Johnson & Johnson: Moving To Higher-Growth Technologies, Capitalizes On Renewed Profitability

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Johnson & Johnson has been a steady dividend income stock with defensive qualities that help protect shareholder returns.

Past 2-year stock performance of more than 20% average annual gain, returning to previous levels of profitability.

The company is selling less profitable business units to make room for higher growth medical technologies that can drive margins and earnings up.

Johnson & Johnson (NYSE: JNJ) has been an iconic company for healthcare, medicine and personal care products for probably as long as most people can remember. As a stable income stock for investors building wealth over the long-term, it has done an adequate job. The company knows it now has to make changes to keep that growth and reliability going for the next decade, and has started to implement those changes.

Earnings power

The company has a market cap of $292.5 billion with annual revenue of $71.3 billion in 2013. The last four quarters of revenues are showing a healthy uptrend. Bottom line figures for 2013 had diluted earnings per share at $4.81, and $5.42 for the latest trailing twelve months.

Earnings per share growth over the past 10 years was around an average annual 6.45%, which is a pretty decent number for a company of this size. In 2011, EPS slipped down suddenly, so its 3-year and 5-year EPS growth don't look impressive (around 1% and lower). However, in the following year they recovered, and now are at their highest EPS level ever.

Stock movement

Close followers of JNJ would have seen this EPS fall as an opportunity to pick up the stock as it was languishing around $60-$65 a share. Since mid-2012, the stock has risen around a compound 26.3% over the past two years to $103.73. It hit an all-time high of $106.74 in July.

Johnson & Johnson 10-year stock chart

Source: Google Finance

Dividends and total shareholder return

The dividend yield is 2.60% and the past 5-year median dividend growth rate, a period that covers that EPS fall mentioned above, held up to a compound 7.22%. Dividends didn't fall along with EPS, with JNJ keeping its record of growing annual dividends every year over the past 10 years.

The company's total shareholder return lagged the S&P 500 since 2009 by more than 5 percentage points, giving an average annual 12.6% growth in the last 5 years versus the index's 17.9%. It is over the last ten years where we see JNJ performed better (8.9% vs. 7.4%).

Here the biggest factor was that the company didn't see as big of a fall during the great financial crisis as the broader market. Its natural defensive qualities as a healthcare sector stock spared it from a big hit, and dividends grew steadily. This is one thing that investors always need to consider when choosing a stock -- how well they will hold up potentially in a market downturn. JNJ's market position and stable product demand help maintain sales and earnings. People still need medicine and healthcare products regardless of sell-offs and bear markets. Dividend investors would welcome the reliable income.

Johnson & Johnson total shareholder return

Source: Johnson & Johnson 2013 Annual Report, p.71

Business Performance

Revenue growth has improved, with average annual growth at 5.1% over the past three years. Likewise, over the same period its return on equity has been improving. Standing at 18.6% in 2013, it could be on its way to get back above 20% like before 2010, when it regularly was in the mid- to high-20s.

The market has realized that JNJ is now at the level of earnings power it had pre-financial crisis, and has re-priced the stock upwards.

The company is selling off less profitable businesses to improve its margins and key performance. An example of this is the recent announcement of the company's plan to sell its Cordis Medical Device unit. This unit creates among other things medical stents, a product market that JNJ originally helped to create. Still, the earnings of the unit have not been fantastic, so the company is wanting to make space for higher-growth medical technologies. It is estimated it could achieve as much as $2 billion.

This follows the $4.5 billion sale of its Ortho-Clinical Diagnostics blood-testing unit earlier this year.

Now that the company has completed its acquisition of Synthes, which cost a total $19.7 billion in cash and stock, the freed up capital from these two sales could fund a multi-billion-dollar war chest for new acquisitions.

Financial strength

Apart from the company's steady earnings growth, per share equity -- its book value -- has risen uninterrupted as well since 2004. Its trailing twelve-month book value per share is $27.59, giving a price-book ratio of 3.76 times. Although that is higher than any of the previous 5 years, it is close to the 10-year median.

Long-term debt stood at about $13.3 billion in the June 2014 quarter. Comparing that with its 2013 reported net income of $13.8 billion, we can clearly see that debt is not an issue for the company, and theoretically could be paid off completely in one year.

Free cash flow is now higher than at any point in the past ten years with a value of $15.8 billion over the past 12 months. Compared to the $73.5 billion revenue over the same 12 months, that's 21.5% -- a solid number that shows durable competitive advantage long-term investors want to see.

Share price and returns potential

JNJ's 3-year and 5-year average shareholder equity growth rate is 9.4% and 11.9%, respectively. If the company can continue growing equity close to the lower of the two, around 9% annually, for the next five years, then we can approximate what the share price may be using the current price-to-book ratio of 3.76.

Book value per share currently is $27.59 over the past 12 months. Compounding that by the 9% growth rate estimate above comes out to $42.45 ($27.59 x 1.09^5 = $42.45).

Multiplying that projected book value per share by 3.76 gives a value of $159.61 five years from now. Assuming you bought the shares at $101.32, that would give you potentially an average annual return of 9.51%, not including dividends. For dividend investors wanting a secure source of portfolio income, that could be an adequate return if that projection proved correct.

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.

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