Johnson & Johnson (JNJ) has its roots in consumer, pharmaceutical and medical products and holds a major piece of market share in each segment. But it has failed to grow at a rate one would expect, despite recent acquisitions. Profitability has decreased in the past few years. Return to shareholders has only been enhanced due to stock repurchases. Share prices surged in 2013; however, this was primarily due to the massive buyback in 2012 and better financial results than 2011. Impending issues still exist due to steadily increasing working capital.
Revenues have remained stagnant over the past few years and profitability has declined. From 2008, revenues have only increased 6% from $63.8 billion to $67.3 billion (2012), while cost of goods sold has increased at the same pace. To maintain profitability, the company has focused on decreasing selling and administration expenses. In this effort Johnson & Johnson has been largely successful, selling and administration expenses have actually declined from $29.1 billion in 2008 to $28.6 billion in 2012. But this hasn't been enough to prevent the company's profitability from decreasing. Net income has declined from $13 billion in 2008 to $9.7 billion in 2011; though, after a better year in 2012, net income increased to $10.9 billion. The company has also suffered losses through its non-operating activities in the last two years, which have added further pressure to its profitability.
Though Johnson & Johnson has suffered from lower profitability in recent years, the company remains cash rich. But it faces several challenges in terms of working capital. The company's receivables and inventory have risen significantly over the past few years, while payables have decreased. As receivables and inventory have increased 16% and 49% respectively over the last five years, payables has fallen by 22% since 2008. This is a red flag. Revenues haven't increased, while inventories have been stacking up. To analyze the cash conversion cycle, we add days of sales outstanding (57 in 2009 & 59 in 2012) to days of inventory on hand (119 in 2009 & 146 in 2012) and subtract the number of days of payables (152 in 2009 & 117 in 2012). This is a worrisome trend, with the cash conversion cycle increasing drastically from 24 days to 88 days. The result is a greater debt load on the company; which has increased at an annual rate of 12% since 2009 from $8.2 billion to $11.5 billion. Even though, Johnson & Johnson has struggled in the last few years, the huge scale of the company has enabled it to increase the shareholders' equity consistently; from $42.5 billion in 2008 to $64.9 billion in 2012.
Johnson & Johnson has had consistent funds from operations, which are much higher than actual profits due to high depreciation costs. But the worrying part has been the increase in working capital, which was $1.5 billion higher in 2012 than it was in 2008. The company has been spending on investing activities by making capital purchases and has made small acquisitions as well. But the overall scale of investing activities has been small, reaching a height of $7.9 billion in 2010, while cash inflow from operating activities was $16.9 billion in the same year.
(click to enlarge)
The company has distributed most of its profits as dividends, increasing the dividend payout ratio consistently. In 2008, Johnson & Johnson paid out 38% of its profits, increasing to an unsustainable 61% in 2012. The company has used the remaining cash after dividends and investing cash flows to buy back shares from the market. This resulted in a sharp increase in share prices since 2012, when Johnson & Johnson bought back shares worth $12.9 billion from the market; resulting in the company reporting negative cash flows for the first time in more than 5 years.
Johnson & Johnson has failed to grow in recent years while expenses have increased. The cash conversion cycle is nearly 3 times that of four years ago, causing the company to issue more debt. The only savior, from a shareholder perspective, has been the increase in EPS as shares have been repurchased regularly to enhance EPS. The company also pays a large amount of profits in the form of dividends which, coupled with the share repurchases, has kept stockholders happy. These recent actions in 2012 have enabled Johnson & Johnson to increase return to shareholders, but this policy of repurchasing large amount of stock from the market is not sustainable.
The stock has a dividend yield of 3%, which might seem attractive to investors looking for regular income. However, Johnson & Johnson seems to have used all of its options in terms of increasing capital gains in the near term. Current shareholders may want to take their profits (nearly 20% over the past year) and invest in something with a stronger growth outlook. However, for long-term buy and hold investors, adding to your position during price dips will allow you to build a position in a company that will likely see solid growth in several years as the economy continues to recover. As an additional incentive, Johnson & Johnson will pay you handsomely to wait.