Johnson & Johnson (JNJ) Is A Better Dividend Stock Than Roche

Introduction

Shares of Johnson & Johnson (NYSE:JNJ), the world-renowned healthcare, medical device, and consumer health conglomerate, are rightfully a key component of many dividend growth portfolios. The company’s long-term dividend history built on a solid earnings and cash flow base, management’s knack for acquisitions, and broad diversification are just a few key aspects that underlie the investment thesis in this company.

However, as an investor with a time horizon of several decades, I seek to diversify my holdings not only across most of the eleven Global Industry Classification Standard (GICS) sectors, but also across multiple economic regions. In this context, and in the GICS healthcare sector, Roche Holding AG (OTCQX:RHHBY, OTCQX:RHHBF) comes to mind. While JNJ is undoubtedly larger with a market cap of about $470 billion, Roche is still a major blue-chip healthcare company with a market cap of about $268 billion. JNJ generated nearly $94 billion in sales in 2021, while Roche generated nearly $63 billion (excluding royalties and other revenue of $3 billion). Founded in 1896 , the Swiss company has survived two world wars, the Great Depression and several recessions, as has JNJ, which was founded in 1886. Unlike Johnson & Johnson, Roche is family-controlled, by the Hoffmann family and associates, who hold the majority of the RHHBF voting shares.

Both companies pay a steadily increasing dividend. In this article, I will point out which of the two companies is the better investment when thinking long-term and focusing on growing earnings that can be used to cover living expenses in retirement. That said, in my discussion of the two businesses, I will also outline why I still believe both stocks are excellent investments. I will also outline the key risks to consider when investing in the pharmaceutical sector in general, and in JNJ and RHHBY in particular, in a discussion-immanent form. Of course, those who are not interested in reading about the operations of the two companies, or are already well-informed, can skip directly to the last section of the article.

As an aside, I have compared the two companies based on their most recent annual results (2021), as I will discuss some metrics that can provide misleading results when viewed on a trailing twelve-month basis or based on quarterly balance sheets.

Why Both Johnson & Johnson And Roche Are Formidable Companies

Johnson & Johnson

Johnson & Johnson is divided into three business segments: Consumer Health, Pharmaceuticals and Medical Devices.

The Pharmaceutical segment accounted for 56% of 2021 net sales ($52.1 billion) and includes the blockbuster drugs Stelara (ustekinumab, binds to interleukins 12 and 23, $9.1 billion, +19% YoY), Remicade (infliximab, binds to TNF-α, $3.1 billion, -15% YoY due to biosimilar competition) and Tremfya (guselkumab, binds to interleukin-23, $2.1 billion, +58% YoY), oncology products Darzalex (daratumumab, treatment for multiple myeloma, $6.0 billion, +44% YoY) and Imbruvica (ibrutinib, treatment for B-cell cancer, $4 billion, +6% YoY), cardiovascular drug Xarelto (rivaroxaban, anticoagulant, $2.4 billion, +5% YoY), and various therapies for neurological disorders such as Invega Sustenna (paliperidone palmitate, treatment for schizophrenia, $4.0 billion, +10% YoY).

I will not go into detail about the segment’s drug portfolio in this article, but suffice it to say that JNJ relies on a number of well-established blockbusters (underscored by solid growth of 14.3% YoY and 11.1% on a two-year compound basis to get a feeling for the impact from the pandemic). Long-term growth prospects are good, but not excellent due to the comparatively small number of significant late-stage candidates. Nevertheless, JNJ is definitely a broadly diversified pharmaceutical company with a solid revenue share attributable to biologics, which are less susceptible to rapidly eroding sales than small molecule drugs after losing their exclusivity (LOE) status.

Biosimilars are the “generics” of biologics, i.e., the generic forms of the original macromolecules with proven similar properties and efficacies. However, they should not be confused with generics of small molecule drugs, which are generally much easier to synthesize and are associated with simpler efficacy studies, easier marketing, and generally higher acceptance. For example, my own research online (e.g., Coghlan et al. J Pharm Sci 2021 110 1572) and with practitioners shows that Humira (adalimumab), AbbVie’s (ABBV) blockbuster biologic, remains solidly prescribed, despite the availability of biosimilars in Europe since 2018 (e.g., Amgevita, Amgen (AMGN), Hulio, Viatris (VTRS), Hyrimoz, Novartis (NVS)). Of course, JNJ also has the balance sheet capacity to acquire promising smaller pharma companies to drive growth in its pharma segment. The segment’s 2021 earnings before taxes (EBT) ($18.2 billion) translates to a very solid 35% margin.

Medical Devices is JNJ’s second largest segment with sales of $27.1 billion in 2021 (29% of total sales). It includes sales related to surgical instruments and devices (36% of segment sales, +19% YoY), orthopedic products such as artificial hips, knees, etc. (32% of segment sales, +11% YoY), vision-related products such as surgical devices and contact lenses (17% of segment sales, +20% YoY) and interventional solutions (15% of segment sales, +30% YoY). The segment as a whole reported 17.9% YoY sales growth, driven by the recovery in 2020, when many elective surgeries were postponed due to the pandemic. On a two-year comparison, the segment grew only 2.2%, underscoring the impact of lockdowns and other actions to contain the spread of SARS-CoV-2. However, the segment’s 2021 EBT margin of 16% indicates a continued recovery, but is also attributable to inventory-related effects from supply chain constraints and a $700 million charge for in-process research and development (IPR&D) – compared to the segment’s 2019 EBT margin of 28%.

Finally, Consumer Health generated 16% of total sales in 2021 ($14.6 billion). The segment’s sales are well diversified across over-the-counter medicines (36% of segment sales, +8% YoY), skin care (31% of segment sales, +2% YoY), oral care (11% of segment sales, flat YoY), baby care (11% of segment sales, +3% YoY), women’s health (6% of segment sales, +2% YoY) and wound care products (5% of segment sales, up 3% YoY). Johnson & Johnson owns well-known brands such as Tylenol, Neutrogena, Aveeno and Band-Aid. Sales of the segment as a whole grew by 4% compared to the previous year and by 2.5% in a two-year comparison. With an EBT margin of 9% for 2021, it seems appropriate to call the performance lackluster, and the weak revenue growth suggests that JNJ has not aggressively implemented price increases relative to competitors. In 2019, the segment generated an EBT margin of nearly 15%, and the decline to 9% in 2021 is due to $1.6 billion in talc-related litigation expenses, inflation, and higher marketing expenses. In 2019, litigation expenses were barely significant, but normalizing 2021 EBT by these expenses would bring the segment’s margin to nearly 20%.

Going forward, JNJ’s owners will no longer have to worry about talc-related litigation risk, as the company will spin off its Consumer Health segment in 2023 and is already in the preparatory stages of filing for Kenvue Inc.’s initial public offering (KVUE) – assuming, of course, that the shares received are sold. In the wake of the spinoff, JNJ’s litigation-adjusted EBT will decline by about 11%, or 5% when not taking 2021 litigation expenses into account.

J&J is also very well diversified from a geographic perspective. 50% of 2021 sales were generated domestically, 25% in Europe, 18% in Asia-Pacific and Africa, and 6% in the Western Hemisphere (excluding the U.S., of course). Its solid geographic diversification dampens the impact of the Drug Price Negotiation Initiative and the Inflation Reduction Act (Morningstar reduced its fair value estimate by 1.8% to account for these headwinds), while increasing the company’s foreign exchange risk.

JNJ is particularly valued for its reliable results, largely due to its broad diversification and fundamentally very good margins. Overall, the company delivers a very stable adjusted operating profit margin of about 26% (comparison to Roche, see Appendix). Operating profit translates adequately into cash flow, as confirmed by a stable and even slightly positive excess cash flow margin (1% ± 3% over the last six years). The average free cash flow margin when normalized for working capital movements and adjusted for stock-based compensation (nFCF, normalized free cash flow) is around 23% (four-year average).

JNJ is a very mature and large company and therefore growing rather slowly. Sales and adjusted operating income have grown at an average rate of about 3% over the last ten years, when using five-year average growth rates. Nevertheless, the company regularly generates a substantial return on invested capital (ROIC) above the weighted average cost of capital (comparison to Roche, see Appendix, there was a substantial income tax hit in 2017), and thanks to excellent cash flow conversion, the cash return on invested capital (CROIC) is also solid indeed, well above the current 6.6% Capital Asset Pricing Model (CAPM)-derived cost of equity. The company has an excellent cash conversion cycle (comparison to Roche, see Appendix) and has even been able to optimize it over the years, mainly due to improved inventory management and extended payment terms with suppliers.

All in all, JNJ is rightly considered a very well diversified (both in terms of products and geographies) and highly profitable company (with the exception of Consumer Health), albeit a very large and mature company that tends to grow slowly. The company is known for its successful acquisitions and the reliable ROIC, CROIC, and working capital management confirm the proper and timely integration of the acquired businesses. I believe the Kenvue spinoff can help management focus on improving its drug pipeline on the one hand to maintain very solid growth in its Pharmaceutical segment, and on the other hand to sustain the recovery of Medical Devices and further cement the company’s top position in this sector.

Roche Holding AG

Roche – which I covered previously in an article in late 2021 – is divided into two reportable segments: Pharmaceuticals and Diagnostics. As with JNJ, Pharmaceuticals is Roche’s largest segment by sales, with CHF 45 billion in 2021, excluding about CHF 3 billion in royalties and other revenue, representing 72% of total sales. Diagnostics contributed 28% of Roche’s 2021 sales (nearly CHF 18 billion), but it is important to note that the segment accounted for only 21% of total sales in 2019. Pharmaceutical segment sales grew 1% in 2021 (or -3.6% on a two-year comparison), while Diagnostics sales grew 29% in 2021 (or 17% on a two-year comparison). Roche’s sales performance since 2019 clearly shows that the company is benefiting from good diversification and how little it has been affected by the somewhat weaker performance of the Pharmaceuticals division in recent years, thanks to tailwinds from extensive testing for SARS-CoV-2-associated ribonucleic acid (RNA) fragments and antigenic proteins on the viral surface. For example, Roche sells the COBAS 6800/8800 test system through its Diagnostics segment, which can analyze 8,800 samples within 24 hours.

Looking more closely at Roche’s Pharmaceuticals segment, the company’s focus on antibody-based cancer therapies quickly becomes apparent. The oncology sub-segment generated sales of CHF 20.5 billion in 2021. Currently, the top-selling drugs are Perjeta (pertuzumab, treatment of HER2-positive breast cancer, CHF 4.0 billion, +2% YoY), Tecentriq (atezolizumab, e.g., treatment of non-small cell lung cancer, CHF 3.3 billion, +21% YoY), Avastin (bevacizumab, e.g., treatment of colorectal, lung and renal cell carcinoma, CHF 3.1 billion, down 39% YoY) and Herceptin (trastuzumab, e.g., treatment of HER2-positive breast cancer, CHF 2.7 billion, down 28% YoY). Perjeta’s weak growth was due to the drug’s approval already back in 2012. Similarly, the sharp declines in sales of Avastin and Herceptin are due to competition from biosimilars and other therapies – the biologics were approved for medical use in the U.S. in 2004 and 2008, respectively. Nevertheless, the strong focus on oncology in general, and antibody-based therapies in particular confirms the importance of Genentech, which became a subsidiary of Roche in 2009 and continues to shine through its excellence in innovation.

The key takeaway from Herceptin is that it was a very early personalized therapy – a current focus for Roche. Together with the strong diagnostics segment – which is expected to lead to increased development of companion diagnostics – Roche is well on its way to becoming a major player in the field of personalized medicine in general and personalized cancer therapy in particular (e.g., collaborations with Adaptive Biotechnologies (ADPT), BioNTech (BNTX) and Vaccibody).

In addition to oncology therapeutics, immunology and neurology are the other two major sub-segments, contributing 19% (+2% YoY) and 14% (+27% YoY) of sales, respectively, in 2021. Notable therapeutics are Actemra (tocilizumab, binds interleukin-6, CHF 3.6 billion, +25% YoY; also approved as COVID-19 treatment) and Ocrevus (ocrelizumab, anti-CD20 – treatment for relapsing forms of multiple sclerosis, CHF 5.1 billion, +17% YoY). Hemlibra (emicizumab, treatment for hemophilia A, CHF 3.0 billion, +38% YoY) is another biologic worth mentioning in Roche’s diverse but obviously oncology-focused portfolio.

Overall, Roche generates about 80% of its Pharmaceuticals segment’s sales from biologics. Since the segment as a whole contributes more than 70% of Roche’s sales, it is reasonable to conclude that Roche is better protected from sales declines due to generic competition than Johnson & Johnson. At the same time, it is important to remember that the biologics industry is extremely competitive, especially in oncology (see my articles on Merck, Keytruda/pembrolizumab and Bristol Myers Squibb, Opdivo/nivolumab) and immunology (see my article on Amgen, Enbrel/etanercept and tezepelumab; and of course AbbVie).

Unsurprisingly, due to headwinds from new therapies (Keytruda, Opdivo) and biosimilars (e.g., bevacizumab, trastuzumab, rituximab), Roche’s Pharmaceuticals segment operating profitability has suffered in recent years, declining from over 43% in 2019 to 34.5% in 2021. I am a big fan of Roche’s focus on biologics in general and its Genentech subsidiary in particular – looking back, management’s decision to acquire the biotech powerhouse in 2009 was a very important factor that cemented the company’s position as a market leader. However, the focus on oncology – especially looking at Keytruda, but also Opdivo – makes me a little nervous. Nonetheless, Tecentriq (even though it did not meet its co-primary endpoint of progression-free survival in the SKYSCRAPER-01 trial), Ocrevus, and Hemlibra are comforting with their expected peak sales of CHF 9 billion, CHF 8 billion+ and CHF 5.5 billion, respectively.

Diagnostics is divided into five sub-segments, of which Core Lab (immunoassays, clinical chemistry and custom solutions) is the largest with 42% of segment sales (+21% YoY), followed by Molecular Lab (kits for pathogen detection, donor screening, etc.) with 27% of segment sales (+21% YoY). Point of Care, which contributes 15% of segment sales, includes SARS-CoV-2 rapid tests, so the nearly 137% YoY growth is hardly surprising. Diabetes Care and Pathology Laboratory together account for 16% of segment sales, up 5% YoY. The segment’s profitability is understandably much weaker than that of the Pharmaceuticals segment, with a three-year average operating margin of 16%. Obviously, the significant growth related to SARS-CoV-2 diagnostics was the main reason for the YoY margin expansion of over 400 basis points in 2021, and it does not seem unreasonable to suspect that the outstanding success of Roche’s Diagnostics division during the pandemic contributed to the decision of appointing Thomas Schinecker, CEO of the segment, as the successor of the current CEO of Roche, Severin Schwan, in March 2023.

Geographically, Roche is similarly diversified as JNJ, with only 42% of sales in the U.S., suggesting that the company is less affected by the Inflation Reduction Act, but of course more exposed to exchange rate fluctuations from a U.S. investor’s perspective (see below). Europe accounted for 26% of 2021 sales, including Switzerland (which itself generated only 1.2% of total sales). Japan accounted for 8%, the rest of Asia (including China) for 16%, and the rest of the world (Latin America, rest of North America, Africa, Australia, Oceania) for 8%.

As with J&J, Roche’s sales grew by an average of around 3% over the last ten years, which is hardly surprising given the maturity and size of the company. Operating profit growth has been somewhat weaker, averaging 2% over the past decade, based on five-year average growth rates. Roche’s profitability is similar to Johnson & Johnson’s (average adjusted operating margin of 29% vs. 26%, Appendix), but of course the tailwinds from the pandemic helped profitability outpace JNJ’s.

Roche’s more conservative management, emphasis on organic growth rather than acquisitions (leaner asset base), and JNJ’s sluggish consumer health segment result in a generally higher ROIC for Roche, by an average of ten percentage points to be exact (comparison to J&J, Appendix). Roche’s excess cash margin is even higher than JNJ’s. Roche’s higher capital expenditures of 28% of normalized operating cash flow versus JNJ’s 11% underscore the latter’s focus on “portfolio management” (so to speak). As a result, the nFCF margins are about the same, so Roche’s CROIC is still significantly better than JNJ’s, well above the CAPM-derived cost of equity of 5.0%. This is a very low estimate indeed and highlights the – in my opinion – shortcomings of the CAPM theory. It is simply not sufficient to calculate the cost of equity based on the volatility of a stock as a measure of risk.

In my opinion, investors should expect a cost of equity of at least 8% for Roche (and J&J), given the obvious risks associated with the drug pipeline, litigation, execution, integration of acquired businesses and, of course, generic and biosimilar competition. With 42% of sales in the U.S., Roche is moderately affected by the Inflation Reduction Act and the Drug Price Negotiation Initiative (Morningstar expects U.S. sales to decline 1% in 2023 and another 1% in 2025). Finally, as with JNJ, multifaceted currency risk should be factored into the cost of equity – Roche generates nearly 99% of its sales outside of Switzerland, but reports its earnings and pays dividends in Swiss francs. Earnings decline when the Swiss franc appreciates (as is currently the case), but the dollar amount a U.S. investor receives increases. Of course, the payout ratio also increases in the process.

From a working capital perspective, Roche’s cash conversion cycle is much longer than J&J’s, but I have trouble calling its working capital management inferior. Ultimately, large U.S. companies are often managed more efficiently but also more aggressively in terms of working capital (see my discussion on this topic), and Roche’s likely more complex diagnostic device manufacturing is another reason. Importantly, however, Roche has steadily improved its working capital management over the years (comparison to J&J, Appendix).

All in all, there is obviously much to like about Roche. Just like JNJ, Roche’s growth, while somewhat slow, has been reliable. The far superior profitability in terms of ROIC and CROIC is worth highlighting, and if there is anything to fault, it is the company’s focus on oncology, a highly competitive field. Nevertheless, the company’s position in this segment is very strong. Clearly, by combining its strength in oncology biologics through Genentech and its companion diagnostics, the company is making a solid bet on the future of personalized cancer care. I like that the company is overemphasizing biologics versus small molecule drugs, which should dampen the impact of competition as treatments reach their LOE.

Which Of The Two Companies Is The Better Income Play?

Now that the specifics of the two companies have been explained, it is time to discuss the qualities of J&J and Roche from an income investor’s perspective.

JNJ’s dividend history is well known – this year’s 6.6% dividend increase marked the company’s 60^th consecutive increase, which is undoubtedly a strong testament to management’s foresight and prudence and, of course, the company’s very wide economic moat. Over the longer term, JNJ’s compound annual dividend growth rate (CAGR) has also been very solid at 6.4% since 2012 and 7.4% since 1995. Aside from the obvious strong performance during the Great Financial Crisis, I think it is a very good sign when a company that was significantly impacted by the 2020 lockdowns can continue to grow its dividend at such a pace. And the great thing is that management has not jeopardized the company’s balance sheet just to reward shareholders.

The dividend payout ratio is currently about 55% of the four-year average nFCF, and a look at the maturity profile (Figure 1) confirms how conservatively the balance sheet is managed. JNJ could simply pay off its upcoming maturities “on the go”, but this is obviously not a good idea from an economic perspective. Equity is always more expensive than debt, and a manageable combination of both sources of capital lowers the cost of capital.

JNJ’s current weighted average interest rate of 2.89% is anything but worrisome, and the current interest rate environment is unlikely to impact the company’s debt service ability. Ultimately, JNJ is one of three companies I know of with an Aaa credit rating (along with Microsoft (MSFT) and Apple (AAPL)). It is also worth highlighting that rating agency Moody’s revised JNJ’s outlook from negative to stable in early 2022, citing the following:

The outlook change to stable from negative reflects J&J’s ongoing progress at resolving litigation uncertainties. Combined with strong operating performance and rising cash levels, J&J is likely to absorb litigation liabilities without material credit profile degradation.

Michael Levesque, Moody’s Senior Vice President

In Roche’s case, operational qualities are top-notch, the growth story is fully intact, and the balance sheet is also rock solid (see maturity profile and nFCF in Figure 2). Its interest coverage ratio is currently 35 times the four-year average nFCF before interest – that is very reassuring indeed.

Roche’s dividend history is not as long as JNJ’s and not as well documented, but Roche has increased its dividend every year since at least the 1991 results announcement in 1992. In direct comparison, Roche’s dividend CAGR since 2012 is 1.8% (6.4% for JNJ) and 9.8% since 1995 (7.4% for JNJ). Clearly, dividend growth at Roche has slowed significantly (Figure 3) – but why? Ultimately, the payout ratio is very similar to JNJ, at about 59% of the current four-year average net financial assets.

In my opinion, a major reason for the weak dividend growth is the ownership structure of the company. Roche’s bearer shares ((RHHBF) – warning, very low liquidity) are predominantly held by members of the Hoffmann, Duschmalé and Oeri families. Given the size of the company (market capitalization of about $268 billion), a squeeze-out of minority investors seems very unrealistic, even in the unlikely event of a significant decline in the share price.

What I think is much more important is the fact that family-owned shares are generally held for the long term. Therefore, the owners are sitting on high double-digit yields on cost and have no real incentive to wave through large dividend increases. Considering that the bearer shares were trading at a price of around CHF 42 in 1992, then those who bought shares in the company back then are sitting on a yield on cost of over 22% today. At that time, the stock yielded only 0.5%, so this example nicely illustrates the benefits of long-term compounding. With such a yield on cost, the controlling owners certainly prioritize first-class balance sheet quality over high single-digit dividend increases. Their purchasing power must be such that they probably do not mind not beating inflation for a few years. Investors starting their journey in 2023 probably see things quite differently.

However, there are a few other reasons that I would consider as a U.S. investor before choosing Roche as a long-term income play. First, unlike JNJ, which pays its dividend quarterly, Roche’s dividend is paid in full after the annual meeting. Investors who are paying their living expenses with Roche’s dividend therefore need much better cash management. Second, when the dividend is paid, the Swiss tax authorities withhold 35% of the gross dividend, part of which can be reclaimed depending on the double taxation treaty between Switzerland and the investor’s tax residence (typically, 20% can be reclaimed). The process requires U.S. investors to file form 82, so the process involves paperwork and some patience (in my experience it usually takes about 1 to 2 months). However, this is only my experience as a European investor and investors should seek proper advice, as brokers might even be able to reclaim the tax automatically on behalf of the investor. Third, U.S. investors are likely to choose the non-voting stock RHHBY ADRs, which are the most liquid to trade and come with a yield that is currently 54 basis points higher (the bearer shares typically trade at what I consider an unwarranted premium). They do incur ADR fees, which are small but worth mentioning. Finally, the strong appreciation of the Swiss franc should be taken into account – the “law” of mean reversion is strong and it seems unlikely from an economic point of view that the Swiss franc (a famous safe-haven currency) can maintain its high valuation indefinitely. As a result of currency depreciation, the net dividend received by a U.S. investor will decline proportionately.

JNJ is more expensive than Roche (see FAST Graphs charts in the Appendix), and the latter seems like a very good deal right now – likely due to pipeline uncertainties, currency headwinds, and the now settled litigation risk at JNJ. However, for the above reasons, I think Johnson & Johnson is the better dividend stock, even though the yield is currently almost 20% lower (2.57% vs. 3.17% for Roche, excluding ADR fees). I think it is unrealistic to expect Roche to return to stronger dividend growth in the future for the reasons discussed above, which largely disqualify the stock as a long-term income play. If the two companies maintain their ten-year average dividend growth rates, JNJ’s yield on cost will exceed Roche’s within seven years. After twenty years, JNJ’s yield on cost would be nearly 9%, while Roche investors would have to settle for just 6% (Figure 4).

Finally, as prudent investors, we are not only concerned with increasing our dividend payout in absolute terms, but also with maintaining our purchasing power. Even from this point of view, I do not think Roche is a particularly wise choice for an investor starting his journey in 2023. Of course, this does not change the fact that both companies are world-class businesses.

Thank you very much for taking the time to read my article. How did you like it, my style of presentation, the level of detail? If there is anything you’d like me to improve or expand upon in future articles, do let me know in the comments section below.

Appendix

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.