Johnson & Johnson: One Of The World’s Safest Stocks Could Return +10% Per Year

Summary:

• The Fed’s potential rate cuts are causing concern in the market, as it could lead to higher inflation and negatively impact stocks.
• Johnson & Johnson is a safe investment option with a history of consistent income and extreme financial safety.
• JNJ’s recent performance, positive business developments, and long-term growth prospects make it a compelling investment for conservative investors.

Introduction

“What’s the Fed going to do?” may be the single most important question this year.

If we were to ask the market, it would tell us that the Fed will cut rates six times this year.

While Fed Funds Futures, the tool used to arrive at this estimate, are highly volatile, I believe the fact that six cuts are now the consensus estimate worries me a bit.

After all, if inflation remains elevated, the Fed will have to keep rates higher for longer, causing markets to price in the impact this could have on the economy.

The same goes for stocks. If markets were to price in higher inflation, they may have to sell bonds again, which is bad news for stocks.

This is what Bloomberg’s John Authers wrote in a recent opinion piece:

For the MSCI World, the proportion is the highest this century, and the share of S&P 500 stocks is even higher. The implication is that a renewed rise in bond yields, which might easily happen if inflation data prove disappointingly strong, could have a horrible effect on the stock market, whacking it back down as Reverse Goldilocks takes over:

Hence, it doesn’t help that some Fed officials pushed back against the notion of an imminent policy move.

Powell, in a press conference, mentioned it was premature to declare victory, emphasizing the need to monitor data and developments, which aligns with my thesis.

We also should be aware that financial conditions haven’t been this loose since the start of the Ukraine invasion, which means if the Fed wants to step up its fight against inflation, it will have to do some damage.

I’m not making the case that the Fed is on a path to full economic destruction to achieve its targets, but recent trends validate my call to focus on safety, meaning buying companies with strong business models and healthy balance sheets.

That’s where Johnson & Johnson (NYSE:JNJ) comes in.

I started covering the stock on September 17, 2023, when I called the stock 20% undervalued.

In this article, I’m updating my thesis by focusing on favorable business developments, top-tier financial health, and the potential to generate annual total returns exceeding 10%.

So, without further ado, let’s get to it!

Consistent Income & Extreme Safety

Going back to the late 1990s, JNJ shares have returned roughly 650%, beating the S&P 500 by more than 100 points. The Health Care Sector ETF (XLV) returned more than 730% during this period.

Over the past ten years, JNJ has returned 130%, which lags both the S&P 500 and the XLV Healthcare ETF by a considerable margin.

While I will explain in this article why I expect JNJ to show better returns in the future, investors still benefited from two major tailwinds during the past decade (and decades before that):

• Consistently rising income
• Extreme financial safety

Founded in 1886, the same year when the Statue of Liberty was dedicated, JNJ has a history of 61 consecutive annual dividend hikes, which makes it one of the few dividend kings in the United States.

The company currently pays $1.19 in quarterly dividends per share, which translates to a yield of 3.0%.

• This dividend is more than twice as high as the S&P 500’s 1.4% yield.
• The Vanguard Dividend Appreciation ETF (VIG) yields 1.9%.

This dividend is protected by $9.93 in expected 2023 earnings per share, which translates to a payout ratio of 48%. In 2024, EPS is expected to grow by 7.4%, which bodes well for dividend safety and potential dividend growth.

JNJ’s most recent dividend hike was on April 18, 2023, when it hiked by 5.3%.

The five-year dividend CAGR is 5.8%, which is very fair for a company this mature with a yield of 3.0%.

Furthermore, the dividend is protected by $23 billion in expected 2024 free cash flow. This translates to 5.9% of its $388 billion market cap and a 51% payout ratio.

This brings me to its financial safety. Its ability to generate a lot of post-dividend free cash flow is one of the reasons why its balance sheet is so healthy.

The company is expected to turn $5.1 billion of 2023E net debt (that’s just 0.2x EBITDA!) into $4.0 billion in 2024E net cash, meaning it is expected to have more cash than gross debt on its balance sheet.

As a result, the company has a triple-A credit rating, which is one of the best ratings in the world.

This means the company has a better credit rating than a lot of developed nations, including the United States, the European Union (technically not a country), Australia, Finland, France, and others!

I’m obviously not making the case that the United States of America is more likely to go bankrupt than Johnson & Johnson, but it is still important to put things into perspective, as a AAA rating is truly remarkable.

Why I’m Bullish On JNJ’s Future

There’s a case to be made that JNJ is out of the woods, at least when it comes to underperforming its peers during the past decade.

Using the data in the chart below:

• JNJ shares are currently trading at a blended P/E ratio of 16.2x.
• Its five-year normalized valuation is 17.7x.
• The 20-year normalized valuation is 16.8x.
• I believe 17.7x is warranted, as JNJ is expected to report improving earnings.
• In 2024, EPS is expected to rise by 7%, followed by 5% expected growth in 2025 and 3% growth in 2026.
• Note that both 2024 and 2025 estimates have been reduced by roughly 3% over the past six months. Longer-term estimates have slightly improved.

If the company returned to a 17.7x valuation, it could return 10% per year, including its dividend.

Since 2009, JNJ shares have returned 10.4% per year.

These assumptions are backed by positive company developments.

For example, in its third quarter, Johnson & Johnson reported a stellar performance, with worldwide sales reaching an impressive $21.4 billion.

This marked a substantial increase of 6.8% compared to the same quarter in 2022.

The U.S. market proved to be a stronghold for Johnson & Johnson during Q3, experiencing an 11.1% growth in sales.

As a result, net earnings for Q3 amounted to $4.3 billion, with diluted earnings per share at $1.69. Adjusted net earnings increased by 14.1% to $6.8 billion, and adjusted diluted earnings per share rose by 19.3% to $2.66.

These figures highlight not only the financial robustness but also the efficiency in managing costs and optimizing profitability.

Adding to that, one of my favorite segments, MedTech, witnessed an impressive 10% sales increase, reaching $7.5 billion.

The U.S. market saw growth of 11.6%, while international markets contributed with an 8.3% surge.

Furthermore, Johnson & Johnson is well-positioned for sustained success, supported by several long-term tailwinds.

The company’s commitment to innovation and strategic product launches, such as CARVYKTI and SPRAVATO in the Innovative Medicine segment, signals a focus on addressing evolving healthcare needs.

Meanwhile, ongoing success in key brands like DARZALEX and ERLEADA, along with advancements in oncology with TECVAYLI and TALVEY, positions Johnson & Johnson as a key player in critical therapeutic areas, fostering long-term growth prospects.

On January 3, Seeking Alpha reported the following (emphasis added):

Shares of Johnson & Johnson were fractionally higher after biopharma Elektrofi signed a multi-million-dollar licensing and collaboration agreement with Janssen Biotech to develop a subcutaneous version of a cancer drug for self-administration. The deal, facilitated by Johnson & Johnson Innovation, granted Janssen exclusive global rights to develop the oncology asset and up to four additional targets. Elektrofi will receive $18M upfront, over $155M in milestone payments per target, and royalties on global net sales when products are commercialized.

Innovative Medicine and MedTech accounted for roughly 40% of total 3Q23 sales, up from 35.3% in the prior-year quarter.

Furthermore, during its 3Q23 earnings call, the company highlighted several positive business tailwinds for Johnson & Johnson.

The company’s strategic focus on Innovative Medicine and MedTech positions it for growth in addressing complex healthcare challenges.

The successful completion of the Kenvue separation stands out as a significant achievement, generating $13.2 billion in cash proceeds.

This separation not only reduced outstanding shares by approximately 7%, enhancing shareholder value but also maintained the quarterly dividend per share.

Importantly, the Kenvue separation is expected to have a full impact on EPS in 2024.

Finally, during the call, the company highlighted a four-layer strategy to address the ongoing talc litigation, which I summarized below.

• Appeal to Supreme Court: They are appealing the New Jersey Bankruptcy Court’s dismissal of LTL’s bankruptcy case. The appeal challenges the validity and application of the Third Circuit’s novel standard requiring “immediate financial distress.” The Third Circuit could rule soon, with a potential Supreme Court appeal in 2024.
• Consensual Resolution: Working with talc claimants’ counsel for a consensual resolution through another bankruptcy. The process is on track, with a vote expected in the next three months (it was six when the Q&A session was held) to determine claimant support for the plan.
• Defense in Tort System: A recent favorable ruling in the Barden case reversed a $223 million verdict, citing unsound and baseless expert opinions. Additional mesothelioma cases are expected to be tried in 2024.
• Challenging Judicial System Abuses: Aggressive challenge of mass tort claims bar and expert abuses through affirmative litigation. Actions against lead experts for defamation are moving forward, with rulings expected shortly on whether they proceed to the discovery phase.

While these talk issues are obviously far from bullish, especially as shareholders are getting involved, I believe a lot of this has been priced in.

All things considered, I continue to like JNJ. I believe it is a great investment for conservative dividend growth investors, especially investors who are increasingly focused on low-volatility assets. This could be investors who are close to retirement, where a shift to lower-risk assets may make sense.

Hence, I’m likely to buy the stock for an income-focused family account this year and add on weakness down the road, as I believe that JNJ is in a good spot to return 10% per year on a prolonged basis, with the biggest risk being litigation.

Takeaway

In the midst of uncertainty surrounding the Fed’s actions and potential market impacts, my focus remains on safety and stability.

Johnson & Johnson emerges as a beacon of reliability with a robust track record, consistently rising income and extreme financial safety.

The company’s 61 consecutive annual dividend hikes, triple-A credit rating, and strong balance sheet make it a standout in today’s unpredictable market.

Despite recent challenges and ongoing litigation issues, JNJ’s strategic moves, innovative products, and positive business tailwinds position it for sustained success.

For conservative investors seeking reliable dividend growth and low-volatility assets, JNJ stands out as a compelling investment with the potential for consistent 10% annual returns.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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