Am I Crazy to Say, 'Don't Buy This Stock'?
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I read an article recently that essentially said, investors should consider Johnson & Johnson (NYSE: JNJ) as a company to buy for “long term gains”. The author pointed out that the company has increased its dividend for 49 years, yet the stock has gone no where for about 10 years. The theory is when a stock stays stagnant for this long, investors start to demand special dividends, more aggressive stock buybacks, or accretive acquisitions. While I won't dispute Johnson & Johnson's dividend history, buying a stock because it hasn't done anything for a while is no sure way to make money. Let's see if Johnson & Johnson deserves a spot in your portfolio or, if the company's best days are behind it.
Johnson & Johnson is like a medicine cabinet in one stock. The company participates in prescription drugs, medical devices, and consumer medicine and products. I've seen many articles over the years touting this company as a core holding of any portfolio. Today the stock sells for about $63.77 and sports a yield of 3.56%. Since the company's dividend is one of the reasons given to buy the stock, let's examine that first. While it's true the 3.56% yield offers a better yield than even a 30-year Treasury bond, that can also be said of some of the company's competitors. Look at Johnson & Johnson's competitors and their yields:
As you can see, in the pharmaceutical industry it's not that unusual for companies to pay a dividend that exceeds the current 30-year Treasury bond rate. Now I know many people will immediately say, none of these companies can compare to Johnson & Johnson when it comes to increasing dividends. This is true, with Abbott Labs coming the closest with about 39 years of increased dividends. However, what's more important is will Johnson & Johnson be able to continue to increase their dividend?
Let's examine Johnson & Johnson's cash flow situation, as it more accurately depicts what the company can afford to pay out in dividends. In the last three years there is a somewhat surprising trend (all numbers in billions):
You can see that in the last three years, not only has free cash flow shrunk, but dividends and share buybacks have increased. Three years ago, the combined dividends and buybacks used about 45% of free cash flow, last year they used up 65% of free cash flow. The challenge Johnson & Johnson is going to face if this trend continues is, they would either need to slow down dividend growth, or cut share repurchases. I'm aware that they have net cash of about $19 billion, however the rate of cash growth is directly correlated to free cash flow growth. With free cash flow growth slowing down, cash on the balance sheet can't grow as fast either in the future. While Johnson & Johnson's dividend is certainly not in jeopardy, these cash flow trends tell a story that many investors might not be aware of.
Another piece of the puzzle is trying to figure out what type of growth we can expect in the future. Analysts are currently calling for 5.87% EPS growth going forward. If you consider that the company grew EPS by 4.54% over the last few years, it seems reasonable with an improving economy that the company's growth rate should pick up some. I know that investors are looking at the fact that the company sells for about 12.4 times 2012 earnings estimates. I've even heard the company's stock called cheap based on historical standards. The problem is in the past, investors were paying for the company's historical growth rate. In the last five years, investors paid between 10 and 19 times earnings for Johnson & Johnson. The difference between then and now is, in the prior five years analyst estimates were for usually 8-10% growth going forward. Given that future earnings growth is expected to be less than 6%, this is still a slower growth rate than analysts predictions for the prior five years. In theory, a lower growth rate should warrant a lower P/E range. If Johnson & Johnson with an 8-10% expected growth rate supports an average P/E of 14.5, then the company with a 6% expected growth rate should support an average P/E of 9.66. With Johnson & Johnson stock selling for about 12.5 times 2012 earnings, it already sells for a premium to what its average P/E probably should be.
If the best growth that Johnson & Johnson can manage is 6% for the next few years, then the company's best days are already behind it. With lower EPS growth, it seems likely the P/E would compress to support this lower growth. Though the company's dividend growth can continue for a while, there are signs that this dividend growth will slow in the future. Combine slower dividend growth, and a slower growth rate, and I just don't see a great investment. Let me know what you think in the comments section below.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Abbott Laboratories, and Johnson & Johnson. Motley Fool newsletter services recommend Johnson & Johnson, and Pfizer. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.