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Johnson & Johnson (JNJ)

Johnson & Johnson lost a $4.7 billion lawsuit in July 2018, and the liability could grow. Read our thoughts on J&J's recent lawsuit issues here (July 25, 2018).

Founded in 1885, Johnson & Johnson is the world’s largest medical conglomerate. With more than 250 subsidiaries operating in over 60 countries, Johnson & Johnson’s three major business units provide it with a very diversified mix of revenue, earnings, and cash flow.

Here are the company’s operating 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 more than a dozen mega-brands (over $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.
Source: J&J Investor Presentation

Business Analysis

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 only 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.

With more than 50 consecutive years of dividend increases under its belt, Johnson & Johnson is a great example. 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.

Very few businesses ever come close to growing as large as Johnson & Johnson has become with more than $70 billion in annual revenue.

However, J&J’s management team is very focused on investing only in markets that the company can dominate. Today, approximately 75% 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.

The company also boasts that 22% of its sales are from new products launched in the past five years. With more than $70 billion in annual revenue, that means J&J successfully commercialized over $15 billion of new products in five years, or more than $3 billion per year. Such results are a testament to Johnson & Johnson’s innovation, R&D processes, brand strength, and scale advantages.

Each of the company’s three operating segments is driven by different factors, with the consumer business providing the most 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.

The company's long operating history and substantial resources have helped it develop over 20 brands with more than $1 billion in annual sales, including well-known consumer brands Neutrogena, Johnson's, and Listerine. The company's smaller consumer brands also enjoy strong market positions: 
Source: J&J Investor Presentation
The off-patent nature of these consumer products means that they generally cost very little for Johnson & Johnson to produce on an industrial scale, providing excellent cash flow each year.

Johnson & Johnson's consumer products are also advantaged thanks to the company's size, which allows it to invest large amounts of advertising behind its strongest and most profitable brands. As a result, the company enjoys strong pricing power that has helped its consumer products sales outpace the 3% to 4% growth rate of the addressable market over the last five years.

The global consumer products market is a massive $350 billion in size (compared to J&J's consumer sales of less than $15 billion), which means that this stable business unit has plenty of runway left and should continue providing steady funding for the company’s high-margin, faster-growing pharma business.

When it comes to pharmaceuticals and medical equipment, J&J's other two segments, 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 upwards of $2 billion per drug), especially compared to past decades.
Sources: Scientific American, Tufts Center For The Study Of Drug Development

The Pharmaceutical Research and Manufacturers of America organization has also noted that only two out of every 10 marketed drugs actually generate enough in sales to at least cover their R&D costs. Increased safety concerns and government regulations add further challenge to competing successfully in this industry.

Thankfully, Johnson & Johnson’s enormous scale allows it access to one of the industry’s largest R&D budgets, $7 billion in 2016, or more than 20% of total pharma revenue. This funds the company’s strong drug development pipeline of more than 35 medications, including more than 10 potential blockbusters ($1 billion+ in annual sales) that are expected to hit the market through 2021.

The company's effective pharma R&D has helped it gain approval for more new molecular entities than any other company from 2011 to 2016, and it also boasts the most $1 billion+ drugs of any business in the world. Even better, the company's success is not overly concentrated in any single drug or treatment area, which reduces volatility. Remicade is the company's largest drug and accounts for less than 20% of pharma sales and under 9% of company-wide sales. 

Simply put, J&J's pharma segment is a proven, well-oiled machine with a solid pipeline and a nicely diversified drug portfolio. An aging global population, increased pace of FDA approvals of new molecular entities, and growing wealth in emerging markets should all help drive the $1.5 trillion pharma market higher over the coming years (the branded pharma market segment is expected to grow 5% annually). 

Thanks to its wide moat, Johnson & Johnson enjoys above average profitability with operating margins north of 25%. The company's strong profitability profile is also due to J&J’s history of good capital allocation decisions. Specifically, management has done a great job of balancing capital returns to investors, primarily through its dividend, against investing in the company’s growth via acquisitions.
Source: J&J Investor Presentation
That includes both smaller, bolt-on acquisitions to grow its consumer products segment, as well as larger, needle-moving pharma deals, such as J&J's 2017 acquisition of Actelion for $30 billion

Actelion is 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 large acquisitions don't always work out, 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 growth investors for years to come.

Key Risks

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 (approximately 9% of company-wide sales).

Remicade's 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.

In other words, 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 that lose patent protection.

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, as previously mentioned, Johnson & Johnson’s drug portfolio is fairly diversified, with Remicade representing its largest drug by far with $7 billion in sales last year (8.6% of J&J’s year-to-date total revenue). However, its next two largest drugs account for only 5.2% and 3.3% of company-wide revenue.

Longer-term, however, J&J will rely on its drug development pipeline of more than 35 medications, including 12 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.

Another risk comes from 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+ platforms, giving it a leg up on smaller rivals.

Finally, the very geographic diversification that helps make J&J 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.

Closing Thoughts on Johnson & Johnson

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 (AAA credit rating), recession-resistant products, and solid long-term growth runway.

J&J seems most appropriate for dividend investors looking for extremely safe current income from a stock that will almost certainly let them sleep well at night. The company’s scale, product breadth, cash flow generation, R&D budget, and geographic diversification seem likely to keep the company relevant for decades to come. 

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