If current projections for dividend growth rate remained at 8.2% per year and those for net income growth rate at ~6% per year, it was shown to be inevitable that the dividend payout ratio would continue to increase.
It was determined, while not desirable, this gap between dividend growth rate and a lower net income growth rate was likely sustainable for at least the next 15 years.
But, even if sustainable, it was believed that neither management nor shareholders would consider it acceptable for net income to grow at ~6% when average net income growth for the last 15 years had been roughly 50% higher at 9.1% per year.
This led to the following as yet unanswered questions -
- What percentage net income growth per year could and should be targeted?
- What percentage of net income needs to be retained in the business to achieve targeted net income growth?
In seeking to answer these questions it is useful to look back to attempt to determine what drove the average 9.1% growth in net income over the last 15 years as displayed in Table 1 below (repeat of Table I from previous article):
In addition to the earnings analysis above, there is a need to analyze the balance sheet and the deployment of funds over the last 15 years before proceeding further.
In doing this it is useful to separate and aggregate the various balance sheet items into those that are integral to the operations of the business and those that are part of the financing aspects of the business.
In the condensed format balance sheet per Table 2.1 below, the assets and liabilities (including treasury stock) have been analyzed and summarized into just two categories - "Investments in business operations (net of depreciation)" and "Net free funds (long term)."
Net free funds (long term)
With reference to the 2012 year column, it can be seen that an amount of $2.63 billion is described as "Net free funds (long term)."
This amount of $2.63 billion is derived by deducting the amount of $20.77 billion described as long term deferred payments (includes deferred taxes and employee related provisions) from the amount of $23.4 billion, comprised of cash net of borrowings plus treasury stock, and described as funds retained for future use.
These long term deferred payments provide a source of interest free funding to JNJ, the amount of which continues to grow over time. JNJ is free to use such funds in any manner it wishes, including holding in cash form or for investment in assets (business operations, by acquisitions or otherwise, or purchase of treasury stock).
Balance sheet strength
Table 2.1 displays the enormous conservatism in JNJ's balance sheet.
At end of 2012 JNJ could pay out all debt and set aside funds to cover all long term obligations and still have $2.63 billion in cash and $80.67 billion invested in business operations, entirely funded by equity.
Funds readily available at end of year 2012 for investments and/or acquisitions totaled $39.6 billion, comprised of $21.1 billion in cash and marketable securities and $18.5 billion in treasury stock (even greater than $39.6 billion as treasury stock is recorded at cost and market value is significantly higher).
JNJ could increase its investment in business operations by a massive 50% without resorting to any capital raising or external financing.
So funding availability is not a constraint on investing for higher rates of net income growth in the business.
Funding of business investment 1998 to 2012
Table 2.1 above clearly shows the changing proportions between years, of net assets/equity invested in business operations versus "net free funds (long term)."
This is understandable as large acquisitions such as Synthes occur at irregular intervals that can be several years or more apart.
Table 2.2 below is an analysis of funds flows over the 15 years 1998 to 2012 reported in block periods of 3 years. As described in footnote to Table 1 above, utilization of 3 year periods tends to smooth out anomalies and abnormalities that occur between 1 year periods (helps to avoid not being able to see the wood for the trees).
The total funds flow for the period 1998 to 2012 could be described in narrative form as follows:
The company generated $124.6 billion in funds from net income of which $64.5 billion (51.8%) was re-invested in the business and $56.6 billion (45.4%) paid out in dividends, with the balance $3.5 billion used to increase cash net of borrowings.
A further $18.1 billion of funds became available due to the long term deferral of payment of taxes and employee and other provisions. These funds were primarily used for investment of $17.8 billion (98.2%) in treasury stock, with the balance $0.3 billion used to increase cash net of borrowings.
Whether or not the above narrative reflects the intent of JNJ management it is an accurate and useful description of the outcome.
The foregoing analysis renders question 2 above largely irrelevant.
There are more than sufficient funds already available so as not to be concerned at the effect of dividend payout ratio on the amount of funds retained for investment to boost net income growth rates.
That takes us back to the question as to what percentage net income growth per year could and should be targeted.
It can be taken as a given that management would strive for and shareholders would welcome a return to net income growth rates of 9.1%, or at least a growth rate to match dividend growth rates, presently 8.2%.
It has been established that availability of funding is not a constraint, so there must be other constraints that need to be identified before they are able to be addressed.
Increasing size of the enterprise -
As the value of the enterprise increases, the proportionate value of investments/acquisitions needs to grow to absorb the available investable funds.
This can be achieved by acquiring increasingly larger enterprises or a greater number of smaller enterprises.
Per tables 2.1 and 2.2 above, funds invested in business operations for the 2010 to 2012 period showed an increase of $20.8 billion (34.8%) between the end of 2009 and 2012. Synthes was acquired in that period, the largest acquisition in JNJ history.
Similarly, funds invested in business operations for the period 1998 to 2000 showed an increase of $5.6 billion (34.4%) between the end of 1997 and 2000. DePuy was acquired in that period.
Proportionally, the Synthes acquisition was similar in size to the DePuy acquisition in its impact on total investment in business assets (both resulted in an increase of ~34%).
Leverage of acquisitions -
Leverage here is intended to refer to JNJ's greater ability to exploit an opportunity due to brand name, sales and marketing infrastructure and access to funds compared to the abilities of the entity targeted for acquisition.
The need for larger and larger acquisitions inevitably pushes the search higher up the value chain where JNJ has progressively less leverage compared to the target.
This can be seen happening as evidenced by these examples -
- DePuy - acquisition date near but ahead of regulatory approval;
- Synthes - acquisition post regulatory approval and significant market penetration already achieved;
- Boston Scientific (NYSE:BSX) and St Jude (NYSE:STJ) - suggestions that these companies might be subject to targeting for takeover by JNJ to maintain JNJ growth (see here).
In the case of Boston Scientific or St. Jude, JNJ could be expected to pay a hefty takeover premium for an enterprise that already has much of the leveraging capabilities of JNJ. Any advantage would possibly be limited to synergistic cost savings. It could just result in adding more of the same rather than using JNJ's leverage to enhance JNJ returns.
A DePuy type acquisition allows the opportunity to "make a profit when buying" and to achieve superior returns due to greatly accelerated market penetration (and profits) compared to what an earlier stage company could achieve.
Synthes would be somewhere in between a DePuy and a Boston Scientific acquisition in regard to the leveraging aspect.
Table 3 above depicts the relative strengths of JNJ and past and potential future targets for acquisition/takeover (the strengths as shown are for illustrative purposes only - a more in-depth analysis might result in different degrees of strength being applied).
Sunshine Heart Inc (SSH) is included above because it can provide a good basis for an example to illustrate how JNJ can potentially make a profit when buying, and achieve superior returns, while paying a premium price from the seller's viewpoint (see more on Sunshine Heart here, here and here).
Quantitative versus qualitative analysis -
The above is a qualitative assessment of what JNJ needs to look for in an acquisition target to take the greatest advantage of its leveraging capabilities and so grow net income at an accelerated rate.
A Part III of "Johnson & Johnson: At The Crossroads" will be required to undertake a quantitative assessment of the ability of JNJ to increase the net income growth rate through acquisitions and internal investments.
"Johnson & Johnson: At the Crossroads - Part III"
In Part III of "Johnson & Johnson: At the Crossroads," it is proposed to drill down into the divisional results to assess the potential of each division to contribute to an increase in the rate of growth of net income in the future. Given differences in profitability between divisions the mix will potentially assume some importance.
Some examples of the potential effect of acquisitions on the net income growth rate will also be included. These examples will include cases for acquisition of a mature entity, most likely Boston Scientific, and an early stage company as it nears regulatory approval, most likely Sunshine Heart.
Disclosure: I am long SSH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As always, please do your own research before any buy or sell decisions. Use of information and research in the article above is at your own risk.