(Sources: Morningstar, GuruFocus, F.A.S.T. Graphs, CSImarketing)
Here is where JNJ takes a clear lead over AbbVie. Johnson & Johnson"s leverage ratio is below the industry average, and its sky-high interest coverage ratio indicates that the company has no trouble servicing its super cheap debt.
AbbVie, thanks to a slew of acquisitions in recent years, has a much-higher-than-average leverage ratio. In addition, its interest coverage is below that of most of its peers. However, while this high debt load is something I plan to watch carefully going forward, it isn"t yet a danger to the dividend. After all, AbbVie still has an A- credit rating and is able to borrow at very cheap rates as well. But in a rising interest rate environment, that might change. So it"s good that management plans to hold off on more acquisitions for now, while it uses the company"s enormous and fast-growing river of FCF to pay down debt.
As for dividend growth potential, this is of key importance, because studies indicate that a good rule of thumb for future total returns is yield + dividend growth. This is because, assuming a stable payout ratio, the dividend growth rate must track earnings and cash flow growth. And since yields tend to be mean-reverting over time, this combines both income and capital gains into one formula.
JNJ"s dividend growth rate potential is smaller than AbbVie"s, due mainly to its larger size. This makes it harder to grow quickly. However, analysts still expect about 7-8% earnings growth from this Dividend King. That should allow for similar payout growth and result in market-beating total returns.
AbbVie"s dividend growth outlook is more uncertain, though larger, thanks to its strong development pipeline. Unlike JNJ, AbbVie has no diversification into non-drug businesses, and so, its growth is more unpredictable and volatile.
However, I conservatively estimate that AbbVie should be able to achieve 10% dividend growth, while analysts expect about 14%. When combined with today"s attractive yield, that should be good for about 14% total returns. That"s far above what the S&P 500 is likely to provide off its historically overvalued levels.
Up until a few months ago, both JNJ and AbbVie investors were enjoying a very solid year. JNJ was tracking the market during a freakishly low-volatility 20% run in 2017. AbbVie was booming thanks to strong growth in Humira and the news that its cash cow wouldn"t get any competition until 2023. However, in recent weeks, JNJ and ABBV have suffered major losses that make them both potentially attractive investments.
| Company | Forward P/E | Historical P/E | Yield | Historical Yield | Percentage Of Time Yield Has Been Higher |
| Johnson & Johnson | 15.5 | 22.4 | 2.60% | 2.90% | 40%/30% |
| AbbVie | 13.0 | 21.5 | 4.00% | 3.00% | 11% |
(Sources: GuruFocus, F.A.S.T. Graphs, YieldChart)
JNJ and AbbVie are now trading at lower forward P/E ratios than their historical norms. More importantly, AbbVie"s yield is much higher than it"s been since the company"s 2013 spin-off. JNJ"s yield is not, but keep in mind that the company"s about to announce its 55th straight annual dividend bump. This should raise the forward yield to about 2.8%.
And even at a 2.6% dividend yield, JNJ"s payout has only been higher 40% of the time. And going off the likely 2.8% forward yield in a few months, 30%. Meanwhile, AbbVie"s yield has only been higher 11% of the time, indicating that it"s likely highly undervalued.
(Source: Simply Safe Dividends)
A rule of thumb I like to use for determining fair value is that I want to buy a stock when the yield is at least at the 5-year average. Taking into account the upcoming JNJ dividend hike, I now estimate that it is fairly valued. And under the Buffett principle that "It"s better to buy a wonderful company at a fair price than a fair company at a wonderful price", I have no issue recommending JNJ today. After all, it"s the ultimate pharma blue chip, with the best dividend growth record in the industry.
Meanwhile, AbbVie is about 17% undervalued, which is why I consider it a more attractive investment today. That"s why I added it to my own portfolio during the recent correction and during the Rova-T freakout.
Note that if I had the cash, I"d have bought JNJ as well, and I highly recommend owning both blue chips in your diversified income portfolio. That"s assuming, of course, that you are comfortable with the complex risk profile of any pharma/biotech company.
Risks To Consider
When it comes to complexity and uncertainty, few industries are as challenging as pharma/biotech. That"s because of numerous risk factors that make it very challenging for companies to consistently grow safe dividends.
For one thing, the same regulatory hurdles that provide a wide moat and windfall profits for a time also make new drug development incredibly tricky and time-consuming.
(Source: Douglas Goodman)
For example, fat profit margins are created by patent protection, which usually lasts for 20 years. However, drug makers need to file for a patent at the start of the development process, which usually takes 10-15 years to complete. That means drug companies only enjoy patent-protected margins for a relatively short time before patent cliffs kick in and generic competition can steal market share.
And we can"t forget that the process itself is highly unpredictable, monstrously expensive, and only getting more so over time.
(Source: Tufts Center For The Study Of Drug Development, Scientific American)
When factoring in all the preclinical, clinical, and follow-up studies, it can cost as much as $ 2.6 billion to develop a new drug. And as we just saw with Rova-T, a promising drug can fail at any time. That can potentially result in a total write-off and gut-wrenching short-term price volatility.
Worse yet, because only about 1 in 10,000 compounds/treatments ends up making it through the FDA regulatory gauntlet, drug makers often have to acquire rivals to obtain promising pipeline candidates in late-stage development. All major M&A activity is inherently packed with risk.
For example, if a company overpays, then even a successful blockbuster drug can end up not contributing much to EPS or FCF growth. Meanwhile, synergistic cost savings, which are often counted on to make deals profitable, might not be fully realized. And what if a key drug that was a major reason for a large acquisition fails in trials? Then large write-offs can result, as may happen with Stemcentrx and Rova-T. And don"t forget that a failed acquisition can lead to a costly break-up fee. For example, in 2014, AbbVie abandoned the $ 55 billion attempt to buy Shire (NASDAQ:SHPG), resulting in a $ 1.6 billion break-up cost to shareholders.
The good news is that according to AbbVie"s CFO, when it comes to additional short-term acquisitions, investors shouldn"t "expect anything major." That"s because, he said, "Running out and buying something of size doesn"t make sense." Holding off on more acquisitions for a few years means that the company will have time to deleverage its balance sheet while it brings its strong development pipeline to market.
In addition, AbbVie does have a pretty good track record on acquisitions, since the $ 21 billion purchase of Pharmacyclics in 2015 was reasonably priced. It gave the company the blockbuster Imbruvica, which is its second-largest but fastest-growing seller.
But even if everything goes right, a company makes a smart acquisition at the right price, and the potential blockbusters in the pipeline are approved, there"s the issue of massive competition to contend with. For instance, patents on drugs are highly specific. Competitors are free to create alternate versions, including of highly profitable biological drugs. That"s why every pharma/biotech and their mother is constantly racing to develop biosimilars to the hottest blockbusters on the market.
In this case, Remicade faces competition from over 20 potential rivals, including Pfizer"s (NYSE:PFE) Inflectra, which is selling at a 10% discount to Remicade. And without patent protection, analysts expect Remicade sales to continue to deteriorate at an accelerating pace. Meanwhile, JNJ prostate drug Zytiga is also expected to see generic competition this year, due to patent expirations.
In order to keep their pricing power, pharma companies are also fighting constant legal battles. That"s to protect patents and also to try to block generic and biosimilar competition for as long as possible. All legal challenges are themselves highly uncertain, and a negative outcome can have a large impact on both the share price and future cash flow growth.
And we can"t forget about the other kind of legal uncertainty: class action lawsuits in case an approved drug ends up being harmful to consumers. For example, Merck (NYSE:MRK) had to pull popular pain drug Vioxx from the market in 2004 when post-clinical studies showed it significantly increased the risk of heart attack and stroke. The company has spent over 12 years in and out of courts, as a plethora of class action suits have continually pushed up the final settlement costs. In 2007, Merck settled most of the cases for $ 4.9 billion. But individual holdouts have continued suing the company, and the total cost is now at $ 6 billion, with several cases left to be settled.
And that is just one extreme case of what can go wrong. Often, legal liability is a death from a thousand cuts. For example, AbbVie recently lost a case in Chicago where a man successfully sued over AndroGel, a testosterone replacement cream. The plaintiff claims that AbbVie"s cream caused him to have a heart attack. While the jury did not find the company strictly liable, it still awarded him $ 3 million. The company faces about 4,000 more such cases over AndroGel. Each case is likely to have a different outcome, and some of them might be thrown out or be reduced on appeal. But the point is that even non-blockbuster products can end up as a major financial liability.
Meanwhile, in the past, JNJ has faced its own legal hassles, including numerous consumer product recalls, defective knee, hip implants, surgical mess, and a $ 2.2 billion settlement over antipsychotic drug Risperdal.
Finally, we can"t forget the other major legal risk: government regulations and healthcare policy, both in the US and abroad.
(Source: HCP)
In the US alone, the rapidly aging population means that healthcare spending is expected to increase by about $ 2 trillion per year by 2025 and consume 20% of GDP. This means that the US government as well as private payers will be desperate to bend the cost curve lower. Blockbuster drugs and their high profit margins are an easy target for populist politicians to go after in this country and around the world.
For example, President Trump announced that:
"One of my greatest priorities is to reduce the price of prescription drugs. In many other countries, these drugs cost far less than what we pay in the United States. That is why I have directed my Administration to make fixing the injustice of high drug prices one of our top priorities. Prices will come down."
The president has also said in the past that drug makers were "getting away with murder", a sentiment many Americans share. And it is true that foreign countries do enjoy lower drug prices, largely because government involvement in healthcare is far more common. Of course, that is why most R&D recoupment is generated in the US.
But that"s not guaranteed to continue. Because even if Congress doesn"t enact outright price controls on drugs, it can easily lift the current ban on Medicare/Medicaid negotiating bulk drug purchases at a discount. That"s a far less controversial proposal that represents low-hanging, cost-saving fruit - one that could potentially hit margins across the entire industry.
In the meantime, Joaquin Duato, JNJ"s executive vice president and worldwide chairman of its pharmaceuticals segment, has said that insurers and pharmacy benefit managers are putting on extra pressure to lower drug prices. This is why the company"s pharma growth plans are focused on volume and not price. It wants to grow profits by expanding indications and launch new medications to treat more conditions, specifically in immunology and oncology.
The bottom line is that pharma is a wide-moat industry with huge potential for future growth. However, it"s also fraught with peril and risk. Drug makers face a never-ending hamster wheel of uncertain, time-consuming, and costly drug development. This means steady growth in sales, earnings, and cash flow is very challenging.
Only enormous economies of scale, highly skilled capital allocation by management, and safe and growing dividends make it worth considering the industry at all. Which is why I avoid all but the most proven blue chips in the industry, and recommend most investors do the same.
Bottom Line: These 2 Industry-Leading Blue Chips Are Likely To Make For Strong Long-Term Income Investments At Current Prices
The drug industry has a lot of favorable characteristics. It"s recession-resistant, wide-moat, and is potentially poised to enjoy a major secular global demographic growth catalyst in the coming years and decades.
That being said, it"s also one of the most complex, cyclical, and competitive industries in which you can participate. That means the best course of action for most investors is to stick with industry-leading, blue-chip dividend stocks - those with shareholder-friendly corporate cultures and proven management teams.
Johnson & Johnson and AbbVie represent the top names in pharma and biotech, respectively. And at current valuations, I am able to recommend both for anyone looking for low-risk exposure to this defensive industry. That being said, AbbVie has better total return potential, and its recent disappointing drug trial results mean that the company is far more undervalued. That"s why I bought it over JNJ for my own portfolio during the correction.
Disclosure: I am/we are long ABBV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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