Johnson & Johnson: Low Beta, Small Alpha

| About: Johnson & (JNJ)
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I look at historic data for sales, earnings, book value, dividends, and shares outstanding over the past fifteen years at Johnson & Johnson.

This historic data is used as a basis to form a view on future expectations.

The future expectations are then valued to arrive at a view on whether the shares are priced to buy (or hold).

The future expectations are also assessed to determine alpha potential arising from faster growth than growth priced by markets.

Johnson & Johnson (NYSE:JNJ) trades at a multiple of 16.91 times 2013 earnings. At first glance that does not look terribly expensive. And it also trades with a dividend yield of 2.9%, which is a substantial premium to market yields: and that suggests it is cheap.

Johnson & Johnson has a beta based on a five year regression, adjusted for beta's tendency to converge to 1, of 0.75. Based on a long-term risk free rate of 4.5%, and a long-term equity risk premium of 5.75%, we arrive in an expected market return of 10.25%. The capital asset pricing model, which adjusts market returns for risk as measured by beta, suggests that investors should expect a long-term return of just over 8.75% [Risk Free Rate + Beta * (Market Return - Risk Free Rate)] from the stock. The good news is that 2.9% of the total return of 8.75% comes from dividends, which leaves a target gain from price appreciation of 5.85%.

The question to answer is whether Johnson & Johnson trading at $93.32 recently, is it priced to deliver a long-term return of 8.75%? In my view, Johnson & Johnson is priced to deliver total annualized returns of 9.25%, if forward earnings growth expectations revert to a ten year annualized rate of about 6.50%. If this growth expectation is achieved, Johnson & Johnson presents an opportunity to capture 0.50% of alpha: that is a total return of 9.25% minus the risk adjusted long-term return expectation of 8.75%. This is tiny, but unlike high beta names where we presently see negative alpha at every turn, it is a positive.

A reversion in forward growth to 6.50% is a huge a leap of faith to make given that over the last five years, earnings at Johnson & Johnson has grown at an annualized growth rate of 3.85%, (and 4.25% excluding the impact of dilution that occurred in 2012 and 2013).

Sales growth has been a disappointment in recent years with 5 year annualized sales growth dropping below 2%. And sales are important for it is from where earnings growth potential arises. The patent cliff has been a challenge with Concerta, Levaquin, and Invega losing exclusivity during 2011 and 2012. Acephex lost exclusivity in 2013. And there is more to come with Velcade and Remicade losing patent protection in 2014 and 2015. Cost savings and growth through M&A is great, but we need to see some organic growth too.

Nonetheless, there is room for optimism.

  • There is some scope for value return through possible non-core asset dispositions.
  • While we must recognize the large cost cuts undertaken during the past several years, and the fact that Johnson & Johnson today is right-sized for its operation, there is scope for improved earnings through further cost cutting.
  • There is some scope for further growth from M&A activity.
  • And the late stage pipeline (download here) suggests that there is potential for organic growth too.

The other point to keep in mind is that having fallen off the patent cliff, we are now approaching the bottom of the cliff. There is much less to lose, and much more to gain through the new patented drugs pipeline. In addition, there is much to gain from limiting what is lost to generic manufacturers in the off patent space. Keep in mind that recent FDA actions against several Indian generic players is likely to help branded generics lose less to less pricey imports.

My forward growth expectation of 6.50% may sound crazy to some given recent performance. Six analysts on Reuters estimate average long-term growth rates of 5.92% with a high estimate of 7.1% and a low estimate of 4.2%. However, I am comfortable that Johnson and Johnson is capable of nominal annualized earnings growth of 6.50%.

Johnson & Johnson operates in the Healthcare sector. This sector is seen as a defensive sector by most investors. Typically, in this sector, we will find low beta companies, with lower sustainable long-term growth rates, and less volatility in earnings growth in the sector. We also expect to find healthy dividend yields. This sector profile is attractive with the markets priced as they are. What the future holds in store for the sector is important too. And it is positive.

The worst of the patent cliff is behind us: the earnings volatility and slow growth in recent years can be expected to slowly reverse course. In addition, innovation continues to be driven by the perpetual quest for immortality. An aging demographic in much of the developed world creates higher demand expectations. The drug cost side of the equation is profitable for generic companies, while the innovators stand to benefit from the need for high quality, as well as from the demand for further longevity. This trend is not going to change anytime soon: the global population continues its relentless growth, and that will drive demand for many years.

What is Johnson & Johnson worth to an investor looking for a long-term return expectation of 8.75% and the following expectations?

  • Sustainable earnings of $4.88. Sustainable earnings what a company can be expected to earn over the course of a typical economic cycle of six years. I estimate cyclically adjusted earnings as median earnings over a six-year period. It is the level of earnings which can be expected to grow at the projected long-term growth rates, notwithstanding departures from the long-term growth rates in the short-term. This is a very conservative estimate, considering $5.52 in earnings during the year ended 2013.
  • Long-term growth rate of 6.50%, which is in-line or slightly below annualized earnings growth of 6.87% (including the impact of buybacks net of dilution, annualized growth in earnings per share was 7.41% over the past ten years) seen during the ten years 2013.
  • Adjusted payout potential of 40%. The adjusted payout potential is that part of sustainable earnings that we can expect the company to return to shareholders via dividends and buybacks, net of dilution. The average adjusted payout ratio over the past six years has run at 44%, with virtually all of the adjusted payout ratio being applied towards payment of dividends.

Mathematically it is calculated as Sustainable Earnings * [1 + Long-term Growth Rate] * Adjusted Payout Ratio / [Long-term Return Expectation - Long-term Growth Rate], that is $4.88 * 106.50%*40%/(8.75% - 6.50%) or $92.39. The stock presently trades at $93.32. Thus the stock is rightly priced, being neither cheap, nor expensive.

In my view, priced as present, Johnson & Johnson will deliver a long-term total return of near 9.25%: that is the 8.75% required rate of return computed using the capital asset pricing model, plus alpha of 0.50%. This alpha would need growth to rise to 7%, which is 50 basis points over growth priced in the model.

For those of you who like viewing historic data, I have included several data tables covering earnings, book value, share count and dividends over the past several years. This data is a combination my analysis and information from a Value Line report, which you can download here.

Shares Outstanding

Source: Value Line data available here and my analysis.

Book Value

Source: Value Line data available here and my analysis.


Source: Value Line data available here and my analysis.


Source: Value Line data available here and my analysis.

Disclosure: I am long JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.