Certain dividend aristocrats and dividend kings can make excellent core holdings for a long-term dividend growth portfolio.
With predictable and steadily growing business models, these companies have not only stood the test of time in all manner of economic environments, but they have also proven to have shareholder-friendly corporate cultures.
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And when it comes to dividend growth legends, they don’t get much better than Johnson & Johnson (JNJ), which has rewarded dividend investors with a remarkable 55 years of consecutive payout growth.
Let’s take a look at this blue chip stock to better understand its durability and learn if it might make sense to add shares of Johnson & Johnson to a diversified dividend portfolio today, especially for investors living off dividends in retirement.
Founded in 1885 in New Brunswick, New Jersey, Johnson & Johnson is the world’s largest medical conglomerate. In fact, with over 250 subsidiaries operating in over 60 countries, Johnson & Johnson’s three major business units provide it with well diversified and consistent sales, earnings, and free cash flow (FCF).
Here are the company’s three segments:
Pharmaceuticals (47% of 2016 sales; 62% of pretax profit): dozens of patented drugs and vaccines to treat oncology, cardiovascular, immunological, neurological, infectious diseases, and diabetes. Remicade, a treatment for a number of immune-mediated inflammatory diseases, is Johnson & Johnson’s largest drug and accounted for 9.7% of company-wide revenue in 2016.
Medical Devices (35% of 2016 sales; 26% of pretax profit): surgical, orthopedic, endomechanical (i.e. hip replacements), and sterilization equipment.
Consumer Products (18% of 2016 sales; 12% of pretax profit): over-the-counter consumer medical and beauty products including over a dozen mega-brands ($1 billion+ in annual sales) such as Johnson & Johnson, Neutrogena, Splenda, Listerine, Tylenol, Motrin, Sudafed, Band-Aid, Aveeno, Pepcid, Benadryl, and Zyrtec
In addition to diversification by product type, Johnson & Johnson also offers investors broad international exposure to faster-growing emerging markets such as Asia and South America.
One of the keys to long-term success in dividend growth investing is purchasing shares of companies that have a stable, growing, and predictable business model. In addition, it’s important for a company to have a a number of durable competitive advantages.
That allows a business to not just grow steadily over time, but also maintain strong profitability and returns on shareholder capital. As a result, these types of companies can leverage their slow but steady top line growth into faster earnings growth, fueling consistent dividend raises over time.
Johnson & Johnson is a great example. You can see that the firm has earned a strong and steady return on capital near 20% for most of the last decade while generating mid-single-digit sales growth and a steady rise in earnings and free cash flow per share over time.
What competitive advantages have enabled Johnson & Johnson to record such impressive fundamentals?
Well the pharmaceutical industry is highly capital intensive, as well as notoriously competitive, with drugs going off patent and rival drug makers launching numerous drugs to steal market share.
Thus J&J’s wide moat is created by two factors, its enormous size and the economies of scale that go with it, as well as its strong consumer name brand products; most of which are the top brand in their respective field.
Very few businesses ever come close to growing as large as Johnson & Johnson has become with more than $70 billion in annual revenue.
However, Johnson & Johnson’s management team is very focused on investing only in markets that the company can dominate. Today, over two-thirds of J&J’s sales are from #1 or #2 global market share positions, and management has shown a willingness to divest underperforming or non-core parts of the business over time.
Each of the company’s three operating segments are driven by different factors as well, with the consumer business providing predictable cash flow to fund growth in pharmaceutical investments. This diversification further adds to J&J’s resilience to economic cycles and helps fund innovation and acquisitions.
In fact, the company has developed over 20 brands with more than $1 billion in annual sales, including a number of leading consumer products:
This gives J&J a big advantage because the off-patent nature of these products means that they generally don’t face high levels of competition and cost very little for Johnson & Johnson to produce on an industrial scale.
However, because of its well-known brands, the company has stronger pricing power that allows its recession-resistant sales to grow at a moderate pace as they continue to gain market share.
That’s because of another advantage Johnson & Johnson has due to its size – the ability to put large amount of advertising behind its strongest and most profitable brands. In fact, over the past five years, J&J’s consumer products sales have outpaced the 3% to 4% growth rate of the addressable market.
Johnson & Johnson Consumer Products Sales Growth
And given that the global consumer products market is a massive $350 billion in size, that means that this highly stable business unit has plenty of growth runway left and can continue providing dependable funding for the company’s high-margin pharma business.
When it comes to pharmaceuticals and medical equipment, large and efficient use of R&D spending is the key to long-term success. That’s because the cost of bringing a new drug through the FDA’s three-stage testing procedure is monstrously expensive and time consuming (as long as 12 years and costing $1.7 billion per drug), especially compared to past decades.
Thankfully, Johnson & Johnson’s enormous scale allows it access to one of the industry’s largest R&D budgets, $9.1 billion in the past 12 months, or about 13% of revenue. That is partially funding the company’s strong drug development pipeline of more than 35 medications, including 10 potential blockbusters ($1+ billion in annual sales) that are expected to hit the market through 2021.
The bottom line is that because of its wide moat, Johnson & Johnson enjoys above average profitability, including a very strong FCF margin that is ultimately what secures and grows the dividend.
This strong profitability profile is also due to JNJ’s history of good capital allocation. Specifically, management has done a good job of balancing capital returns to investors, primarily through its dividend, against investing in the company’s growth via acquisitions.
That includes both smaller, bolt-on acquisitions to grow its consumer products segment, as well as larger, needle-moving pharma deals.
For example, Johnson & Johnson recently made the following purchases to strengthen its medical devices segment:
- Abbott Medical Optics for $4.325 billion
- Electrosurgical tool maker Megadyne Medical Products
- Torax Medical, which makes an acid reflux management system
- Neuravi Limited, maker of advanced vascular devices for treatments of strokes
And then of course was there’s the recent $30 billion purchase of Actelion, a leading pulmonary hypertension drug maker. Johnson & Johnson paid for this deal with its overseas cash reserves, and management expects the deal to ultimately result in long-term top and bottom lines sales growth acceleration of 1% and 1.5% to 2%, respectively.
While I am generally not a big fan of large acquisitions, Johnson & Johnson’s management team deserves the benefit of the doubt. J&J is no stranger to large deals (the company bought orthopedic products business Synthes for $20 billion in 2012 and acquired Pfizer’s consumer health care business for $17 billion in late 2006) and has acquired more than 100 companies over the past 20 years.
Combine this strong track record of disciplined acquisitions with the secular trend of a growing and fast-aging global population, and Johnson & Johnson has a strong growth runway to continue enriching dividend lovers for years to come.
No company is without risk, not even Johnson & Johnson.
Despite its diversification, much of the company’s profits are still derived from patented medications, whose patents will eventually expire. For example, take a look at Johnson & Johnson’s largest drug, Remicade (9.7% of company-wide sales).
Its European patents expired in 2015, and its two sets of U.S. patents expire in 2018 but have already faced real challenges. In fact, Pfizer (PFE) gained approval to begin shipping a biosimilar in November 2016 that competes with Remicade, which is expected to reduce U.S. sales of the drug.
This means that J&J’s most important business unit (in terms of profits and growth) is stuck on a kind of hamster wheel, in which new acquisitions and drug development is being largely offset by declining medication market share from legacy drugs.
And speaking of new drugs, it’s important to realize that even the most promising potential breakthroughs might fail to achieve FDA approval. In fact, only one in 5,000 new potential drugs ends up making it to market, which explains why pharmaceuticals and biotech is such an unpredictable industry.
Indeed, the nature of the pharma industry can create some volatility. Pharma companies spend years and hundreds of millions or even billions of dollars developing a drug.
If the drug is one of the lucky few that gains FDA approval, the pharma company can rely on patents and IP rights to gain a nice return on the heavy R&D investment (R&D is typically 15-20% of pharma companies’ revenues) needed to bring the product to market. PWC’s chart illustrates this long cycle:
Once a patent expires, competition from cheaper generic drugs enters the market, taking share and creating price pressure.
As a result, a drug’s revenue follows a bell curve pattern and requires the pharma company to consistently invent new drugs to replace revenue losses due to patent expiry. Depending on the size of the drug, this is not always an easy task and pipeline disappointments can be a risk.
The following chart, courtesy of Statista, highlights the revenue curve of Lipitor from 2003-2016. You can see that sales dropped from $12.4 billion to $2.3 billion in just five years.
Fortunately, Johnson & Johnson’s drug portfolio is fairly diversified, with Remicade representing its largest drug by far with $7 billion in sales last year (close to 10% of JNJ’s total revenue). However, its next two largest drugs account for only 4.5% and 3.2% of company-wide revenue.
Longer-term, however, J&J will rely on its drug development pipeline of more than 35 medications, including 10 potential blockbuster drugs, to keep growing its pharma business. Its acquisition of Actelion, while not without risk, will also give it firepower to offset future Remicade declines.
Next there’s the ever present threat of regulatory changes, either in government healthcare spending (changes in Medicare or Medicaid) or in drug pricing. For example, the Trump administration has promised to clamp down on high drug prices by allowing Medicare to negotiate bulk drug prices, which up until now it has been prevented from doing.
Ongoing consolidation among health systems and insurance providers have also challenged the pricing environment for Johnson & Johnson’s medical devices business in recent years. However, this business segment is still #1 or #2 in the majority of categories in which it competes and has a number of $1 billion plus platforms, giving it a leg up on smaller rivals.
Finally, the very geographic diversification that helps make JNJ such a safe investment can also result in temporary growth headwinds. That’s because a strong U.S. dollar means that when it comes to reporting results (and paying dividends in U.S. dollars), local currencies can be worth less, eating into Johnson & Johnson’s top and bottom line growth.
For example, in 2016 the strong U.S. dollar (which could get stronger as interest rates rise) decreased JNJ’s overall sales growth by 33%.
Johnson & Johnson’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Johnson & Johnson has a Dividend Safety Score of 98, meaning it’s payout is among the safest on Wall Street. That’s not surprising given the company’s incredible streak of raising its dividend for 55 straight years, making it one of just 22 dividend kings in the S&P 500.
This amazing consistency is courtesy of two key factors. The first of which is the company’s extremely stable and recurring cash flow, courtesy of its recession-resistant products. In fact, the company’s sales and EPS declined just 3% and 4%, respectively, in fiscal year 2009 while management raised the dividend by more than 5%.
In addition, management has taken a very disciplined and long-term view towards safeguarding the growing payout. Specifically, the company’s EPS and FCF payout ratios have historically been limited to moderate levels, in which the dividend consumes only 30% to 60% of EPS and FCF per share.
This helps ensure that the company has plenty of resources to reinvest in the business and service its debt while continuing to pay dividends throughout almost any type of economic environment.
And speaking of debt, that’s the other important protective factor supporting Johnson & Johnson’s dividend. That’s because an overly leveraged balance sheet can reduce the financial flexibility of a healthcare giant such as JNJ, which is constantly acquiring peers to help its growth.
Fortunately, Johnson & Johnson’s balance sheet is pristine. In fact, it is only one of two companies (the other being Microsoft) whose credit rating is AAA, higher than even that of the U.S. Treasury.
That’s understandable when we consider JNJ’s net cash position (over $12 billion), its very strong current ratio (short-term assets/short-term liabilities), and the enormous amount of free cash flow it generates.
And when we compare Johnson & Johnson’s credit metrics against those of its peers, things look even better. For example, the company’s leverage ratio (debt/EBITDA) is much lower than the industry average, with a much lower debt/capital ratio, and a high interest coverage ratio.
In other words, JNJ’s highly disciplined approach to debt gives it some of the greatest and lowest cost access to debt of any company on Wall Street. This allows it to sell 20-year bonds that pay as little as 1.65% interest and helps maximize the company’s long-term ability to keep growing while providing safe and steadily increasing dividends.
Johnson & Johnson’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
JNJ’s dividend Growth Score of 70 indicates that investors can likely expect better than average (relative to the S&P 500’s 20-year median payout growth of 5.7%) dividend growth going forward. Again, this isn’t surprising given the company’s healthy payout ratios, numerous growth opportunities, and excellent track record of moderately growing dividends for more than half a century.
You can see that Johnson & Johnson’s annual dividend growth has slowed a bit over the last 20 years but has remained at a solid 7% pace over the last five years.
Of course, given the company’s large size, JNJ’s investors should have no illusions about this dividend king being a high-growth stock. That means that double digit dividend growth, such as occurred over the past two decades, isn’t likely to be repeated.
However, JNJ’s strong growth runway should allow for long-term organic growth (excluding acquisitions) of 3% to 4%. Ongoing acquisitions could boost top line sales growth to 4% to 5%, which combined with steady share buybacks (1.2% annually over the past five years) and increasing margins (from ongoing cost cutting), should make 6% to 8% annual earnings per share growth achievable.
And since JNJ’s payout ratios are now in sweet spot of balancing dividend security, growth, and the company’s financial flexibility, investors can likely expect long-term dividend growth of 6% to 8% per year as well.
Over the past year, Johnson & Johnson has basically matched the market’s strong run. However, today’s valuation might be a bit rich.
For example, JNJ’s forward P/E ratio of 19 is both slightly higher than its historical median of 17.7, as well as the S&P 500’s current forward PE of 17.8.
Meanwhile, while JNJ’s 2.5% dividend yield is certainly better than the S&P 500’s 1.9%, it’s only slightly higher than the stock’s 22-year average yield of 2.3%. In fact, over the past two decades JNJ’s yield has traded above the current amount 55% of the time.
In other words, while today’s share price may not be obviously expensive, if you’re willing to wait for a correction, you may be able to achieve a more attractive entry point.
If you choose to buy JNJ today and the stock’s valuation multiples remain constant over time, then you can likely expect long-term total returns of around 8.5% to 10.5% (2.5% yield + 6% to 8% annual earnings growth).
When it comes to buy-and-hold forever dividend growth stocks, they don’t get much better than Johnson & Johnson thanks to its extremely secure payout, outstanding dividend growth track record, unbeatable balance sheet, recession-resistant products, and solid long-term growth runway.
That being said, all of these factors appear to be priced into the stock today, meaning that, while JNJ has the qualities to be a core part of a conservative retirement portfolio, investors looking to open or add to an existing position might want to wait for a correction.
Income investors seeking more yield can review some of the best high dividend stocks here while they wait.