Johnson & Johnson: Still A Compounding King ?
Seeking Alpha Analyst Since 2020
Summary
- Johnson & Johnson is a Dividend King but the majority of its returns come from being a Compounding King.
- The pharma indutry is inherently unpredictable due to the nature of the product development and approval process, the limited intellectual property time horizons and the high levels of litigation.
- However, the balance of probabilities is that Johnson & Johnson will be around in 10 years with similar prospects to those it has currently.
- The forecast CAGR is 8.3%.
As a member of the highly exclusive "Dividend King" club Johnson & Johnson is one of only 24 companies with over 50 years of consistent dividend growth. Therefore many investors consider it a "fire & forget" purchase that will remain with them through their retirement. However, what many also forget is that the vast majority of Johnson & Johnson shareholder returns come from it being a "Compounding King" able sustain high returns on incremental capital over time.
Source: FAST Graphs
Over the past 10 and 20 years Johnson & John has generated shareholder returns of 10.8% and 7% respectively. Earnings growth has been largely consistent throughout the 20 year period therefore the main differentiator in returns was the initial purchase price (blended PE's of 13.63 and 27.65 in June 2011 and June 2001 respectively), highlighting the importance of price upon returns.
So what can one expect from Johnson & Johnson in the future? A useful tool in forecasting future shareholder returns is projecting a company's returns on incremental capital i.e. the return on the earnings a company retains in its business each year.
Intrinsic value compounding rate = ROIC x reinvestment rate
Reinvestment rate is the percentage of owner earnings retained each year. To see how I calculate owner earnings and ROIC see article here.
The owner earnings reinvestment rate for Johnson & Johnson was 24% in the previous 2 years (see accounts analysis here). It has been higher in the past but it is always prudent to choose the conservative figure when projecting in to the future. ROIC was approximately 26% in the previous 2 years and it has been consistently sustained at this level or above for 20 years. Therefore:
Intrinsic value compounding rate = 24% x 26% = 6.2%
Johnson & Johnson's market cap as of 29th June 2020 was c.$368b. If this capitalisation is compounded at 6.2% for 10 years (and the PE remains constant) the market value would be $687b, creating $319b of value for the shareholder over the period.
Johnson & Johnson also provides value to its shareholders via its stable and steadily increasing dividends therefore these must be accounted for in shareholders returns. Dividends have increased at an average rate of 5% per annum over the previous 5 years and the 2019 dividend payout was $9.9b. If the value of dividends keep increasing at 5% for 10 years the shareholders will receive $131b in dividends over the period.
The sum of the ten year capital returns ($319b) and dividends received ($131b) creates a total $450b return for the shareholders over the period. Against the current market cap of c.$368b this is a 122% return over ten years. The CAGR would be 8.3% which aligns with past returns as outlined in the graphs above.
The question, as ever, is can such returns be sustained in to the future? Johnson & Johnson has demonstrated impeccable financials over time that are the hallmarks of durable competitive advantage. 20 year averages are as follows:
- Gross margin: 70%
- Net margin: 18%
- Interest coverage: x36
- ROIC: 28%
However, over half of Johnson & Johnson's revenues are generated in the pharma sector which is generally unpredictable due to the nature of the product development and approval process, the limited intellectual property time horizons and the high levels of product related litigation.
The drug development process has a 90% failure rate and even those drugs which reach the final Phase III (patient testing) have a historical failure rate of c.60%. Johnson & Johnson has the second largest R&D spend in the pharma industry (after Roche) and can demonstrate success e.g. over 25% of 2019 revenues were generated by products introduced in the previous 5 years. This statistic is simultaneously alarming because it highlights the dependency on constant R&D success in order to sustain and/or grow revenue. Johnson & Johnson's current development pipeline can be viewed here.
A positive for the pharma industry generally is that the long term trend for the numbers of drugs in development is upward, indicating pharma is in no way a dying industry. The CAGR of worldwide prescription drug revenue is projected to be 6.9% between 2019 and 2024.
When a drug is successfully developed the revenues generated by it are time limited by the expiration of patents. A patent lasts 20 years from the date of filing but in most cases this time frame is halved to 10 years after the testing period finally brings the drug to the marketplace. Patents contribute approximately 80% of pharma revenue therefore their expiration can have signifiant effects on a pharma company's revenue from year to year. For example, Johnson & Johnson's Remicade sales fell by $946m (17.8%) in 2019 compared to 2018 due to the patent expiring in some European countries. It is concerning that the patents on Johnson & Johnson's most lucrative product Stelera (7.8% of 2019 revenues) begin to expire in 2021 and are projected to have expired in all markets by 2024.
The pharma/consumer health industry is highly litigious which creates significant levels of ongoing risk. For example, Johnson & Johnson is currently in the news for claims that Johnson's Baby Powder caused ovarian cancer. Damages have been reduced to $2.12b from $4.69b upon appeal and, at first glance, this may appear to be inconsequential in the long term to a company with annual revenues of $82b. However, Johnson & Johnson has been selling Baby Powder for over 100 years, highlighting that essentially any pharma/consumer health product is a potential landmine that could blow up at any time. Despite Baby Powder's longevity Johnson & Johnson has recently announced it will be discontinued. In addition to directly impacting revenues, high profile litigation may also chip away at general consumer confidence in Johnson & Johnson and impact their wider product sales. Johnson & Johnson is also a defendant in a series of lawsuits related to wholesale pricing (where it is alleged that pricing and marketing amounted to fraudulent conduct) and has been named in over 2,800 lawsuits related to the marketing of opioids (including claims such as false advertising, consumer fraud and unjust enrichment). It is highly probable that the risk of varied litigation will remain with the company ad infinitum.
In comparison to the uncertainties inherent within the pharma category, Johnson & Johnson's medical device and consumer categories are an oasis of stability. However, the concern is they are too stable i.e. neither category has grown its revenues over the last 9 years despite the favourable tail-winds of an ageing population in developed countries and an expanding middle-class in developing countries. I can't foresee anything that will move the needle in these categories in the future.
So is Johnson & Johnson a worthwhile investment? The nature of its product categories is unlikely to fundamentally change in the future and management has a long term track-record of generating high ROIC and then reinvesting and compounding those returns at the same high rate. Despite the uncertainties inherent within the pharma industry the probability is that Johnson & Johnson will be around in 10 years with similar prospects to those it has currently. Therefore this is a sensible investment for the investor looking for both long-term capital appreciation and dividend returns, especially in the context of the Buffet Indicator currently forecasting returns of only 1% for the US stock market and 30 year US Treasury yields being at only 1.39%.
Analyst's Disclosure: I am/we are long JNJ.
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