(Editor's Note: This article includes discussion of a micro-cap stock. Please be aware of the risks associated with these stocks.)
Hope for the future
I also said in that article that this Part VII in the series would address the dividend side of the equation and hopefully long-term dividend growth investors would get more joy out of that conversation.
I will now explore how JNJ management might, in a lower earnings growth environment, best go about satisfying the needs and wants of their shareholders in a manner consistent with the best interests of the company in the long term.
That will represent a win for the shareholders, a win for the management and a win for the company.
Base Forecast of Earnings and Dividends
The following assumptions are common to both the Base Forecast per Table 1 below and to all other forecasts in this and ensuing articles:
- Base long-term earnings growth rate -- 6.51% per year (compares to analysts' consensus growth rate forecast of 6.22% over next 5 years). At a 6.51% per year growth rate, earnings will double every 11 years per Table 2 of my article, "Johnson & Johnson: Last 7 Years' Earnings More Than Previous 107 Years," which for convenience is repeated below -
- Normalized earnings 2012 year -- $13,440M (per my article, "Johnson & Johnson: When Special Items Are The Norm") used as base forecast for projecting future earnings at 6.51% per year growth rate;
- Assumed long-term P/E ratio for JNJ -- 16 times earnings, plus cash and marketable securities, minus loans payable and long-term debt, to calculate market cap;
- Total yearly new cash investment in growth of the businesses for year 2013 equals $15,032M (net assets increase 30% of prior year earnings -- $4,032M; add amount equal to estimated depreciation and amortization $3,500M; plus estimated R&D expense $7,500M). The $15,032M for 2013 is escalated in subsequent years by 6.51% per year projected earnings growth rate;
- Number of shares of treasury stock remains unchanged from 31 December 2012 level. This is achieved through a policy of using cash for buybacks sufficient to cover dividend reinvestment plan, shares issued as employee compensation, and any other movements. This effectively converts these non-cash items to cash items; and
- Dividend payout ratio -- Based on normalized earnings of $13,440M, the dividend payout ratio for 2012 is 49.2%. Based on the foregoing assumptions, yearly Free Cash Flow (FCF) calculates to 70% of net earnings after allowing for the above assumption for 30% of earnings required to be reinvested in increasing net assets employed in the business. Therefore, while the dividend payout ratio is below 70%, JNJ will accumulate additional cash. Once the dividend payout ratio exceeds 70%, part of the dividend will have to be met from existing cash reserves, and when these are exhausted, additional borrowings would be required.
All of the foregoing assumptions are incorporated in the projections per Table 1 below.
For the scenario in Table 1, the selected target dividend growth rate is 10.41% per year.
At 10.41% per year, growth rate dividends will double every 7 years (see Table above). That means a purchase of JNJ shares at a 3% yield will give a yield on cost of 6% in 7 years; 12% in 14 years and 24% in 21 years.
Table 1 - JNJ Financial projections based on a 6.51% earnings growth rate and a 10.41% dividend growth rate
Going through Table 1 above, I make the following comments -
- Earnings -- Yes. To achieve a compound earnings growth rate of 6.51% per year, JNJ must lift earnings to $50.5bn per year by 2033;
- Market cap -- At a P/E ratio of 16 and earnings of $50.5bn, market cap could be expected to increase to ~$771bn by 2033 after allowing for net cash/borrowings;
- Share price -- With no increase in net shares outstanding and with a market cap of ~$771bn, the share price would increase to ~$277.00 per share by 2033;
- Dividend growth 10 years 2013 to 2022 -- Dividend growth could be maintained at 10.41% per year for the next 10 years through 2022 while at the same time increasing cash reserves by $19bn, from ~$21bn at end of 2012 to ~$40bn at end of 2022. At that point in time, the dividend payout ratio would have passed the 70% point (71.1%) after which dividends would be required to be met in part from cash reserves (see re FCF 70% of earnings in assumptions above). The only way to avoid this would be to sharply drop the dividend growth rate in 2022 from 10.41% to match the 6.51% earnings growth rate so there would be no further increase in the payout ratio above 70%;
- Dividend growth 14 years 2013 to 2026 -- Dividend growth could be maintained at 10.41% per year for the next 14 years through 2026, thus quadrupling the dividend per share from $2.40 at 2012 to $9.60 at 2026. At the same time cash reserves would decrease by ~$7bn from ~$40bn at end of 2022 to ~$33bn at end of 2026. At that point in time, the dividend payout ratio would have reached 82.1%. The problem here is even if the dividend growth rate from 2027 onwards were sharply reduced from 10.41% to the same level as the 6.51% earnings growth rate, the dividend payout ratio would remain constant at 82.1% of earnings, which is above the FCF of 70% of earnings. That would eventually result in cash reserves being used up and new borrowings would be required to fund dividends;
- Dividend growth 21 years 2013 to 2033 -- It would be technically possible for dividend growth to be maintained at 10.41% per year for the next 21 years through 2033, thus increasing the dividend per share by 8 times from $2.40 at 2012 to $19.20 at 2033. At that point in time, the dividend payout ratio would exceed 100% and the dividend would be paid partly from retained earnings. Dividends would possibly need to be suspended for a period after 2033 to get the payout ratio down and to reduce debt and restore cash reserves. While technically possible, this is obviously neither practicable nor desirable and JNJ would not be expected to pursue such a course.
- Return on long-term investment in JNJ -- Growth of an individual investment in JNJ based on a shareholder with 100 shares acquired or already owned with a market value at end of 2012 of $6,948. The example in Table 1 shows that the initial investment of $6,948 together with re-invested dividends grows to $65,534 by end of 2033, a gain of $58,586. If an investor were to acquire 100 shares at a current share price of say ~$89, the gain would be reduced to ~$56,000;
- Return on long-term investment in JNJ (in real $ terms) -- For those wanting to know the gain in real dollar terms, I have deflated the future market value by 2.5% per year to arrive at a figure of $39,018 and a real gain of $32,070 (a little over 4.5 times the initial investment of $6,958).
Smoothing the dividend growth rate
In Table 1 above I have demonstrated while it is technically feasible for JNJ to grow its dividend by 10.41% for the next 21 years with just a 6.51% earnings growth rate that would position JNJ badly for further dividend growth beyond 2033.
Let us look at lowering the projected dividend growth rate to around the latest indicative dividend growth rate targeted by JNJ. The 1st quarter dividend was 61 cents per share and 2nd quarter 66 cents per share. If the 3rd and 4th quarter dividends are held at 66 cents per share, the full year 2013 dividend will total $2.59 per share. A 2013 dividend of $2.59 is 7.9% above the $2.40 dividend for 2012.
In Table 2 below, I have calculated the dividend growth rate that would result in the dividend payout ratio reaching 70% by 2033, with all other assumptions including earning growth rate of 6.51% unchanged from Table 1.
Table 2 projections demonstrate a dividend growth rate of 8.27% per year could be maintained for the next 21 years through 2033, while at the same time surplus cash would increase to $81bn.
Table 2 - JNJ Financial projections based on a 6.51% earnings growth rate and an 8.27% dividend growth rate
Going through Table 2 above, I make the following comments:
- From 2034 onwards, JNJ could maintain a dividend payout ratio of 70% and a dividend growth rate of 6.51%, an option not available under the scenario in Table 1; and
- The scenario in Table 2 leaves the company in a solid financial position with a stable outlook for dividend growth investors at end of 2033 versus the rather poorer financial position and unstable outlook for dividend growth investors per the scenario in Table 1;
- Restricting the dividend growth rate to 8.27% results in surplus cash increasing by about 4 times from $21bn to $81bn compared to the $59bn reduction per scenario in Table 1; and
- The retention of underutilized cash by the company per Table 2 scenario results in a lower long-term return to long-term shareholders versus the scenario in Table 1. The higher return in Table 1 might be illusory as the P/E ratio and consequent market cap would likely decrease in Table 1 due to the poorer financial position and outlook for future dividend growth.
- Provided JNJ can grow earnings by ~6.5% per year over the next 21 years through 2033, it should be possible to grow dividends by ~8% or slightly higher over the same period;
- In addition to ~8% per year dividend growth per item 1 above, JNJ is likely to generate surplus cash, which if not utilized, will result in lower returns for long-term investors than might be possible;
- Possibilities for use of any surplus cash could include -
- Special cash dividends - not particularly attractive to long-term dividend growth investors unless able to be re-invested in JNJ shares. A preferable option might be for one or more share buybacks to utilize surplus cash;
- Acquisition of a large mature entity such as Boston Scientific (BSX) to absorb much of the existing surplus cash and boost earnings; and
- Acquisition of an early stage company as it nears regulatory approval, such as Sunshine Heart (SSH), in conjunction with one or more share buybacks. 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).
I will provide further projections for the use of surplus cash based on the above possibilities in succeeding articles.
These further projections will also explore possible higher dividend growth rates under the various scenarios.
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.