(Editors' Note: This article includes discussion of a micro-cap stock. Please be aware of the risks associated with these stocks.)
Scenario 1 - Buyback
In Part VIII of this series on Johnson & Johnson (JNJ), I provided the first of three different scenarios to show what might be done to profitably employ surplus cash while limiting increases in the dividend payout ratio.
That first scenario, labeled the "Buyback Scenario," involved using surplus cash for yearly buybacks of shares for the next 21 years.
Virtually every metric improved very significantly under the "Buyback Scenario" when compared to the "No Buyback Scenario."
The results were so compelling, I concluded the "Buyback Scenario" should be seen as a benchmark, a framework against which to measure outcomes under alternative scenarios, such as major acquisitions or a combination of acquisitions and buybacks.
Scenario 2 - Acquisition of mature stage corporations
This, the second of the three different scenarios to be explored, involves the purchase of mature corporations over the next 21 years to utilize excess cash and at the same time to limit increases in the dividend payout ratio.
The reasons why Johnson & Johnson might need to look at acquisitions of mature stage corporations were covered in a previous article, "Johnson & Johnson: Last 7 Years' Earnings More Than Previous 107 Years'".
The problem for JNJ is that its base earnings level from which it has to grow future earnings is now very large (the last seven years earnings total $80.7bn, which is more than the previous 107 years earnings total of $71.3bn).
Even a modest future earnings growth rate requires huge increases in net income in absolute terms in the years ahead. This in turn requires ever increasing and huge amounts to be invested in continuing the growth of the business at acceptable levels.
The difficulties associated with sourcing projects to achieve these high investment levels was discussed in an earlier article in this series (see here). I quote from that article:
The need for larger and larger acquisitions inevitably pushes the search higher up the value chain where JNJ has progressively less leverage compared to the target.
This can be seen happening as evidenced by these examples -
- DePuy - acquisition date near but ahead of regulatory approval;
- Synthes - acquisition post regulatory approval and significant market penetration already achieved;
- Boston Scientific (BSX) and St Jude (STJ) - suggestions that these companies might be subject to targeting for takeover by JNJ to maintain JNJ growth (see here).
Proportionally, the Synthes acquisition was similar in size to the DePuy acquisition in its impact on total investment in business assets (both resulted in an increase of ~34%).
This second scenario looks at the potential impacts on JNJ if it is in fact forced further up the value chain and is required to target mature stage corporations to achieve satisfactory earnings growth.
By way of example, I have chosen Boston Scientific as a suitable proxy for a mature stage corporation operating in the healthcare sector, and with higher projected earnings' growth rates than JNJ, based on analysts' consensus forecasts.
Details of assumed acquisition cost and projected earnings are shown in Table 1 below.
Table 1 - Assumptions for acquisition cost of corporations such as Boston Scientific
Assumed Acquisition Cost -
It is assumed a takeover premium of 30% to 40% would be required to effect a deal. The 35% takeover premium per Table 2 might be on the low side at 20 times forecast earnings for 2014. It is further assumed the acquisition would be effected as of January 1, 2014 and JNJ would record earnings from the acquired entity from beginning of 2014.
The projected acquisition cost of $27.8bn amounts to ~33% increase over projected business assets of $84.7bn at end of 2013 per Table 2 below. This would be similar to the 34% increase resulting from the earlier stage Synthes and DePuy acquisitions mentioned above.
Further acquisitions of five similar businesses are assumed to take place through the 21 year period to 2033, as sufficient cash is accumulated.
As indicated in Table 2, these acquisitions necessarily become increasingly frequent as the enterprise continues to grow. By 2032, the acquisition cost of the sixth BSX type business for $27.8bn represents just a 7.3% increase in net assets (compared to a 34% increase for the first acquisition).
Projected Earnings -
The yearly earnings 2014 to 2016 are projected based on Analysts' consensus forecasts of BSX EPS. The assumed earnings growth rate of 7.83% for years 2017 to 2033 is based on Analysts' forecast 5 year rate. It is noted BSX is and has been making a number of acquisitions of early stage enterprises to boost earnings growth rates. This might not be sustainable in the long term and the BSX growth rate might come back to the assumed JNJ earnings growth rate of 6.51%. In that sense the projected long-term earnings growth rate for BSX might be optimistic and thus overly favorable to this scenario.
Table 2 - Acquisitions of mature stage corporations' scenario
Going through Table 2 above, I make the following comment:
Number of acquisitions required - Under the "Acquisition of mature stage corporations" scenario, a total of 6 corporations of the present size and attributes of Boston Scientific would need to be acquired over the next 21 years to utilize excess cash. This is after paying dividends growing at 8.27% per year.
Table 3 below shows the projections for the "Buyback" scenario. It will be noted the assumptions at the foot of the table are the same as for the "Acquisition of mature stage corporations" scenario in Table 2, with the one exception. The exception is the use of excess cash to buy back shares rather than acquire mature stage corporations.
Table 3 - Buyback scenario
Comparison of "Buyback" scenario to "Acquisition of mature stage corporations" scenario:
In Table 4 below, I provide a comparison of the results at the end of 2033 between the "buyback" scenario per Table 3 and the "Acquisition of mature stage corporations" scenario per Table 2 above (hereinafter referred to as the "acquisitions" scenario).
Going through Table 4 above, I make the following comments:
- Size of the JNJ entity - JNJ grows to a larger organization under the acquisitions scenario. Market cap grows to $1,149bn under the acquisitions scenario compared to $909bn under the buyback scenario. Net investment in business operations grows to $445bn under the acquisitions scenario compared to $252bn under the buyback scenario.
- Dividend payout ratio - Under the buyback scenario, we have been able to still have 8.27% dividend growth but hold the dividend payout ratio down to 52.8%. This compares to the higher 55.4% payout ratio under the acquisitions 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 $74,753 by the end of 2033, a gain of $67,805. Under the acquisitions scenario, the gain is ~4% less at $65,278. If an investor were to acquire 100 JNJ shares at a current share price of say ~$94, the gain under the buyback scenario would be reduced from $67,805 to ~$65,300, and under the acquisitions scenario from $65,278 to ~$62,800;
- 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 $44,507 and a real gain of $37,559 (~5.4 times the initial investment of $6,958). Under the acquisitions scenario, the real gain is ~4% less at $36,054.
- Surplus Cash and Treasury Stock (at cost) - Cash is reduced to $15.7bn under the buyback scenario, compared to the $16.4bn under the acquisitions scenario. But combined total of Cash and Treasury Stock (at cost) is $135.3bn greater under the buyback scenario than under the acquisitions scenario.
- Surplus Cash and Treasury Stock (at market) - Cash and Treasury Stock (at market) grows to a massive $465.8bn by 2033 under the buyback scenario, compared to the $157.6bn under the acquisitions scenario.
- Unrealized gain on Treasury Stock - Unrealized gain on Treasury Stock grows to $295.6bn by 2033 under the buyback scenario, compared to $122.8bn under the acquisitions scenario.
From a long-term dividend growth investor's viewpoint -
The scenario for using surplus cash for purchase of Treasury Stock promises higher financial returns for long-term dividend growth investors than acquisitions of mature stage corporations similar in attributes to Boston Scientific per scenario described above.
I see accumulation of a large holding of Treasury Stock as a complementary form of reserve to cash, with the benefit of increasing value over time.
From purely an investment viewpoint, I would prefer the buyback route with its better financial outcome for individual shareholders.
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.
As stated in Part VIII of this series, 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.
The Johnson & Johnson official viewpoint -
Comment from the Seeking Alpha Transcript of the JNJ 2nd Quarter earnings call -
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 fairly clear that JNJ management would prefer acquisitions to share buybacks.
From the Johnson & Johnson "Our Credo" viewpoint -
The following is an extract from the Credo -
We must experiment with new ideas. Research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reserves must be created to provide for adverse times.
Although I have seen comments to that effect, I consider the Credo does not say that shareholders come last.
Rather, to paraphrase, it says, "If we firstly strive to respect and do our best to look after all those who use our products or services, and our suppliers, and the wider community, then that is in the best long term interests of shareholders and will result in a fair return to shareholders."
I see nothing in the Credo that would suggest JNJ undertake an aggregation and consolidation of significant healthcare companies resulting in a likely reduction of competition and innovation in the sector.
That is especially so when the alternative of share buybacks indicates superior returns for shareholders.
Based on all of the foregoing, I do not believe JNJ should be targeting mature corporations such as Boston Scientific and similar large healthcare companies for acquisition.
The buyback scenario is likely to provide superior returns to shareholders than a scenario of acquiring mature stage corporations to utilize surplus cash.
The buyback scenario continues to be the benchmark, the framework against which to measure outcomes under other possible scenarios.
For Part X of this series, I will explore projections based on acquisition of an early stage company as it nears regulatory approval, such as Sunshine Heart (SSH). I will also examine how such an early stage acquisition might support the JNJ Credo. 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, here, and here).
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.