Johnson & Johnson (JNJ) boasts numerous competitive advantages as the largest healthcare and pharmaceuticals company in the world and a long-term track record of strong total returns fueled by decades of rising dividend payments and stock price appreciation. Thanks to an attractive dividend yield and a solid growth outlook, Johnson & Johnson's total return potential still remains reasonable today given the generally low risks facing the company. That being said, they are not attractive enough to make me view the stock as a buy right now. In this article, I will compare the bull and bear cases for JNJ, beginning with the reasons to be bullish.
The Bull Case
1. First and foremost, Johnson & Johnson's business model possesses the durable competitive advantages necessary to continue generating attractive returns on invested capital while simultaneously fending off sustained heavy competition in the healthcare, consumer products, and pharmaceutical spaces.
- The main driver behind this conviction is the company's strong innovative capabilities, consistently replenished by its heavy investments in research and development and protected by patents. Johnson & Johnson spends about $1.3 billion per year just on medical device research and development as an integral part of its new product roll outs in the coming years. These projects are expected to generate an additional $7 billion on an annual basis in marginal sales. Add to that the billions that it spends every year on pharmaceutical and consumer product research and development, and the company's total annual research and development budget reaches the double digit billions of dollars, making it one of the top ten largest in the world. Not only does the company pour a significant amount of money each year into advancing its intellectual property, but it also has a very impressive track record of achieving a high return on investment for those dollars. Over the past eight years, Johnson & Johnson has brought fourteen "blockbuster" drugs to market that have achieved over $1 billion in annual sales each.
- Backing up one step, we see that Johnson & Johnson's ever-growing research and development competitive advantage is fueled by another key competitive advantage: the size and scale of its business. This enables them to invest a lot of operating cash flow into this portion of their business without depriving the rest of their business of needed capital expenditures while also continuing to grow their dividend and make strategic acquisitions when necessary. At this point, these two qualities have formed a virtuous cycle whereby the company's research and development prowess fuels above-average growth across the business, which, in turn, gives the company above-average operating cash flow with which it can, in turn, invest even more into its research and development program, which then produces above-average growth, and so on.
- Another competitive advantage for the company is its status as a worldwide leader in a number of healthcare and consumer products categories. This gives it strong brand power, which, in turn, boosts profitability and cash flow stability by enabling the company to charge higher prices for its products while also generating sticky customer loyalty. Johnson & Johnson's strong pricing power is evidenced by the fact that, despite carrying some lower-margin divisions, the company has posted gross margins above 69% during the past five years.
- Further strengthening the company's competitive positioning is the fact that it has broad business, product, and geographic diversification. This allows Johnson & Johnson to continue to grow even if one of the segments is underperforming. This can be seen in the last quarterly report where declines in Medical Devices and Consumer were offset by pharmaceuticals.
- Another advantage the company enjoys is high switching costs in the device segment, which prevents many medical facilities from switching over to competitor products even if the competing device's pricing is actually cheaper.
- Finally, Johnson & Johnson's extensive sales force serves as a competitive advantage by enhancing the company's revenue and profitability across the business while also acting as an ancillary business by attracting smaller biotech companies looking for a larger partner to launch a new drug with.
2. A second reason to hold Johnson & Johnson today is due to its impressive growth track record and solid outlook.
The company has grown earnings over the past 10 years at a rate of 4.8%. Additionally, the company managed to grow earnings before, during and after the last recession, showing that the company's products are in demand regardless of market conditions. This is in large part due to the diversified nature of its products that generates among the highest and most stable returns on invested capital in the entire medical industry.
In its most recent earnings release, Johnson & Johnson grew earnings per share at a 2% rate year over year while reporting flat revenue growth year over year. As with previous quarters, Pharmaceuticals was the primary driver of growth as revenues for this segment grew 4.1% to $10.2 billion. Revenue for Immunology grew 6.9% while Oncology improved 9%. Stelara, which treats immune-mediated inflammatory diseases and is Johnson & Johnson's top-selling product, had sales growth of 36%. Revenues for Darzalex, treatment for multiple myeloma, improved 46%. Sales for the Medical Devices segment declined 4.6% to $6.5 billion, largely due to weakness in Orthopedics. The company also saw weakness in Spine surgeries.
Consumer revenues dropped 2.4% to $3.3 billion as gains in Beauty and Over-the-Counter were more than offset by declines in Oral Care, Women's Health, and Baby Care. Johnson & Johnson reiterated its revenue guidance of $80.4 billion to $81.2 billion but tightened its earnings per share expectations to range of $8.53 to $8.63. The midpoint for earnings per share guidance remains unchanged at $8.58, and so has our estimate for 2019.
Despite current slow to flat growth, I expect earnings per share to grow at a rate of 6% per year through 2024 due to gains in revenue and share repurchases which is consistent with Johnson & Johnson's earnings growth composition in the past. I also expect most of this growth will come from revenue expansion as the buyback is good for a low single-digit gain annually.
- The main driver of the company's growth will be via its drug pipeline. With over 350 total programs, including 44 stage three trials for new drugs and indication expansions, Johnson & Johnson has plenty of cause for optimism. With its talented and proven research and development pharmaceutical team focused on six major treatment areas, including the lucrative field of immunology and oncology, the company expects 31 major drugs/indication expansions to proceed to either the next stage of approval or receive final clearance for sale this year alone. Furthermore, by 2021, the company expects to have launched an additional 14 blockbuster drugs with annual sales of $1 billion+ each on an annual basis.
- Johnson & Johnson's consumer goods segment will also drive robust growth, thanks to continued strength in its widely popular household name brands like Tylenol and Listerine.
- Medical devices should also continue to perform well thanks to high switching costs as well as through its presence in fast-growing international markets.
- Finally, if past history is any indication, Johnson & Johnson should also boost its growth by executing strategic and earnings accretive acquisitions.
The Bear Case
While the company's competitive advantages are numerous, strong, and appear durable for the foreseeable future and its growth prospects remain solid, there are also reasons to be negative on the stock.
- Of most immediate concern is the December 14th release of research by Reuters that stated Johnson & Johnson knew its baby powder could be contaminated with asbestos. After examining documents, the report stated that the company discussed ways to address the issue between 1971 and the early 2000s. Johnson & Johnson has denied this report, but the company has more than 12,000 product liability lawsuits related to its baby powder. Then, on December 24th, a Missouri circuit court judge dismissed a motion by the company to reverse its $4.7 billion jury award to plaintiffs claiming that its talc products caused their ovarian cancer. An appeal is likely to occur, leaving significant uncertainty for the ultimate cost to the company.
- In addition, Johnson & Johnson needs to overcome remaining litigation surrounding central nervous system drug Risperdal, surgical mesh products, and metal-on-metal hip and knee implants and several product recalls.
- Furthermore, though of significantly lesser concern, the company will have to continue navigating the typical challenges and risks facing healthcare and pharmaceutical companies such as patent defense, potential drug price controls from government agencies, regulatory delays and nonapprovals, and increasingly aggressive generic competition.
- Given the company's strengths and risks, the fourth reason I do not view the stock as a buy right now is due to its valuation.
- Central to Johnson & Johnson's total return outlook is its dividend. Backed by a stable business model and a reasonably low dividend payout ratio, the company has ample room to continue growing its dividend, even in a prolonged recession. This has proven true time and again over the past 56 years as it is one of the select few stocks to have eclipsed the half century mark of consecutive annual dividend raises. In fact, its recent momentum has been quite impressive, with an average payout raise of 6.7% over the past 10 years. Given my mid-single digits growth outlook for earnings per share and the company's high free cash flow margins, I see little reason why the dividend should stop growing now. As a result, the 2.7% dividend yield will serve as a safe and growing component of total returns to investors for the foreseeable future.
- Another major component of total returns will come from earnings per share growth. This will be fueled by expected strong performance in the company's current late-stage pipeline of cancer drugs that should command strong pricing power. I expect that these drugs, in combination with equally strong performance in the pipeline of immunology drugs, should offset much of the losses that will be suffered from patent expirations on current drugs, while continued steady growth in the medical device and consumer products segments will combine with a consistent share repurchase program to push earnings per share growth to about 6% per year.
- The final component of total returns involves the earnings multiple at which the stock trades. Using the current share price and midpoint for earnings per share, Johnson & Johnson trades with a price-to-earnings ratio of about 16.5. The stock has a 10-year average earnings multiple of 15.8. Therefore, if shares revert to this average by 2024, then valuation could be a near 1% annual headwind to total returns over this time frame.
Adding all three components together, I expect about 8% total returns per year over the next half decade. While this is certainly not bad, especially given the company's strong competitive advantages, it is not mouthwatering either.
In conclusion, taking into consideration the company's valuation and current slew of litigation risks, I do not view the stock as particularly attractive right now. At the same time, however, I view it as reasonably priced given its many competitive strengths and solid growth outlook, making it a hold. That being said, for defensive investors wishing to focus on stable and growing income over time, we are hard pressed to find a blue chip stock with a better combination of current dividend yield, consistent growth record, recession resiliency, and potential to sustain its record of excellence. Therefore, for such investors, Johnson & Johnson remains attractively priced and I would view it as a buy for them.
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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.