Last month, I introduced “quality snapshots” that I have been creating for dividend growth companies. The snapshots are based on company quality assessments from data providers that I respect.
For the snapshots, I created a scoring system based on these quality ratings:
• Value Line’s Safety Rating
• Value Line’s Financial Grade
• Morningstar’s Moat Rating
• S&P’s Credit Rating
• Simply Safe Dividend’s Dividend Safety Rating
Here’s how they work:
Only a few dividend growth companies (8) scored in the highest category (dark green = 5 points) on all of the metrics. Here is that list of high-quality dividend growth companies.
Last month, I wrote about one of these high-quality companies – Procter & Gamble (PG) – as May’s Dividend Growth Stock of the Month. This month, I have selected another one, Johnson & Johnson (JNJ), as June’s featured stock.
This is the 2nd time I have reviewed JNJ as a Dividend Growth Stock of the Month. In June, 2015, JNJ came across as an all-around excellent dividend growth stock selling at a fair valuation at that time.
In the 3 years since then, JNJ has returned 9.8% of its 2015 price in dividends alone and delivered an overall total return (price + dividends) of 35% if the dividends were reinvested back into JNJ.
Johnson & Johnson’s Dividend Record
JNJ’s 56-year dividend growth streak makes it a Dividend Champion and also a Dividend King (stocks with dividend increase streaks of 50+ years).
It yields 67% more than the S&P 500, and 20% more than the average Dividend Champion, but it does not reach the 5% threshold that I use to call a stock “high yield.”
JNJ’s annual dividend increases had been declining for several years prior to 2018.
That trend reversed this year. June’s increase of 7.1% was a jump from last year’s 5.4%.
JNJ’s 5-year annual Dividend growth rate has been 6.7%.
JNJ gets an all-but-perfect dividend safety score of 99 from Simply Safe Dividends. That rates as Very Safe on their rating scale as shown below. (For more insight into dividend safety, see Dividend Growth Investing Lesson 17.)
Here’s a good illustration of why JNJ’s dividend safety is rated so high.
[Source of all yellow-bar graphs: Simply Safe Dividends]
The Free Cash Flow (FCF) payout ratio (dividend divided by FCF) is a modest 50%, and it has been in that area for years. Dividends are paid out of cash flow. This is a pretty reliable indicator of the safety of JNJ’s dividend.
Johnson & Johnson’s Business Model and Quality
Johnson & Johnson is the world’s most comprehensive manufacturer and distributor of health care products, medical devices, health and wellness consumer goods, and related services.
JNJ was incorporated in New Jersey in 1887. JNJ is a holding company with more than 260 operating companies located in 60 countries and conducting business in virtually all countries of the world.
JNJ’s annual revenues are about $71 billion. The company and its subsidiaries have about 134,000 employees. They are engaged in the research, development, manufacture, and sale of a broad range of products related to human health and well-being.
JNJ operates in 3 segments:
• Consumer Products (baby, beauty, health, and healing products)
• Pharmaceutical (immunology, cardiovascular & metabolic disease, pulmonary, hypertension, infectious diseases and vaccines, neurosciences, oncology)
• Medical Devices (surgery, orthopedics, cardiovascular disease & specialty)
The company’s business strategy is to create value by developing accessible, high quality, innovative products and services. New products introduced within the past five years accounted for approximately 22% of 2017 sales. That’s an unusually high proportion, especially for such a mature company.
This display shows how JNJ’s sales are split geographically and by segment. About 50% of sales are made overseas, and its pharmaceutical segment accounts for nearly 50% of total revenue as well.
CFRA, in its report on JNJ, notes the advantages of JNJ’s diversified business structure, global footprint, and benefits of scale:
Our risk assessment for JNJ reflects that its products are largely immune from economic cycles, that it does not rely on any single product category or customer for sustained growth, and that it enjoys competitive advantages owing to its substantial financial resources, business scale, and global sales capabilities.
JNJ has many successful brands. Here are examples:
• Pharmaceutical: REMICADE (JNJ’s largest product, treats immune-mediated inflammatory diseases); SIMPONI (rheumatoid arthritis, active psoriatic arthritis, active ankylosing spondylitis and moderately active to severely active ulcerative colitis); SIMPONI ARIA (moderate to severe rheumatoid arthritis); STELARA (plaque psoriasis and Crohn’s disease); CONCERTA (attention deficit hyperactivity disorder); XARELTO (oral anticoagulant for prevention of deep vein thrombosis); INVOKANA (type 2 diabetes); and many others.
• Consumer: JOHNSON’S; LISTERINE; AVEENO; NEUTROGENA; TYLENOL; SUDAFED; BENADRYL; ZYRTEC; MOTRIN; PEPCID; STAYFREE; CAREFREE; BAND-AID; NEOSPORIN.
JNJ faces competition in all of its product lines, both locally and globally. To maintain its edge and provide for future growth, JNJ spends heavily on R&D – $10.6 billion in 2017 (or about 15% of sales). R&D spending goes to discover, test, and develop new products, improve existing products, and demonstrate product efficacy and regulatory compliance prior to launch. Research facilities are located not only in the USA, but also in many countries around the world.
JNJ has a solid pipeline of drugs in developmental stages. The company has 8 pharmaceuticals in development that it believes could each generate $1 billion+ sales by 2021, plus about 10 line extensions having $500 million+ in sales potential each.
In 2017, JNJ invested a record $35.2 billion in mergers and acquisition. About $30 billion of that went to acquire Actelion, the company’s largest acquisition to date. Actelion added a new therapeutic area (hypertension) to its Pharmaceutical segment.
While some analysts believe that JNJ overpaid, the company believes that Actelion will add value through leading medicines already on the market, cutting-edge new therapies, and promising new products now in the late stages of development.
As with most healthcare companies, Johnson & Johnson is involved in numerous product liability claims and lawsuits involving multiple products. It is not feasible to predict the ultimate outcome of litigation.
JNJ has established accruals for product liability claims and lawsuits, including estimates of legal defense costs when those costs are probable and can be reasonably estimated. For some matters, the company has accrued additional amounts, such as estimated costs associated with settlements, damages and other losses.
Significant litigation areas include:
• DePuy ASR™ XL Acetabular System and DePuy ASR Hip Resurfacing System
• Body powders containing talc, primarily Johnsons Baby Powder
Another important headwind facing JNJ is the fact that its largest product, REMICADE, is experiencing biosimilar competition. A biosimilar version was introduced in 2016, additional competitors continue to enter the market, and JNJ projects declining sales in the USA. There are also significant challenges to patents covering REMICADE, with the exact legal situations varying from country to country.
Despite the headwinds, Morningstar awards JNJ a Wide moat rating, which is its highest rating. A company’s moat addresses whether it can maintain its competitive advantages for an extended period. Morningstar examines historical financial performance; competitive advantages vs. competition; intangible assets such as patents and brands; cost advantages; pricing power; and efficiencies of scale in determining its moat ratings.
S&P awards JNJ an AAA credit rating, one of only two that it gives. (Can you guess the other AAA company? The answer is at the end of the article.)
Overall, as you can see below, JNJ rates as an extremely high-quality company. It would probably be on many people’s lists of the top 25 quality companies in existence.Johnson & Johnson’s Financials
Value Line gives Johnson & Johnson its top Financial Strength Grade rating of A++. Let’s take a look and see if we agree. We’ll examine a variety of financial metrics.
Return on Equity (ROE) is a measure of financial efficiency. ROE measures a firm’s efficiency at generating profits from each dollar of shareholders’ equity (also known as net assets or assets minus liabilities).
The average ROE among Dividend Champions is 22%, and for S&P 500 companies it is about 13%. The following chart shows JNJ’s ROE since 2008.
JNJ’s ROE had been running in the 20%-25% range for several years. Last year’s drop to 2% appears to be a one-time aberration in JNJ’s historical record. ROEs are calculated with only 12 months’ data. Fluctuations in company’s earnings or business cycles can affect the ratio dramatically. It is important to look at the ratio from a long-term perspective.
Debt-to-Capital (D/C) ratio measures how much the company depends on borrowed money to finance its activities. Most companies finance their operations through a mixture of debt and equity (shares sold on the open market) as well as their own cash flows.
High debt can “juice” the ROE number, so I like to check debt to see if that is happening. All else equal, the higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt repayments create a constant draw on the company’s cash flows.
A typical D/C ratio for large companies is 50%. Let’s look at JNJ’s debt ratio.
JNJ has a relatively modest debt ratio of 34%. Its debt ratio has risen in recent years, with the spike in 2017 apparently attributable to the Actelion acquisition.
As we saw earlier, S&P’s credit rating for JNJ is AAA, the highest rating category it has. That rating helps to lower the interest rates that JNJ pays on its debt.
Operating margin is a measure of profitability. It measures what percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Per a report from Yardeni Research just published a couple of weeks ago, the operating margin across S&P 500 companies is around 11%-12%, as shown in the following graph.
Johnson & Johnson’s operating margin has been much higher than that average.
JNJ’s operating margins have been in the 25%-30% range for the past decade, more than double the S&P 500 average. This is excellent performance.
Earnings per Share (EPS) – that is, a company’s officially reported profits per share outstanding – is always of interest. We want to see if a company has had years when it lost money, or if its earnings are steadily increasing or declining.
JNJ has an outstanding earnings record. Its earnings have been consistently positive over the past 10 years, and in 5 of the last 9 years, JNJ’s earnings have increased over the year before. The consensus forecast for earnings growth in 2018 stands at 11% as of this writing.
Free Cash Flow (FCF) is the cash a company has left after paying its expenses. Excess FCF allows a company to pursue investment opportunities, make acquisitions, repurchase shares, and pay/increase dividends.
As with earnings, the significant number to examine is the per-share amount, and again we look for trends.
As with its earnings, JNJ has an outstanding FCF record. Cash flow has been solidly positive every year, and it has gone up in 6 of the past 9 years.
Here is a summary of the items above:
Overall, this is a very good financial picture. There are no warning flags, and 7 out of 11 categories are in the green.
Johnson & Johnson’s Stock Valuation
My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.
Step 1: FASTGraphs Basic. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.
The basic valuation estimate uses a price-to-earnings (P/E) ratio of 15 (the historical long-term P/E of the stock market) as a baseline “fair value” reference. That’s shown by the orange line on the following chart. The black line shows JNJ’s actual price.
JNJ’s actual P/E is 15.9 (circled), so this valuation method suggests that JNJ is a little overvalued. JNJ’s price is above the orange fair-value reference line.
To calculate the degree of overvaluation, we make a ratio out of the P/Es: 15.9 / 15 = 1.06. In other words, JNJ’s current price is 6% above the fair price as estimated by this first method.
I call anything within +/- 10% of fair value “fairly valued.” That’s because valuation is really an assessment, there are unknowable factors, and it shouldn’t be represented as more precise than it is.
The fair price is calculated by dividing the actual price by the ratio 1.06. We get $122 /1.06 = $115 for a fair price.
Note that I round all dollar amounts off to the nearest dollar. That’s another way to avoid creating a false sense of precision in making valuation assessments.
Step 2: FASTGraphs Normalized. The second valuation step is to compare PG’s price to its own long-term average P/E ratio. This gives us a valuation estimate based on the stock’s own long-term valuation instead of the market’s long-term valuation that was used in Step 1.
Using JNJ’s 5-year average valuation changes the picture, because JNJ’s 5-year average P/E ratio is 16.9 (circled). Therefore, the blue fair-value reference line shifts upwards from its position when 15 was used in the first step. Now JNJ looks a little undervalued.
The degree of undervaluation is calculated the same as in the first step: Make a ratio out of the P/Es. We get 15.9 / 16.9 = 0.94. So when viewed from this perspective, JNJ is 6% undervalued.
Again, I would call this “fair” valuation. The fair price suggested by this 2nd approach is $122 / 0.94 = $130.
Step 3: Morningstar Star Rating. Morningstar approaches valuation differently. They use a discounted cash flow (DCF) model for valuation. Many investors consider DCF to be the best method of assessing stock valuations.
Morningstar’s approach is comprehensive and detailed; that’s one of the reasons I like it. In their model, Morningstar ignores P/E ratios. Instead, they make a detailed projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.
Morningstar considers JNJ to be undervalued, as shown by the 4-star rating on their 5-star scale.
However, when you look at the numbers, Morningstar’s estimate is that JNJ is 6% undervalued, the same as we got in the previous step.
The reason that Morningstar calls this “undervalued” (rather than “fairly valued,” as I did) is that they consider JNJ’s valuation to be very predictable, with low uncertainty. I’ll go with their nomenclature, but the numbers are the same.
Step 4: Current Yield vs. Historical Yield. My last step is to compare the stock’s current yield to its historical yield.
This way of calculating fair value is based on the idea that if a stock’s yield is higher than usual, it may indicate that its price is undervalued (and vice-versa).
JNJ’s 5-year average yield is 2.77%, while its current yield is 2.94%. Again, we use a ratio to compute the degree of undervaluation: 2.77% / 2.94% = 0.94, or 6% undervalued (again!).
So in this step too, JNJ’s fair price computes to $122 / 0.94 = $130.
Now let’s average the 4 valuation methods.
Thus, I conclude that JNJ’s current price is about 3% below the stock’s fair price. That is fairly valued in my book. For a high-quality company like JNJ, that becomes an attractive situation for many investors.
As a comparison point, CFRA has a 12-month price target of $170 on JNJ, which is much higher than our fair value estimate and 39% above the stock’s current price.
Beta measures a stock’s price volatility relative to the S&P 500. I like to own stocks with low volatility for 2 reasons:
• They present fewer occasions to react emotionally to rapid price changes, especially sudden price drops that can induce a sense of fear.
• There is industry research that suggests that low-volatility stocks outperform the market over long time periods.
JNJ’s 5-year beta is 0.7 compared to the market as a whole (defined as 1.0), which means that its price has been 30% less volatile than the index. This is a positive factor.
In their report on JNJ, CFRA shows the recommendations of 24 analysts who cover the company. Their average recommendation is 3.5 on a scale of 5. This translates to a “strong hold.” This is a neutral factor.
Share Count Trend
I like declining share counts, because the annual dividend pool is spread across fewer shares each year. That makes it easier for a company to maintain and increase its dividend. By buying back its own shares, the company is essentially investing in itself and making each remaining share into a larger piece of the pie.
JNJ’s share count has essentially been flat for years. This is a neutral factor.
What’s the Bottom Line on Johnson & Johnson?
Johnson & Johnson is a classic dividend growth stock. Indeed, I often use it as an example to illustrate dividend growth investing itself.
Here are JNJ’s positives:
• Good dividend resume typical of a mature high-quality company: Mid-range yield (2.9%); proven commitment to its dividend with 56 straight years of increases; strong dividend safety; this year’s increase of 7.1% exceeds JNJ’s 5-year average increase.
• Stock is around 3% undervalued.
• High quality company with wide moat, great brands, good new-product pipeline, heavy investment in R&D, and world-wide presence.
• Good financials, including modest debt, steadily positive earnings and cash flows, and highest credit rating (AAA).
• Generally low-volatility stock.
And here are JNJ’s drawbacks:
• Mid-range yield may be too low for some investors.
• Company is so large and mature that its growth prospects are moderate.
Overall, I see JNJ as a good investment opportunity at this time. I own JNJ in my Dividend Growth Portfolio. It occupies an 8.6% position in the portfolio and supplies about 7% of the portfolio’s income.
That said, this is not a recommendation to buy, hold, or sell JNJ. Any investment requires your own due diligence. Think not only about any company’s quality and business prospects, but also about how and whether it fits your personal financial goals.
Quiz answer: The only other company beside JNJ with a Triple-A credit rating is Microsoft (MSFT). That company also landed in the “perfect score” collection of high-quality companies described at the beginning of the article. I also own MSFT in my Dividend Growth Portfolio.
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