Editors' Note: This article includes discussion of a micro-cap stock. Please be aware of the risks associated with these stocks.
This is Part V of a series about Johnson & Johnson (JNJ) being at a crossroads with a need to address the gap between a current dividend growth rate of ~8% and a lower projected net income growth rate forecast of ~6.3% (click on each to see Parts I, II, III & IV).
Earnings Growth Rate Decline
Table 1 below shows JNJ achieved double digit percentage rate growth in earnings and earnings per share for the 52 years from 1958 to 2010.
This run came to a halt in the two year period 2011 to 2012 when earnings showed a material decline due to a number of Special Item charges.
Even after adjusting 2012 results for Special Items (see here), the earnings growth rate for the 9 years to 2012 was only in the high single digit range at 7.8% (EPS growth rate higher at 8.6% due to a reduction in outstanding shares in the period).
It is understandable that the difficulties in 2011 and 2012 would have not only caused Special Costs to be incurred, but also to have depressed sales revenue and net earnings.
But this does not explain why growth forecasts for the next 5 years are only ~6.3% per year (see here).
It is believed that neither management nor shareholders would consider it acceptable for net income to grow at slightly over 6% when net income growth rates for the last 50 years through 2010 have been in the double digit range.
It was promised in this part to look at how an acquisition of an early stage company like Sunshine Heart (SSH) as it nears regulatory approval could boost JNJ's long-term net income growth rate (for more information on Sunshine Heart see here and here).
Sunshine Heart is particularly useful for illustrative purposes for those readers that might want to review a real life example of the type of company that could provide a future acquisition opportunity for JNJ to boost profit growth rate (or be of interest to Medtronic (MDT), Boston Scientific (BSX), St. Jude (STJ) and others). An example based on Sunshine Heart is included further below.
Identifying and exploiting a key strategic advantage is paramount:
A company does not grow profits and pay ever increasing dividends over the period JNJ has unless it has shown excellence in planning and execution for long-term growth throughout its history.
And that planning cannot just rely on profit and cash flow projections going out 15 or 30 years or more, as important as these might be, because the certainty surrounding such long-term projections diminishes rapidly beyond a few years out.
Strategic considerations are far more important for long-term planning.
Johnson & Johnson's Key Strategic Advantage
In discussing JNJ's strategic framework as a road map to drive growth, JNJ's CEO identifies among other things innovation, optimization of infrastructure, and excellence in execution as key drivers.
It can be argued that in the final analysis, excellence in execution and its exploitation is at the core of JNJ's key strategic advantage in driving net income growth. All other strategic advantage has dependence on that core.
JNJ's CEO further says that:
Our productivity in the pharmaceuticals group leads the industry and our model for executing launch plans is best in class.
We executed roughly 100 alliances, licensing and acquisitions, collaborations and strategic partnerships across the enterprise last year.
It is contended that JNJ's execution capabilities are the single largest defining factor in being able to attract outside parties to join, sell to, or collaborate with JNJ on favorable terms to JNJ.
An example for illustrative purposes only:
A relatively small but highly innovative enterprise ("SHIE") has developed and obtained approval of a drug and now faces the hurdle of execution of the marketing and distribution phase.
Against competition from others, JNJ successfully bids $1 billion (a 100% premium over what SHIE might expect to extract in value from its own exploitation of the opportunity).
JNJ, based on its own valuation of ~$3 billion, makes a $2 billion "profit when it buys" and secures a product that has the potential to progressively add to its overall net income growth rate for years to come.
An analysis of SHIE and JNJ valuation assumptions (see below) reveals that the huge difference in valuations is not due to JNJ innovation. The difference is solely due to the reflection in JNJ's assumptions of the quality, speed, certainty, and efficiency of execution that it is capable of.
That is not to say that innovation is not of strategic importance in feeding suitable opportunities into the machine of execution.
But it is quality, speed, certainty, and efficiency of execution that adds great value to all other initiatives.
Exploitation Of This Strategic Advantage Is Key To Long-Term Income Growth
The assumptions for the above described example -
SHIE's plan which values its opportunity at ~$500 million might look something like this:
- Initial marketing set up and distribution costs including infrastructure to ramp up worldwide sales over a 3 year period -- $300M cap raise at outset to fund this.
- Expected enterprise value at end of 8 years, including all accumulated net cash flows, based on achieving X% level of market penetration by 5 years after end of initial ramp up period and with 5 years to patent expiry -- $5 billion.
- Risk adjusted discount rate to arrive at a present value for the enterprise -- 25% (note that the time and cost to set up to execute and any lack of expertise or ability in the area of execution will increase actual and perceived risk thus requiring a high risk adjusted discount rate).
- Based on above assumptions, estimated value of drug opportunity for SHIE is ~$500M based on calculation of NPV = ($5bn/(1+.25)^8-$300M) = $539M
JNJ's plan for the same drug might look something like this:
- Initial marketing set up and distribution costs including infrastructure to ramp up worldwide sales over a 1 year period -- NIL. Any such costs are assumed absorbed out of initial cash flows. Note Medtronic report of launch of new product using existing infrastructure with no increase in staff (see here).
- Expected enterprise value at end of 4 years, including all accumulated net cash flows, based on achieving x% level of market penetration by 3 years after end of initial ramp up period and with 9 years to patent expiry -- $6 billion.
- Risk adjusted discount rate to arrive at a present value for the enterprise being acquired -- 17%;
- Based on above assumptions, estimated value of drug opportunity for JNJ is ~$3 billion based on calculation of NPV = ($6bn/(1+.17)^4 - $0) = $3.202 billion.
The Sunshine Heart Example:
There is no suggestion that Johnson & Johnson is presently considering an acquisition of Sunshine Heart, nor that it might do so in the future.
It is just that Sunshine Heart is a good example for illustration of the earlier stage opportunities referred to above. If successful in its endeavors, Sunshine Heart should in the next few years, be substantially de-risked from the regulatory aspect; through its unconditional FDA approved pivotal trial it should have proven up the efficacy of the device demonstrated in the already completed 20 person feasibility trial; and by then there should be an idea of the level of acceptance and rate of uptake from commercial sales in Europe.
Table 5 below is a projection of JNJ's operating profit growth rates without Sunshine Heart.
Table 4 below shows the projections for JNJ in Table 5 combined with projections for Sunshine Heart per Table 3 below to determine the projected impact on JNJ's profit growth rate.
The outputs from the projections of profit growth rates are summarized in Table 2 below.
From Table 2 it can be seen how acquisition of a small high growth company like Sunshine Heart could have a meaningful impact on profit growth rates. In the example the future profit growth rate shows an increase from 6.3% to 7.7%.
Table 2 - Projected impact of acquisition on JNJ profit growth rates
Before proceeding further, it is probably useful to provide some information on Sunshine Heart for those readers unfamiliar with this micro cap.
Sunshine Heart C-pulse attributes and comparisons to alternative therapies, in a nutshell -
The heart muscle beats continuously all our lives. It cannot rest even in periods of inactivity.
But the heart muscle can become tired and weakened from various causes. This can lead to the onset of Congestive Heart Failure (CHF) where the heart is unable to pump sufficient blood for the needs of the body including the heart itself.
Treatments for CHF include -
- Drug therapy and use of pacemakers -- these do not rest the heart but are designed to make the tired and ailing heart work harder in an effort to maintain blood supply. Mostly these therapies do not stop the rate of worsening of CHF. They just slow the rate of worsening in what is a progressive disease;
- LVAD's such as those from Thoratec and Heartware -- these take over the pumping from the heart, but operate in the bloodstream. This entails risks of blood clotting and strokes and so requires the use of anti-coagulants (due to risks, use of these devices is mostly limited to very end stage CHF);
- Intra-aortic balloon counter-pulsation therapy -- reduces the workload of the heart and increases blood flow to the heart muscle. Can only be used for limited periods due to high risk of blood clotting and strokes;
- Extra-aortic balloon counter-pulsation therapy (Sunshine Heart C-pulse) -- The C-pulse system does not take over from the heart. It employs proven counter-pulsation technology, to reduce the workload of the heart, and to create additional blood flow to the heart muscle. This provides ongoing permanent support and allows a tired heart muscle some opportunity to rest and recover, in a measurable way (NYHA Heart Failure class improvement). For further information see here. As it is outside the bloodstream it can be used indefinitely (one patient on device for > 2 years). Out of a 20 patient feasibility trial 2 patients have become asymptomatic for CHF and have been weaned off the device. A further 2 patients are undergoing a weaning process. Other patients have improved by 1 or more classes of CHF. For the history of its development and additional information on the C-pulse System and the Counter-Pulsation therapy it delivers, see my recent article "Medtronic And Sunshine Heart: Pacemaking And Counter-Pulsation - A Tale Of 2 Technologies".
Target markets and market caps of heart assist device companies
Blood contacting LVADs -
- Thoratec -Market Cap $1.7bn ) Shared target market in U.S.
- Heartware-Market Cap $1.5bn ) of 50,000 to 100,000 patients
Sunshine Heart-Market Cap $74M- Target market in U.S. 1.5M patients
Placing a Value on Sunshine Heart
Sunshine Heart expects completion of its current 388 person U.S. FDA approved pivotal trial and one year follow up by end of 2016. PMA is targeted for 2017.
By 2015-2016, it should also have completed its EU post approval trial designed to introduce the product and establish reimbursement in the EU and to have commenced commercial sales of the product in the EU. (Sunshine Heart C-pulse system already has CE Mark approval for commercial sale in the EU).
Based on the above, 2016 is possibly the earliest point at which a potential suitor/s might make a bid.
For JNJ, it would be not too different timing to the DePuy acquisition with minimal technical and regulatory risks remaining.
That is the ideal timing for JNJ when it does not have to take the technical and regulatory risks and it can immediately start to exploit its strategic advantage in execution.
In the article "Sunshine Heart Risk and Reward", calculations were made of the potential value of the C-pulse system by the year 2027. These calculations were made on the basis that the C-pulse system would be acquired by a larger entity with the execution capabilities of a JNJ.
These projections are re-worked in Table 3 below on the basis of an acquisition in the 2016 to 2017 period. Note that these are not forecasts, they are merely projections based on assumptions that might or might not come to pass. They are for the purpose of illustrating the potential impact on JNJ's overall profit growth rate of acquisition of a small, early stage, but potentially high profit growth company.
Table 3 - Sunshine Heart Projections
No attempt is made to place a valuation on Sunshine Heart in the eyes of either JNJ or Sunshine Heart, as was done in the fictional SHIE example above.
However, similar considerations would come into play as for the SHIE example.
It has been suggested that Heartware would be a good proxy for placing a valuation on Sunshine Heart. Sunshine Heart is tracking along a similar path to Heartware, but possibly 3 to 5 years behind in the regulatory approval processes and in commercialization in the EU and U.S.
Thoratec (THOR) made a $282 million, cash and scrip takeover bid for Heartware (HTWR) when it was at about the same stage of clinical development as Sunshine Heart is today. The takeover did not proceed due to regulatory objections.
Table 4 - Combined Projections for Johnson & Johnson and Sunshine Heart (for illustrative purposes only)
Table 5 - Base JNJ Projections by Division (for illustrative purposes only - totals as included in Table 4 above)
The main conclusion, as described above, is that exploitation of its execution capabilities is the key strategic advantage that JNJ can use to leverage acquisition opportunities and so increase the profit growth rate.
Summary of other important conclusions about increasing profit growth rate (discussed in detail in earlier parts of this series):
- Using idle cash to acquire net income producing assets will give an immediate boost to the net income growth rate (as stated in earlier parts that is a "no brainer");
- Acquiring net income producing assets that are likely to have future net income growth rates lower than the likely future overall growth rates of the combined existing divisions will give a short term boost to net income growth rate. But in periods subsequent to the period of acquisition the overall net income growth rate will decline unless the acquisition can be made to equal or exceed the growth rates of the combined existing divisions;
- Bearing in mind 2 above, and in relation to the acquisition of the Pfizer consumer division, the consumer division income growth rates were positive in the overall profit mix both in the period of acquisition and in subsequent periods. However, if reduced sales growth rate and margins are the pattern for the future then consumer division will be a drag on efforts to increase the overall net income growth rate. That is just a mathematical fact. There is no suggestion of a sale or spin-off of the consumer division as it almost certainly provides significant strategic advantages to the overall group;
- As JNJ grows it needs to continually find projects in which to invest that portion of net income retained in the business in order to further grow net income. As per 2 above, these funds need to be invested in projects that have likely net income growth rates equal to or greater than the existing overall growth rate. This can be done through internal investment in the business such as the excellent work being done in the Pharma division as per the recent Pharma review. But this becomes increasingly difficult because ever larger projects need to be developed and/or acquired to keep up with the amount of investment required to be made. The example was given in Part II, where the 2012 Synthes acquisition, the largest in JNJ history, was, as a proportion of investment in assets used in the business, only equivalent to the DePuy acquisition in 2000;
- In Part IV, consideration was given to whether an acquisition of Boston Scientific or St. Jude would be strategic for building a business in the heart health area. Considering that JNJ already has considerable expertise in this area (for example, Biosense Webster, Inc., are a worldwide leader in the diagnosis and treatment of cardiac arrhythmias), the strategic advantage would likely be limited. On this basis, an acquisition of Boston Scientific or St. Jude, both of which have a lower net income growth rate than JNJ, is not considered advantageous to long term profit growth. Also, in the case of Boston Scientific or St. Jude, JNJ could be expected to pay a hefty takeover premium for a mature enterprise that already has much of the leveraging capabilities of JNJ.
- Together with a potential 30% to 40% takeover premium, the acquisition cost of a Boston Scientific or a St .Jude would likely be in the order of $18 billion. Unless the acquisition was positive for earnings growth rate increase in the long term, JNJ would be better off buying back more of its own stock. That way the net income on a per share basis would show an immediate boost; the total amount payable in dividends would reduce; its own shareholders would benefit from any price premium in the buy-back price; and without an acquisition increasing the starting level of profits, future profit growth rate requirements would be easier to meet.
- In Part II it was noted the need for larger and larger acquisitions has pushed the search higher up the value chain to more mature companies where JNJ has progressively less leverage compared to the target. Examples of this are -- DePuy acquisition date near but ahead of regulatory approval; and 12 years later Synthes acquisition post regulatory approval and significant market penetration already achieved. From a strategic point of view JNJ needs to search for earlier stage opportunities where it can most effectively use its leveraging capabilities to achieve faster and higher levels of profit growth than the target could hope to do (as per the fictional SHIE example above). Sunshine Heart has been identified as one such opportunity.
This article has concentrated on how JNJ might increase its earnings growth rate.
It is proposed to write one further article in this series from the perspective of managing dividend growth in a scenario where there is continuing difficulty in closing the earnings/dividend growth rate gap.
Caution: 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.
Additional caution: Investing in micro cap companies is not suitable for all investors and can be risky. It's important that investors thoroughly perform their own due diligence and analyze the potential risks. Due to illiquidity, share prices can fall despite strong fundamentals and possible inability to raise sufficient additional cash to continue to fund ongoing operations is always a serious concern. Fuller details of risks associated with Sunshine Heart as identified by the company may be found with their form 10-12B/A registration filing with the SEC and their other SEC filings.