In most situations, I do not like to see a company display a declining dividend growth rate over an extended period of time. The reason why is probably obvious enough: when a company starts slowing down the rate of its dividend growth, it usually signals that the company has not been growing earnings as fast as it once did, or will not grow earnings as fast as it once did (an exception would be a company like Disney, which chooses to allocate excess capital to its buyback rather than to its dividend by a 4:1 ratio).
Today, I'd like to take a look at Johnson & Johnson (JNJ). From 1993 to 2008, Johnson & Johnson never had an annual increase less than 11%. From 1993 to 2006, the dividend growth rate was only less than 13% once (a 12% increase in 1999). To be sure, Johnson & Johnson's dividend growth rate in the 1990s and through most of the 2000s was a magical time for shareholders.
The last five years have all seen increases in the high single digit range (7-9%), and my guess is that this will come to represent a new normal for Johnson & Johnson shareholders compared to what shareholders experienced from 1993 to 2008.
For those of you keeping score at home, the recent Johnson & Johnson increases have been as follows:
The 2009 increase was 8%.
The 2010 increase was 9%.
The 2011 increase was 7%.
The 2012 increase was 7%.
And recently, the company announced its 2013 increase, which raised the quarterly dividend from $0.61 per share to $0.66 per share, for a growth rate of 8.2%.
There is a reasonable temptation to believe that Johnson & Johnson will return to its double-digit dividend growth heydays of 1993 to 2008, especially considering that the 2009-2012 period both witnessed (1) a terrible financial crisis that wreaked havoc in the United States, and is still causing severe troubles in Europe, and (2) a relentless string of recalls for Johnson & Johnson over the past couple of years could signal that the dividend growth rate could return to the status quo ante once the company overcomes its string of recalls and lawsuits related to them.
Since Johnson & Johnson is my largest personal holding, I think about its long-term dividend growth rate more than I do for most other companies. In this case, I believe we've already entered a "New Normal" where most Johnson & Johnson dividend increases will be around 7-9% annually (and maybe a 10%-11% increase during the occasional very good year) rather than the 11-15% annual growth rates that shareholders experienced from 1993-2008.
If you review Johnson & Johnson's earnings growth history, you will see that the company managed to grow earnings at a rate commensurate with the typical 11-15% increases. During every year between 1993 and 2008, Johnson & Johnson's payout ratio stayed between 34% and 39%. But ever since 2008-2009, the company has been both slowing its dividend growth rate to the high-single digits while simultaneously raising its payout ratio from 40% to 46%. The dividend increases have gotten smaller, and they still haven't kept up with earnings (again, this is in comparison to Johnson & Johnson's robust 1993-2008 stretch).
The question going forward, then, is whether these 7-9% increases represent a new normal compared to the 11-15% dividend growth rates of the 1993-2008 stretch. I believe it does, and here is why:
First of all, the consumer division has stopped becoming a robust source of growth for the company. When you look at the sales for the over-the-counter pharmaceuticals and nutritionals, skin care, baby care, women's health, oral care, and wound care, you will see that the sales growth for each of these segments has been uninspiring over the past three years (in fact, the company's consumer division had lower sales in 2010 than in 2012, and most analysts expect the consumer sales division to post the same results in 2013 that it did in 2010 (which is actually a decline, when you take into account inflation).
The good news, of course, is that the quality of the earnings in the consumer division is phenomenal. The consumer division held up phenomenally well during the worst of the 2009 period, and there are pockets of high growth within the consumer division. Neutrogena is growing sales at a fast pace in the United States, while Listerine is finally starting to take off outside the United States.
In my opinion, Johnson & Johnson's future dividend growth will rely on the success of the pharmaceutical division, as well as the medical device division. That's where the company's growth story lies.
If you look at the pharmaceutical division, you will see a comprehensive division that is growing sales at about 4% each year while the operational earnings are increasing 6.8%. Over the long-term, you need double-digit earnings growth to create fertile ground for double-digit dividend growth. When you look at the pharmaceutical division, there are only two segments that are currently experiencing double-digit growth in terms of sales. The oncology division has been growing sales by 28%, but it only accounts for $2.6 billion worth of the company's sales. Sales at the neuroscience division are in decline, and growth in the infectious disease division have only increased by 0.2%.
The source of growth for us as shareholders is immunology. That means Remicade, Simponi, and Stelara. That's an $8 billion division growing at 15-20% annually, and that's where I anticipate future growth from the pharmaceutical division will come from.
And lastly, there's the medical device segment. We're starting to see the impact of the Synthes acquisition, as operational growth has been at 8.6%. Right now, a lot of the growth in the medical device segment has not been fully appreciated on the company's balance sheet because we still have not seen "the finished product" what the company will look like with the Synthes acquisition, and the division has been hit with unfavorable currency translation of 4-5%. This should prove to be a worthwhile pocket of future growth for shareholders.
Johnson & Johnson has excellent earnings quality. They sell products in dozens of countries that get sold no matter the economic environment. It's the ultimate "sleep well at night" stock. But I do believe we have entered a new normal where the dividend growth of 11-15% has been turned into 7-9% increases (with the potential to have a 10-11% increase here and there).
You need double-digit earnings growth to get double-digit dividend growth (unless Johnson & Johnson wants to increase its payout ratio). You're not going to be getting double-digit earnings growth from the consumer division (you're looking at 4-5% growth at best). The pharmaceutical division should give you high-single digit earnings growth. And the medical device division cannot give you high enough double-digit earnings growth to offset the low growth from the consumer division. That's why I think shareholders should expect a "New Normal" of 7-9% dividend growth instead of 11-15% dividend growth experienced from 1993-2008.