- The U.S. is now home to only three AAA-rated corporations, and J&J is one of them.
- J&J is exceeding expectations with the best pharmaceutical division of all the pharma giants.
- J&J's free cash flow is so strong it should be considered a core holding.
Background: Johnson & Johnson (NYSE:JNJ) may be the bluest of all U.S. blue chip stocks now. The other two companies with AAA ratings by Standard & Poor's are Exxon Mobil (NYSE:XOM), which is the contender for #1 but operates in a commodity business; and Microsoft (NASDAQ:MSFT). (Note: Per a comment, ADP (NASDAQ:ADP) was recently taken off the AAA list and this article has been therefore edited.) Mr. Softee has serious issues with the decline of Windows-based computing machines relative to smartphones and tablets, concomitant with the relative failure of Windows 8. Meanwhile, J&J marches forward in the growing healthcare field and the positive brand/corporate image that Exxon Mobil cannot match.
J&J was formed in 1886 by three Johnson brothers. Clever marketers, they realized that Johnson & Johnson & Johnson was a name that was a bit unwieldy, so the current name was created. It remains in place today; J&J is one of a tiny number of corporations that has both stuck to its knitting and kept an unchanged name for so long.
JNJ stock is trading up today (Tuesday April 15) following the release pre-market open of well-received Q1 results, which are discussed below. The sales and earnings beat with the increase in 2014 guidance caught my attention, and I investigated further.
Introduction: J&J, a multinational with vast reach, is comprised of over 200 subsidiary companies operating in three corporate areas. The legacy and now smallest segment is consumer products. These include Band-Aids, baby care products, Tylenol and other OTC meds, and many others. This is rapidly becoming a no-growth cash cow. It has also been the source of some well-deserved embarrassment. There have been numerous product recalls in the OTC pharma division due to inadequate quality control within J&J. My and the Street's assumption is that this will not happen again. This was so shocking, coming from this fine company, that it was a material negative for my view of the stock for several years, but I am finally willing to forgive and forget and own the shares.
The emerging leader of the three divisions is pharmaceuticals (Janssen). J&J has come through a weak patch and has developed a growth engine here, both in the U.S. and internationally.
Finally, the very large medical devices division has become a slow-growth, high-margined steady Eddie segment with strong secular cash generation prospects.
Ultimately, JNJ is a cash generation machine that is in my view attractive to all but the most aggressive equity investors.
Discussion: Q1: The company exceeded expectations cleanly despite foreign currency headwinds. Adjusting for what actually are reasonable one-time events brought GAAP earnings down from $1.64 to an adjusted, diluted $1.54 (all data are per share where appropriate), which I and the analytic community are using as "earnings" and which beat expectations by about 4% and exceeded prior year comparable results by 7%. Sales grew yoy and exceeded expectations a small amount, as well. The star was pharmaceuticals, with strong revenue growth in the U.S. and mid-teens growth internationally despite some foreign currency translation losses. The company's drug product portfolio is broadening and growing, and overcoming the inevitable occasional loss of exclusivity.
Pharmaceutical sales grew 17% ex-U.S. yoy. Medical devices and diagnostics grew much less strongly; more and more J&J is looking like other Big Pharma companies before they divested some or all of their medical devices and diagnostics divisions. R&D as a percentage of sales of 10% is also Big Pharma-like. But only J&J has a triple-A credit rating and probably the best corporate reputation in its field (Merck may be next).
The company signed a definitive agreement to sell its Ortho Clinical Diagnostics division to the Carlyle Group around midyear. This will cause a 10-15 cent per share profit loss. Nonetheless, the strong Q1 led the company to increase yearly EPS guidance several cents to a $5.85 (midpoint of the guided range).
That J&J has hugely profitable consumer and MD&D divisions, even if relatively slow-growing, is the result of decades of growth and reinvestment in the company and sustaining its image with its target audience. What this plus a relatively low debt level, and only minor under-funding of its pension plan, have led to are massive free cash flow (NYSE:FCF) positivity. Johnson & Johnson is a free cash flow machine.
Rather than dissect this very large and multinational company, I want to discuss its prospects for FCF growth and return of profits via J&J's preferred way, namely dividends. Periodically the company has performed share buybacks, but they appear mainly to sterilize issuance of new shares. The share count is precisely unchanged from 1999.
The reason to focus on dividend growth is that Johnson & Johnson is so large, at about $75 B in projected sales this year (before the sale of Ortho) and mature that it is unlikely that its projected growth rate of 5.5% (Value Line projection) over the next few years will be altered a lot. Even a single mega-hit product has trouble moving the needle much when a company is this large.
It is critical to remember, again, that J&J is a true AAA-rated company. And, OTC quality control (serious) problems aside, it does try to act that way. For example, the company has $50 B in intangibles and goodwill, which comprises most of its book value. Unlike (say) CVS Caremark (NYSE:CVS), a high-quality company in its own right, and a number of other companies, J&J does not ask investors to accept that amortization of intangibles and goodwill is not a cost. J&J's FCF exceeds its GAAP earnings.
Why J&J is a very attractive stock in the current environment: A behemoth with slow growth and a high debt load and/or high capital spending requirements, or one in a commodity business such as an oil producer, has some negatives to total return-oriented investors who want a regular flow of growing dividends along with a stock price that tends to keep pace with dividend growth. J&J is right and starts with an attractive dividend yield.
The current payout is $0.66 per share. The board is expected to increase the second quarter dividend to (Value Line) $0.71/share. This payout rate would still be under 50%, and would leave the company accruing net cash. Here are the projected FCF numbers for 2014. Assuming earnings of $5.85 (my guess is they will be higher), capital spending is projected at $1.10 and total cash flow is projected to be $7.50. Long-term interest of $430 MM is roughly 15 cents per share. Subtracting $1.10 and $0.15 from $7.50 gives $6.25. Subtracting $2.79 in dividends yields $3.46 per share in free cash generation - after dividends. With the stock at $99, we are looking at a dividend yield of 2.85% and a retained FCF increment with an additional (retained) yield of about 3.5%.
This FCF strength has a high likelihood of continuing and increasing. If the stock price were not to change and sales were to increase 5.5% yearly, then the increasing focus on high-margined pharmaceuticals suggests that profits can increase faster; and dividends can be paid out at a higher percentage of profits than now.
So the case is being made that investors seeking dependable income can look at JNJ as a source of bond-like income. Over a 10-year period, a 7% dividend growth rate doubles the payout. If the share price were not to change, the terminal dividend yield would be 5.7%. This might indeed be what Mr. Market would require in a much higher interest rate environment; that we cannot control. But we can compare this projected cash return with returns available from current debt instruments as well as from other equities.
When we compare this theorized average 4% yield over a 10 year period from dividends, plus retained earnings, we can look at high quality tax-exempt bonds yielding only 2.5%. With JNJ's dividends being "qualified", the maximum tax rate on them if they are held for a sufficient period of time is such that simply as cash return vehicles, they are superior to a tax-exempt bond. Taxable corporate bonds lack any tax advantages. A 10-year T-bond only yields 2.6% now and has no tax advantages.
In addition, comparing a well-run corporation with a bond must consider the potential for appreciation or depreciation of the equity's trading price. In this case, if I am correct about dividend growth of 7%, I am going to assume that JNJ's dividend yield based on the then-market price will be 4% in 10 years. This would imply something on the order of a 5.7/4.0 increase in the share price; let us call it 4% price increase annually.
Thus what I view as a conservative, cash-on-cash view of JNJ stock suggests a 7% low-risk total return year after year. This is sort of a bad-to-mediocre case scenario, though not a worst-case one.
However, looking at matters differently provides what I view as a strong chance that the market takes this equity and moves it much higher much sooner. This is the reasoning. It is partly technical and partly fundamental.
The technical part is as follows. We can all see the chart and the outperformance of this equity recently. The chart is both strong and not extended. It "wants" to go higher, at least to my eyes.
From a fundamental standpoint, everyone on the Street knows that J&J is conservative with its guidance. It is selling its Ortho Diagnostics division and in the conference call affirmed that this will cost it 10-15 cents per share in lost earnings, and that it has no special plans to do a large share buyback to make back the lost earnings. Despite that, it raised yearly guidance a nickel a share. This suggests to me that 12-month forward earnings for J&J are probably going to be $6. With interest rates in a renewed and surprising downtrend, I speculate that investors are going to focus on dividends from the highest-quality corporations and move away from REIT and utility income.
Let's compare which is more attractive amongst different income stocks. A fine REIT, Public Storage (NYSE:PSA), with the highest safety ranking from Value Line, and which must pay out almost all its earnings, provides a mere 3.3% yield, and these are not qualified dividends and thus lack any tax advantages. And, of course, this and other REITs very generally must sell new equity in order to grow. Now, I am long certain REITs in my IRAs, but that's a subset of the investing universe. In general, I'll take J&J right now over the REIT universe; and the same is true versus the MLP and related universe.
The utility sector has become popular again as a safe haven against the tech and biotech sell-offs this year. What do you really get from purchasing this sector? The well-known Utilities Select Sector SPDR ETF (NYSEARCA:XLU) is within a quarter of a point of its fall 2007 all-time high. It yields a mere 3.55% and has a P/E of 16. Based on J&J's understated earnings, the no-growth/slow-growth utility sector is trading at about the same forward P/E as one of the world's great long-term growth engines, Johnson & Johnson. It would appear that investors are overpaying to get a small amount of higher current yield, without remembering that the utility sector has numerous challenges and is financially weaker than J&J and other of the highest-quality blue chips.
Now, unfortunately this is not the 1950's from the standpoint of having over 30 AAA-rated corporations based in the U.S. (plus others in that low-debt era that were debt-free and therefore not rated at all), compared to only 4 now. And that brings me to my next point.
Let's go forward a year and assume the financial and economic world is similar to today's. We could be looking at $7/share in FCF from JNJ. If you had some confidence that nominal GDP in J&J's markets were going to grow at a 3-5% pace and that this company was likely to at least maintain its share of the pie, why would a conservative investor not wish to accept a 5% FCF yield? If so, that would place the stock at $140. What about a 4% FCF yield? That would put it at $175.
Too many people have gone overboard comparing the current investment environment with Y2K. Yes, both periods had richly-valued stocks and bubbly IPOs. However, the cash and bond markets were inherently attractive then, and it is in the bizarre undervaluation of cash and bonds in 2000 that the real nonsense was seen. The S&P 500 was yielding about 1.5% in dividends and had an earnings yield (reciprocal of the P/E) of perhaps 3.3-3.5%, whereas in much of 2000, yields on cash as well as long-term Treasuries were 6%. Cisco (NASDAQ:CSCO) was trading with a P/E of perhaps 150X and Yahoo! (NASDAQ:YHOO) traded to a peak valuation of 100X sales, as I recall. The sell-off in the markets in 2000 had nothing to do with recession, which only began around April 2001; it was simply a resetting of relative valuations that were badly skewed.
I am suggesting that just maybe, the investor class could be fundamentally under-valuing the special cases of the greatest of the great corporations by not focusing enough on actual free cash generation and prospects for its growth.
Thus, here we have a rare bird, a storied company with pristine, AAA finances, operating in a "sunrise" field with a stable of high-margined cash cows, and we are looking at a high (by current terms) FCF yield that probably most of us expect to increase over time, understanding that we can only guess at the rate. The entirety of this cash accrues to shareholders one way or the other. Meanwhile competing interest rates are very low. So the current FCF yield on JNJ shares is extremely competitive, especially when one adjusts for the very high quality of the company.
JNJ might therefore come to be looked at as a bond substitute, which of course would represent a paradigm shift amongst analysts. If not, then it and its shareholders have a strong chance, in my view, of simply ambling along, as it were, with high single digit total returns which appear attractive on a risk-adjusted basis given the paltry high-quality alternatives.
Risks: Of course, anything can happen to any corporation. J&J operates in the medical field, and the changes occurring in the U.S. in health care financing could lead to onerous taxation or reimbursement cuts. Global recession could make payors around the world cut reimbursements. Competition could hurt its consumer division. The company could make a poor but large acquisition. The pharmaceutical division could have pipeline failure.
The stock market could head down, and competing interest rates and inflation could soar. The 1970's were difficult times for medical companies, and something like that era could come back. So, nothing hypothesized herein is at all certain.
Summary: My goal in writing this article is to suggest that investors not focus overly much on the details of Johnson & Johnson's business. What will be, will be; with this company, good news tends to beget more good news in coming quarters. The company is so large, strong, varied and well-run that my focus is on treating it two ways from an investment standpoint. One is as either a bond alternative or as an alternative to income stocks. On that basis, I like it on a multi-year basis, even if I am sacrificing a small amount of current income to the alternatives. The other way is to consider the possibility, which I find to be realistic, that investors will begin to realize the reality of the current interest rate landscape and then think out of the box, revaluing JNJ shares upward sooner and more sharply than anyone is now projecting. We may be in a truly low interest rate environment for longer than projected, based on the latest moves in rates, and if so, strange revaluations of certain securities could occur, and significant capital gains could result.
Based on positive fundamentals and strong technicals, and the FCF-based considerations discussed above, I find JNJ shares attractive for new money investment at the current price, both for current and growing income and for possible capital gains over the next 1-2 years.