Johnson & Johnson: A dividend growth star on the decline?

Johnson and Johnson has in the past been a favorite dividend growth stock of mine and a stock I used to hold. However my opinion on the stock has changed and  it’s not a favorite of mine anymore.  In fact,  I think it may be a dividend growth star on the decline. Let me explain why.

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To set some context  for the analysis, I’m going to apply the dividend growth stock analysis framework I have outlined.

Core Business

Johnson and Johnson is one of the biggest health care companies in the world. It has interests in pharmaceuticals, medical devices, and consumer diagnostics. Its a well trusted name and has a number of well known brands in its product portfolio including Johnson’s baby shampoo (which we use for the kids!), Tylenol, Band Aid, Sudafed, Motrin etc. The list goes on. Its been paying growing dividends for years. 25 of them infact. So what’s not to like about J&J?

J&J pharma division currently delivers much of its profits, approximately 36% ,but its been going through some tough times, like much of big pharma, with a variety of patent expirations.

Aciphex, Concerta, and a number of its other consistent performers are recently off patent or will have come off patent within the next year. That’s close to $2.5B in revenues at risk. You can add to that another $5B in at risk revenue from the patent expiry of Remicade in 2014.

It needs solid pharma pipeline growth to replace this lost revenue, let alone grow it.

So how is the pipeline looking?

JNJ has had recent pipeline set backs for both blood thinner and Alzheimer drugs, two potential blockbusters .

So things are currently not great on the pharma side of the business.

Where’s the growth?

Medical devices is expected to be a solid growth area for the company going forward.

J&J seems to be pivoting and betting its future growth on medical devices as a category, with a $20B acquisition of orthapedics company, Synthes.

I always get a little nervous when a business bets much of their future growth on acquistion in an area that historically hasn’t been their dominant business. You rely on seamless integration of the new business to make the acquisition a success.  Integrating a $20B acquisition properly is not easy and it take time and focus to do.

My overall thesis on the J&J business isn’t positive in light of whats highlighted above, at least in terms of prospects for consistent profitability increases and hence dividend growth.

What do the numbers say ?

I am pulling these numbers referenced below from the Key Ratios tab for JNJ in Morningstar.com

10 year / 5 year revenue growth

JNJ’s compound revenue growth over a 10 year period has been a modest 6% p.a, not bad in the circumstances.

A closer look though reveals a “tale of two halves”.

2002-2007 revenue growth was an impressive 11% p.a.

2007 to 2012 (trailing TTM) has been a less than impressive 2% p.a! This is no doubt influenced by the pharma declines that we discussed above.

10 yr / 5 year operating cash flow growth

JNJ’s operating cashflow growth over a 10 year period has been respectable, a modest 7% p.a.

But its the same “tale of two halves” again, only worse.

2002-2007 operating cashflow growth was an impressive 14%p.a.

But 2007- 2012? 0%. That’s right. 0% There has been no operating cash flow growth at JNJ in 5 years (and thats not because of a single bad year either).

Dividend Growth Rates

The 10 year dividend growth rate from 2002-2012 is 11% p.a. Impressive.

2002-2007, 15% p.a, even more impressive! 2007-2012? 8% p.a over the period.

8% is still not a bad growth rate in dividends for someone like JNJ for this last 5 year period. Frankly, it’s a bit of a surprise given the 0% growth in their operating cash flow from 2007-2012.

So what’s going on?

Dividend Payout Ratio

No surprise, JNJ’s dividend payout ratio has ballooned from 36.8%  in 2002 to 77.8% for 2012.

As a dividend growth investor, that makes  me a little nervous.  Can JNJ continue to pay dividends? Sure, they are a big business generating a lot of cash flow.

But can they raise dividends at rates that would be acceptable to me for  the next 10-20 years??

Wrap Up

To believe JNJ can continue to be a dividend growth star, you have to believe that their pharma pipeline will”magically” come good (evidence suggests its struggling).

You have to believe that their major medical device acquisition will be easily integrated without any hiccups and suddenly make up for declines in the pharma business.

You also have to overlook what the financials are telling you in terms of slowing revenue growth, poor operating cashflow growth and a dividend payout ratio thats blowing out.

Thats not a bet I’m willing to make.