Johnson & Johnson is one of the most revered dividend aristocrats (it has raised its dividend 58 years in a row). The company has incredibly strong fundamentals derived from its well-diversified three-pronged business model that contributes to consistent profitability and a strong balance sheet. It is one of only two AAA-rated companies (the other being Microsoft), signifying its extremely strong capacity to meet financial commitments. Johnson & Johnson’s share price hit a four-year low during the March downturn, but has since rebound and is now trading near all-time highs. Is Johnson & Johnson sill a buy at any level? Is it time to sell covered calls? We answer these questions in the conclusion of this article after first providing a detailed review of the health of the business, valuation, risks and dividend safety.

JNJ Share Price:

Overview:

Johnson & Johnson (JNJ) is one of the largest healthcare conglomerates generating over $82 billion in annual revenues from the sale of medicines, medical devices, and consumer health products across the globe. The company conducts its operations via three business segments:

Pharmaceutical (~55% of YTD 2020 revenue): focused on offering treatments in six important therapeutic areas - cardiovascular & metabolism, immunology, infectious diseases & vaccines, neuroscience, oncology, and pulmonary hypertension.
Medical Devices (~27% of YTD 2020 revenue): provides orthopedics products for joint reconstruction, trauma, spine, sports medicines and power tools; surgical products, bio-surgical, endo-mechanical, and energy products, breast and body aesthetics, and ENT devices; vision care products related to cataract, laser refractive surgery and disposable contact lenses; and interventional solutions for treating heart rhythm disorders and neurovascular care.

Consumer Health (~17% of YTD 2020 revenue): provides over-the-counter (OTC) analgesics, products for digestive health, oral care, skin health/beauty, baby care, women’s health, and wound care. Some of the well-known consumer health brands of the company include Tylenol, Pepcid, Listerine, OGX, Clean & Clear, Stayfree, Band-Aid, Neosporin, etc.

Three-Pronged Business Model Helps Operational Stability and Consistent Profitability

JNJ’s three business segments have historically worked together to provide overall steady operational performance even during periods of economic downturn. The Pharmaceuticals business segment, although constrained by finite patent protection, has been a steady high margin business that has seen volume-based growth over the years; the Medical Devices segment, although not performing too well in the recent past owing to COVID-19 related pressures, provides long-term growth opportunity from the need for improved access to medical care for an aging global population; and the Consumer Health business has been a slow grower, but provides strong pricing power and predictable cash flows.

Recent Earnings Beat Comes as No Surprise

JNJ’s recent 3Q20 earnings results, beating market estimates, come as no surprise as the company has a habit of beating estimates time and again. JNJ beat consensus earnings estimates by a solid $0.22 per share and topped the sales target by $0.88 billion, driven by strong sales growth of some key pharmaceutical products, and a strong rebound in medical devices. On the back of operational strength in the quarter, JNJ also increased its 2020 operational sales guidance by $1.3 billion (at mid-point of the guidance range) and tightened the adjusted EPS range to $7.95 - $8.05 from $7.85 - $8.05. For 2021 JNJ is expecting strong growth vs. 2020.

3Q20 Earnings Snapshot:

JNJ’s worldwide sales increased by 1.7% to $21.1 billion in Q320, with an estimated two to three points of the growth hampered due to the pandemic. Sales in the US market grew by 2.7%, while the international market remained subdued and grew 0.6% YoY.

The pharmaceutical segment grew operationally by 4.6% and witnessed a COVID-19 related headwind of 200 bps as there were continued delays in diagnosis and slower new patient starts. The business saw the tenth consecutive quarter with sales exceeding $10 billion, as seven key brands saw double-digit growth rates including immunology brands Stelara and Tremfya; oncology brands Erleada, Darzalex, and Imbruvica; and pulmonary hypertension brands Opsumit and Uptravi.

Medical Devices saw the sharpest recovery as sales declined by 3.9% vs. 32.5% in Q220, primarily because of the resumption of medical procedures across the globe. The monthly trends were encouraging as the September decline reduced to 3.3% compared to a 20.1% decline in June. Two of the company’s largest markets for medical devices, the US and China, returned to growth, with China growing by almost 17%.

Consumer Health grew by 3.0% operationally driven by strength in the OTC medicines (up 4%, has gained 0.7 points in market share YTD), oral care (up 10.8%), wound care (up 13.5%), and skin health and beauty franchise (up 0.9%). The US market remained strong as it grew by a solid 11.6%, but the international market remained nuanced and declined by 2.7% YoY.

WIth regards to profitability, gross and adjusted operating margins were essentially flat YoY. Pharmaceuticals margins continued to grow (up 340 bps) and made up for a major portion of the profits. Going forward, JNJ’s management anticipates operating margins to come in at the levels seen in 2019 of around 31.3% for the full year 2020, which is encouraging considering the impact COVID-19 has had on the business this year.

Pause in the COVID-19 Vaccine Trial (ENSEMBLE) Does Not Materially Impact Profitability

JNJ announced a temporary pause in the further dosing of all its COVID-19 vaccine candidate clinical trials, including the Phase 3 ENSEMBLE trial, due to an unexplained illness in a study participant. The temporary pause is disappointing from a public health standpoint as it will delay the timeline by which the company’s vaccine could have been in the market. However, it does not materially impact JNJ’s profitability because it is planned to be distributed on a not-for-profit basis after its launch.

Strong Balance Sheet and Solid Free Cash Flow Fortifies Dividend Safety

Despite its AAA credit rating, which bestows it with the ability to raise large amounts of debt on favorable terms, JNJ has maintained a conservative stance and avoided taking excessive leverage on its balance sheet. The company’s total debt at the end of Q320 stood at $37.8 billion, including $7.5 billion debt it took in August of this year to benefit from the low-interest rate environment, and fund the $6.5 billion Momenta acquisition. With ~$30.8 billion in cash, the net debt of $7.0 billion is extremely low considering JNJ’s massive size, and comes down to leverage of just 0.2x TTM EBITDA (1.2x TTM EBITDA using gross debt).

WIth regards to FCF generation, JNJ has a solid track record, having generated incremental FCFs over the years. After some significantly low FCF during the first two quarters of 2020, which totaled ~$5.5 billion, the company looks to get back on track as it generated FCF of ~ $7.5 billion in Q320, taking the YTD 2020 total to over $13.0 billion.

Source: JNJ Factsheet and 3Q Results Presentation

JNJ’s management has maintained that the dividend remains a top priority and has accordingly distributed ~7.9 billion in dividends year-to-date, representing a FCF payout of 61%. The company has increased its dividend for 58 consecutive years now, and the most recent dividend of $1.01 per share results in total dividends of $3.98 for 2020, and a yield of 2.7%, well above S&P500's dividend yield.

Source: Multpl, JNJ and Blue Harbinger Research

Going forward, we believe the company’s capability to generate stable free cash flows is greater than any of its rivals, and with growing cash flows and a track record of annual dividend increases, dividend payments by the company should further accelerate in the future.

Pharma Pipeline Helps Maintain its Status Quo, Medical Devices Innovation is Important

Unlike other large pharma companies, JNJ doesn’t have an exceptional record concerning its pharmaceutical research productivity to offset the impact of patent expirations. Also, the company has historically relied more on innovation rather than research breakthroughs in its medical devices business. Accordingly, there have been some concerns surrounding its longer-term growth trajectory. However, to offset the impact of lower research productivity, at times the company has used its strong financial position to grow through acquisitions.

JNJ has historically had a strong immunology presence. But with its key drug Remicade already past its peak and facing biosimilar competition, Stelara’s peak not far away, and Tremfya being the only promising candidate, JNJ does not really have a strong pipeline to maintain its strength in immunology in the coming years. However, the recent acquisition of Momenta has changed the game and bolstered JNJ’s immunology pipeline to a large extent. Momenta’s FcRn antibody has shown promising results in uncommon immune-mediated diseases and could potentially add multibillion-dollar sales through multiple products, many of which could be first-in-class indications in rare diseases.

JNJ’s oncology pipeline remains strong as Darzalex, Imbruvica, and Erleada, which are already seeing strong patient uptake, are in advanced stages of clinical trials for various other oncology indications. Also, its non-small cell lung cancer candidate Amivantamab, currently in Phase 2 trials, has received breakthrough therapy designation from the FDA and can potentially be the next multi-billion dollar blockbuster product.

On the Medical Devices side, JNJ maintains a strong position in endoscopy, energy, aesthetics, and endo-mechanical tools. However, it lags behind its peers such as Stryker and Zimmer when it comes to innovation in orthopedics. Although late, the company did submit a 510(k) for its VELYS robotic-assisted solutions for total knee arthroplasty in the US and seems very positive on this front. JNJ had earlier secured the FDA’s breakthrough device designation for transbronchial microwave ablation technology using robot-assisted bronchoscopy.

Overall, we think that the current pharma pipeline helps JNJ to maintain its status quo as a major pharma player over the next few years, while innovation remains the key for growth in the Medical Devices business and JNJ has to work a lot on this front to catch up with its peers. We also expect JNJ to leverage its balance sheet strength to further bolster its pipeline by remaining active on the M&A front, as it has done in the past, and maintain a steady growth rate in the longer-term.

Brief Round-up of Other Important Updates

Opioid Litigation: JNJ continues to pursue a comprehensive final resolution to litigation and has been in negotiations with state, local and tribal governments for an all-in settlement of the litigation for $5 billion. The company recorded $1 billion in litigation settlement related expense in Q320, in addition to $4 billion already recorded in 2019 concerning the initial agreement in principle.

Talc Lawsuit: Recently, JNJ agreed to pay $100 million for settling thousands of the cases filed against it by women of a particular ethnic group blaming the talcum powder for causing cancer. JNJ is facing about 19,400 lawsuits relating to the talc but has continued to claim that the talc is safe and does not contain asbestos, and does not cause cancer.

Valuation:

JNJ’s stock often attracts investors because of its operational stability, strong free cash flow generation, and safe and regularly growing dividends. In the recent past, there has been some talk about an entry price into its shares, considering they are trading near all-time high levels.

To assess the fair value of JNJ relative to the broader market, we compared the stock’s price to its large-cap pharma peers, medical device peers, and to the broader S&P500 and the Dow Jones index, of which JNJ’s stock is a component. Year to date, JNJ’s stock has lagged behind the S&P500 index and its medical devices peers. However, it has outperformed the large pharma peer group as well as the Dow Jones index.

We also assessed the stock based on its current trading multiples vis-à-vis its historical multiples, select set of large pharma and medical device peers, and S&P500. Over the past 10 years, JNJ’s stock has traded at a median PE ratio of 19.6x, while the median EV/EBITDA ratio has been 12.6x (range of 7.4x-17.9x). Though the stock’s current PE multiple of 23.3x is higher than its historical median PE, it is well below the select large-cap pharma and medical devices peer group’s average multiples, as well as S&P500 PE multiple of 35.1x. On current EV/EBITDA, the stock is trading well below the select large-cap pharma and medical devices peer group’s average multiples, indicating that there is still some upside potential.

Overall, we believe that JNJ is an extremely safe long-term investment bet and is one such stock that can be bought at almost any price owing to its fundamental strength, and the excellent financial flexibility that comes with its large scale of operations, diversity, sustainable profit margins and low leverage on its balance sheet.

Risks:

Litigation risks: JNJ has historically faced regulatory actions and litigation on account of product efficacy or safety concerns. The company is already facing thousands of lawsuits on its talc which allegedly caused users to develop cancer over the years. It is also entangled in the opioids litigation with state, local and tribal governments. A comprehensive solution to this litigation could cost the company billions of dollars in expenses, and any further litigation can create bottom-line pressures on P&L.

Pricing pressure: Due to factors such as current higher unemployment rates caused by the pandemic, healthcare reforms, competition, etc., pharmaceutical companies often face continued pressure on pricing, which can impact their growth and margins. However, relative to its competitors, JNJ seems to be well-positioned to tackle the pricing pressure as its growth is more volume-based and less price-based.

Patent expirations and biosimilar competition: Pharmaceutical companies often face the risk of revenue depletion due to the impending expiration of patents on key products and competition from biosimilars. Large pharma companies such as JNJ have often replenished the potential revenue loss by bringing new products to the market either through research efforts or through M&A activity. Failure to timely act in this area can create a negative impact on the topline.

Stalling of procedure recovery due to a new wave of COVID-19 infections: The lockdowns, imposed by governments the world over, due to of COVID-19, restricted many patients from visiting hospitals for medical procedures. Though some procedure recovery was seen in the third quarter, the demand for medical devices has not yet reached pre-pandemic levels. With many countries facing a new wave of coronavirus infections, any new lockdown imposition can negatively impact the demand for medical devices. However, governments seem to be reluctant to impose further lockdowns at this time.

Failure to successfully integrate large acquisitions: Amidst the industry consolidation there is also an event risk related to large acquisitions. JNJ recently completed its $6.5 billion acquisition of Momenta. If the company is unable to successfully integrate Momenta’s products and operations and its clinical work, there can be a significant financial impact.

Conclusion:

To some investors, Johnson & Johnson is a “buy” at any price. And considering its 58 straight years of dividend increases and AAA credit rating, it’s hard to disagree. Specifically, if you are looking for steady long-term price appreciation and steady long-term dividend appreciation, Johnson & Johnson has delivered and it’s positioned to continue delivering.

As noted, the share price is currently trading near all-time highs, and some investors are left wondering if now is a good time to generate extra income by selling covered call options against your existing JNJ position.

Selling covered calls is one of the least risky options trading strategies (the big risk is the shares get called away from you at a higher price), plus you get to keep the upfront premium income the trade generates—no matter what.

And as you can see in the table above, selling a November 20th call contract with a $155 strike price (5.2% out-of-the-money) puts an extra $1.24 of upfront income in your pocket. That comes out to an extra 10.1% income on an annualized basis ($1.24/$147.35 current price X 12 months). And if the shares get called, you sell them at a 5.2% gain versus the current market price (not bad for 1-month). Furthermore, the shares aren’t expected to trade ex-dividend again until November 24th (after the contract expires), so you don’t have to worry about that added volatility. Plus, the company already announced earnings just last week (so you don’t have to worry about that added uncertainty during the duration of this trade either). If you are so inclined, selling covered called at this level is attractive.

Overall, whether or not you sell covered calls, Johnson and Johnson is an attractive “sleep-well-at-night” dividend stock. It has delivered growing dividends for 58 consecutive years, and we expect this track record to continue growing. We also expect the shares to steadily rise over the long-term. We are currently long shares of Johnson & Johnson.

Johnson & Johnson: Bedrock Dividend Growth? Time to Sell Calls?