Published March 6th, 2017 by Nicholas McCullum
Johnson & Johnson (JNJ) is one of only two companies to hold the coveted AAA credit rating from Standard & Poor’s. The other is Microsoft (MFST).
This stellar credit rating is a testament to the strength and stability of Johnson & Johnson’s business model.
The company has delivered strong shareholder returns over the years, driven by steadily increasing dividend payments. In fact, Johnson & Johnson is one of the most popular dividend growth stocks among dividend growth bloggers.
Johnson & Johnson is also a Dividend Aristocrat, an elite group of companies with 25+ years of consecutive dividend increases.
This post will discuss the many reasons why Johnson & Johnson holds a perfect credit score from S&P.
Just How Good is AAA?
For investors that aren’t familiar with S&P’s credit ratings, it can be hard to appreciate just how rare Johnson & Johnson’s perfect credit score is.
Before diving into Johnson & Johnson’s company-specific credit factors, I wanted to provide a baseline.
The following diagram displays the credit ratings of the 50 American states and how they have changed over time.
Source: The Pew Charitable Trusts
Note that there are only 15 states with a AAA credit rating. Moreover, the United States Federal Government has a credit rating of AA+ from S&P, which indicates that the ratings agency has more faith in Johnson & Johnson’s ability to repay debt than they do in the domestic government.
Think about that for a second… Rating agencies have more faith in Johnson & Johnson to pay its debt than the United States government – and the government has the ability to tax.
In the past, there were many more AAA-rated companies in the United States. The number has slowly trickled down over time. This trend can be seen in the following diagram.
Johnson & Johnson and Microsoft became the last two companies to hold the AAA credit rating when Exxon Mobil (XOM) was downgraded to AA+ on April 26, 2016.
The ratings agency cited concerns about low oil prices which led to deteriorating cash flow and rising leverage for the oil and gas supermajor.
Johnson & Johnson is considered more creditworthy than the federal government, all but 15 states, and all but 1 other company. Clearly, this AAA credit rating is rare– now let’s examine why Johnson & Johnson holds this coveted classification.
Johnson & Johnson Business Overview
Johnson & Johnson is a massive healthcare conglomerate with more than 260 subsidiary companies.
The company is divided into four segments for reporting purposes:
- Consumer ($13.3 billion of 2016 sales)
- Pharmaceutical ($33.5 billion of 2016 sales)
- Medical Devices ($25.1 billion of 2016 sales)
Each segment’s contribution to fiscal year 2016’s Adjusted Income Before Tax can be seen in the following diagram.
Source: Johnson & Johnson Fourth Quarter Earnings Presentation, slide 31
As a globalized company, Johnson & Johnson is suffering from the continued strength of the U.S. dollar. As the domestic currency strengthens in value, the company’s international revenues become less valuable when swapped back to USD.
However, the company’s growth prospects remain strong. Johnson & Johnson’s competitive advantages come from it’s strong brand, massive economies of scale, and robust research and development spending.
Examining Johnson & Johnson’s Balance Sheet
Many of the reasons for Johnson & Johnson’s stellar credit rating can be found by looking at the company’s balance sheet.
Johnson & Johnson has been able to deliver consistent business growth without stretching (or overleveraging) its balance sheet. This has two main benefits for the company and its shareholders.
First, Johnson & Johnson is not burdened by large interest payments.
If an economic recession were to occur that substantially effected the company’s earnings-per-share (not likely given its history), the company does not have to worry about delivering large coupon payments to their bondholders. Rather, their payments are small because of their minimal debt levels.
Secondly, typically low levels of leverage allow Johnson & Johnson to be opportunistic., Johnson & Johnson is able to finance large acquisitions without affecting its perfect credit rating, as was recently seen with the large Actelion acquisition.
In order to get a more precise sense of the conservative nature of Johnson & Johnson’s balance sheet, it is important to consider the numbers at hand.
The company’s long-term debt levels over time can be seen in the following diagram.
Source: Value Line
Johnson & Johnson’s shareholders’ equity (or book value) has increased at roughly the same rate as their long-term debt, which means the company’s leverage has remained constant.
However, these numbers are relatively meaningless unless they can be benchmarked against some of Johnson & Johnson’s competitors.
In their 2016 proxy statement, Johnson & Johnson identified the following Dividend Aristocrats as members of their peer group:
For benchmarks, I’ve specifically selected only Dividend Aristocrats from Johnson & Johnson’s peer group since they likely represent the best-of-the-best in terms of safety and balance sheet strength.
If you’re interested, Johnson & Johnson’s full peer group can be seen below.
Source: Johnson & Johnson 2016 Proxy Circular, page 40
The following diagram displays the long-term debt to shareholders’ equity ratio for Johnson & Johnson and this peer group over the long-term.
Source: Value Line
It is difficult to discern any meaningful trends from the above diagram because fiscal year 2015 represents an outlier for Colgate-Palmolive. Here is the same graphed, but with a significant zoom applied to the y-axis:
Source: Value Line
Clearly, Johnson & Johnson has maintained a significantly lower leverage level than its Dividend Aristocrat peers. The only competitor that really comes close is Abbott Laboratories after the spinoff of AbbVie in 2013, but Johnson & Johnson’s long-term trend is still superior.
Johnson & Johnson’s low leverage ratio and high credit rating also have the added effect of reducing their financing costs. Naturally, investors are willing to accept less yield on a AAA bond than any other credit because of the lower risk involved.
This has helped Johnson & Johnson minimize their net interest expense to $500-$600 million for fiscal 2017 (for comparison, their FY2016 revenues were $71.9 billion).
Source: Johnson & Johnson Fourth Quarter Earnings Presentation, slide 32
Johnson & Johnson’s balance sheet has contributed to their perfect credit rating. I also believe that their incredibly consistent earnings mix is a contributor. This is discussed in the next section.
A Remarkably Consistent Earnings History
Among large-cap companies, Johnson & Johnson has a very consistent history of growing their adjusted earnings-per-share. The company’s recent earnings-per-share history can be seen below.
Source: Value Line
Notice that there was only a single fiscal year (2015) where Johnson & Johnson failed to grow their adjusted earnings-per-share. Before that, the company was on a remarkable streak of per-share earnings growth lasting more than three decades.
The company also reports ‘operational’ adjusted earnings-per-share numbers, which exclude currency exchange rate effects. Using constant currencies, Johnson & Johnson has a 30+ year streak of earnings-per-share growth.
A large driver of this growth is the company’s portfolio of iconic brands. Many of Johnson & Johnson’s products are seen as household necessities, which ensures that consumers generate sales regardless of economic conditions.
Some of Johnson & Johnson’s most popular brands can be seen below.
Source: Johnson & Johnson CAGNY Presentation, slide 5
Johnson & Johnson’s products are also diversified by segment. Their products are clustered into six categories.
This benefits the company because if there is any demand shift in any one particular product cluster (say, OTC drugs), then there are five other categories to pick up the slack until demand returns to normalized levels.
The following diagram shows how no one product category composes more than 30% of the company’s revenues.
Source: Johnson & Johnson CAGNY Presentation, slide 8
Another contributor to Johnson & Johnson’s steady earnings growth is their high degree of geographic diversification.
More than half of the company’s revenues come from outside North America, isolating Johnson & Johnson from any regional economic downturns.
Source: Johnson & Johnson CAGNY Presentation, slide 12
To conclude, while balance sheet analysis is of utmost importance when determining credit ratings, Johnson & Johnson’s steady earnings mix is also certainly a contributor to the company’s perceived creditworthiness.
Clearly, Johnson & Johnson is a remarkably stable business.
Their strong balance sheet and sustainable earnings growth has allowed the business to realize market-beating total shareholder returns over the long run.
Source: Johnson & Johnson Fourth Quarter Earnings Presentation, slide 18
The current bull market has been ongoing for more than seven years, which has led many to speculate that a bear market is on the horizon. Johnson & Johnson’s conservative financial positioning will allow them to withstand the most severe economic downturns, which makes this stock a robust defensive position for the dividend growth investor.
Johnson & Johnson’s dividend history, stability, above average dividend yield of 2.6%, and growth prospects make it a favorite of The 8 Rules of Dividend Investing.