In this article we're focusing on Johnson & Johnson (NYSE:JNJ) and comparing it to a similar sized rival in Novartis (NYSE:NVS). Although the two companies have an ocean between them, with JNJ being listed in the US and Novartis in Switzerland, the two stocks are of a similar size, with JNJ having a market cap of $288 billion and Novartis having a market cap of $213 billion.
Furthermore, the two companies sit in the same GICS sector of health care and also within the same GICS sub industry of health care equipment and services. Therefore, we thought it would be worthwhile to compare JNJ to a sector and sub industry peer so that investors who are deciding upon their allocation to those spaces can get a clearer picture of how to allocate their capital. We hope you enjoy the article and are open to your suggestions on future pieces!
The first port of call for many investors in this space (mega cap healthcare) is often dividends. On this front, JNJ does not disappoint since it currently yields 2.7% and, although shy of the key 3% level, we think it has huge potential to push beyond. That's because JNJ's payout ratio is just 50%. To us, that seems incredibly low. Sure, the company has a huge R&D expense each year as its pharmaceuticals division burns through cash trying to find the next big blockbuster drug. However, as a mature company in a mature industry, we think that a higher payout ratio could be warranted and is affordable. This would bump up JNJ's yield and make it an even more attractive income play.
Indeed, Novartis currently pays out 69% of profit as a dividend and this makes a difference to its yield. Shares in the company currently yield 3%, which appears to be a key level for investors right now. Of course, if JNJ were to become more generous with its profit distributions then it could become the more attractive income play, so it clearly has a lot of potential in that space.
In terms of profitability, we're not surprised to see that JNJ delivers impressive results. Indeed, the company continues to deliver high returns to shareholders and this is evidenced via its return on equity, which was 18.6% last year. This represents a strong performance, especially when JNJ has only low levels of financial gearing, with its debt to equity ratio being just 22%. Indeed, such a low level of debt means that it could easily afford to increase its balance sheet risk so as to pursue acquisitions, should it choose to do so. We feel confident that it has the financial strength to withstand substantial M&A activity.
In addition, JNJ delivers return on assets of 10.4%, which is ahead of its sector peer, Novartis, which has a return on assets number of 6%. This is still attractive, while its return on equity figure is also very respectable at 13.3%. Both, though, are behind the equivalent figures for JNJ. As you'd expect for health care stocks that are heavily involved in pharmaceuticals, margins are high. JNJ again edges out its rival with operating margins of 28% versus 20% for Novartis, although it must be said that both numbers are impressive given the size, scale and complexity of the businesses involved here, with it arguably being more difficult to keep costs low at large, unwieldy businesses.
When it comes to valuation, JNJ seems to offer an opportunity relative to Novartis. That's because it trades at lower valuations than its peer. For example, its P/E ratio (NYSE:TTM) is 19.5, while Novartis' P/E is 22.5. That's a discount of 13.3% and we're struggling to see why Novartis deserves it. Sure, it has a slightly higher yield, but as we've mentioned that's largely due to a more generous payout ratio that could be copied by JNJ going forward. In addition, JNJ trades at a discount to Novartis based on the EV/EBITDA ratio, with it having a ratio of 11.2 versus 13.6 for Novartis. That's a discount of 17.6% which, in our view, is difficult to justify. Therefore, we feel that JNJ could outperform Novartis going forward.
Income seeking investors may be more attracted to Novartis than JNJ, but we think the latter has more potential for brisk dividend growth going forward. That's because of its lower payout ratio and higher profitability, with JNJ delivering strong returns despite a low-risk balance sheet. In addition, the two companies' valuations, we feel, highlight a mispricing in terms of JNJ trading at an unwarranted discount to its European peer. Therefore, we believe that JNJ could outperform Novartis going forward as investors realize the mispricing and take action to correct it.
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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.