Johnson & Johnson's Pharma Pipeline To Continue Delivering Dividend Growth

| About: Johnson & (JNJ)
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Summary

Johnson & Johnson has driven 30+ years of adjusted earnings increases and more than 50+ years of annual consecutive dividend increases!

We like Johnson & Johnson's diversified presence, and generally view its consumer portfolio as the core foundation and its pharmaceutical pipeline the icing on the cake.

R&D will eat up some profits as Johnson & Johnson continues to invest in its business and the company remains acquisitive.

Let's take a look at the firm's investment considerations as we walk through the valuation process and derive a fair value estimate for shares.

By The Valuentum Team

Dividend Aristocrat Johnson & Johnson (NYSE:JNJ) is in a class by itself. Founded in 1886, everybody seemingly has come into contact with its brands in one way or another; 70% of sales are generated from #1 or #2 global leadership positions across its markets. J&J has driven 30+ years of adjusted earnings increases and more than 50+ years of annual consecutive dividend increases!

We like its diversified presence, and generally view its consumer portfolio as the core foundation and its pharmaceutical pipeline the icing on the cake; the US MedTech market is also growing nicely. There's a lot embedded in J&J expectations, however. Management expects to file 10 new drugs through 2019 that have potentially as much as $1 billion in annual sales, individually. The first of these new drugs was filed for approval in mid-November. It also believes it has 10 potential line extension filings with $500+ million in incremental sales potential. Its top-notch positions across the consumer spectrum act as a solid foundation for payout sustainability, but any large disappointments from its pharma pipeline could influence the pace of long-term dividend expansion.

R&D will eat up some profits as J&J continues to invest in its business and the company remains acquisitive, but we have no qualms with either. Share repurchases will be ongoing, but a net-cash rich balance sheet offers considerable incremental flexibility to grow the payout, in our view. Free cash flow has averaged ~$14.7 billion during the past three years (2013-2015), well in excess of its yearly runrate cash dividend obligations (~$8.2 billion). This drives the firm's impressive Dividend Cushion ratio of 2.7, suggesting there is additional room for healthy dividend hikes from its current competitive yield of ~2.8%. With the bulk of the dividend analysis in our rear view, let's dig into the remainder of Johnson & Johnson's investment thesis.

Johnson & Johnson's Investment Considerations

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Investment Highlights

• J&J has built one of the most comprehensive health care businesses, generating approximately 70% of revenue from top positions in its respective markets. The firm is focused on innovation while broadening its geographic presence. Consumer product sales are ~20% of its operations. The company was founded in 1885 and is headquartered in New Brunswick, New Jersey.

• We're fans of J&J's capital allocation strategy. It uses ~30% of free cash flow in value creating acquisitions, and the other ~70% is returned to shareholders through dividends and share repurchases. The firm plows about ~10% of annual sales into R&D -- a focus we like.

• J&J's pharma portfolio is impressive. REMICADE has 75% share of the US market for IV immunology products, and the therapy has exclusivity through 2018 in the US. STELARA (exclusivity through 2023 in US) and SIMPONI (exclusivity through 2024 in US) are other key profit drivers. The company's pipeline continues to be robust.

• J&J's dividend track record is solid. The firm's annual dividend payout has advanced from just $0.43 per share in 1997 to its current robust payout. J&J is a holding in both newsletter portfolios, and we expect future dividend expansion.

Business Quality

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Economic Profit Analysis

In our view, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.

The gap or difference between ROIC and WACC is called the firm's economic profit spread. Johnson & Johnson's 3-year historical return on invested capital (without goodwill) is 33.8%, which is above the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.

In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Image source: Valuentum

Image source: Valuentum

Cash Flow Analysis

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Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Johnson & Johnson's free cash flow margin has averaged about 22.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.

The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Johnson & Johnson, cash flow from operations increased about 25% from levels registered two years ago, while capital expenditures fell about 4% over the same time period.

Valuation Analysis

We think Johnson & Johnson is worth $121 per share with a fair value range of $97-$145.

The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.3% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 1.4%.

Our model reflects a 5-year projected average operating margin of 31.9%, which is above Johnson & Johnson's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.6% for the next 15 years and 3% in perpetuity. For Johnson & Johnson, we use a 9.6% weighted average cost of capital to discount future free cash flows.

Image source: Valuentum

Image source: Valuentum

Image source: Valuentum

Margin of Safety Analysis

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Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $121 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.

Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Johnson & Johnson. We think the firm is attractive below $97 per share (the green line), but quite expensive above $145 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

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We estimate Johnson & Johnson's fair value at this point in time to be about $121 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Johnson & Johnson's expected equity value per share over the next three years, assuming our long-term projections prove accurate.

The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.

The expected fair value of $149 per share in Year 3 represents our existing fair value per share of $121 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.