack

As we briefly mentioned above, the company re-launched their once proud Johnson’s Baby brand with new branding and enhanced formulas geared more towards millennial parents who seek more natural health and beauty products. The millennial generation is one that now actually looks at ingredient labels, something consumer companies have not been accustomed to from a customer base standpoint for some time. Ingredients such as parabens and sulfites are things Millennials have decided to avoid, for the most part, and so are being phased out of Johnson’s products.

The launch took place in Q3 and was received well by the consumer as the segment achieved 4.3% growth during the quarter. The Baby Care segment saw Q4 growth of 2.1% worldwide. As posted on their Johnson’s Baby website, the company now uses 50% fewer ingredients.

Photo Credit

As the company continues rolling out their their new and improved Baby Care products, the company is taking on an attack from Reuters, as the safety of one of their long-time best-selling baby products, Johnson’s Baby Power, comes into question.

As we mentioned in our introduction, Reuters released a report in mid-December claiming the company’s baby powder contained asbestos, and the company knowingly withheld this information from the public. Johnson & Johnson strongly defended itself by taking out full-page newspaper ads in support of its product. JNJ CEO Alex Gorsky appeared on CNBC’s “Mad Money” after the report stating, “any suggestion that Johnson & Johnson knew or hid information about the safety of talc is false.”

Since the Reuters report was released in mid-December, investors will be focused on its impact in the coming quarters. There is definitely more to come from this story as investigations are being ordered and over 11,000 lawsuits are pending.

The results of cases tried before the Reuters article have been mixed. JNJ has won about half and lost about half, but has appealed all of them. The largest award was for $4.7B to 22 women, so there is clearly some large downside risk to this whole thing.

Awards this large can take a decade or more to get paid out, however, and are almost always reduced significantly. One can look to some of the largest awards in US history, against firms like Exxon or various tobacco companies, and most were reduced by several orders of magnitude after many years.

At this point, the range of outcomes for these matters is anywhere from “nothing but legal costs” to something pretty extreme. In analyzing this stock, it is worth considering both cases.

Litigation expenses, in the near term, are definitely going to increase. They doubled during the quarter vs. 4Q17 ($1.29B vs. $645M). This is material to its earnings, though the company was still able to grow EPS despite this increase.

At the high end of historical punitive damages awards, you might evaluate what it would look like if JNJ had to pay out as much as $20B. This is just about 5% of its Enterprise Value. So, even an outsize overall judgement does not seem catastrophic.

The Dividend Stock Blueprint

Next, let’s move onto the astonishing dividend track record of the company.

When one thinks of a great dividend stock, many think about the blueprint Johnson & Johnson has laid out over the last 50 plus years. The company recently increased their dividend for an impressive 56th consecutive year, which is a main reason many DGI investors like JNJ as a building block in their portfolio. Johnson & Johnson is considered a “Dividend King” given their 50+ years of dividend increases.

Over the years, investors have bought JNJ for its conservative approach, low stock price volatility, and a dividend that is both stable and growing. JNJ has been a staple in many dividend growth portfolios for some time now, and I do not expect that to change anytime soon, as the company continues to maintain strong growth in earnings and operating cash flows.

Photo Credit

Dividend investors are always on the hunt for stable income and rising dividend payouts over time when investing in dividend stocks. You can get more dividend income in two ways:

  • You can buy more shares; or,
  • A company can increases their payout per share (achieved through share repurchases and/or absolute payout increases)

Dividend investors prefer the second method, as there is not much to do on their end but sit back, relax, and collect a growing dividend check. The power of compounding dividends cannot go unnoticed.

As it currently trades, JNJ has an annual dividend yield of 2.79%. The yield at first glance is nothing to write home about, but as we mentioned above, the opportunity for dividend growth with 56 consecutive years of growth is astonishing.

In order to determine the reliability of a dividend, we like to look at the company’s payout ratio. Currently, the company maintains a payout ratio of only 44%, which tells us that the company uses only 44% of their EPS to pay for their dividend. A payout ratio this low tells investors the opportunity for further growth going forward is likely. If a company had a payout ratio above, say, 60-80% (excluding REITs), we would not have as bullish an outlook going forward.  

Another area we like to gauge in order to determine future dividend growth and current stability is free cash flow, or FCF. Free cash flow can be used for increasing dividend payments, debt paydowns, and stock repurchases.

Through the first nine months of the year, the company had generated FCF of $13.6 billion. After paying dividends for that time period, the company has been able to retain $6.5 billion of their FCF. The remaining funds could be used to pay down the remaining $29.5 billion in long-term debt or buy back additional shares. The company has grown FCF 14% in 2017 and 4% on a TTM basis as of Q3, the last two years, and had positive FCF four of the past five years.

Based on the company’s continued EPS growth combined with growth in FCF and a low payout ratio, we believe the dividend is well covered and should continue to rise moving forward, despite the legal risks mentioned above.

A Look At Valuation

Last year was full of ups and downs for JNJ investors as the stock rose 5.5% to $147 within the first few weeks of the year before falling 18% to $121 in late May. From there, the stock steadily increased back to $147 before the Reuters report came out in mid-December, causing the stock to sell-off 13%, erasing $40 billion in market cap to close the year. The stock is up 1% through the first month of 2019, as investors wait to see if there is any fallout from the asbestos claim. 

Based on the recent slide, we believe the current valuation offers a compelling long-term opportunity for investors to scoop up some JNJ, but let’s first take you through a few valuation metrics.

Forward Price/Adj EPS

5-Year Avg P/E

Current Yield

5-Year Avg Yield

15.0 16.7 2.79% 2.81%

Source: Estimates from FastGraphs

Currently, the stock trades at a forward P/E of 15.0x, while the company’s five-year average has been about 16.7x, suggesting the stock is undervalued compared to recent history.

Another way you can value a consistent dividend grower is by looking at their current yield compared to average yield, or the DYT (Dividend Yield Theory). Currently, the stock yields 2.79%, which is about in-line with their five-year history of approximately 2.81%, suggesting the stock is fairly valued from this standpoint. Overall, the stock appears to be slightly undervalued, which could prove to be a solid entry point to start earning that growing dividend.

Lastly, let’s take a look at the Old School Value DCF Valuation Chart to see where the stock trades compared to calculated fair value:

Investor Takeaway

JNJ has a strong moat that comes from:

  • Its diversified portfolio across 3 major business segments
  • A strong consumer brand with a great reputation
  • Its many products (medicines and drugs) that are necessities and will keep selling even during a downturn
  • Its medical devices which have high switching costs
  • A large patent portfolio

Due to the nature of the industry, many risks do present themselves, such as the current allegations surrounding asbestos within the company’s name brand baby powder.

Another risk that must be considered these days is how China and/or international markets affect a company. As it relates to international sales in general, JNJ generated close to 50% of its sales overseas and with that comes currency risks, which weighed heavily on the reported results the last few quarters due to the strong dollar. Any weakness in the US Dollar will certainly be welcomed by the company.

We are obviously big proponents of JNJ stock for long-term investors, or really any investor looking for a stable dividend payer. We do not pride ourselves on timing the market; we choose to focus on fundamentals first and foremost. From a fundamental perspective, Johnson & Johnson is one of the most profitable companies in its space that pays a consistently growing dividend, while maintain strong cash flows.

As the stock currently sits right now, it appears to be trading slightly below fair value, representing a quality entry point for investors. The stock may see continued pressure from investors if anything comes of the asbestos claim, so if you are looking to invest, be sure you do it in tranches and do not buy all at once.

Note: We hope you all enjoyed the article and found it informative. As always, we look forward to reading and responding to your comments below and feel free to leave any feedback. Happy Investing!

Author’s Disclaimer: This article is intended to provide information to interested parties. We have no knowledge of your individual goals as an investor, and we ask that you complete your own due diligence before purchasing any stocks mentioned or recommended.

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