(Editors' Note: This article includes discussion of a micro-cap stock. Please be aware of the risks associated with these stocks.)
In Part VII of this series on Johnson & Johnson (JNJ), I provided scenarios for possible JNJ long-term dividend growth rates. The assumed long term earnings growth rate was 6.51% under assumptions described in detail in Part VII.
The preferred scenario for the 8.27% dividend growth rate showed dividends could be grown at this rate for the next 20 years to the end of 2033.
But this resulted in the projected dividend payout ratio increasing to ~70% by 2033.
At the same time, the present surplus cash of $21bn at end of 2012 increased to $81bn by end of 2033. It was concluded it would not be desirable to have so much under utilized cash. But increasing the dividend growth rate above the 8.27% would result in further increasing the dividend payout ratio to totally unacceptable levels.
I undertook to provide three different scenarios, to show what might be done to profitably employ the surplus cash while limiting increases in the payout ratio.
For convenience of readers, I repeat below Table 2 from Part VII together with summarized assumptions reflecting the above described scenario (we will refer to this as the "No Buyback" scenario):
"No Buyback" scenario
Purchase of Treasury Stock
The first of the three different scenarios to be explored is the purchase of Treasury Stock to utilize excess cash and at the same time limit increases in the dividend payout ratio.
I note that some JNJ shareholders have philosophical reservations about share buybacks. My philosophy on share buybacks for accumulating Treasury Stock:
- For retired investors who might need to progressively sell some of their stock to supplement earnings (annuity-like drawdown), the availability of company share buybacks would facilitate progressive decreases in investment in the retirement phase. This could be seen as a service to shareholders, similar to the Dividend Reinvestment Plan (DRIP), which facilitates progressive increases in investment in the accumulation phase;
- Where there are insufficient investable opportunities for surplus cash, what better investment than the company's own shares? And these shares are a valuable liquid asset for making acquisitions should large and suitable acquisition opportunities emerge down the track. Treasury stock increases in value with increases in the company's share price and so has greater value for a future acquisition;
- If a premium is to be paid to acquire shares in a similar business, with similar profitability to JNJ, then that premium would be better paid to JNJ shareholders for their shares, should they elect to sell; and
- Unlike surplus cash, share buybacks have the effect of increasing earnings per share (EPS).
The figures in Table 1 below are derived from the Table above from Part VII. The only change to assumptions is to include provisions for regular yearly share buybacks for the 20 years 2013 to 2033. The assumed price for share buybacks is at a premium of 7.5% to the end of year share prices calculated from estimated market cap at year-end.
Assumptions for share buybacks by year are:
- 2013 -$18bn
- 2014 to 2019 -$4.5bn per year
- 2020 to 2026 -$6.0bn per year
- 2027 to 2033 -$10bn per year
Table 1 - "Buyback" scenario
Comparison of Buyback scenario to No Buyback scenario:
Table 2 below shows a comparison of the results at the end of 2033 between the Buyback scenario per Table 1 and No Buyback scenario above from Part VII of this series of articles.
Going through Table 2 above, I make the following comments:
- Dividend payout ratio - Under the buyback scenario, we have been able to still have 8.27% dividend growth but hold the dividend payout ratio below 50% (very little change from the starting payout ratio of 49.2% for all years of the projections). This compares to the 70% payout ratio under the no buyback scenario;
- Return on long-term investment in JNJ - Under the buyback scenario, the initial investment of $6,948 together with re-invested dividends grows to $73,831 by the end of 2033, a gain of $66,883. Under the no buyback scenario, the gain is a little over 20% less at $54,087. If an investor were to acquire 100 shares at a current share price of say ~$91, the gain under the buyback scenario would be reduced from $66,883 to ~$64,000;
- 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. Under the buyback scenario, that gives a real market value of $43,948 and a real gain of $37,010 (~5.3 times the initial investment of $6,958). Without buybacks, the real gain is 21.4% less at $29,391.
- Surplus Cash and Treasury Stock (at cost) - Cash is reduced to $6.9bn under the buyback scenario, compared to the $81.2bn under the no buyback scenario. But combined total of Cash and Treasury Stock (at cost) increases by $82.7bn to $182.4bn under the buyback scenario. This is due to reduction in total dividends due to buyback of shares increasing cash availability, which is in turn used to purchase more Treasury stock.
- Surplus Cash and Treasury Stock (at market) - Cash and Treasury Stock (at market) grows to a massive $489.2bn by 2033 under the buyback scenario, compared to the $188.4bn under the no buyback scenario.
- Unrealized gain on Treasury Stock - Unrealized gain on Treasury Stock grows to $306.8bn by 2033 under the buyback scenario, compared to $88.7bn under the no buyback scenario.
Virtually every metric improves very significantly under the buyback scenario.
Most importantly, with earnings growth of just 6.51% per year, a high dividend growth rate of 8.27% is able to be maintained for the next 20 years with the dividend payout ratio remaining below 50% similar to the current payout ratio.
The case for using surplus cash for purchase of Treasury Stock appears quite compelling.
The Johnson & Johnson official view:
Alex Gorsky, JNJ Chairman, during the JNJ 2nd Quarter earnings call, from the Seeking Alpha Transcript:
As you remember, earlier this year we announced that we were going to be exploring the future. The Diagnostics group at an enterprise level. And the initiation of this process was really part of a broader strategic planning process across Johnson & Johnson. Recognizing that we wanted to be very disciplined and decisive about what we are going to do with our businesses and our capabilities going forward.
And Dominic Caruso, JNJ CFO, per the same transcript:
As far as any larger, more significant share buyback program, as we said before, we always evaluate that in the spirit of utilizing our strong cash flows, but quite frankly in the priority, we've always said, first our dividend, second to use in building our businesses to generate even more sustainable cash flows for the future, and then finally, considering an additional return to shareholders as appropriate given the first two.
It is clear that JNJ is, as would be expected, looking in a very detailed way at the future deployment of funds surplus to meeting requirements for continually growing dividends. And it is also fairly clear that JNJ management would prefer acquisitions to share buybacks.
So, I would not recommend rushing out and buying JNJ shares in anticipation of making a profit when JNJ announces it is undertaking a massive buyback of shares.
Rather, Table 1 should be seen as a benchmark, a framework against which to measure outcomes under alternative scenarios, such as acquisitions or a combination of acquisitions and buybacks.
For Part IX of this series, I will explore whether existing surplus cash could be more profitably used for acquisition of a large mature entity such as Boston Scientific (BSX) to boost earnings. A sufficient increase in earnings will keep the dividend payout ratio down in a similar manner to a share buyback because both increase earnings per share.
In the subsequent part, I will explore projections based on acquisition of an early stage company as it nears regulatory approval, such as Sunshine Heart (SSH). 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).
In accordance with my philosophy espoused above, I will prefer the buyback route unless the acquisition projections show a better financial outcome for individual shareholders than the above buyback projections.
JNJ, in accordance with its ethos, might give a heavy weighting towards acquisitions that grow the delivery of health services, despite a potentially lower return to shareholders.
If I were a shareholder, I would probably not argue with that. But I would want to know that it was a conscious decision and how much that decision might cost in shareholder returns.
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.