By Cagdas Ozcan
Johnson & Johnson (JNJ) is one of the biggest and most diverse healthcare companies in the world. The company operates through three divisions: Pharmaceuticals, consumer and medical devices and diagnostics. Healthcare sector has some of the best dividend paying companies, and JNJ is one of these attractive investments.
The company has a rich history of dividends. Johnson & Johnson has increased dividend payments every year since 1997. At the moment, the company pays $2.44 in annual dividends, which represents a yield of 3.00%. In order to assess the trend in free cash flows and dividend safety, we decided to apply our free cash flows model to Johnson & Johnson. We also estimated the fair value of the company to see whether it offers a fair entry point, currently. Results of the analysis are discussed below.
Free Cash Flows
Free Cash Flows
Depreciation and other noncash charges
Funds from Operations (FFO)
change in noncash current assets
change in noncash current liabilities
Operating Cash flows
Free Operating Cash Flow
Source: SEC Filings
In the previous three years, the company has experienced some volatility in its net income. Especially in 2011, the net income went down substantially. The same pattern is evident in funds from operations of the company. At the end of 2011, FFO stood at $12.8 billion, the lowest in three years being evaluated here. The cash flows from operations stood at significantly improved levels in 2012 as compared to 2011. Johnson & Johnson also invests a substantial amount of capital in the business, and in the previous three years, the amount of capital expenditures has remained between $2.3 and $2.9 billion. At the end of 2010, the firm spent $2.38 billion in capital expenditures. However, by the end of 2012, the capital expenditures for Johnson & Johnson had gone up to $2.93 billion.
The company generates healthy free cash flows. Although, the capital expenditures have been increasing, the firm has been able to post impressive free cash flows. Johnson & Johnson's free cash flows have shown the same pattern as its operating cash flows and FFO. Free cash flows came down in 2011, and then again went up in 2012. At the end of 2012, free cash flows stood at $12.46 billion.
Funds from Operations(FFO)/Total Debt
FFO/Capital spending requirements
(Free Operating Cash Flow + interest expense)/ Interest expense
Debt Service coverage
For our analysis, we have used four ratios. The first ratio indicates that the debt of the company is adequately covered with the FFO. The ratio fell substantially in 2011, but again went over the safe number of "1" in 2012. At the moment, the firm is generating enough cash flows to cover the long term debt. The second metric indicates that one of the most important components of the firm is easily covered with the FFO of the company. As I mentioned, capital expenditures are an integral cash outflow for Johnson & Johnson, and the analysis shows that the firm is able to meet its capital spending requirements through its internally generated funds.
Third metric in the table indicates that the firm is able to meet its interest payments sufficiently. Interest coverage is extremely strong for the company, and it should not face any trouble paying its interest obligations. Finally, debt service coverage ratio is also extremely strong for Johnson & Johnson. Debt service coverage ratio fell slightly in 2011; however, it again went up in 2012, and currently stands at even better levels than 2010. Short-term debt payable in 2012 was substantially lower than the previous two years, which has resulted in a better debt service coverage ratio than the previous two years. Another factor for better debt service coverage ratio in 2012 is an increase in cash flows of the company.
In order to determine the fair value of the company, I utilized two different models. The first model is based on the discounted earnings. In this model, I use a discount rate of 11%, and a five year earnings growth estimate of 6.3% (based on Morningstar estimates). The terminal earnings growth rate is '0' based on the 5-year discounted earnings model. This terminal growth rate suggests a conservative valuation. Based on these estimates, the stock is fairly-priced between $62 and $85. Thus, at the current valuation, Johnson & Johnson is trading within its fair value range.
The second model utilizes a simple formula, named O-Metrix score. This score is calculated as following
O-Metrix = (Dividend Yield + EPS Growth) / (P/E Ratio) x 5
JNJ offers a yield of 2.97%, and is expected to grow its earnings by 6.3% over the next 5 years. As the stock has a trailing P/E ratio of 21.25, its current O-Metrix score is 2.61. This score is below the current market average score. Therefore, we do not expect much capital gains from Johnson and Johnson.
Johnson & Johnson is one of the biggest names in the healthcare sector. The company has impressive free cash flows. Our analysis shows that trend in cash flows and debt metrics of the company is strong, and it should not have any trouble with its debt. Strength of free cash flows will allow the company to maintain its current dividend levels, and grow them in the future. In our opinion, Johnson & Johnson is a solid dividend investment. It could be a perfect replacement for fixed income instruments. However, its current valuation is on the pricey side of the market. The stock has returned almost 20% in the last quarter. Therefore, it is better to wait for a pullback before investing.