Investors in Johnson & Johnson (JNJ) have recently been in for quite the upward ride. Over the past three months, the stock price has risen nearly 10%, bringing the year-to-date return to around 4%. Through this report, I will present my belief that the recent price advancement of Johnson & Johnson has been due to speculation and the fundamental picture of the company is steadily weakening.
Is This Really Growth?
A simple, but reliable, item to look at when examining an organization is retained earnings. Retained earnings are the portion of earnings that the firm does not pay out as dividends, but rather invests back into itself. If a firm is consistently growing and it believes that its future prospects are strong, it will progressively invest more capital into itself. In the chart below, the retained earnings for JNJ can be seen for the past 10 years.
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The above image paints a surprisingly bullish picture. Johnson & Johnson has steadily been pouring capital back into its operations. It is signaling to the market that the best method of satisfying investors is internal investment, rather than dividend payments. An increase in retained earnings typically means that the firm believes it has strong future prospects and its internal investment will grow to greatly benefit its shareholders. However, this metric in isolation can be fairly useless. In order to put retained earnings growth into perspective, we must examine the growth rate of retained earnings. By normalizing changes in retained earnings, we can better determine if the firm is consistent in its investment.
The above chart shows the retained earnings of JNJ and the retained earnings growth as a percentage. By adding the retained earnings growth rate, we can gain a better understanding of the consistency of JNJ's internal investments. Even though JNJ is investing more and more into its operations, for the past four years, JNJ has been slowing this internal investment. This is a powerful signal in that it shows that for the past four years, JNJ has steadily viewed internal investment with less and less confidence.
This slowing in internal investment eventually trickles down to the stockholder. As the firm slows internal investment, its competitive edge is weakened due to a declining willingness to spend on firm improvements. As the competitive edge weakens, JNJ could find its market share gradually shift to competitors. A firm that fails to steadily invest in itself and defend its market share will eventually encounter a decrease in revenues due to an increase in competition. To illustrate this point, I have included an image showing the revenue growth of JNJ for the past 10 years.
It is very intriguing to note that during the past four years, Johnson & Johnson has been struggling to maintain positive earnings growth. This struggle can be seen in the wild oscillations in revenue growth starting in 2008. In eight of the past 16 quarters, JNJ has had negative or near zero growth in earnings. This situation is even starker in the light of the fact that for the years 2002-2008, JNJ experienced an average revenue growth of 10%. The dramatic decline in revenue growth has coincided perfectly with JNJ's decision to decrease its retained earnings growth rate in 2008. In other words, ever since Johnson & Johnson decided to slow its rate of internal investment, it has experienced decreased and weakening revenues.
Declining Growth Capacity
In the previous analysis, I made the argument that since JNJ is decreasing its rate of internal investment, its ability to defend its revenues is steadily declining. Additionally, I showed that this is indeed the case and revenues have been declining for the past four years. I will now make the argument that Johnson & Johnson has been selling its capacity for future growth and positioning itself for further declines.
When a firm struggles in its operations and needs to raise capital, it typically relies on selling additional shares on the market or raising debt capital. Ever since 2008, JNJ has been on the fundamental decline and in order to attempt to buoy the firm, JNJ has been issuing debt. The chart below shows two things: the debt to equity ratio and how much interest the firm pays out each quarter to debt holders.
The debt to equity ratio provides a quick picture as to how the firm chooses to capitalize itself. It is important to note that as the ratio increases, the firm is typically taking on additional debt. The interest expense shows the quantity of money that the firm paid in the form of debt payments for the period studied. When JNJ encountered troubles in 2008, it increased its quantity of debt and increased its interest expenses by over 400%.
Currently, JNJ is paying around $500 million per year to satisfy its debt holders. This is very bad for two reasons. The first reason is that this $500 million would be much better spent on anything besides interest expense. During the hardships of 2008, if JNJ had chosen to not raise debt, it would have had an additional $2 billion, which could have been spent on bettering the firm. The second reason that these higher levels of interest expense are bad is that this form of capitalization steals away from stock holders. For example, if the firm had decided to pay a dividend equal to the current cost of its interest expense, the dividend rate would increase by nearly a third of a percent per year.
The fundamental landscape of Johnson & Johnson shows a company that is less and less willing to invest in itself. As its willingness to invest decreases, its revenues have been suffering. This suffering could be mitigated by investing capital back into the business; however, the decision to raise debt has sacrificed nearly $500 million per year - which could have been used for future growth, but must instead satisfy debt holders. Despite this situation, the stock price has rallied over 9% in the past three months. It is my belief that the majority of these traders have ignored the fundamental picture and have, therefore, caused the firm to be overvalued. I believe that their oversight is our opportunity. Since the stock price has decoupled from fundamentals, I believe a short is warranted.