Johnson & Johnson: A Merger Lies Ahead

Since Altria stock has crossed the $50 per share mark, I have been critical of the American tobacco giant’s valuation that has put the company at over 22x profits. Altria makes all of its money in the USA, so there is no angle about earnings being misstated due to the strength of the United States dollar in the past year. Even though I still find the stock pricey, I have revised my figure upward in light of the planned Anheuser-Busch takeover of SABMiller. With SABMiller increasing over 50% in the past two months in response to the takeover, the 27.3% Altria stake in SABMiller has increased the value of Altria’s holding by $10 billion. It also has the possibility of owning over 10% of the combined Anheuser-Busch Sab Miller Inbev megabrewery if it chooses to hold onto the stock and reinvest the cash portion in the stock.

Anyway, as I revised my Altria figures upward, I asked myself whether it is possible to predict accretive acquisitions ahead of time. Although it can never be done with 100% certainty, there are three strong guidelines that can alert you to potential value-changing behavior: (1) the company has “secret” assets on its balance sheet like Altria with the SABMiller stake or Kansas City Southern in days when it owned the Janus Funds; (2) the company has obvious areas for additions, such as when Coca-Cola or PepsiCo buy a popular new beverage; or (3) the company has a lot of cash on hand like Berkshire’s $45 billion hoard after the Precision Castparts acquisition goes through.

It is this third third element that has caught my attention about Johnson & Johnson. Although it has been criticized regularly for what seems like the entire millennium, this bluest of blue chips has spent the past fifteen years doing exactly what it has always done: growing earnings, and giving annual dividend hikes to boot. Coming into 2000, Johnson & Johnson was making $1.49 per share in profits. Now, in 2015, it is making $6.10 per share in profits. This included a period of extensive recalls and very few breakout years, yet the profits have hummed along and quadrupled even though the ending measurement period in 2015 marks a year in the which the U.S. dollar is unusually strong.

Better yet, the smoothness of the profits is extraordinary. During every year between 2000 and 2015, the earnings per share increased compared to the year previous. The dividend went up every year, and has done so since 1963. At the height of 2007, J&J was making $4.15 per share in annual profits. During the lows of 2009, J&J was making $4.63. The annual payout increased from $1.62 to $1.93. Although volatile profits are fine when a company delivers over 10% over the long term like ExxonMobil or Emerson Electric, it is nice to own something where profits will be stable and the dividend will continue marching upward during bad overall economic conditions.

But there is an aspect to Johnson & Johnson that has gone underreported: the company’s swelling cash hoard. Fifteen years ago, Johnson & Johnson had $7.5 billion in cash on hand. Now, it has over $34 billion in available cash. To me, that suggests room for around $20 billion acquisitions.

Now, there are a lot of different ways to spend $20 billion. The trick with Johnson & Johnson is that over ⅔ of its cash sits outside the United States locked in foreign subsidiaries. This is all a result of the incentive structure for repatriating earnings. The United States is one of the only industrialized countries that charges companies taxes on money earned outside the home country simply for the act of transferring the cash to the home country’s subsidiaries.

The U.S. corporate tax rate is 39.1% for U.S. corporations, although J&J actually pays a 20.0% tax rate due to effective use of available tax offsets that exist in the pharmaceutical development industry. Clearly, Johnson & Johnson is accumulating more cash than it is able to deploy by reinvesting into foreign subsidiaries. I would expect, then, a series of acquisitions in the $2-$10 billion range as Johnson & Johnson gobbles up European or Asian healthcare companies.

With the exception of the late 1990s and possibly 2007-2008, there’s really no such as a bad time to buy Johnson & Johnson. People who buy the stock today at $95 will do just fine. And they will do just fine not only because the company is humming along as usual despite some headlines that are frequently critical of the company, but also because Johnson & Johnson has a swelling cash hoard. Between now and the next few years, look for Johnson & Johnson to augment its earnings power with some mid-tier bolt-on acquisitions. The $34 billion cash position is unusually large for the company, and I would expect the executives to be actively searching for an opportunity to put it to use.