Texas Instruments – Deep-dive analysis

It has been a while since I did a deep-dive analysis post on my blog, and I wanted to pick a business that is more closer to my area of expertise i.e. firmware, semiconductors, signal processing etc. Folks, let me introduce you to Texas Instruments (ticker: TXN).

Note: In the broader semiconductor industry, Texas Instruments is commonly referred to as “TI”. However, in the interest of being consistent with the associated stock ticker, I will refer to this company as “TXN”.

The first thing that comes to most people’s minds when they hear about TXN is…..calculators! Interestingly though, in my case atleast, that is NOT how I first heard about TXN. In fact, the calculator that I used during my engineering studies was a Casio, it served me well and did its job. But if you were to think that calculators is all there is to TXN, you would be dead wrong! Let us get into that a little later in the post. First, let us go into the history and background for this company.

History & Background

TXN’s history can be traced back to two physicists who developed a seismographic process to aid in oil exploration. This parent company was called Geophysical Services Incorporated (GSI) founded in 1930. During the early stages of World War II, GSI was exploring ways of using their oil exploration technology for submarine detection. This prompted a massive shift towards developing defense electronics. By around 1951, the defense electronics division of GSI was growing faster than the original geophysical division. A resulting re-org resulted in the birth of a new company called Texas Instruments, as we know it today.

TXN was at the forefront of the first ever integrated circuit or IC chip ever developed, which revolutionized the semiconductor industry. This eventually led to the development of the first hand-held calculator based a single-chip microprocessor. TXN is also credited with the development of a first known speech synthesizer chip which found its way into the Speak and Spell toy (picture above).

As one can see, this company has come a long way since its humble beginnings in the 1930s and is today one of the powerhouses of the semiconductor industry.

Like I said before, my first introduction to TXN was not through its famous calculators. Rather, I came across TXN while studying signal processing in my engineering studies and using one of the older versions of their Code Composer Studio IDE while working with one of their digital signal processing chipsets.

Since then, I have played around with several of their software driver components for firmware engineering development work/side projects ranging from PCIe root-complex/endpoint software pieces, A2D/D2A converters and also development boards such as the MSP Launchpad kit. As an engineer, it is easy to tell when components such as these (and the associated supporting documentation) have been designed with care and with quality in mind.

Business Breakdown

One of the first things that catches your attention when you open the investor relations page on ti.com is the following quote by their current CEO, Rich Templeton.

The best measure to judge a company’s performance over time is growth of free cash flow per share, and we believe that’s what drives long-term value for our owners.

To a serious long-term dividend growth investor such as myself, there is nothing more satisfying than reading this upfront. TXN reiterates this point in all of their presentations and company filings. To achieve this goal, the company adopts a three-pronged strategy:

• Strong business model: divided across two primary segments: analog and embedded processing built around four competitive advantages: manufacturing and technology, broad product portfolio, diverse and long-lived positions and efficient market channels.
• Disciplined allocation of capital
• Efficiency: striving to maximize output from every dollar that is spent.

The business segments can be further elaborated as follows:

• Analog: Further sub-divided into power and signal chain categories. The Power category includes products that will help customer manage power in their electronic devices. The portfolio includes battery-management systems, power switches, regulators. The Signal chain category includes products such as data converters, clocks, amplifiers etc. It is therefore, not at all surprising to see TXN’s battery charger and DC/DC converter components in teardowns of smartphones such as iPhone.
• Embedded Processing: In TXN’s own words, these are the digital “brains” behind the electronic equipment. Products in this portfolio can range from low-cost simple microcontrollers to complex motor controller systems.

Per the numbers in 2020, Analog is responsible for about 75% of sales, with Embedded Processing contributing about 18%. The remainder of the sales are classified in the “Other” segment which includes calculators and custom ASICs (application specific integrated circuits).

Also, per the latest available 10-K, here is a table denoting the markets for each of the products manufactured by TXN specified in decreasing order of revenue.

As one can see, Calculators (atleast as of 2020) accounts for no more than 2% of TI’s revenue. More importantly, you can see what the management really means by “broad product portfolio” as a competitive advantage when you see the above table. TXN has its tentacles spread in several sectors in the market! And none of these sectors are going to be irrelevant atleast in my lifetime.

I wanted to look at the revenue trends across the two main segments for the last 10 years.

So Analog segment’s revenue has been consistently growing, while the Embedded Processing was increasing during the first 5 year period but has since been decreasing. This does not concern me in any manner, and I think TXN should be investing in both these segments rather than becoming a one-trick pony and only focusing on analog semiconductors.

Dividend History

TXN is one of the popular names in the dividend growth investing community. Lets take a look at the dividend history to see why.

I borrowed the above graph from one of the recent company presentations. If you look at this graph, it is not at all surprising to see why this stock gets so much love in the dividend investing community 🙂

TXN, at the time of writing this, is yielding about 2.44% (annual dividend of $4.60). They have been increasing their quarterly dividend for nearly 16 years, with a 3-year, 5-year, 10-year dividend CAGR of 16.98%, 20.75% and 22.35% respectively. The last increase to the quarterly dividend was announced during Sep. 2021 and was about 13%.

Seriously, can anyone tell me what is not to like here?

Financial Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

• Is the company’s revenue growing?
• How profitable is the company?
• What are the company’s assets and how much does the company owe in the short-run and the long-run?

Analysis over the last 10 years show that total revenue has remained largely flattish. But what is interesting is that net income (and consequently net margin), during the same time period, has increased. The median net margin over the last 10 years has been around 22%. The last 5-yr average for net margin is about 31%.

I wanted to take a closer look at the free-cash-flow numbers. From the company’s slide-deck, I found this out:

This is exactly the kind of trendline that a long-term investor would like to see for Free-cash-flow growth, nice and consistent and TXN has been doing this for the last 16 years. In addition to the net-income growth, it appears that TXN has also been focusing on capital expenditures wherever feasible, thus sticking by one of the stated competitive advantages regarding efficiency.

TXN has a rock-solid balance sheet, with cash and cash equivalents effectively covering whatever the company owes as short term liabilities. And the long-term liability also does not look concerning whatsoever.

I also wanted to take a look at the total shares outstanding to see if the management has been focusing on share buybacks.

In this case, we want to see if the number of shares outstanding has been reducing and as we can see, during the 16 year period starting from 2004, management has been focused on share buybacks, thus using capital effectively and also providing value to the shareholders. Put this in perspective of the dividends paid and cash returned per share during the same time period has seen an annual growth of nearly 17%. Quite staggering!

My final comparison is w.r.t overall performance versus the S&P 500.

For this estimation, the comparison was performed against SPY which is an ETF that tracks the S&P 500 index and the chart computes how an amount of $10,000 would grow from 1995 to present day. TXN comfortably outperforms the S&P 500 during this period. FWIW, I performed the same test without dividends re-invested and the numbers were fairly similar.

Future Outlook

TXN has stated that it is focusing on building a third wafer fab for its 300mm analog product line in Richardson, Texas. Generally, the construction of a fab is a capital intensive exercise, so I will be keeping a close eye to see how this impacts the free-cash-flow generation in the next few years. Given that the management sees this as a move to support demands for the next three years, I think this is a positive move. In addition to this, in October 2021, TXN completed its acquisition of Micron Technology’s 300mm semiconductor factory in Lehi, Utah. So I see TXN well positioned to meet demands for next few years.

I am fairly confident about the safety of the dividend in the coming 5-10 years atleast.

Risks & Market Characteristics

• Competitive Landscape: It may sound obvious, but it is worth re-stating that the semiconductor industry is fiercely competitive. TXN is no different, as it faces and will continue to face competition from semiconductor suppliers from different geographies (particularly Asia). For this reason, they need to consistently re-evaluate their landscape, spend on R&D and innovation and defend their market share aggressively.
• Semiconductor cycle: TXN outlines this in one of their investor slide decks, simply stated: this refers to the ebbs and flows of supply and demands in this industry resulting in building and depleting of inventories. We had one such ebb very recently when the semiconductor shortage due to surge in demand and the inability of the manufacturing capacity to keep up with this. TXN tries to safeguard against this by understanding the customer demands and managing inventories accordingly. However, it is worth noting that this can have an impact on the overall revenue numbers.
• TXN has stated that due to the nature of the market and associated seasonality, they typically expected the first and fourth quarters of the year to be weaker than the other two quarters.
• Hiring and retaining top talent: This may sound like a no-brainer, but this is especially critical for the analog semiconductor industry. Top talent and management are not easy to find and replace in this domain.

Valuation

I used the Discounted Cash Flow valuation model to estimate the intrinsic value for this business. For my estimation, I used analyst estimates for revenue for the next two years of $17.93b and $18.72b respectively. Based on the last five years, I assumed a average net margin of roughly 30% and net income to free cash flow ratio of about 110% (again averaged for the last five years). These numbers are fairly conservative looking at the recent trends in both FCF and net income growth. I used these to estimate the future cash flows for the next five years and then discounted them to obtain the present value of the company. Also for my estimation, based on the Capital Asset Pricing Model, I am assuming a equity rate of 9.4%. Adding in a margin of safety of around 10%, I estimated the fair value of the stock to be around $142. TXN, at the time of writing this, is trading at $190. So I am not really a buyer at these prices.

My estimation does not look way off if you look at the non-GAAP FWD price to earnings ratio (currently around 23.62). EV/EBITDA (FWD) is also at 17.98, higher compared to the 5-year average of 16.55.

While this seems slightly overvalued at present, this is one of those stocks that I will double-down on when the stock dips appreciably. Until then, I will simply dollar-cost average into this position.

Management

One of the things that the curious investor would immediately notice is that most of the management, CEO, COO, and most of the senior VPs have been with TXN for several years (20+). For instance, Rich Templeton, the CEO, joined TI straight out of college back in 1980. It is pretty awesome that the company has hired their CEO from within the organization.

I have listened to Rich Templeton talk in interviews and conference calls and kind of like the guy. It is helpful that he is an electrical engineer himself and therefore his answers are crisp, to the point, with no bull-shitting around. In a recent interview, when asked about a question on decision making, he said something very interesting:

“In our business, you will be rewarded for moving fast and correcting as you go. And if you find people avoiding mistakes, you will find people probably avoiding taking action…and that’s usually, especially in a technology business, very problematic.”

I find that comment very insightful, in the context of leading a business in a sector that changes as dynamically as the semiconductor industry. It is a valuable insight if you look at another big name in the semiconductor industry, Intel (ticker: INTC), who were sitting on their backside and executing poorly when AMD and NVIDIA were encroaching on their market share. A lot of this was, IMHO, due to poor management. Thankfully, INTC now has an engineer as its CEO and while these are still early days, the initial signs of a turn-around happening look promising.

Here is a snapshot for the reviews from Glassdoor with Rich Templeton getting a 95% approval rating. Overall reviews also look acceptable.

Summary

My analysis shows why I am very confident about TXN and its management. This company is going to be around for the next several years and if they stay true to their guiding principles of their business, they will return cash back to me, the shareholder. It should come as no surprise as to why I have TXN in the “Core” category of my dividend portfolio.

Do you have TXN in your portfolio? Does your analysis line up with what I have presented here? Please drop a comment to let me know what you think.

PS: You can connect me with on Twitter at @LifeWDividends. I am here to learn with you and from you.

Discl: Long TXN, INTC

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Costco – Deep-dive Analysis

Time for another deep-analysis post. In my last post in this category, related to Johnson and Johnson, I covered one of my “Core” holdings. In this post, I would like to cover a holding from the “Growth” category. As I have stated previously, the “Core” holdings represent the “sleep-well-at-night” category i.e. the foundation of my dividend growth portfolio. On the other hand, the “Growth” category are relatively early in their dividend growth history. These stocks are currently in an aggressive phase of growth and will (hopefully) continue to be in this phase for atleast the next decade or so. Eventually though, these companies will graduate into the “Core” category. But my hope is that, I will be in my retirement by that point in time. 🙂

Alright, enough with the background! Lets dive into the deep analysis for Costco (ticker: COST)

History & background

My first introduction to Costco was when I went to shop there with my room-mates, one of whom was a Costco member. I was a graduate student back then and, like all people in their student-life, very watchful of what I am spending on and eventual load on my wallet. The Costco business model seemed very interesting at first glance: Unlike other big-box retail stores, the store is a warehouse with controlled entry and exit points. The available merchandise is limited, but items could be bought in bulk quantities at a cheaper average cost to the consumer. The catch is that the consumer has to sign up for a Costco yearly membership, and there are three distinct levels of membership with each level having their own perks.

Costco made its humble beginnings when it opened its first warehouse back in September,1983 under the leadership of Jim Sinegal and Jeff Brotman. Among the two founders, I was particularly impressed with Jim Sinegal’s background. From starting out as a grocery bagger in FedMart, he worked his way up the chain to eventually becoming the VP of merchandising and distribution.

A few years ago, I read about Jim in the book titled “The Everything Store” , which was Jeff Bezos’s biography. In a breakfast meeting that Jeff had with Jim, Jim explains Costco’s business model as follows:

Though the selection of products in individual categories is limited, there are copious quantities of everything there – and it is all dirt cheap. Costco buys in bulk and marks up everything at a standard, across-the-the-board 14 percent, even when it could charge more. It doesn’t advertise at all, and earns most of its gross profit from annual membership fees... The membership fee is a one-time pain, but it’s reinforced every time customers walk in and see forty-seven-inch televisions that are two hundred dollars less than anyplace else. It reinforces the value of the concept. Customers know they will find really cheap stuff at Costco.

The other striking thing about shopping at Costco, and this is something that I have noticed across several warehouse locations here in the US, I could visibly tell that the employees there were happy. They must be being treated very well. A little digging around showed why. Here is what Jim Sinegal mentioned in one of the interviews a few years back:

It’s really pretty simple. It’s good business. When you hire good people, and you provide good jobs and good wages and a career, good things are going to happen.. We try to give a message of quality in everything that we do, and we think that that starts with the people. It doesn’t do much good to have a quality image, whether it’s with the facility or whether it’s with the merchandise, if you don’t have real quality people taking care of your customers.

Costco is known to have a better average pay rate for its employees as compared to the larger retail industry. Over 90% of the Costco employees qualify for a employer-sponsored health insurance plan, while the rest of the industry is at about 60%. It is, therefore, no surprise that Costco sees less employee turn-over rate. At the time of writing this, Costco has about 273,000 employees worldwide, operating across 800 or so warehouse locations in the world.

Business Breakdown

As stated previously, Costco uses a membership-based big-box retail store model. Members have access to limited selection of branded and private-label merchandise in larger volumes at lower costs relative to other retail stores. Costco purchases its merchandise directly from the manufacturers, routing them to specific docking points before transporting them directly to the warehouse locations. This distribution model helps them eliminate “the middle men” and helps in lowering distribution costs.

Merchandise is categorized into the following:

• Food and Sundries: including dry foods, packaged foods, groceries, candy, alcoholic beverages, cleaning supplies
• Hardlines: major appliances, electronics, hardware, garden and patio
• Fresh foods: meat, produce, deli and bakery
• Softlines: small appliances and apparel
• Ancillary: gas stations and pharmacy

I did a breakdown of the merchandise sales across these categories since 2015 and this is what I found out:

As one can see, the “Food and Sundries” category drives most of the merchandise sales. However, the sales across all categories are showing an upward trend during this time period.

As a Costco member myself, I can vouch for the quality of the products that I buy from their stores. Even the private label in-house brand, Kirkland Signature, matches the other well-known brands for quality. From my personal experience, this was especially useful when shopping for diapers and wipes. Any parent reading this post can back me up here, the number of diapers and wipes needed when you have a young one is no laughing matter, it can be quite expensive. Costco was a life safer here. I could get the Kirkland diapers and wipes from Costco at a relatively lower cost compared to other well-known brands such as Pampers and Huggies.

Another important detail for the consumer is that Costco has a fantastic return policy on its merchandise sales, 90-day return for all major appliances and no-time limit for the other merch. This makes the entire shopping experience for the consumer very rewarding.

Membership

It is amply clear that maintaining or improving the membership base is a critical metric for Costco. I wanted to explore how Costco was doing in this regard. For this purpose, I analyzed the membership data since 2015.

Year	2015	2016	2017	2018	2019	2020
Total paid members	44600	47600	49400	51600	53900	58100
Worldwide membership renewal rate	88%	88%	87%	88%	88%	88%
US and Canada membership renewal rate	91%	90%	90%	90%	91%	91%

So the total membership base is increasing steadily. From what I could tell, the average YoY growth in total number of paid members is about 6%. However, what is interesting to note is that the membership renewal rate is fairly constant during this period: 88% worldwide and about 91% in US and Canada. This is telling me that the existing members choose to renew more often that not and the number of new members is consistently growing.

I also wanted to analyze the membership fees and how much revenue Costco was earning relative to the total revenue. Here is the data since 2008.

So the membership fees are averaging around the 2.15% of the total revenue since 2008. During the same time frame, total revenue for Costco has grown at a CAGR of nearly 11%. This shows that the membership fees have remained pretty flat for more than a decade. Quite impressive!

Warehouses

I wanted to analyze the warehouse growth for Costco. Since 2010, this is what the data looks like:

Year	2010	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
Number of warehouses	527	540	592	608	634	663	686	715	741	762	782

So this shows that the average YoY growth in number of warehouses is about 4%. From the last investor presentation, Costco has about 804 warehouses worldwide. About 90% of them are in the US and Canada. About 4% of stores in Europe, about 7% in Asia (Japan, Korea, Taiwan and China) and remaining in Mexico and Australia. This represents a decent geographical spread, however there is scope for growth here as far as expanding into newer geographical markets.

Dividend History

At the time of writing this, Costco has an annual forward dividend yield of 0.71%. So nothing to get excited about there. 0.71% is well below the standard inflation rate. So why would a dividend growth investor choose to invest in Costco? The answer lies in dividend growth rate. Here is what the data looks like for the last decade

3-year Dividend CAGR	12.42%
5-year Dividend CAGR	12.32%
10-year Dividend CAGR	13.36%

So on an average a 12% dividend growth rate, and if the stock is bought at the right value, the yield on cost over the long-run would be phenomenal. If you are curious about this subject, please read my post on yield-on-cost to understand this better.

Apart from the regular quarterly cash dividend, Costco has a practice of occasionally rewarding its shareholders with a “special dividend” every now and then. The most recent special dividend of $10/share was announced last year (2020).

I also analyzed the dividend payout ratio since 2008 and found this:

So the payout ratio is currently hovering around the 30% mark. This mean that there is plenty of runway available to the Costco management to increase their dividends if they choose to do so.

Financial Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

• Is the company’s revenue growing?
• How profitable is the company?
• What are the company’s assets and how much does the company owe in the short-run and the long-run?

For Costco, the company’s revenue is growing steadily over the last decade, as seen in the previous section. I also analyzed the Net margin since 2008 and it has remained flat for nearly a decade, this is a sign of a good stable business.

For the same period, Free Cash Flow, which I obtained by using the Cash Flow from Operations less Capital Expenditures, is trending upwards.

I then analyzed the trendlines for assets as compared to liabilities.

In this case, I am looking for trendlines that are diverging apart with assets growing much faster than liabilities. And the above graph reinforces that.

I also looked at the total number of shares outstanding on the filing date for the same time period.

Ideally, I would like to see a trendline that grows downwards. But in this case, I see an trendline in the opposite direction. Share buybacks, when done for the right reasons, will boost shareholder equity. This is not concerning at the moment, but it is something that I will keep an eye on in the long-run.

For my final analysis, I wanted to see how the stock has performed for a long-duration with dividends re-invested as compared to other big-box retailers. For this analysis, I picked Walmart (ticker: WMT) and Target (ticker: TGT). The comparison with Walmart was going to be particularly interesting, since Walmart also highlights how they offer products at a lower-cost to the customer. The model uses a hypothetical $10,000 invested starting at 1995 to present.

Costco has absolutely crushed this with a total return of almost 6800% as compared to Walmart’s 1655%! The comparison between Costco and Target is more closer in this respect with both stores offering relatively similar total returns.

Valuation

At the time of writing this, Costco is trading at a forward Price-to-Earnings ratio of near 41. So right of the bat, it is ridiculously overvalued based on this metric alone. I actually went back through historical data to see the trend in PE ratio since 2008.

So the PE has been trending up and it is at its peak at present. I used two other models to estimate the fair value. I performed a Discounted-Cash-Flow evaluation with a perpetual growth rate of 2.5% and FCF to Profit Margin ratio estimate of ~90%. After accounting for debt and also adding in a margin of safety, my fair value estimate is about $209. I also used a two-stage Dividend discount model evaluation and this yielded a fair value of roughly $266. At the time of writing this, Costco is trading at a price to $447. So clearly, well over my fair value estimates.

Management

I have already talked about Jim Sinegal above. He was the CEO and chairman of board until 2011 and remained on the board until his retirement in 2018. The current CEO and chairman of board of directors, Craig Jelinek, has almost been with Costco since its early days. He started out as a warehouse manager and worked up the ranks to now become the CEO.

Craig has not changed a whole lot of the company’s core founding principles since Jim’s departure. But as far as Costco’s business, he has transformed the company into a retail powerhouse. At the start of 2021, Costco was the 3rd largest global retailer and 14th in the list of Fortune 500 companies, with a market cap of almost $164 billion.

The board of directors also includes a name that most people in the investing community are familiar with, Charlie Munger. Charlie, in numerous interviews, has raved about Costco’s business model and it is not surprising to see why.

As seen through Glassdoor, Costco sees favorable rating amongst its employees with about 90% of them approving of the current CEO.

Risks

Every investment comes with its share of risks, and even a great company like Costco is no different. The biggest risk that Costco faces is its competition with another heavy weight like Amazon. A few years back, when Amazon bought the Whole Foods business, there was a lot of scare amongst investors about what this would mean for other retail giants such as Walmart, Target etc. Based on my research, I think Costco is well-positioned to ward off such threats. It has a unique business model with plenty of scope to grow into new areas and markets.

Summary

Costco is one of my biggest bets in the “Growth” category of my dividend portfolio. I am very bullish about this business and will always be on the lookout for adding to my existing position, whenever such an opportunity presents itself.

Do you own this stock? If yes, does your analysis line up with what I have presented above? Please let me know in the comments below.

Thank you for stopping by and reading this!

Disclosure: Long COST, TGT, no position in WMT at the time of writing this

Johnson and Johnson – Deep dive analysis

In this post, I would like to analyze Johnson and Johnson (ticker: JNJ). This is the first of what should be a continuing series of posts, where I attempt to analyze every single holding in my dividend stock portfolio. Before going ahead, I want to state that this is by no means a recommendation to invest in Johnson and Johnson. I am simply sharing my analysis on this company for education. Please read my full disclaimer here. So, lets dive in!

My first introduction to JNJ was through their baby care products such as baby powder and baby shampoo. But very soon, I also noticed some other products around the household that also had a JNJ imprint on it, such as Band-aid, Tylenol etc.

History

JNJ was founded way back in 1886 by three brothers, Robert Wood Johnson, James Wood Johnson and Edward Mead Johnson. It was interesting to read that around this time, the practice of sterilizing equipment prior to a surgery was not common and this is what motivated Robert Wood Johnson to join his brothers into launching this business. Their first line of products included sterile surgical supplies and household medical equipment.

JNJ went public in the year 1944 and around this time, Robert Wood Johnson II drafted what is called the “Credo” document, basically a mission statement for the company. It is interesting that the Credo finds mention on JNJ’s website and their earning’s presentation even to this day and the statements are relevant in today’s context as well.

Since then, JNJ has grown through several acquisitions and is today one of the largest companies in the world in terms of market capitalization. What started as a company with only 14 or so employees, at the timing of writing this, employs over 132,000 people worldwide. Also, as things stand, JNJ is one of only two companies in the US (the other being Microsoft (ticker: MSFT)) that boasts of a AAA credit-rating, a rating higher than that of the U.S. Government. Quite incredible!

Business breakdown

JNJ’s business can be broken down into three primary segments: Pharmaceuticals, Consumer Health and Medical Devices. I found it particularly interesting looking at their recent and past 10-Ks SEC filings that Consumer Health is not the dominant part of their business, even though they have so many strong and well-known brands in the market. From the last 10-K, Consumer Health only represents about 17% of all the overall revenue, with Medical Devices making about 31% and Pharma making up the remaining 52%. Given this broad moat, JNJ is unlike other company in this domain. In fact, it is more like a healthcare ETF in its own right!

I was interested to see how the segments have been performing over the last few years. From what I could tell, most of the revenue growth seemed to be from the Pharmaceuticals segment, with the other two segments appearing relatively flat/tapering down slightly.

JNJ has been consistently spending on R&D, as it should given the very competitive nature of the business they are in. This is something that I am paying a close attention to it in their earnings presentations. From the earnings presentation in their last 10-K, I noticed that their pipeline for regulatory submissions to the US. FDA on the equivalent counterpart in the EU is reasonably full, thus driving growth for the coming few years.

Another noticeable aspect of JNJ’s sales is its geographic spread: while 50% of sales revenue comes from the US, close to 22% of revenue comes from Europe, and a good 18% or so comes from Asia-Pacific and Africa with the remaining coming from the western hemisphere. This diverse international exposure de-risks the business from over exposure to only one geographical market.

Dividend History

JNJ gets a lot of love in the dividend investing community. And it is not surprising to see why. The company has a history of increasing their dividends consecutively for 58 years, at the time of writing this. Just let that sink in for a second. 58 years includes things like the dot-com boom in the late nineties, and then the Great Financial crisis in 2008-2009. The company has been un-affected during all that turmoil and managed to return value back to their shareholders in the form of dividends.

I looked at the more recent dividend history to get a sense of the recent dividend growth rate. Here is what I could glean:

3-year Dividend CAGR	6.23%
5-year Dividend CAGR	6.17%
10-year Dividend CAGR	6.55%

So the dividend growth has been steady over the last decade with no apparent sign of slow-down. The last dividend hike was announced in April this year and it was about 5%.

Financials and Performance

The central question that a dividend investor is interested in is how safe is the dividend in the long run. To answer this, I look over the company’s financial statements to decipher the following:

• Is the company’s revenue growing?
• How profitable is the company?
• What are the company’s assets and how much does the company owe in the short-run and the long-run?

To determine is the revenue is growing, I looked at the basic EPS trend from the period of 2008-2020.

While I can see the revenue growing, the growth rate here seems to be slower than the dividend CAGR seen above. This was further confirmed when I looked at the dividend payout ratio, I could see a gradually increase in payout ratio during the same period. At the time of writing this, JNJ just released strong Q2 results for this year and raised the EPS guidance for the full year. This is a great sign and I am confident that the dividend payout ratio will sneak back into a safer range.

A quick note: For the year 2017, notice that the EPS drops alarmingly in the graph above. This is due to a change in the tax code for that financial year.

While I was on the income statements, I also looked at the Net Margin (Net Income as a percentage of the Revenue). Aside from 2017, the Net Margin seems to be around the 20% mark on an average. A steady Net Margin usually points to a strong and stable business.

From the balance sheet, I took a quick look at the debt to equity and debt to asset ratios. Here is a plot of the total debt/liabilities compared to total assets.

I am generally looking for trendlines that are converging that will prompt me to dig deeper. In this case, the trendlines seem like parallel trains, so nothing to worry about. However, when I looked deeper into the assets I could see that Goodwill is a fairly substantial portion of the total assets and it has been steadily growing in the past decade. This is not a concern at this moment, but this is something that will need to keep a close eye on in the near future.

I then looked at the total shares outstanding trendline. I am looking for a trendline that is trending downwards. Share buybacks when done for the right reasons will boost the equity value of the shareholders and as we can see through the graph above, JNJ is trending in the right direction here.

Finally, I compared JNJ to the overall S&P 500 performance. While capital appreciation is not the central goal of my portfolio, it does matter when it comes to gauging the overall performance of the stock. I have this data thanks to Dividend channel for a period of 1995-present starting with an initial capital of $10,000 and with and without dividends re-invested.

JNJ has clearly outperformed the broader market here, with an average total return of roughly 12% with dividends re-invested. To illustrate the point of why dividends matters, the total return without dividends reinvested comes up to about 10%. It is, therefore, very clear that dividends play a massive role in total returns obtained by the investor.

Management and Other Company details

While the engineer in me likes to breakdown the numbers, analyze data and evaluate business in a quantitative manner, that alone is not enough to understand the inner workings of a business. After all, numbers can only tell you so much. There are real people between those numbers and sometimes it is important to analyze business qualitatively as well.

So in that pursuit, I closely look at the management that runs the business. After all, these people are the face of the company. I listen to them speak during the conference calls and earnings presentations. Furthermore, this team provides the necessary leadership to the organization, motivates employees to perform their day-to-day roles efficiently. If a company has a fantastic balance sheet, but a clown as a CEO, it does not exude a lot of confidence in me as an investor about the long-term prospects of the business.

JNJ has this area pretty well covered though. Their current CEO, Alex Gorsky, has been with JNJ since 1988 rising up the ranks from a sales representative for Janseen Pharmaceutica to marketing, to management and finally the CEO and the chairman of the board. I really like organizations that hire from within, and where management have a long-standing history with their company.

I looked into the company’s outlook through Glassdoor to see how the employees rate working there:

The ratings are generally positive with around 95% of the employees approving of the current CEO.

Fair Value Estimation

For a fair value estimation, I used the Discounted Cash Flow model. For this estimation, I computed the Free-cash flow for a 5-year preceding period by subtracting capital expenditures from the total cash flow from operating activities. For my future cash flow estimation, I assumed a conservative net margin of 18% and computed FCF/net margin estimates based off that. I assumed a terminal growth rate of 2.5% to be on the conservative side. Furthermore, I estimated the required rate of return by using the weighted average cost of capital model (or WACC). Per my estimation, this came up to about 7%. Putting all the numbers together, the fair value of equity today, less debt and adding some margin of safety, is about $162.

At the time of writing this (EOD 8/2/2021), JNJ is trading at a share price of $172.27, so slightly above my estimated fair value above.

Risks

Any deep analysis is not complete without a discussion of risks associated with a stock pick. Even a solid business like JNJ has risks associated with it. With JNJ, as is typical with other companies in the healthcare sector, there are always risks associated with lawsuits due to consumer healthcare products or pharmaceuticals.

A few that come to mind with JNJ, is the lawsuit associated with their baby powder product, where it is alleged that the powder was contaminated with asbestos leading to ovarian cancer. More recently, there were reports of JNJ’s COVID-19 vaccine being linked to blood clots in women. At the time of writing this, JNJ is recalling their Neutrogena line of products related to sun-screens due to the presence of benzene which is considered to be carcinogenic.

Even in the presence of such risks, I am fairly confident that JNJ still has a solid foothold with its business to weather any storm.

Summary

JNJ is one of my “sleep-well at night” stock picks and I am fairly confident that this business will remain relevant in my lifetime at-least. It is for this reason that I have put it in the “Core” category of my dividend portfolio. However, as with all things in life, even a solid company like JNJ will cease to exist one fine day. It is for this reason that I manage a diversified portfolio with stock picks from different sectors.

Disclosure: Long JNJ