Johnson & Johnson (JNJ, Financial) has a market cap of over $300 billion, making it the largest publicly traded health care company and 6th largest publicly traded U.S. company overall. Johnson & Johnson has a streak of 30 consecutive years of earnings increases; the longest streak of increasing earnings I have encountered. In addition, the company has 52 consecutive years of dividend increases.
When I last analyzed Johnson & Johnson I was impressed by their strong pharmaceutical sales growth. Johnson & Johnson is the focus of part 52 of the 54-part Dividend Aristocrats In Focus series. The company’s business operations are analyzed below.
Business overview
Johnson & Johnson divides its operations into 3 large segments: Consumer, Pharmaceutical, and Medical Devices & Diagnostics (referred to as MD&D from here on out). Each segment’s percentage of total revenue contributed to Johnson & Johnson through the first 9 months of fiscal 2014 is shown below:
- Consumer: 19.4% of company revenues
- Pharmaceutical: 43.4% of company revenues
- MD&D: 37.2% of company revenues
Johnson & Johnson’s consumer segment is its smallest despite controlling well-known brands including: Johnson’s, Bebe, Aveeno, Neutrogena, Band-Aid, Bengay, Neosporin, Listerine, Tylenol, Motrin, Benadryl, Mylanta, Zyrtec, Nicorette, Pepcid, Splenda, and Visine. When a segment generates $10.89 billion in sales over three quarters, and it is the smallest company segment, that speaks to the size and success of Johnson & Johnson rather than the consumer segment being "small." Johnson & Johnson’s consumer segment generates about 65% of sales internationally, with 35% coming in the U.S.
The company’s pharmaceutical segment is its largest, generating over 40% of total company revenue. The segment has generated $24.3 billion in sales through the first 9 months of fiscal 2014. The company’s top 5 pharmaceuticals based on percent of pharmaceutical sales generated through the first 9 months of fiscal 2014 are shown below:
- Remicade: 21% of total pharmaceutical sales
- Olysio/Sovriad: 8% of total pharmaceutical sales
- Zytiga: 7% of total pharmaceutical sales
- Stelara: 6% of total pharmaceutical sales
- Prezista: 6% of total pharmaceutical sales
Johnson & Johnson’s top 5 pharmaceutical products make up 48% of its total pharmaceutical revenue. Juxtapose this with AbbVie (ABBV, Financial), whose top pharmaceutical product generates 70% of total revenue. Johnson & Johnson’s pharmaceutical portfolio is well diversified from a product standpoint as well as geographically. The company generates 54% of pharmaceutical revenues in the U.S. and 46% internationally.
Johnson & Johnson’s MD&D segment is its second largest by revenue. The segment generates 45% of revenue in the U.S. and 55% internationally. The MD&D segment is divided into seven separate divisions based on product use. The MD&D segment’s seven divisions are shown below along with percent of total revenue generated for the segment:
- Cardiovascular Care: 8% of total segment revenue
- Diabetes Care: 8% of total segment revenue
- Diagnostics: 5% of total segment revenue
- Orthopedics: 35% of total segment revenue
- Specialty Surgery/Other: 13% of total segment revenue
- Surgical Care: 22% of total segment revenue
- Vision Care: 10% of total segment revenue
Like Johnson & Johnson’s other segments, the MD&D segment is well diversified. The segment’s largest division is orthopedics, which has generated just over 1/3 of the segment’s revenue thus far in 2014.
Competitive advantage
Johnson & Johnson is perhaps the most stable company I have analyzed. It has numerous competitive advantages that support its leading position in the health care market. Stock price volatility does not represent true underlying business risk. It does however represent market perceptions of risk.
Out of 138 businesses with 25 or more years of dividend payments without a reduction, the average long-term price standard deviation is 29.4%. Johnson & Johnson has the lowest long-term price standard deviation of any of these businesses, at just 16.10%; even lower than stable utility Dividend Aristocrat Consolidated Edison (ED, Financial) which has a long-term price standard deviation of 16.41%. Johnson & Johnson is more stable than most utilities.
Johnson & Johnson’s low price volatility is evidence of a strong competitive advantage. The company’s 30-year streak of consecutive earnings increases and 52-year streak of consecutive dividend increases is more evidence. Johnson & Johnson’s competitive advantages fall into 4 categories:
- Size, scale, and incumbent competitive advantage
- Research & development and intellectual property competitive advantage
- Brand competitive advantage
- Diversification competitive advantage
Johnson & Johnson is the largest publicly traded health care corporation in the world with a market cap of over $300 billion. The second largest is Novartis (NVS, Financial) with a $261 billion market cap. Johnson & Johnson has a strong competitive advantage due to its size, global reach, and history in the health care industry. The company’s long history gives it deep connections to governments and other health care constituents that start-up companies would not enjoy. Additionally, the scale of its operations makes it many of its suppliers largest customer which helps it keep input costs low. Finally, the company’s solid cash flows let it invest for the future in research and development and brand building.
Johnson & Johnson’s research and development division is well funded. Johnson & Johnson spent 11% of sales, or $8 billion on research and development in its full fiscal 2013. The company will likely spent a similar amount through fiscal 2014. Johnson & Johnson is getting results from its research and development department. The company has 18 pharmaceutical products in Phase III development in the U.S. Johnson & Johnson currently generates about 25% of sales from products it has developed in the last 5 years. Johnson & Johnson’s research and development department is the company’s growth engine and source of its largest competitive advantage. Very few companies can spend $8 billion per year on research and development and still generate $13.8 billion in profits.
In addition to intellectual property generated through its research and development activities, Johnson & Johnson also commands premium pricing through its well known consumer brands. Many of the company’s household name brands were mentioned earlier including: Listerine, Tylenol, and Band-Aid. Johnson & Johnson has developed strong brand recognition for its corporate name as well. The company is well-respected and has a reputation for ‘doing the right thing’. The company has a long history of voluntary product recalls which have supported its image as a conscientious company.
Finally Johnson & Johnson has a competitive advantage due to its wide diversification. The company is well diversified within the health care industry, and even further diversified within each of its three segments. This gives the company’s management the flexibility to reinvest cash flows into more profitable divisions. Additionally, the company can take larger risks on any one product as its wide diversification leaves little doubt future cash flows will pour into the company.
Future growth prospects
Johnson & Johnson has grown sales at 5.9% through the first 9 months of 2014 versus the same time period a year ago. Adjusted EPS have grown 9.8% over the same time period. Johnson & Johnson has seen relatively slow growth over the last decade, with revenue per share growing at about 4% a year and EPS growing at about 6% per year. The company is expecting about 7% to 8% EPS growth over full fiscal 2014. Going forward, I expect Johnson & Johnson to continue growing EPS somewhere around 6% a year based on its projections and historical growth numbers.
Johnson & Johnson’s growth will be driven by rapidly growing health care demand in emerging markets and aging populations in developed markets. The health care benefits from aging populations as older people tend to require more health care. As the baby boomer generation in America continues to age, Johnson & Johnson will likely see its sales rise.
Dividend analysis and shareholder return
Johnson & Johnson currently has a dividend yield of about 2.6%. The company has a payout ratio under 50% of current year EPS. Going forward, I expect Johnson & Johnson to grow its dividend payments slightly faster than overall company growth. Over the past decade, dividends have grown at nearly 9% a year, well above the company’s EPS growth rate of about 6% per year.
Shareholders of Johnson & Johnson can expect total returns of somewhere around 7.6% to 9.6%. Returns will come from EPS growth of between 5% and 7% combined with dividends of 2.6%.
Valuation
Johnson & Johnson is currently trading at a P/E ratio of about 18. For comparison, the S&P 500 is trading at a P/E ratio of about 20. Johnson & Johnson has traded at a discount of about 0.85x over the last 5 years to the S&P 500’s P/E ratio. It is odd that such a secure company would trade at a discount to the market. I believe Johnson & Johnson should trade in line with the S&P 500’s P/E ratio due to Johnson & Johnson’s amazing consistency and strong competitive advantages. At current prices, the company appears somewhat undervalued.
Final thoughts
Johnson & Johnson is an extremely high quality business due to its strong competitive advantages. The company ranks in the Top 25 using The 8 Rules of Dividend Investing due to its extremely low standard deviation, and decent dividend yield, payout ratio, and growth prospects. Johnson & Johnson makes a good investment for risk adverse investors seeking limited volatility and stable dividend growth and income.
