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Is Johnson & Johnson a Buy?

- By Ben Reynolds

Most dividend growth investors are likely aware of health care giant Johnson & Johnson (JNJ). The company is widely considered to be one of the best stocks for dividend growth.

The company has increased its dividend for 57 consecutive years. Johnson & Johnson is a member of the Dividend Aristocrats, an elite group of 57 stocks in the S&P 500 Index with at least 25 years of annual dividend increases.

Even more impressive, the company's nearly six decades of dividend growth qualify it as a member of the Dividend Kings. Membership in this group is even more exclusive as there are only 24 such companies with at least 50 years of dividend growth.

Past performance is no predictor of future results. Despite the company's rightful place as one of the great dividend growth stories of all time, is Johnson & Johnson a buy?

Company background and recent news

Johnson & Johnson is a diversified health care company composed of three segments: pharmaceuticals (representing approximately 49% of annual sales), medical devices (34% of sales) and consumer products (17% of sales). The company was founded in 1886 and today has more than 125,000 employees around the world. It trades with a market capitalization of $348 billion and generates annual revenues of more than $81 billion.

Johnson & Johnson's stock has been more volatile than usual in recent months following a Dec. 14 report that the company's baby powder was contaminated with asbestos. The report found the company may have known about this issue as far back as 1971. As a result, it is facing approximately 12,000 product liability lawsuits related to its baby powder, though the company has said that its talc powder has not been the cause of cancer in these cases.

Several large verdicts have been awarded to plaintiffs in these cases, with the most recent resulting in a total $325 million decision in favor of a plaintiff who blamed her rare asbestos-related cancer on the company's talc-based products. As with most of these verdicts, Johnson & Johnson will appeal.

In addition, the company has been named a defendant in a court case in Oklahoma dealing with the opioid crisis in that state.

These headline issues have impacted the stock. Shares of the company are down 1.6% year to date, while the S&P 500 has gained almost 10%.

Recent financial results

The headline news regarding the company has distracted investors from Johnson & Johnson's financial results. Released on April 16, the company's first-quarter results were positive. Earnings per share totaled $2.10, topping estimates by 6 cents and improving 2% from the previous year. Revenue of $20 billion was essentially flat, but beat the average analyst estimate by $473 million.

Pharmaceuticals remain the primary contributor to the company's revenue growth as this segment grew 4.1% to $10.2 billion. On a reported basis, the immunology portfolio grew 7% while oncology was 9% higher. Stelara, which treats immune-mediated inflammatory diseases, had revenue growth of 36%. Growth was due to higher rates of uptake in Crohn's disease. Stelara is Johnson & Johnson's top-selling product. Sales of Darzalex, which treats multiple myeloma, grew 46% year over year as the product took market share in the U.S. and Europe.

The medical device division produced $6.5 billion in revenue, which was a decline of 4.6% from the previous year. Weakness in orthopedics was the main cause of the decline. Stryker Corp. (SYK), with its Mako robot, has placed immense competitive pressure on the rest of the knee replacement industry. Johnson & Johnson did see growth in the area of hips. Interventional solutions grew 14.3% due to a strong gain of 18.5% in electrophysiology.

Revenues for the consumer division declined 2.4% to $3.3 billion. Wound care, baby care, women's health and oral care more than offset gains in over-the-counter and beauty segments. In OTC, Tylenol expanded its market share and is now the top-selling branded adult painkiller in the U.S. Neutrogena's new product innovation helped drive growth for beauty. Competitive pressures and destocking of products ahead of new launches were the main causes of declines in the other segments within consumer.

Valuation and expected returns

Johnson & Johnson expects to earn between $8.53 and $8.63 per share in 2019. Achieving the midpoint of this guidance would represent nearly 5% growth from 2018.

The company has averaged nearly 6% earnings per share growth over the last decade. We anticipate Johnson & Johnson will be able to maintain this growth rate through 2024 due to increases in revenue, largely from the pharmaceutical division.

Shares of the company closed Friday's trading session at $131. Using the midpoint for earnings per share guidance for the year, the stock trades with a price-earnings ratio of 15.3. The stock has an average price-earnings ratio of 15.8 over the last decade. Therefore, we don't expect an expanding valuation to be a meaningful contributor to total returns over the next five years.

As stated above, Johnson & Johnson has a long and storied dividend growth history. The company has increased its dividend:

  • By a compound annual growth rate of 4% over the past three years.
  • By a CAGR of 5.1% over the past five years.
  • By a CAGR of 6.3% over the past 10 years.

The company raised its dividend by 5.6% for the upcoming June 11 payment. The annualized dividend payment of $3.80 represents an earnings per share payout ratio of just 44%, which is slightly less than the 10-year average payout ratio of 47%.

Some investors prefer to use free cash flow as a measure of dividend safety. Johnson & Johnson generated $3.54 billion in cash flow from operating activities in the first quarter of fiscal 2019 and spent $656 million on capital expenditures, resulting in free cash flow of approximately $2.9 billion. The company distributed $2.4 billion in dividends during the same period for a free cash flow dividend payout ratio of 83%.

Looking out over a longer time horizon, the company's payout ratio is in a much better position. Johnson & Johnson generated $22.2 billion in cash flow from operating activities in fiscal 2018 and spent $3.67 billion on capital expenditures for free cash flow of approximately $18.5 billion. The company distributed $9.5 billion in dividends during the same period for a free cash flow dividend payout ratio of 51%.

Using either earnings per share or the long-term free cash flow, the company's dividend appears very safe.

Based off the new annualized dividend, Johnson & Johnson's stock yields 2.9%, which compares very favorably to the average 2% yield of the S&P 500.

Annual returns will consist of the following:

  • 6% earnings per share growth.
  • 2.9% dividend yield.

We expect shares of Johnson & Johnson can offer a total annual return of nearly 9% through 2024.

The bottom line

There is little question that Johnson & Johnson offers one of the best dividend growth streaks in the market. Nearly six decades of dividend growth prove the company has been able to experience multiple economic cycles and still continue to increase payments to shareholders.

Lawsuits linking the company's baby powder to cancer have impacted the stock over the past several months. Headline news is likely to continue given that Johnson & Johnson has also been sued over its role in the opioid epidemic. Given the company's size, however, we don't expect either issue to have a meaningful long-term impact on the company.

Still, we reserve buy recommendations for stocks offering at least 10% total annual returns through 2024. Shares of Johnson & Johnson sit below this threshold, causing the stock to receive a hold recommendation. That said, on a further pullback, the stock will be a buy.

Disclosure: No positions in any stocks mentioned.

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This article first appeared on GuruFocus.