Johnson & Johnson: Don't Miss The Pullback Opportunity

Aug.14.14 | About: Johnson & (JNJ)


JNJ can comfortably grow its dividend per share by 6%-7% per annum over the next few years with both free cash flow and earnings payout levels being steady.

Shares trade on an assumption of 5%-6% dividend growth, which is below the potential.

The stock also trades at more than 10% discount from its peers' average valuation, presenting a buying opportunity.

Share price of Johnson & Johnson (NYSE:JNJ) has recently dropped by about 6% since reaching its 52-week high of $107 in early July, presenting a buying opportunity for long-term dividend investors. In this article, I will elaborate on both cash flow and dividend analyses to support my long-term buy thesis.

First of all, I ran a cash flow model to project JNJ's free cash trend in near term to gauge the company's capacity for future dividend growth. My analysis is based on current consensus revenue estimates which predict the top line to grow by 3.5% CAGR from $75.0B in 2014 to $80.3B in 2016. In the past 3 years, JNJ was able to maintain a steady operating cash flow margin within a tight range at around 23%. To be fair, I assumed the operating cash flow margin to remain steady at 23% through 2016. For capital expenditure, I assumed the spending to reach $4.2B by 2016, which is above current consensus estimate at around $4.0B. As such, free cash flow is modeled to grow by 3.0% CAGR from $3.8B in 2014 to $14.3B in 2016 (see chart below).

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JNJ paid quarterly dividends of $0.66 and $0.70 per share in Q1 and Q2 2014, respectively. Hence, it is expected that annual dividend in 2014 will be $2.76 with dividends in Q3 and Q4 being the same at $0.70 per share. Based on my share count estimate (discussed later), I projected total dividend spending in 2014 to be $7.7B, representing a 5.6% growth from $7.3B in 2013. Assuming the same dividend spending growth rate through 2016, total dividend payment will reach $8.6B by 2016. Given my free cash flow projections over the period, free cash flow dividend payout ratio will rise gradually from 53% in 2013 to 60% in 2016. I believe the 60% free cash flow payout is still within a comfortable range for JNJ as cash surplus after dividend payment still amounts to more than $5.5B in each of the forecast years, and this capital can be deployed for future share buybacks (see chart above).

For share repurchase, I assumed that 75% of the annual cash surplus will be spent on this matter and this means a buyback value of $4.2B-$4.3B per annum. Given JNJ's historical buyback level and the fact that the company's board has recently approved a $5B new buyback plan, I believe this buyback forecast is completely achievable. Assuming an average buyback price of $105 in 2014 with an annual appreciation rate of 7.5%, total share count will be reduced by 114M over the 3-year forecast period. To account for potential dilution impact as a result of equity issuance, I applied a 50% haircut on the share count reduction. As such, average share count is projected to decline to 2.7B by 2016. Based on my projected dividend spending, dividend per share was forecasted to grow by 6.3% CAGR from $2.76 in 2014 to $3.12 in 2016. Given the current consensus EPS estimates, my dividend per share forecasts imply that earnings payout ratio will stay steadily at about 46% over the forecast period, which is below the level in the past 3 years. As both free cash flow and earnings payout ratios in my model are within reasonable ranges and current consensus long-term EPS growth estimate for JNJ is at 7%, dividend per share growth of 6%-7% per annum over the next few years is a very possible scenario (see chart below).

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Based on the above projections, I expect JNJ's quarterly dividend to reach $0.79 by Q2 2016, which implies a 3.1% yield on the current price of $101.7 (i.e. yield on cost). It should be noted that downside risk on my forecast is limited by the facts that both free cash flow and earnings payouts are at very reasonable levels and the stability is expected to persist. However, an upside is more likely as an annual dividend per share growth of 8%-9% over the next 2 years will only result in very slight increase in the payout ratios.

From an absolute value perspective, JNJ shares are inexpensive. Based on Gordon Growth Dividend Discount Model with 8.5% cost of equity (CAPM model suggests a 6.5% cost of equity based on 3% risk-free rate, 6% equity risk premium, and JNJ's 5-year beta of 0.60), JNJ's current share price of $101 implies a dividend growth rate in between 5.5% and 6.0%, which is about 100 bps below my conservative estimate of 6%-7% (see table below).

Further, JNJ also offers better value relative to its consumer products and pharmaceutical peers. With a consensus long-term EPS growth estimate of 7.1%, JNJ trades at 10.3x 2015 forward EBITDA and 16.0x 2015 forward EPS. This compares favorably to average comps EBITDA and P/E multiples of 12.4x and 18.5x, respectively, with a similar average long-term EPS growth estimate. Moreover, JNJ's various profitability metrics (e.g. EBITDA margin and return on capital) are superior to peer averages and its balance sheet is less leveraged (see chart below).

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In conclusion, JNJ has sufficient capacity to offer investors long-term dividend stability and healthy growth with limited downside risk. As the shares are now trading on a low dividend growth assumption and notable discount relative to industry peers, a buy rating for income investors is warranted.

All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.

Disclosure: The author is long JNJ. 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.