Johnson & Johnson: Best-In-Class Dividend Growth Stock

Johnson & Johnson (JNJ) has raised its dividend for 57 consecutive years and thus it is a Dividend King. Thanks to the strength of its brands and its solid growth trajectory, it has always been a slow-moving stock. However, the stock has been facing a series of litigation issues since December and hence it has entered a remarkably volatile period. As a result, it has shed 6% in the last week and is now trading 12% lower off its peak, in December. The big question is whether the stock has become a bargain.

Business overview

Johnson & Johnson is an outstanding company. It has grown its operational earnings for 35 consecutive years and its dividend for 57 years in a row. The company has 26 brands/platforms that generate more than $1 billion in annual sales, with 14 of them generating more than $2 billion in annual sales.

Source: Investor Presentation

Johnson & Johnson generates approximately 70% of its sales from the Nr 1 or 2 position. It is also the Nr 5 in the U.S. and Nr 8 globally in R&D investment. Thanks to this leading position, it currently generates about 25% of its sales from products that were introduced in the last five years. This is an impressive accomplishment for a mature company that has a market capitalization of $348 billion, which reassures investors that management never rests on its laurels; instead it continuously tries to keep the company in its enviable, multi-decade growth trajectory.

Growth prospects

Johnson & Johnson is well-known for its consumer products but the main growth driver of the company is its pharmaceutical segment, which generates about half of the total revenues. The consumer segment has stumbled in the last two years, as it has become very easy to launch a new product online and market it at a minimum cost via social media. This is reflected in the performance of this division, which grew its revenue by only 2% last year. Moreover, the medical device segment grew its revenue by only 1% last year whereas the pharmaceutical segment achieved 12% revenue growth. A similar trend was observed in the first quarter of this year as well.

It is thus evident that Johnson & Johnson relies primarily on its pharmaceutical business to keep growing its earnings at a meaningful pace. Indeed this segment has exciting growth prospects ahead. In the first quarter, it posted 8% revenue growth mostly thanks to strong uptake of Stelara in Crohn’s disease and market share gain of Darzalex in the U.S., Europe, Japan and Latin America, as well as strong momentum of Imbruvica. These brands will continue to drive growth in the upcoming years thanks to increased penetration.

Moreover, Johnson & Johnson expects up to 10 major launches over the next three years. Each of these launches is expected to generate more than $1 billion in annual revenues. Furthermore, the acquisition of Actellion, which cost $30 billion, is likely to provide another source of growth. Thanks to all these growth drivers, management expects to grow the operational earnings per share by 5.7%-7.6% this year and will continue growing them at a significant rate in the upcoming years.

Dividend

Johnson & Johnson has raised its dividend for 57 consecutive years and thus it is a dividend king. It has been able to achieve such an impressive dividend growth streak thanks to its consistent earnings growth record. The company has grown its operational earnings for 35 consecutive years. These growth streaks are impressive, particularly given the intense competition in the pharmaceutical business and the shocks in the cash flows that are sometimes caused by the expiration of patents.

Moreover, the company has a low dividend payout ratio, which stands at 42%, and a pristine balance sheet. Given also its promising growth prospects, Johnson & Johnson is likely to continue raising its dividend for several more years. Therefore, investors can purchase the stock at its current 2.9% dividend yield and rest assured that the dividend will keep rising for the foreseeable future.

Litigation issues

Johnson & Johnson has been facing a series of litigation issues in the last six months. Last week, the stock plunged 6% on a single day, as it was found to have a role in the opioid epidemic in Oklahoma. In addition, in early May, Johnson & Johnson agreed to pay approximately $1 billion to settle a group of lawsuits that accused the company of selling defective metal-on-metal hips that eventually failed. The settlement cleared 95% of the ~6,000 cases but there are still ~4,500 lawsuits from patients who received artificial hips that were not made entirely of metal. Nevertheless, if these pending lawsuits are eventually settled at a similar price to the above, they will not have a significant effect on Johnson & Johnson.

The greatest risk facing Johnson & Johnson is the issue with its baby power (Talc). In December, the company was reported to have been aware that its baby powder contained asbestos, which is carcinogenic. According to the report, an external lab notified the company of this issue as early as 1957. Johnson & Johnson has rejected the allegations, stating that studies of more than 100,000 people have shown that its baby powder is not carcinogenic. Moreover, the company resumed its talc production in many Asian countries early this year, when its product was analyzed and no asbestos was found in the product.

Nevertheless, while the company will do its best to defend its product, the risk has not disappeared. In fact, as there are about 12,000 pending lawsuits related to the presence of asbestos in the baby powder, the financial impact on the company could be huge. To provide a perspective, a jury in California awarded $29 million to a woman who claimed that talc caused her cancer. If all the pending lawsuits had a similar fate, Johnson & Johnson would have to pay $348 billion (12,000 times 29 million) and thus its entire market capitalization would evaporate. Of course this is an extreme scenario, only for indication purpose. If the company ended up paying 10% of the above amount ($35 billion), its stock would temporarily plunge but the company would easily pay that amount within a few years thanks to its AAA credit rating, its $33.8 billion of cash and receivables and its ~22 billion of earnings per year.

Overall, the pending lawsuits have increased the stock price volatility of Johnson & Johnson and may cause a plunge of the stock in the future, in the event of negative developments. However, we are confident that these headwinds will not affect the long-term growth trajectory of the company. We thus view the recent correction as an investing opportunity.

Valuation

Johnson & Johnson is currently trading at a price-to-earnings ratio of 15.3, which is slightly lower than its 10-year average of 15.8. The cheap valuation has partly resulted from the litigation risk facing the stock. It is remarkable that the stock has a much cheaper valuation than the other well-known dividend aristocrats, such as Procter & Gamble (PG) and Colgate-Palmolive (CL), mostly due to its reliance on its pharmaceutical business, which is perceived as risky by the market. However, given the consistent growth record of Johnson & Johnson and its exciting growth prospects, we find its current valuation attractive, particularly given the rich valuation of the broad market after a decade-long bull market.

Final thoughts

Johnson & Johnson has incurred a correction in the last six months, mostly due to its pending litigation risks. However, while these risks are material, we view them as temporary headwinds. The pharmaceutical giant has an enviably consistent growth record and ample room to keep growing for many more years. As a result, investors focused on high-quality dividend stocks will find Johnson & Johnson stock to be a strong holding.

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