In Part I of "Johnson & Johnson: At The Crossroads", consideration was given to whether a dividend growth rate of 8.2% was sustainable if net income growth rate remained around the projected 6%.
It was determined that this gap between dividend and net income growth rates was likely sustainable for at least the next 15 years.
It was further determined, with ample funds available for investment, management and shareholders would wish to see these funds utilized to increase net income growth rates to the 9.1% of the last 15 years, or to at least match the dividend growth rate of 8.2%.
It was also recognized that as JNJ grows in size it needs to increase the size of internally grown businesses and/or target more or larger businesses for acquisition. The example was given of the $5.6 billion increase in the 3 year period 1998 to 2000 resulting in a 34% increase in business investments.
But, in the 3 year period 2010 to 2012 it took $20.8 billion, including Synthes, the largest acquisition in JNJ's history, to increase business investment by a similar 34%.
It was further noted that larger acquisition targets probably mean more mature targets where JNJ would not have the same leverage as when acquiring earlier stage acquisitions.
What is left to analyze to seek a way forward -
Firstly, it is proposed to expand on previous total company analysis and to drill down into the divisional results to assess the potential of each division to contribute to an increase in the rate of growth of net income in the future. Given differences in profitability between divisions it is assumed the mix will potentially assume some importance.
It is also intended to provide some examples of the potential effect of acquisitions on the net income growth rate, including -
- A case for acquisition of a mature entity, using Boston Scientific (NYSE:BSX) as an example, to test whether JNJ might be able to effectively increase net income growth rate in such a scenario; and
- A case for acquisition of an early stage company as it nears regulatory approval, using Sunshine Heart (NASDAQ:SSH) as an example, to illustrate how JNJ, through its leveraging capabilities, can obtain superior returns while paying a fair price in such a scenario.
Historical Results of Divisions
Consumer division -
Details of investment in business assets, sales and operating profits for Consumer division for the 15 year period 1998 to 2012 are shown in Table 1 below.
The $20 billion increase in assets in the 2004 to 2006 period was primarily due to the Company completing the acquisition of the Consumer Healthcare business of Pfizer (NYSE:PFE) on 20 December 2006 for a purchase price of $16.6 billion in cash.
But for the Pfizer acquisition, it would appear sales growth over the 15 year period 1998 to 2012 would have been relatively flat instead of the average 7% per year increase. In addition, from the 2001 to 2003 period onward, the operating profit as a percentage of sales has shown a steady decline from 18% to 14%. Operating profit as a percentage of assets employed is running at a low 8 to 10%.
Assuming JNJ rectifies its manufacturing problems there should be a higher than usual percentage increase in sales in the 2013 to 2015 period due to coming off the depressed sales in the 2010 to 2012 period.
Beyond that it seems sales growth is likely to be flattish unless there were to be another Pfizer type acquisition. For reasons discussed further on, increasing Consumer division sales by acquisitions is unlikely to contribute to overall net income growth rate increase in the long term.
It seems likely that average sales growth rates of 5% per year for the period 2013 to 2015 and 3% per year for the period 2016 to 2027 could be within expectations.
Margins might continue to progressively fall by a further 1 percentage point to 13% by the 2025 to 2027 period.
Pharma division -
Details of investment in business assets, sales and operating profits for Pharma division for the 15 year period 1998 to 2012 are shown in Table 2 below.
For the Pharma division, operating profit as a percentage of sales has historically been 3 to 4 times that for Consumer division and that continues to be the case.
The same is true for operating profits as a percentage of assets employed.
For the 2010 to 2012 period, there was a dramatic decrease in sales growth to nil and also a fall off in margin from over 30% in earlier periods to ~27%. This is attributed mainly to patent expiry and generic manufacturers challenging patent rights.
There is optimism that JNJ's pipeline will offset patent expiry of existing drugs. Shortened effective periods of patent protection might continue to affect sales growth with a constant process of development of new drugs replacing old required.
And as discussed earlier, the pipeline has to produce ever larger absolute amounts of sales revenue just to maintain percentage sales growth over an ever larger sales base.
Pharma is different from the other two divisions with respect to the sheer size of "capital" type drug development expenditures on R&D which are written off currently against operating profits.
The nature of drug development is such that growth can be expected to occur in bursts.
Sales growth has averaged ~7% per year over the last 15 years but for reasons discussed above this is not likely to be achieved over the next 15 years.
All things considered, a sales growth rate of 5% for the 2013 to 2015 period and 3% per year for 2016 to 2027 might be within expectations. Operating margin of 27% per year for 2013 to 2027 would be in line with margin for the 2010 to 2012 period.
MD&D division -
Details of investment in business assets, sales and operating profits for the MD&D division for the 15 year period 1998 to 2012 are shown in Table 3 below.
Following the DePuy acquisition in the 1998 to 2000 period, sales grew rapidly through 2006. Since 2006 the rate of sales growth has tapered off both in terms of percentage growth and absolute sales growth. Average rate of sales growth over the 15 year period 1998 to 2012 was ~9%.
Operating profit as a percentage of sales was similar to Pharma in the latter part of the review period.
Operating profit as a percentage of assets employed was in the order of 28% to 29% in the 2004 to 2009 period, falling to 16% in the 2010 to 2012 period due to the impact of the Synthes acquisition late in the 2012 year.
Sales growth of ~9% per year over the 15 year period 1998 to 2012 was the highest rate of the three divisions.
Coming off a much higher sales base, a sales growth rate of 9% for the 2013 to 2015 period and 8.5% per year for 2016 to 2027 might be within expectations. Operating margin of 27% per year for 2013 to 2027 would be in line with margin for the 2010 to 2012 period.
What If? Projections For Divisions
Table 4 below shows projections for operating profit rates of growth for each division and in total for the 15 year period from 2013 to 2027. The assumptions for sales and operating profit margins used in the projections are as per the indications given at the end of the historical divisional analyses above.
Understanding what drives operating profit growth rates -
The drivers of operating profit growth rates include:
Continuing internal improvement -
- Organic sales growth;
- Organic margin growth (higher sales prices, lower supplier prices and cost reductions through greater efficiency or scale);
Cash acquisitions -
Acquiring an operating business that already has sales revenues and profits will have an immediate and possibly quite substantial impact on the rate of profit growth. And where idle cash is used for the acquisition there is little or no offsetting loss of income.
But unless that new acquisition has the ability to grow sales and/or margins at a faster rate than the existing divisions it will not contribute to the rate of growth in subsequent periods. It might well have an adverse impact on the rate of profit growth in future periods.
This can be seen from Table 1 above where the acquisition of the Consumer Healthcare business of Pfizer in 2006 resulted in a large increase in sales and profits in the 2007 to 2009 period followed by a decrease in sales and profits in the 2010 to 2012 period. Some of that decrease might have been due to internal problems but it seems likely sales and profits would have been at best flat without those difficulties.
Divisional mix -
It can be seen in Table 4 above that 2016 to 2027 operating profit growth rate projections for Consumer, Pharma and MD&D are held constant at 2.8%, 3% and 8.5% respectively. And yet the overall operating growth rate increases from 5.7% to 6.0%.
This is primarily due to the MD&D division, which has the highest profit margin, projected to grow sales at a faster rate (8.5%) than the Consumer division (3%). Over time this increases the proportion of MD&D and reduces the proportion of Consumer in the mix.
Medical Health Growth Markets
With an understanding of what drives operating profit growth rates it is clear that potential acquisition targets should display certain characteristics of high and sustainable margins and high and sustainable growth rates.
With the acquisitions of DePuy and Synthes, JNJ is currently a leader in orthopedics where demand is escalating due to a growing elderly population in the U.S. and around the world.
Another large market addressed by JNJ is Oncology through the Pharma division.
Large and growing markets with unmet needs such as the above are what is required for long term high revenue growth rates together with good operating profit margins.
And there could be no better target in the health care market than heart failure which is stated to be responsible for more hospitalizations than all forms of cancer combined.
Acquiring Boston Scientific would place JNJ in a leading position in the heart health market.
"Johnson & Johnson: At the Crossroads - Part IV"
With heart health identified as a large and growing market, Boston Scientific would be a suitable acquisition target for JNJ to enter this market and assume some leadership.
It is proposed to analyze the potential effect of an acquisition of Boston Scientific (BSX) on JNJ future net income growth rates in Part IV of "Johnson & Johnson: At the Crossroads."
It is also proposed to analyze how, following an acquisition of Boston Scientific, an acquisition of Sunshine Heart (SSH) as it nears regulatory approval could further boost JNJ's long term net income growth rate.
As previously mentioned, Sunshine Heart will provide an excellent example to illustrate how JNJ, through its leveraging capabilities, can obtain superior returns while paying a fair price in such a scenario.
Disclosure: I am long SSH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As always, please do your own research before any buy or sell decisions. Use of information and research in the article above is at your own risk.