Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments viz., (1) Consumer; (2) Pharmaceutical; and (3) Medical Devices and Diagnostics. The company was founded in 1886 and is based in New Brunswick, New Jersey.

JNJ is a part of the dividend aristocrats, S&P500 index, and DJIA index. It has been raising its dividend for last 48 years. The latest increase in dividend was 9.3% in May 2010. My objective here is to analyze JNJ to determine fair price range for buying and adding to existing positions.

Trend Analysis
Here I am looking at trends for past 10 years of corporation’s revenue and profitability. These parameters should show consistently growth trends. The trend charts are shown in image below.

• Revenue: Overall had a growing trend.
• Cash Flows: In general, a growing trend. The free cash flow is generally close to net income. Operating cash flow is always higher than net income.
• EPS from continuing operation: Overall a growing trend.
• Dividends per share: Consistently growing dividends.

Johnson and Johnson - Trend Analysis

Risk Parameter Calculation
Here I use the corporation’s financial health to assign a risk number for measuring risk-to-dividends. The risk number for risk-to-dividends is 1.29. This is a low risk category as per my 3-point risk scale for dividend sustainability.

Quality of Dividends
This section measures the dividend growth rate, duration of growth, consistency over a period of past five years.

• Dividend growth rate: The average dividend growth of 13% (stdev. 2.5%) is almost same as average EPS growth rate of 13%. Dividends have grown inline with earnings per share.
• Duration of dividend growth: 48 years.
• 4 year rolling dividend growth rate for past ten years: Less than 10% for past 10 years.
• Payout factor: It has been in the less than 40%. It was at 44% in 2009.
• Dividend cash flow vs. income from MMA: Here, I analyze how the dividend cash flow stacks up against the income from FDIC insured money market account. The baseline assumption is (a) stock is yielding 3.6%; and (b) MMA yield is 1.75%. Last 10 years average dividend growth rate has been 13%, and I expect JNJ dividend growth rate to be 11%. With my projected dividend growth of 11%, the dividend cash flow is twice the MMA income at the price of $130. What this means is, I could pay up to $130 and still the dividends cash flow would be twice MMA based income. Is there anything more to ask for?

Fair Value Calculation
This section determines what price I should pay to buy a given stock

• Net present value (NPV) price based on 15 year DCF: $48
• Average high yield price calculated based on past 10 years: $75
• Pricing based on past 10 year relative price-to-earnings ratio. $92
• Pricing based on price-to-earnings ratio of 12: $55
• Graham number: $44

The range of fair value is calculated as $52 to $63.

Qualitative Analysis
JNJ is one the largest and most diversified health care company. For a company, which has 250 operating/subsidiary companies it is unique in a sense that it continues to perform with such a consistency year after year.

• It is a global company with approximately 50% of its revenue outside of US. All three market segments contribute significant portion of revenue.
• Investing in JNJ is a good proxy for foreign and emerging markets.
• JNJ is highly innovative and spends close 10% of its revenue on R&D and new product development.
• For growth, it uses organic internal opportunities and inorganic through strategic acquisitions.
• It generates free cash flow, which is generally, greater than its net income.
• It remains to be seen how JNJ is affected due to new health care legislation.
• Future risks include failure of any potential patent candidate or adverse effect of any existing drugs.

Conclusion
I like JNJ’s large size, global reach, diversified revenue streams, and multiple products. JNJ is more about substance rather than panacea. It has very good balance sheet. The dividend growth follows the growth in EPS. At current yield, the dividend cash flow is almost four times the MMA interest income in 10 year time period. The stock’s current risk-to-dividend rating is 1.29 (low risk). Since the share price is my fair value buy range, I added to my existing company even though I am fully allocated.

Full Disclosure: Long on JNJ.

This article first appeared on The DIV-Net on July 1, 2010.

As dividend investors, while it is important to focus on dividends, it is also equally important to monitor the risk of capital erosion over a period of time. Dividend growth and intermediate sustainability is good, but it is less likely to be a substitute for significant loss of capital. Pfizer and GE are examples of capital erosion. These two companies were not only able to sustain their dividends but kept with their growth in last decade. However, the value of individual’s holding kept eroding over the last decade or so. For example:

• PFE was trading around $43 per share from 1999 to 2002. In last couple of years, it has been trading around $16. At the same time, it has paid cumulative dividends of only $8.22 per share.
• GE was trading around $40 per share from 1999 to 2002. In last couple of years, it has been trading around $18. At the same time, it has paid cumulative dividends on only $9.00 per share.

In recent days, four companies viz. BP, Johnson & Johnson, and Procter & Gamble, and Toyota Motors are (were) getting quite a bit of attention in news media. Rarely a day goes by when their woes, or management response to product issues, are not discussed in the financial media or general TV news channels. Three of these four corporations also happen to the good dividend paying companies.

Johnson & Johnson is one company that had been widely praised for its response Tylenol cyanide poisonings in 1983. JNJ took swift actions on recall and tamper proofing the product, even at the cost of loss in short term market share. The products market share temporarily dropped from 35% to 8%. In this case, JNJ regained the market share in next couple of years.

• McNiel, a JNJ subsidiary, is in the news for recalling 43 over the counter medicines that are believed to be contaminated. As of this writing, it has had four recalls in last six months (i.e. late 2009 and early 2010).
• The recall of Tylenol is not that unusual. Not long ago, in 2008, Tylenol was recalled due to manufacturing problems. JNJ was issued stern warning from FDA for violations and failing to report and investigate the problem quick enough. With the re-occurrence of this problem, it seems measures do not seem to be working.
• I do not believe JNJ will have any noticeable impact on its financials because Tylenol, and other related recall products, have only $0.5billion contribution to $15.6 billion revenue. This is probably the reason there has not been a significant impact on JNJ share price.
• However, it is these kind of events that affects perception and have impact on longer term.

Procter and Gamble has been in news due to concerns related to its new product performance. Apparently, the new diaper product, Dry Max, which replaced the old product (Cruisers and Swaddlers) is causing rashes among kids. While I like PG’s continued stream of innovative products, managements initial response to this issue leaves lot to be desired.

• For quite a few weeks, there was a growing concern. All PG did was plain rebuttal and termed it as false rumors. This issue also has a Facebook fan page with more than 10,000 members.
• It was only recently that PG muscled marketing team to engage with community to convey their side of the story. While this issue is still open, U.S. Consumer Product Safety Commission launched an investigation last month.
• To me, PG’s response to this concern was nothing to cheer about. Instead of offering rebuttals, it should have engaged with the community from the beginning. They should have understood the significance attached to its products. While it may not be dangerous, the questions around quality of its new product will affect its brand image.
• Pampers is a brand with more than $5 billion revenue. It may not affect in short term, but slow erosion can have a long term affect.

BP is other companies facing headwinds due to due to oil spill in Gulf of Mexico. Here also, a lot remains desired regarding to BP’s readiness for such disasters and its initial response.

• It is hard to believe that a company can go in deep seas to explore and find oil, but was not capable enough to anticipate risk factors. There does not seem to have any indication that it had Plan B or Plan C.
• It is also hard to believe that, at first instance, the company did not correctly anticipate the scope of spill and/or quantity of oil flow.
• In addition, it’s also had a fire in refinery in Texas.
• All this demonstrates something is wrong with the management focus.
• Even though BP continues to maintain its dividends, which I do not think it can or will, it will affect its brand image. Over long term, the slow erosion will affect BP’s balance sheet.
  

It is easy to look back and decide based on past performance. However, it is the sustainability of dividends and value of capital in future that matters the most. This sustainability is driven by brand image and moat of a given company. Both go together and may feed into each other. Brand image is something that we can observe because it is more about conversation and media coverage (good or bad). It is more about how consumers are reacting to company events.

The power of great brands is indisputable. Often investors pay more for business with brands because they provide moat. Contrarily, businesses will have to develop certain moat over a period of time in order to develop that brand image. Brand image and business moat is something that management needs to protect and sustain over a period of time.

It is common in business for things to go wrong. However, it’s the management response to such event that affects brand image. In case of JNJ and PG, I do not think there would be any financial impact in short-to-intermediate term. Managements that continue to use this type of approach in problem resolutions will be lead to slow erosion of value. In case of BP and Toyota, no amount of dividends will replace the loss of capital.

It is close of five year now that I have been a long term buy and hold, and dividend growth focused investor. When I meet friends, acquaintances, or colleagues, on many occasions the discussion starts from what’s market doing today and steers towards trading/investing is nothing but a poker game. I get a sense that many of these folks think that buying (and selling) stocks is just a gamble of some kind. Irrespective of this, I believe both, trading and investing, have their own set of pros and cons depending upon what context an individual is looking at it. In the end, both trading and investing is done to make money. Some use approach of capital appreciation, some use dividend income, some do trades to generate income. The key is to have a plan and execute it with consistent results.

When it comes to dividend investing, many individuals think of high yields (perhaps Cramerica syndrome!). It shows lack of patience and tendency to read too much into the business media. They do not understand dividend growth and sustainability.

There are two very significant aspects that investors need to understand about dividend growth investing and sustainability. These are (a) quality of dividends; and (b) potential for capital appreciation.

• Quality of dividends is related to how and from where the company is paying dividends. Good quality of dividends from companies that consistently generates cash from selling products or services, manages dividend with payout ratio, prudent uses capital for growth, and remains focused on its core competency. It is ideal to have everything in a company, but ideal situations and scenarios are either in short supply or not practical. Occasionally, companies will have issues and stumble, but those should be short lived. As long as quality of dividends are good, I believe the dividends are sustainable. These dividends add to the total return.
• Potential of capital appreciation is related to individual’s cost basis and future growth in value. Buying a stock at fair value builds-in a level of safety margin. Furthermore, I believe as the company grows and expands, it will grow its earnings and hence the dividends will grow. This growth in the company is bound to result in value over a period of time (and hence capital appreciation).

Thus, the key is to invest in companies which can grow its operating cash flow with consistency and can sustain it. A company that consistently generates cash is likely have to less downside risk. Even if they do get affected by market downturns, such companies experience less downward pressure. In addition, the continued dividends keep adding to the total returns. Examples of such companies are Proctor and Gamble (PG), Johnson and Johnson (JNJ), Becton, Dickinson and Company (BDX), T. Rowe Price Group (TROW), Sysco Corporation (SYS), Emerson Electric Company (EMR), Dover Corporation (DOV), and Jonn Wiley Sons (JW.A).

Dividend investing does not mean focus on high yield only. It is about consistency and sustainability which inherently focuses on total returns.

It has been close to three years since I started dividend focused investing. If I look at this from a 30year+ investing cycle for individuals, then these three years may look like nothing. However, the continued anxiety and slide in ones portfolio value will turn our hair gray. I am learning that there will be winners and losers in our investment portfolios. All we have to do is minimize the losers.

Sysco Corporation (SYY): SYY was one of the most non-glamorous stocks when I had initiated my position. My current dividend yield on cost is 5.35%. As of March 2009, my total return has been 13.1% including dividends.

Johnson & Johnson (JNJ): I had waited for close to one year to initiate a starter position in this company. It was worth a wait, and as the saying goes, every company will come down at some point in time. Its price has again come down and I am tempted to add some more, even though it has reached by allocation level. My current dividend yield-on-cost is 3.4%. As of March 2009, my total return has been 6% including dividends.

Consolidated Edison (ED): My objective was to just get a utility stock in my portfolio, and hence this was a no brainer purchase. I bought it during the market boom when slow growers like utility stocks were out of favor. I had read a lot about utility stock being less volatile and slow grower, well this was a real example for me. My current dividend yield-on-cost is 6.9%. As of March 2009, my total return has been 12.9% including dividends.

Duke Energy (DUK): This was the second utility stock purchased during the same period. My current dividend yield-on-cost is 7.14%. As of March 2009, my total return has been 10.31% including dividends.

Health Care Property Investors Inc. (HCP): I had initiated starter position in August 2006. Since then I have added two times to bring to my allocation level. My current dividend yield on cost is 7.19%. As of March 2009, my total return has been 9.4% including dividends.

Reality Income Corporation (O): This was my second REIT holding. My current dividend yield on cost is 6.83%. As of March 2009, my total return has been 8.3% including dividends.

National Retail Properties (NNN): My third REIT holding was in NNN. My current dividend yield on cost is 7.74%. As of March 2009, my total return has been 9.9% including dividends.

Beneath every rose lies a thorn. My portfolio resembles this proverb. Above holdings were the roses, while the thorns have been BAC, GE, WFC, WL, and C. While I sold C and WL, I continue to hold BAC, GE, and WFC. These stocks have not only suspended their dividends, but their stock prices also have gone for a toss.

Even if the markets turn back up, my hair will continue to remain gray!

A quick and simple answer is, no it does not affect dividend growth if dividend investors understand what it really means.

Corporations pay dividends from the combination of profitability, cash flow, income, prudent money management, etc. With the current state of economy in United States (and other parts of the world) majority of the corporations are facing negative growth. In such a scenario where will dividend growth come from? In these challenging environment dividend investors need to look at the macro economic scenario and understand how it will play out in long haul over a period of next 10 years, 20 years, or 30 years.

We read a lot about demise of US dollar. At a very fundamental level, which country’s currency becomes a global currency will depend upon political maturity and economic stronghold at global level.

• United States: Every nation in this world wants to do business with US because of its strength in free market system, strength of its institutions, innovative and entrepreneurial business environment, and open minded consumer base. History shows us that every bust is followed by a boom albeit of a different economic form or shape or pattern. Looking back 100 year or more we can see boom and bust in different sectors such as first in textile industry, then infrastructure industry, then automobile industry, then space and airline industry, then hardware and software industry, and finally real estate and financial industry. The present financial crisis may shrink US GPD by couple of trillion dollars from 13 trillion, but still it will be the largest economy.

There is definitely some rational logic behind demise of dollar and I would agree to most of them. However, there is fundamental flaw in this chain of reasoning. While there is lot of talk of demise of dollar, it does not talk about its replacement? Which currency in the world will replace US dollar? There is also a lot of discussion that emerging markets (particularly BRIC nations) will be the driver of global economy. In order for BRIC nations to provide leadership at global stage, these nations have to demonstrate political maturity and economic foresight to the global citizens.

• China: It has a long way to go in demonstrating trust among in own people first and then among League of Nations. History suggests that world domination comes only after prosperity of its own citizens. A nation cannot dominate beyond its borders with struggling and constraint population. It’s currency, Yuan, has trust issues among the global nations. Who wants to trade in Yuan?
  
• Brazil: It is still just a potential and needs to show political maturity and independent thought at world stage.
• India: It is too diverse, too much democratized, and busy with inconsequential bickering with neighbors. It’s economy is growing but still not in top five to have any meaningful bargaining power. It’s currency, Indian Rupee, is still searching an identity and role at world stage.
• Russia: It may perhaps have some legacy military strength; however, it is still confused between communism and free market economy. Its currency, Rubble, is no way near to be global currency.
• Japan’s stagnant economy and aging demographics is not able to support the cause of Yen being global currency.
• The nearest contender is European Euro. Last few years it has thrown challenge to the US Dollar’s status. I believe the issue with Euro is that it represents the bigger economies (e.g. UK, France, Germany, etc) and smaller economies (other European nations). It represents multiple countries. Other than the largely available European market, it does not have any other argument or bargaining strength. Individual countries still continue to use their own currencies and have not shows any inclination to phase it out. I believe it is still in its infancy, in a sense that it still needs to shows its resilience amidst fragmented political landscape.
  

While in long term evolutionary basis, 30 or 40 years down the line, one may see the change, but I don’t expect this to see within next 20 years time frame. I would go only so far as saying that for next 12 to 20 years, BRIC nations will be the catalyst in real global growth and corporate earnings. Here in US we are facing some head winds and perhaps may continue to do so in near future. I cannot predict when this will end.

I can say that in next 10+ years, there will be quite a large number of US and other multinational corporations that will still standing on their own strengths. There are quite a few corporations that are well positioned to continue their growth in developed markets and emerging economies. Mentioned below is the list of companies that are deriving their revenue (and hence earnings) from all types of economies. Figures in bracket indicate approximate percentage revenue from emerging markets. Most of these corporations have paid growing dividends in last five years as measured in their native currency.

• Proctor and Gamble (35%)
• Unilever (30%)
• Johnson and Johnson (60%)
• Qualcomm Inc. (60%)
• Intel Corporation (50%)
• International Business Machines (45%)
• Microsoft Corporation (33%)
• ABB (27%)
• The Coca Cola Company (60%)
• Pepsico Inc. (50%)
• Cadbury PLC (24%)
• Nestle (26%)
• Siemens AG (23%)
• Vodaphone PLC (20%)
• Exxon Mobil Corporation (60%)

Summary is…

I cannot predict what will happen to the value US Dollar and/or future growth from emerging markets. Dividend growth investors have many choices to position themselves which will blunt the effect of these issues. Invest in dividend growth companies that have notable presence in all markets. After that, the discussion of dollar demise becomes purely academic in nature.

Another option is to simply track Dow Index which can done by Dow Diamonds (DIA).

Full Disclosure: Long on PG, UL, PEP, JNJ, and INTC