A New Growth Spurt for an Old Stalwart

04/01/2013 7:45 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

The name may be old, but new drugs coming to market...plus a handsome dividend...make this blue chip attractive, says Josh Peters of Morningstar DividendInvestor.

Johnson & Johnson (JNJ) holds a leadership role in diverse health-care segments, including medical devices (40% of sales), pharmaceuticals (35%), and over-the counter medicines (25%).

This diversification has limited the hit from group-specific challenges (device failures, drug patent expirations, OTC manufacturing problems) and allowed the firm’s research efforts to continue developing next-generation products.

The pharmaceutical group has a robust late-stage product pipeline, with several potential blockbusters in late-stage development or recently approved. The company has also created new medical devices, including ceramic orthopedics and minimally invasive surgical tools.

Meanwhile, J&J generates substantial free cash flow (nearly 20% of sales), allowing it to return cash to shareholders without giving up on growth-enhancing acquisition opportunities.

J&J has raised its dividend for 50 consecutive years, a record that underscores the firm’s longstanding devotion to shareholder returns. We expect annual hikes for many more years to come, and its dividend remains one of the safest around.

However, the pace of growth has clearly declined, from routine increases in the mid-double digits before 2007 to mid-single-digit increases in 2009, 2011, and 2012. Growth in earnings per share has slowed even more sharply, with adjusted EPS rising just 2.8% on average between 2008 and 2012. Continued dividend growth in excess of EPS growth has resulted in a somewhat higher payout ratio (47% in 2012 versus 39% in 2008).

Slowing growth has also taken a toll on the stock price, which until the past few months was trading scarcely higher than the cost of our Builder Portfolio’s first purchase in January 2005.

The consolation prize is that J&J’s dividend yield has improved significantly, from less than 2% for most of the 1995-2005 stretch to 3.2% today. A higher yield reduces the pressure on the firm to grow at unlikely rates—it’s very difficult to expand a $67 billion top line at double-digit rates—and gives shareholders a reason to accept a more modest pace of growth.

After four years of disappointing growth, J&J is poised to return to accelerating growth in all three of its major groups. The drug group faces only minor near-term patent losses.

Further, several new drugs are in the early phase of their launch (Xarelto for atrial fibrillation, Endurant for HIV, Incivo for HCV, Zytiga for prostate cancer), and despite increasing competition should start to contribute meaningful sales. Also, the potential 2013 approval of canagliflozin (which we place at a 60% chance) could further add to growth.

On the device side, the Synthes acquisition not only provides close to 500 basis points of acquired growth in 2013, but also adds the steady growth of the trauma industry, with good exposure to faster-growing emerging markets. Finally, toward the end of 2013, the consumer group should see gains as manufacturing remediation efforts pay off.

From here, we expect long-run EPS growth averaging 6% annually. Two percentage points of this forecast comes from anticipated share repurchases or acquisitions, with the balance derived from a 4% growth rate for revenue and net income. We expect the dividend rate to grow roughly in line with EPS, including a 6.6% hike to be announced in April.

The shares recently traded close to our fair-value estimate of $77, but we wouldn’t require much of a discount to consider them attractive for income investors.

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