- Fundamentals are healthy with improved outlook for the MD&D segment.
- Valuations remain reasonable relative to those of peers and overall market.
- Current valuation implies 6.0%-6.5% dividend growth rate and JNJ will have sufficient capacity to sustain dividend growth at above 6.0%.
- With a pessimistic dividend yield assumption, downside risk is only ~12%.
Share price of Johnson & Johnson (NYSE:JNJ) has risen by 11% over the past 3 months, outperforming a gain of 3% for S&P 500 Index. Many investors are wondering whether JNJ's valuation has become somewhat stretched due to the notable price appreciation in a short period. In my view, the stock is nowhere near overvaluation and the price uptrend should persist from here owing to the company's healthy fundamental prospects.
JNJ's Pharmaceutical segment delivered a strong performance in Q1 2014 with 12% organic growth and 2% expansion in operating margin primarily driven by strong sales of a few higher-margin drugs. Management recently held an analyst conference to review the Medical Devices & Diagnostics ("MD&D") segment as the division has been experiencing flattish performance over the past few years. Looking forward, management expects improved revenue growth of 3%-6% driven by new product growth, significant emerging market exposure (~20% of the segment revenue), and continued market share gain. For the Consumer division, it is expected that revenue growth should also trend higher given its new product pipeline.
At ~$100, JNJ trades at 10.3x forward 2015 EV/EBITDA and 15.9x forward 2015 P/E, both of which are in line with average multiples from its North American pharmaceutical peers. Given JNJ's slightly higher consensus long-term earnings growth estimate (i.e. 7.8% vs. peer average at 7.1%), above-average return on equity and return on capital performance, and less leveraged balance sheet, I believe the stock should reasonably trade at least on par with its peers' average level or even command a modest valuation premium (see chart below).
JNJ's 15.9x forward P/E now trades at 7% premium over the same multiple of S&P 500 Index. Again, provided that 1) the current valuation gap is fairly in line with the stock's 1-year average market premium of 6%; 2) JNJ's consensus long-term earnings growth estimate of 7.8% is not far off from the average estimate of 8.9% for S&P 500 companies; and 3) the stock's 2.8% dividend yield is above S&P 500's average at 1.9%, I view the current relative valuation for JNJ/S&P 500 to be completely reasonable (see chart below).
JNJ's current value also makes good sense on an absolute basis. Based on current annualized dividend of $0.70 per share and 9% cost of equity (the CAPM model only calls for ~7% cost of equity based on 3% risk-free rate, 6% equity risk premium, and JNJ's 5-year beta of just 0.6), the Gordon Growth Dividend Discount Model predicts that the current share price of ~$100 implies a dividend growth rate in between 6.0% and 6.5%, which is in line with the most recent dividend hike (at 6.1%) and slightly lower than historical CAGR of 7.2% since 2009 (see chart below).
I have performed free cash flow projections to gauge the company's capacity for its capital plans (e.g. capex, dividend, and share repurchase) (see chart below).
Given that JNJ has been able to maintain a somewhat stable operating cash flow margin over the past 5 years, my analysis was based on consensus revenue estimates from 2014 to 2016. I assumed a flat operating cash flow margin of 23% throughout the forecast period, which is below the margin's 5-year historical average at 25% and 24.4% actual level in 2013. It is noted that the market now expects improved profitability over the next few years as EBITDA margin is projected to expand from 32.3% in 2013 to 34.7% in 2016, meaning that my operating cash flow margin estimate would be conservative. For capex, I assumed the figure to increase steadily and reach $4.1B by 2016. Based on these assumptions, annual free cash flow was projected to reach $15B by 2016, which is significant higher than my estimated annual dividend commitment of $9B for 2016 based on a growth rate of 6.5% per annum from 2013, suggesting that JNJ will have ample resources to sustain dividend growth at above 6% over the next few years.
The continued price uptrend has pushed JNJ's dividend yield below 3%. However, I believe price downside remains limited with healthy dividend growth prospects. I believe 3.5% to be a likely dividend yield ceiling for JNJ because 1) it is in line with the average dividend yield during period from 2009 to 2012 when JNJ's price performance was mostly flat and the yield reached its highest level; 2) after 2012, the dividend yield never exceeded 3.5% and continued to trend down; and 3) a dividend yield at above 3.5% would be very compelling for JNJ as its peers' current average yield is only 3.1% (see peer table above) and a higher dividend yield alongside with JNJ's above-average fundamentals (i.e. better earnings growth potential, higher capital profitability, and healthier balance sheet) would draw a large investment demand. As such, assuming a 6.5% dividend growth in the next cycle and a 3.5% yield, this pessimistic scenario would result in a share price of $85, representing a price downside of just 12% after accounting for the dividend income (see sensitivity table below).
In conclusion, JNJ's valuation remains very reasonable despite the recent run-up. Given the company's promising prospects (e.g. improved MD&D outlook) and limited downside risk (12% with conservative assumptions), investors are recommended to continue accumulating shares at the current level.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.