Josh Peters, editor of Morningstar DividendInvestor, and analyst Damien Conover, argue that Johnson & Johnson is too cheap despite slowing growth and numerous problems.
While many of its competitors are approaching a major patent cliff, Johnson & Johnson (NYSE: JNJ) has successfully passed this hurdle and is on the verge of returning to growth with several new potential blockbusters.
The well-positioned company has survived the loss of patent protection on antipsychotic Risperdal and neuroscience drug Topamax by bringing forward a robust set of replacement drugs. Within this group of new drugs, rivaroxaban for cardiovascular disease and bapineuzumab for Alzheimer’s offer the potential to revolutionize treatment, and we peg the drugs’ probability of approval at 80% and 50%, respectively. We expect the company will deploy its enormous cash flow from operations for small acquisitions to augment internal development efforts. J&J’s medical devices and consumer health products greatly reduce the company’s earnings volatility and offer investors an opportunity to own a health-care conglomerate.
The Dividend: What’s New?
There certainly isn’t much doubt about J&J’s ability to maintain its current $2.16 per share dividend, which at $6 billion a year is the third-largest annual payout of all US companies. The balance sheet on Sept. 30 shows cash and securities of $15.1 billion and total debt of only $12 billion. Operating cash flow now tops $18 billion annually, easily supporting the firm’s financial obligations, while the broad diversity of revenue across different products and countries translates into a very reliable dividend.
Growth, however, has become much more challenging in recent years. Although per-share earnings have continued to expand, revenue has stagnated in the low $60 billion range. Last year’s 3% drop in sales was the first annual decline since 1932. Not only has J&J had several patent expirations to contend with, but pressures on consumer spending worldwide have been so great that even some health-related expenditures have been delayed or forgone because of economic stress. The dividend has continued to rise, but the growth rate has fallen from a roughly 15% annual clip prior to 2005 to just 6.5% in 2009 and 10.2% this year.
Worst of all, a series of highly publicized product recalls have hurt sales for J&J’s consumer product unit and damaged what was a sterling reputation around the world. Whether this was merely a lack of oversight or the product of overly aggressive cost-cutting, investors may question the ability of management to maintain the firm’s historically top-rate performance.
As J&J’s growth has slowed, the valuation of the stock has contracted. The price/earnings ratio dropped from 31 in 2000 to 18 in 2005; based on management’s outlook for earnings in 2010, the stock is currently trading at a p/e of 13.5. However, this may be the most hopeful sign for future returns.
With a current dividend yield of 3.4%, J&J’s valuation no longer expresses an expectation of double-digit growth that probably isn’t attainable anyway. Based on a mid-single-digit growth rate for revenue—which, at about nominal GDP, is far less than past performance—and continued share repurchases, we estimate J&J can increase its dividend rate at an average annual pace of 8% over the next five years. The next increase (likely to be announced in April) may fall a bit short after a weak 2010, but we believe the strength and diversity of the company’s finances and competitive position will allow J&J shares to generate better returns going forward.
[Though drug stocks have badly lagged the market of late, they’ve retained their supporters. Paul Justice and Robert Goldsborough recently recommended a health-care fund that lists Johnson & Johnson as its largest holding. In contrast, Michael Shulman is betting against the top drug makers, on expectations that cost-cutting governments will push for even bigger discounts on medicines.—Editor]
