Published by Nicholas McCullum on April 21, 2017
Johnson & Johnson (JNJ) is one of the most stable businesses around.
The company’s statistics are impressive:
- 33 years of consecutive earnings-per-share growth (currency-adjusted)
- The lowest stock price volatility of any Dividend Aristocrat
- One of only two companies to hold the coveted AAA credit rating from Standard & Poor’s (the other being Microsoft (MSFT))
- The third most popular dividend growth stock among dividend growth bloggers
- 54 years of consecutive annual dividend increases
Johnson & Johnson’s dividend history is particularly impressive. The company qualifies to be not only a Dividend Aristocrat, but a member of the Dividend Kings – a group of elite companies with 50+ years of consecutive annual dividend increases.
The stock of a stable company like Johnson & Johnson does not typically undergo rapid price fluctuations. However, the company’s stock price decline by ~3% on Tuesday after the company reported earnings for the first quarter of 2017.
Source: Yahoo! Finance
After surging for most of 2017, Johnson & Johnson’s stock is presenting more of a bargain today. This article will describe the events that caused Johnson & Johnson’s recent price swing and describe why this presents a buying opportunity, rather than a reason to be concerned.
The catalyst behind Johnson & Johnson’s stock price decline was their first quarter earnings release.
On the surface, the company’s performance appears satisfactory:
The most notable statistics are listed below.
- Company-wide sales increased by 1.6% driven by 2.0% operational growth and a negative currency effect of 0.4%.
- Adjusted earnings-per-share increased by 5.8%
- Operational adjusted earnings-per-share increased by 7.5% (which excludes the effect of currency fluctuations)
Here’s what the company’s Chairman and Chief Executive Officer, Alex Gorsky, had to say about the company’s first-quarter results:
“Johnson & Johnson’s first-quarter results are in line with our expectations and we are confident we will achieve the full-year financial guidance we established at the beginning of the year.”
“The pending acquisition of Actelion demonstrates our ongoing commitment to bringing innovation to patients with significant unmet needs, and provides a unique opportunity for us to expand our portfolio with leading, differentiated in-market medicines and promising late-stage products. We look forward to the associates from Actelion joining the Johnson & Johnson Family of Companies.”
I was surprised to see this company’s stock decline by 3% on the back of 7.5% operational earnings-per-share growth. Indeed, it was not the company’s earnings that disappointed the markets – rather, Johnson & Johnson’s revenue figures were below expectations.
What was particularly concerning was domestic revenue numbers. While company-wide sales increased by 1.6% (and 2.0% ex-currency), the company’s domestic sales were up by only 0.6%. For comparison, the company’s international sales increased by 3.6% ex-currency.
It appears that Johnson & Johnson is experiencing very minor weakness in its domestic sales right now.
However, the company still has very strong growth prospects, and its earnings power still increased in the quarter. Thus, the company’s stock price decline caused a corresponding decrease in its price-to-earnings ratio, pushing Johnson & Johnson into buying territory.
Fundamentally, Johnson & Johnson remains an attractive stock. It has robust growth prospects, a durable competitive advantage, and is one of the most recession resilient stocks I have seen. Each of these factors is analyzed in detail below.
Historically, Johnson & Johnson has driven growth through a healthy combination of organic business expansion and bolt-on acquisitions. In the past ten years, Johnson & Johnson has spent about 30% of its free cash flow on acquisitions, with the remainder earmarked for dividends and share repurchases.
Source: Johnson & Johnson Actelion Transaction Presentation, slide 5
In the near-term, Johnson & Johnson’s growth will be boosted by a sizeable acquisition announced in the first quarter of 2017 – the purchase of Actelion (ALIOF) for approximately $30 billion.
Actelion is a pharmaceutical and biotechnology company that was founded in 1997 and is based in Switzerland. The company is known for its advancements in the treatment of pulmonary arterial hypertension.
More details about Actelion’s business model can be seen below.
Source: Johnson & Johnson Actelion Transaction Presentation, slide 11
The transaction would see Actelion spin-off its drug discovery operations and early-state clinical development assets into a new entity, which will be called Idorsia and will be publicly-traded.
Existing Actelion shareholders will receive one share of Idorsia for every Actelion share, and Johnson & Johnson will hold 16% of the entity with the rights to an additional 16% via a convertible note.
Source: Johnson & Johnson Actelion Transaction Presentation, slide 24
The financials behind the transaction are very attractive.
First of all, Johnson & Johnson was able to deploy some of its substantial international capital to fund the acquisition. For the company to deploy this capital on shareholder-friendly activities like share repurchases, it must be repatriated to the United States, which means that Johnson & Johnson must pay the hefty 35% U.S. corporate tax rate on this capital (less any taxes already paid overseas).
This transaction allows Johnson & Johnson to build shareholder value while avoiding these unnecessary repatriation tax payments. Johnson & Johnson’s capital is more powerful when left overseas if the company can find attractive opportunities to invest it, which is certainly the case with this transaction.
Secondly, the Actelion transaction is expected to be immediately accretive to Johnson & Johnson’s earnings-per-share. Actelion is expected to boost the bottom line by $0.35-$0.40 in the first full year (which would be fiscal 2018). For context, Johnson & Johnson is expecting adjusted earnings-per-share of $7.00-$7.15 for fiscal 2017.
More details about the accretive qualities of this transaction can be seen below.
Source: Johnson & Johnson Actelion Transaction Presentation, slide 26
The Actelion transaction is expected to close in the second quarter of 2017, subject to the necessary regulatory approvals. The boards of directors of both companies have already voted unanimously in favor of the acquisition.
Transactions similar to this will be a key component of Johnson & Johnson’s growth story moving forward.
Competitive Advantage & Recession Resiliency
Johnson & Johnson’s competitive advantage is evident in its remarkable 30+ year streak of increasing operational earnings-per-share. The company’s economies of scale, substantial research & development spending (~$9 billion in each of 2015 and 2016), and brand power (11 brands with $1 billion+ in annual sales) allow the company to growth through all economic environments.
Johnson & Johnson is also exceptionally recession resistant. The company managed to grow its adjusted earnings-per-share during each year of the global financial crisis of 2008-2009.
- 2007 adjusted earnings-per-share: $4.15
- 2008 adjusted earnings-per-share: $4.57 (9.6% increase)
- 2009 adjusted earnings-per-share: $4.63 (1.3% increase)
- 2010 adjusted earnings-per-share: $4.76 (2.8% increase)
I would expect Johnson & Johnson to perform just as well (or better) during the next recession since the company is even larger and the next economic downturn is unlikely to be as severe as the last.
Valuation, Dividend, & Expected Total Returns
Johnson & Johnson’s future shareholder returns will come from valuation changes, current dividend yield, and earnings-per-share growth.
Johnson & Johnson reported adjusted earnings-per-share of $6.73 for fiscal 2016. Management is forecasting adjusted earnings-per-share between $7.00 and $7.15 for fiscal 2017. For the sake of valuation, I will take the midpoint of this guidance band ($7.075).
Today’s stock price of $121.86 represents an 18.1x multiple of 2016’s earnings and a 17.2x multiple of 2017’s expected earnings (using the midpoint of the company’s guidance).
The following diagram compares Johnson & Johnson’s current valuation to its historical averages.
Source: Value Line
Johnson & Johnson’s current valuation appears in-line with its historical average. I believe the company is trading somewhere near fair value. With that said, buying high-quality businesses at fair value it a great method for building long-term wealth.
Johnson & Johnson is a robust dividend stock. Last year’s 6.7% dividend increase marked the company’s 54th consecutive dividend increase and brought their quarterly dividend payment to $0.80 per share (or $3.20 annually). The company’s current stock price of $121.86 is priced at a forward dividend yield of 2.6%.
Johnson & Johnson’s dividend history suggests that the company tends to raise its dividend payments in late April of each year. Watch out for an upcoming dividend increase from this healthcare giant.
Looking next at earnings-per-share growth, the consistency of Johnson & Johnson’s bottom line is remarkable. The company’s adjusted earnings-per-share since 2001 can be seen below.
Source: Value Line
Note: The above diagram shows one year of negative earnings growth because it is presenting adjusted earnings-per-share, not operational earnings-per-share (which adjusts for currency fluctuations).
Johnson & Johnson has compounded its bottom line by ~7.8% since 2001. Over full economic cycles, I expect Johnson & Johnson to comfortably manage 6%-8% annual growth in adjusted earnings-per-share.
To conclude, Johnson & Johnson’s expected total returns will be composed of:
- 2.6% dividend yield
- 6%-8% earnings-per-share growth
for total returns in the range of 8.6%-10.6% with minimal impacts from valuation changes.
While generally a low volatility dividend stock, Johnson & Johnson’s price moved sharply downwards after their earnings release. These large price swings are not typical for this company.
I view this price decline as irrational behavior by the markets. The company’s operational earnings-per-share in the quarter increased by 7.5%. Temporary sales weakness has not decreased the company’s intrinsic value by 3% like its stock price would suggest.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham
The company continues to be a compelling investment. Johnson & Johnson’s above-average dividend yield, fantastic earnings history, and reasonable payout ratio make it rank favorably using The 8 Rules of Dividend Investing.
This makes Johnson & Johnson a buy at current levels.
If you are interested in reading more about the investment prospects of Johnson & Johnson, the following Sure Dividend articles might be of interest: