(Editors' Note: This article includes discussion of a micro-cap stock. Please be aware of the risks associated with these stocks.)
In my recent article, "Johnson & Johnson: Part V - Unacceptable Earnings Growth Decline - Reversal Strategy", I explored issues for Johnson & Johnson (NYSE:JNJ) in reversing a decline in earnings growth rate, from double digit growth for 1958 through 2010 to analysts' consensus forecast growth rate of ~6.3% for the five years 2013 to 2017 (for the two year period 2011 to 2012, earnings showed a material decline due to a number of large Special Item charges).
In that article, I proposed JNJ should target early stage entities rather than more mature companies to increase the earnings growth rate above the analysts' 6.3% forecast (currently 6.22%).
This could be done both through internal innovation (new drug development) and acquisition of early stage companies with potential for high growth.
In Table 1, further below, it can be seen why it is more likely early stage companies coming off a low base will be able to achieve high growth rates for extended periods.
In the same article, I used a real life example, Sunshine Heart (NASDAQ:SSH), for illustrative purposes only, to show how a high growth acquisition could potentially lift the projected earnings growth rate for JNJ from the analysts' consensus forecast of ~6.3% to ~ 7.7% in future periods.
However, no conclusion was made as to whether JNJ has any likelihood of achieving a return to, and to sustain long term, the double digit growth rates of the past.
In this article I now seek to provide some answers on future growth rates likely to be achievable by JNJ in the context of a long-term investor seeking long-term growth. In that context and in an approximate sense only -
- Near term equates to - Less than 7 years;
- Medium Term equates to - Greater than 7, less than 10 years;
- Medium to Long Term - Greater than 10, less than 15 years; and
- Long Term - Greater than 15 years
Last 7 Years' Earnings More Than Previous 107 Years'
Yes, the headline is correct.
The respective earnings totals are:
- Last 7 years' earnings $80.7bn;
- Previous 107 years' earnings $71.3bn
(see reported net income in nominal dollars as per "Johnson & Johnson 2012 Historical Financial Review")
That is a total of $152bn of earnings over the last 114 years.
If historical dollar earnings were converted to current dollar terms using CPI published tables, the heading would remain valid if altered slightly to, "Last 9 Years Earnings More Than Previous 109 Years". The respective inflation adjusted earnings totals are: last 9 years $107.8bn, previous 109 years $89.5bn.
With such a high proportion of earnings out of the last 114 years accumulated in the last 7 years, is it possible that total earnings in the next 7 years will be greater than the total for the previous 114 years?
That is an important question, as it goes to the heart of whether JNJ can return to the double digit growth rates of the past.
It requires average net earnings of ~$22bn per year for the 7 years 2013 to 2019.
In order to best illustrate the mammoth task JNJ faces to achieve double digit earnings growth going forward, I find it useful to present my case in a rather unusual way. Please read on.
The "Doubling Penny"
The origins of this term are said to derive from this story based on doubling a grain of wheat on the 64 squares of a chess board.
An alternative story has developed to demonstrate the enormous/fantastic power of compounding at high earning/interest rates for long durations in respect to financial investments. The question is what does one penny grow to if progressively doubled and accumulated for 30 days? The calculation of the answer of $10.7M is shown in table 1 below.
I still find it remarkable, and I am sure you will be surprised too, how the "Doubling Penny" appears to become absolutely turbo charged from about the 25th period on.
Please read the notes to Table 1 as they are important in understanding the process of evaluation that follows.
Great for the investor/lender; extremely onerous for the investee/borrower
The story about the wheat grains referred to above, involved the inventor of the chess set being paid a reward of his asking by a local ruler. He asked to be rewarded by being paid according to progressively doubling wheat grains on the 64 squares of the chess board, to which the ruler readily agreed. The result came to more than all the wheat in the world. The ruler could not possibly meet his obligation.
In the case of managing a high earnings growth company like JNJ (investee/borrower), the shareholders' funds are a liability of the company to the shareholders (investor/lender) and the management has the responsibility for managing the investment.
If the shareholders have expectations of a return to continuing high earnings growth rates of the past, there needs to be an assessment of whether those expectations/obligations are too onerous to be realistically met by management.
Process for comparing JNJ's net income growth to the "Doubling Penny" growth table
My first step in this process was to determine how many years on average it has taken JNJ to double profits over the last 30 or so years.
The average number of years I calculate it takes JNJ to double net income between periods becomes a period in the "Doubling Penny" table.
To assist in my deliberations and calculations, I have constructed Table 2 below to determine how many years it takes to double an initial amount at various interest/growth rates.
After some trial and error, I found that doubling profits in 5 year blocks is a good fit for JNJ's reported earnings over the 35 year period 1972 to 2006.
From Table 2 above, I can see that a period of 5 years is consistent with an earnings rate of ~15% (14.87%) cumulative over the 35 year period 1972 to 2006.
I found at end of 1971, the cumulative earnings of JNJ since inception are $784 million and the cumulative earnings for the 5 year period 1972 to 1976 are $820 million (greater than the cumulative earnings of $784 million for all previous periods). In relation to this statistic, I especially ask the reader to refer back to Note 1 in Table 1.
I now needed to find a period in Table 1 where the $820 million for the 1972 to 1976 period and the cumulative earnings of $1,604 million through end of 1976 might best fit to enable a comparison of growth of JNJ earnings against the "Doubling Penny" from 1976 onwards.
This comparison is important in assessing whether JNJ has any possibility of continuing to deliver the high earnings growth rates of past periods in the long-term future. We need to know how many "periods" before JNJ reaches the "Doubling Penny" turbo charged phase from around period 25 on, and how many years does that calculate to, based on the selected 5 year "periods" referred to above.
The best fit I could find was period 17 in Table 1.
Actual reported JNJ earnings, accumulated in periods of 5 years, 1972-1976 to 2007-2011, are compared to the "Doubling Penny" table starting at Period 17 in Table 3 below.
A combination of 2012 actual results and forecasts for 4 years 2013-2016 comprise the next block of 5 years. Thereafter, I have included projections for sequential five year periods through 2041, the last period corresponding with Period 30 of the "Doubling Penny" Table 1.
Table 3 - Comparison of JNJ's net income growth to the "Doubling Penny" growth table
I am absolutely awed by the results of the comparison.
Table 1 indicates for the 35 years from 1972 to 2006, JNJ not only grew net income at ~15% per year, but the growth (measured in periods of 5 years) was remarkably uniform, with little variation from the uniform growth path of the "Doubling Penny."
What is even more remarkable is that the 16 periods prior to period 17 represent another 80 years of growth (at 5 years per "period"). And the average growth rate for all of that time has to be around 15% for cumulative actual results to be slightly ahead of the "Doubling Penny" at the start of Period 17.
So it can be confidently said that JNJ has grown earnings over the 115 years from 1892 to 2006 at a rate of ~15%, and that growth rate was remarkably uniform over the 35 years 1972 to 2006.
(It is noted that there were sales but nil earnings reported from 1892 to 1896, but that is not material to the conclusion.)
Period 2007 to 2011 - "Doubling Penny" Period 24
This period was adversely affected by high levels of Special Items. But this does not explain the extent to which JNJ actual results suddenly fall $24,958M behind the "Doubling Penny" as per Table 3 above.
In Johnson & Johnson: At The Crossroads - Part III, Table 1 shows 2007-2009 Consumer Division operating profits increasing by 63% compared to the 3 year period 2004-2006, due mainly to the acquisition of Pfizer's (NYSE:PFE) Consumer division in late 2006. So there were significant additions to earnings in that period.
And yet by 2011, at the end of "period" 24, JNJ cumulative results had fallen significantly behind the "Doubling Penny" for the first time in over 115 years, with a significant gap of $25bn opening up.
It appears that other issues might have clouded the existence of the "Doubling Penny" turbo charged phase starting to come into play in this period.
Period 2012 to 2016 - "Doubling Penny" Period 25
This period includes actual reported net income for 2012 and forecast net income for the 4 year period to 2016.
The forecast net income is based on JNJ Adjusted Net Income for 2012 of $14,345M projected by year 2013 through 2016 at a growth rate of 6.3% per year (per analysts' consensus forecasts referred to above). I have used the JNJ figure of $14,345M rather than my preferred "normalized income" estimate of $13,440M as per my article, "Johnson & Johnson: When Special Items Are The Norm", on the basis the $14,345M growing at 6.3% reflects the current "market expectation".
By 2016, at end of "period" 25, JNJ cumulative results are projected to fall much further behind the "Doubling Penny" with the gap increasing by $89bn to $114bn.
That increased gap of $89bn is more than the total current market expectation of ~$78bn earnings for this 5 year period 2012 to 2016.
It equates to an average ~$22bn per year shortfall if it is to be made up over the remaining 4 years 2013 to 2016.
Further analysis and findings:
1. Will the next 7 years' earnings be greater than the total for the previous 114 years?
I now go back to the important question I posed earlier on, as it goes to the heart of whether JNJ can return to double digit growth rates:
"With such a high proportion of earnings out of the last 114 years accumulated in the last 7 years, is it possible that total earnings in the next 7 years will be greater than the total for the previous 114 years?"
We know from above that the reported earnings for the 114 years through 2012 total $152bn (last 7 years plus previous 107 years).
Based on the assumptions I have used for Table 3 projections, the forecast for the 7 years' earnings 2013-2019 totals $129.2bn, a $22.8bn shortfall.
Let us be more optimistic and start with the Adjusted Earnings of $14,345bn for 2012 per JNJ and extrapolate at a 10.41% growth rate for the 7 years through 2019. The result is $152.1bn for the 7 year period through 2019, near enough to the $152bn cumulative earnings at the start of the period.
That raises further questions.
Firstly, where will the additional $22.8bn over and above current market expectations come from?
That is an additional earnings requirement of ~$3.2bn per year to make up over this 7 year period.
An acquisition of St Jude (NYSE:STJ) or Boston Scientific (NYSE:BSX), or even both, would not give nearly enough increase to meet the additional $3.2bn per year earnings growth required (additional $3.8bn per year if starting from 2014).
It would take an acquisition of a business the size of Medtronic (NYSE:MDT) to come near to bridging this gap.
Secondly, if the $152bn for 7 years through 2019 should be achieved, how will the doubling to $304bn in the next 7 years through 2026 be achieved? We know from Table 2 above that earnings must double every 7 years to continue to grow earnings at a 10.41% growth rate.
To speculate that the recent below average JNJ dividend growth is a 'new normal' seems premature.
It is my finding, based on the foregoing analysis, that the possibility of JNJ achieving double digit growth over the next 7 year period through 2019 is remote without a major acquisition/s.
It is highly doubtful that the Pharma division alone could generate the additional $22.8bn earnings required over that period.
Even if JNJ could achieve double digit growth over the 7 year period to 2019, the possibility of continuing to grow earnings at double digit rates beyond 2019 appears so remote as to be not realistic.
Notwithstanding that, JNJ should remain a great investment for Elle_Navorski and like minded dividend growth investors.
2. If double digit growth is no longer possible, what growth rate might be achievable?
I would like to step back here from the "Doubling Penny" based analysis and review the nature and quality of JNJ's outperformance over the 35 year period 1972-2006 when it consistently grew earnings by ~15% per year.
Over the same 35 year period, GDP grew an average 4.1% per year, inflation averaged 4.7% per year, and the global pharma market is estimated to have grown by around 11.5% (see Table 4 below).
(4) A source not found for 11.5%. But I have made some estimates that the global pharmaceutical market in 1971 was likely less than $15bn and on that basis, growth through 2006 would have been in the order of 11% to 12% per year. Similar or higher growth rates are likely to have applied to medical devices (e.g., pacemaker growth would be a useful proxy) over that period.
Deduction of the underlying 11% to 12% growth in the global pharma market from JNJ's 15% profit growth over this period would reduce outperformance to ~3% to 4%.
Achievable target growth rates:
Add those outperformance levels to actual and forecast global pharma growth rates for 2007-2012 of 6.9%, and 2013-2017 of 4.5%, and we arrive at what might be achievable target growth rates for JNJ of:
- 9.9% to 10.9% for 2007-2012; and
- 7.5% to 8.5% for 2013-2017 (within the range of 7% to 9% per Tim McAleenan Jr. article referred to above).
But we need to look a little more closely at other factors potentially impacting JNJ's future pharma growth.
JNJ's 2012 pharma sales of $25.4bn (growth virtually flat since 2007 sales of $24.9bn) are less than 3% of the global pharma market at 2012 of $963bn. So it would seem there is plenty of room for high rate growth.
It is not necessarily that simple.
The global pharmaceutical market is expected to grow by 4.5% per year over the 5 years to 2017.
It is estimated generic sales are currently 76% of total global sales and this percentage is expected to increase. This means generic is growing faster than the average and branded is growing slower. If generic reached 78% of all sales by 2017, that would imply a growth rate of only 2.7% for branded, which is JNJ's primary market segment (at 80% generic, the implied branded growth rate would be only 1% per year).
In order to achieve 15% yearly pharma sales growth for 5 years through 2017, JNJ would need to double pharma sales to ~$50bn per year by 2017 and increase market share by over 60% (assuming total market growth of 4.5%).
In order to achieve 15% yearly pharma sales growth for 10 years through 2022, JNJ would need to quadruple sales to ~$100bn per year and increase market share by over 160% (assuming total market growth of 4.5%).
If market growth in the segment JNJ addresses has a lower growth rate of 2.7%, then JNJ would need to double its market share by 2022 to achieve 15% per year sales growth.
That would be no easy task, with at least 15 "big pharma" competitors hotly contesting the branded market, often with multiple drugs addressing the same indication.
At the end of the day, JNJ's sales growth will be largely governed by the number of new branded drugs brought to market, and the recent Pharma division review is encouraging in that regard.
The message I seek to convey is that pharma is an ongoing increasingly tougher market to expand market share in than it was in the past. A once largely untapped market has reached a stage of maturity in the U.S. and Western world and growth now has to be sought in emerging markets. This is also true for the total organisation including Consumer and MD&D divisions, as is evidenced in Table 5 below.
The growth pattern of the global pharma market is very similar to what we have already observed for JNJ. Steady high growth rates through 2006, followed by a decline through 2012, and a predicted further decline going forward.
A similar trend can be seen in the GDP statistics in Table 4.
I believe that it is not only JNJ that has entered the "Doubling Penny" turbo phase.
All three, the U.S. and Western economies; the U.S. and Western countries' pharmaceutical markets; and Johnson & Johnson; have entered the "Doubling Penny" turbo phase.
We are running out of availability of "wheat grains" in our parts of the world to accumulate enough "wheat grains" to meet the rapidly growing obligation under the "Doubling Penny" agreement (see Table 1 - Days 25 on).
We are finding temporary relief through sourcing additional "wheat grains" in emerging markets.
3. Returning to the question of what growth rate/s might be achievable?
In Item 2 above, I suggested that with the lower forecast growth in the global pharma market and in JNJ's wider markets, earnings rates expectations might need to be reduced from ~15% in the 1972-2006 period, and ~10% in the 2007-2012 period.
The appropriate growth rate range derived above for 2013 onwards is in the range 7.5% to 8.5%.
We already have analysts' consensus forecasts for earnings growth rate of ~6.3% for the 5 years 2013-2017. We also have an Adjusted Earnings figure from JNJ of $14,345M for 2012.
What I plan to do now is to use my 2012 year "Normalized Earnings" figure of $13,440 (because I think it is more correct for the purpose) and a slightly higher growth rate forecast of 6.5% to project JNJ net income for the next 22 years 2013 to 2034 (I have checked and the results are not very different to using the $14,345 and the 6.3% growth rate).
This will become the "Base Forecast."
I will then make similar projections using targeted earnings growth rates of 7.5%, 8.0% and 8.5% to cover the 7.5% to 8.5% range mentioned above.
These projections will be compared to the "Base Forecast" to determine how much additional net income (in absolute dollar amounts) JNJ has to produce to meet the higher growth rate requirements.
The results of this exercise are displayed in Table 6 below:
Table 6 - Incremental net earnings required for JNJ to achieve growth rates higher than the Base Forecast:
We are now in a position to review the reasonableness of meeting the higher than Base Forecast growth rates.
At 7.5% growth rate:
Yearly earnings need to increase above Base Forecast at 2020 by $1.7bn (~8%); at 2027 by $5.2bn (~12%); and at 2034 by $12.2bn (~16%).
That all looks highly achievable through 2020 (8 years out), with excellence in execution together with excellence in innovation driving internally generated growth, supplemented with acquisitions.
Still looks realistically achievable through 2027 (15 years out), with excellence in execution together with excellence in innovation driving internally generated growth, supplemented with acquisitions.
Likelihood of maintaining this level above the Base Forecast diminishes rapidly beyond 2027.
Timing of the incremental growth in earnings is important. It is not just yearly earnings but also cumulative earnings that must keep up with the table, otherwise the growth rate will be less than the nominated 7.5%.
At 8.0% growth rate:
Yearly earnings need to be above Base Forecast at 2020 by $2.6bn (~15%); at 2027 by $8.1bn (~23%); and at 2034 by $19.4bn (~32%).
Achieving these incremental earnings with internally generated growth would appear to be difficult through 2020 and increasingly difficult thereafter.
Significant acquisitions would appear to be imperative to maintain JNJ's growth at 8.0%.
This is particularly so in a much lower global markets growth scenario, such as the global pharma market expected to grow at only 4.5%.
Unless acquisitions have very high growth rates, multiple acquisitions would be required.
An acquisition in 2020 with earnings of $2.6bn per year, and a similar growth rate to the Base Forecast, would grow its earnings through 2027 to $4.1bn, $4bn short of the $8.1bn incremental earnings required for that year.
A further acquisition in 2027 capable of contributing the shortfall $4bn per year earnings would, together with the 2020 acquisition earnings, grow incremental earnings through 2034 to $12.6bn, $6.8bn short of the $19.4bn incremental earnings required for that year. Further acquisition/s would be required.
But, even the scenario of acquisitions described above would not keep up with the cumulative earnings per the table. As mentioned above that would mean the actual growth rate would be less than 8% unless even more and earlier acquisitions were made.
A combination of acquisitions together with strong internally generated growth makes this a realistic possibility through 2020 (8 years out), particularly for a company with the track record of JNJ.
Likelihood of maintaining this level above the Base Forecast diminishes rapidly beyond 2024 (12 years out).
At 8.5% growth rate:
Yearly earnings need to be above Base Forecast earnings at 2020 by $3.6bn (~23%); at 2027 by $11.1bn (~36%); and at 2034 by $27.2bn (~51%).
A combination of acquisitions with strong internally generated growth could make this a tough but realistic possibility, up to but unlikely beyond 2022 (10 years out).
4. Example of Base Forecast Supplemented with an Acquisition (illustration purposes only)
I already have figures available for Sunshine Heart from my previous article, "Johnson & Johnson: Part V - Unacceptable Earnings Growth Decline - Reversal Strategy".
Table 7 below is an update of those figures with an estimate for tax included to arrive at a net earnings forecast.
Table 7 - Sunshine Heart C-pulse projections (not a forecast, for illustration purposes only)
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 a potential high growth acquisition to lift JNJ's earnings growth rate (for anyone wishing to know more about Sunshine Heart, see here and here).
Table 8 below is similar to Table 6 above, but with the Sunshine Heart projections incorporated into the Base Forecast, effective 2017, in the same way as an acquisition would increase the Base Forecast.
Table 8 - Incremental net earnings required for JNJ to achieve growth rates higher than the Base Forecast plus SSH C-pulse:
It can be seen that even with a potential high growth acquisition similar to Sunshine Heart C-pulse, projected earnings do not keep up with the 7.5% growth rate requirement.
This is due to the effect of the acquisition being diluted by the ever increasing high levels of existing base earnings.
5. Example of Base Forecast Supplemented with a St Jude type acquisition in addition to an SSH type high growth acquisition (illustration purposes only)
Net income for 2012 for St Jude was $752M and growth rates per analysts consensus forecasts are, by year 2013 to 2017, 6.34%; 6.62%; 8.26%, 8.26%, and 8.58%.
It is assumed the acquisition would take place in late 2013 with increased earnings resulting from 2014 onwards.
I have calculated earnings 2014 to 2017 based on the foregoing assumptions and then made further projections based on the 2017 projected net income continuing to grow at a rate of 8.5% through 2034.
Table 9 below is based on the combined JNJ plus SSH net earnings per Table 8 plus the projected STJ earnings calculated as described above.
7.5% Growth Rate:
It can be seen that the inclusion of the two acquisitions results in earnings more than match a 7.5% growth rate through 2027.
By 2034 the cumulative net income is still ahead of the required growth but the yearly figure has fallen behind.
8.0% Growth Rate:
More or larger acquisitions would be required. These would be required by at least 2022 to catch up to and match the requirements for an 8.0% growth rate.
8.5% Growth Rate:
More or larger acquisitions would be required. These would be required by at least 2019 to catch up to and match the requirements for an 8.5% growth rate.
JNJ's high growth rate path was interrupted around 2007 as it entered what I like to call the late stage "turbo charged" phase of the "Doubling Penny" phenomenon.
Which in simpler terms means it is a mature company, with the greater part of its operations targeting mature markets; and it has grown a huge earnings base from which further growth at the high growth rates of the past will no longer be achievable.
From around 2007 on, achieving exponential growth at the growth rates of ~15% for the past 115 years became not only difficult, but, as the ruler referred to above found out, quite impossible.
This should not take away from the fact that this company has performed brilliantly over a period spanning 3 centuries.
It should also not cause dividend growth investors to give up their love affair with JNJ stock.
The company will still likely achieve huge earnings growth in absolute terms even in a low growth, low inflation environment. Just nowhere near enough to sustain long term double digit growth.
What earnings growth rates might be achievable and for how long?
Based on the above findings, upper limits on likely sustainable net earnings growth rates are -
- Near term - Less than 7 years - up to 8.5%;
- Medium Term - Greater than 7, less than 10 years - up to 8.0%;
- Medium/Long Term - Greater than 10, less than 15 years - up to 7.5%; and
- Long Term - Greater than 15 years - 7.5% or less.
Hope for the future
This article, Part VI in a series of articles on JNJ, has further addressed the earnings side of the equation.
My next article, Part VII in the series, will address the dividend side of the equation.
Hopefully long-term dividend growth investors will get more joy out of that conversation.
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.