Johnson & Johnson Has Let Shareholders Down

| About: Johnson & (JNJ)

Summary

JNJ spends about the same amount each year on the buyback as it does the dividend.

But while the dividend attracts countless shareholders, the buyback has been extraordinarily ineffective.

JNJ's buyback effectiveness is one of the worst in the US among mega-caps due to enormous dilution from options.

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Johnson & Johnson (NYSE:JNJ) is one of the best companies in the US in terms of returning capital to shareholders. Management makes buying back stock and paying dividends a collective priority and the formula has worked; dividend investors in particular can't get enough of JNJ's capital returns. The dividend is a big piece of it but the buyback consumes about the same amount of money as the dividend on average, making the effectiveness of it a priority for holders as well. In this article, I'll take a look at what JNJ has spent buying back stock and what it has to show for it.

As a note, I'll be using data from company filings.

We'll begin by taking a look at JNJ's share count from the past six year-end periods to give us an idea of where it has come from.

You can see we're not off to a good start here as the share count hasn't really budged for the past several years. And if you were to look back even further, the story is the same; JNJ's share count really doesn't move much Y/Y up or down. There are some years where the count goes up but slight reductions later level off those increases. At any rate, the moves we are talking about here are so diminutive that it really doesn't matter; the lesson here is that JNJ's share count is roughly flat on average each year.

Okay, so what? If JNJ's share count is flat every year, why should you care? The reason I think holders would be interested to know this is because of the following; have a look at how much JNJ spends every year just to keep the share count flat.

The numbers here are absolutely staggering irrespective of whether or not those dollars are actually accomplishing anything. While the number varies year-to-year rather wildly, on average, JNJ has spent $7.6B annually over the past five years buying back stock. That's almost exactly what the dividend has cost over the same time period but also keep in mind that those dollars have done almost nothing to reduce the float. But how is that possible? How can a company throw$38B at buybacks in five years and have almost nothing to show for it? In a word: dilution.

JNJ hands out stock options like they are candy and those options count towards the diluted share count each year. The math is a little fuzzier with options than shares but we can get an idea of the magnitude of what JNJ is doing by taking a look at the proceeds and excess tax benefits that accrue to JNJ when options are exercised.

We can see that just the tax benefits and proceeds to JNJ collectively make up over a billion dollars a year, and while that means lots and lots of options are being exercised - with commensurate increases in the share count - it also means the cost of the buyback is effectively being reduced. After all, these billions of dollars represent cash that JNJ can use to offset the enormous money it is using to buy back stock. The influx of options dollars coming to JNJ in the past three years has fallen off from 2012 and 2013 but on average, over this time period, the benefit was about $1.8B. That, by extension, takes average net spending on the buyback to $5.7B instead of the gross amount of $7.6B we looked at earlier.

Here's the thing; when we tie all of this back together, the scorecard for JNJ is horrendous when it comes to assessing the buyback. Over the past five years, JNJ has spent a total of $37.9B buying back stock and if we reduce that number by the benefits of exercised options, it falls to $28.7B. That's better, but it is still a lot of money. And keep in mind that JNJ's share count is only 1% lower than it was at the end of 2011/beginning of 2012, so the benefit to the share count has been almost nonexistent. In fact, the reduction in the float over that time period, roughly 32M shares, is worth about $4.1B at today's stock price. That implies that the $24.6B difference between the net number and what the reduced share count would be worth has been spent on frictional costs as well as simply sopping up excess float from options.

Obviously, any buyback has frictional costs due to timing of repurchases but with JNJ's stock flying, those costs should be minimal or even negative. In other words, with JNJ shares near their highs, the buyback should have likely produced some type of profit, not frictional costs. However, it has issued so many options that its buyback has frictional costs of almost 86% over the past five years. Said another way, only 14% or so of the money actually spent on buybacks - net of options benefits - actually went to reduce the float. That is absolutely terrible and it is fair to say that JNJ's buyback is just another way to pay employees. I'm not against compensating people and tying their goals to that of the organization but when stock compensation costs as much as the dividend each year, shareholders should take notice. After all, imagine what JNJ could spend on the dividend if it wasn't handing out stock options to everyone with a pulse. At any rate, if you're long JNJ, you should consider if this is the type of company that has shareholders in mind when it makes capital allocation decisions; I'm not so sure that it is.

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.

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