By: Dividend Sensei
With the US economic expansion now its second longest in history (10th year), many are worried that the next recession could strike relatively soon. In fact, there is reason to think the next economic downturn (and bear market) might come in 2020.
So naturally investors want to know what companies they can turn to to keep growing their wealth and income over time, even when the next economic storm strikes. Let’s take a look at three reasons why one legendary dividend king, who has grown its dividends for 55 straight years, in all manner of economic, industry, and interest rate environments, is a great choice for your diversified income portfolio. In other words, a bank vault safe dividend growth stock that will help you sleep well at night during the next recession.
Johnson & Johnson: The Ultimate Low Volatility Sleep Well At Business Model
The essence of any sleep well at night or SWAN dividend stock is a source of highly stable and recurring cash flow to fund our dividends. In the world of investing healthcare is often seen as one of the most defensive sectors because drug, medical device, and consumer products sales tend to hold up well in all economic environments.
Johnson & Johnson is the most diversified medical conglomerate in the world, with over 250 subsidiaries manufacturing products in over 60 countries around the globe. It literally sends thousands of medical products around the world, across its three main segments:
- Pharmaceutical: 43% of sales
- Medical devices: 28% of sales
- Consumer products: 26% of sales
What’s great about JNJ is that it enjoys the strong margins of its patented medications, which saw 17.5% sales growth in Q2 2018. However, pharmaceutical sales and earnings can be extremely volatile over time due to patent expirations. So the company’s medical devices (2.5% sales growth), and consumer products (0% sales growth), help to stabilize its cash flow over time. In Q2 of 2018 JNJ’s overall revenue was up 6% while its adjusted EPS rose a very impressive 18.5%, thanks to higher margins on its drugs.
That cash flow is supported by a very wide moat created by three major competitive advantages. The first is JNJ’s enormous scale, both in terms of R&D spending ($11 billion in 2017), as well as a global supply and manufacturing chain that allows the company to enjoy industry leading profitability and returns on capital. JNJ is planning on increasing its R&D spending by $30 billion over the next three years, funded by tax cuts.
|Company||Gross Margin||Operating Margin||Net Margin||FCF Margin||Return On Invested Capital|
|Johnson & Johnson||66.9%||28.6%||21.8%||23.0%||23.3%|
(Sources: GuruFocus, Morningstar, CSImarketing)
The most important profitability metrics to focus on are free cash flow margin and return on invested capital or ROIC. Free cash flow is what’s left over after running the business and investing in growth (including R&D). It’s what funds the dividend, as well as share buybacks and repays debt. JNJ is able to convert almost 1/4th of its revenue into FCF, thanks to its strong margins on drugs, as well as its large number of patents on its medical devices.
Meanwhile ROIC is a good proxy for quality management, that allocates shareholder capital well. JNJ’s ROIC is over three times the industry average, which is a testament to its efficient, and lean corporate culture. In other words, despite its enormous size and complexity, JNJ is running circles around its rivals in terms of efficient investment of shareholder capital.
That profitability is also supported by strong pricing power across its segments. In pharmaceuticals it enjoys patent protection on its blockbuster drugs. While these eventually end the enormous R&D spending helps support one of the industry’s largest drug development pipelines. Today JNJ has 21 drugs in development to treat 75 different conditions, including 10 potential blockbusters that are expected to generate over $1 billion in annual sales each. In fact, analyst firm EvaluatePharma estimates that JNJ’s current drug development pipeline should generate about $14.9 billion in additional sales over the next five years.
The company also has 75 to 95 new medical devices set to launch over the next five years which management projects will generate an additional $7 billion in annual revenue. Medical devices have very high switching costs, because medical professionals (like surgeons) train on specific devices and systems and thus very rarely change medical device providers. In consumer products JNJ’s is still able to enjoy rich (nearly 25%) operating margins despite a lack of patent protection. That’s due to strong brands, including 12 with over $1 billion in annual sales, such as: Listerine, Johnson’s shampoo, Bandaid, Tylenol, Motrin and Neutrogena.
The company’s strong product development pipelines, across all its segments, combined with a large push into overseas markets (such as China and India), represents a major growth catalyst for JNJ. As does a rapidly growing, and aging world population that will cause demand for healthcare products to only rise over time.