Johnson & Johnson: How Does An $11 Special Dividend Sound To You?

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Summary

Actelion's current free cash flow is not able to explain the hefty price paid for the acquisition.

The expected boost in long-term EPS growth of 1.5-2% is neither able to explain the salty acquisition price.

The $30 billion could have been used in a more shareholder friendly manner.

The price Johnson & Johnson (JNJ) paid for acquiring Actelion has most likely been a bit too high and destroyed shareholder wealth.

Even through the acquisition of Actelion is already old news, as a new JNJ shareholder, I became interested in what kind of earnings the acquired company has recently generated and whether the acquisition price was reasonable or not. JNJ released recently a SEC filing covering the financials behind the transaction in more detail. As I have mentioned already many times before, I am personally not interested in net income because of GAAP and IFRS standard issues. Instead, I always focus my attention first on the cash flow statement as that provides a much better picture of a company's true earnings power. Since I recently bought JNJ in the expectation to generate a reliable and growing dividend stream during my retirement, the condensed cash flow statement of Actelion was especially of great interest to me. After all, a $30 billion transaction must create shareholder value in the long term and provide an even stronger dividend growth for JNJ's current shareholders. By the way, that amount would actually translate into roughly an $11 special dividend.

As JNJ has already mentioned in an old press release, the transaction was financed 100% with cash. The good thing about this is that increased interest payments will not be decreasing the near- or long-term cash flows.

Source: SEC filing

The transaction adds around $30 billion to JNJ's original balance sheet. Majority of this addition is goodwill and intangibles ($25 billion) and it means that from now on 56% of JNJ's balance sheet comprises of these items when it previously was only 37%.

Source: SEC filing

Next, let's look at what kind of cash flow Actelion has produced in 2016 fiscal year (Used CHF/USD 1.036). Operating cash flow was around $950 million and capital expenditure related cash outflows were around $59 million. Therefore, Actelion generated free cash flow (FCF) of around $895 million. This provides a P/FCF price tag of 33.5 ($30 billion / $0.895 billion). That sounds quite salty.

Source: SEC filing

If we exclude the hefty price tag and assume no growth in Actelion's cash flow, we could expect approximately a $0.33 instant accretion to JNJ's FCF ($895 million / 2685 million). This covers at the moment only one month's worth of dividend. So, without any growth, the paid price sounds absurd. However, JNJ has mentioned that the acquisition should increase its long-term EPS growth by 1.5-2%. In 2016, FCF per share was around $5.75. I was not able to find anywhere what kind of EPS growth the markets are expecting from the company, but we could assume a 6% growth from this moment onwards. In ten years, this would mean a $10.3 FCF per share ($5.75*1.06^10), and with a 50% payout ratio, a $5.15 annual dividend. If management's expectations regarding boosted growth after the Actelion acquisition are able to materialize, the FCF per share in ten years could be $12.8 (($5.75+$0.33)*(1+.06+.0175)^10). With the same payout ratio, this would mean a $6.4 annual dividend. The bigger dividend growth at least in a ten-year period is not able to cover the hefty acquisition price tag.

If greater future dividend potential is not able to explain the high price tag, does an increase in JNJ's valuation do this? When considering an additional $30 billion addition to JNJ's current balance sheet and a current free cash flow addition of $895 million, this would mean a return on assets (RoA) of only 3% for the acquisition. JNJ's current RoA is at the moment 11%, so the acquisition would decrease this value to around 9.5%. Even though JNJ's growth component increases after this transaction (which would increase the value of the company), the decrease in RoA actually diminished the value of the company. As JNJ's valuation does not increase by much after the acquisition, the salty acquisition price cannot be explained by increase in valuation either.

In short, I consider the price paid from Actelion as too high and a special dividend of $11 could have been a more shareholder friendly way of using the "excess" $30 billion. However, I nevertheless consider JNJ as a solid hold as the company is operating in a sector with favourable long-term prospects.

Disclosure: I am/we are 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.

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