Johnson & Johnson (JNJ) Outshines Roche as a Dividend Stock

Exploring the Investment Potential of Johnson & Johnson and Roche Holding AG

Shares of Johnson & Johnson (NYSE:JNJ), a globally recognized leader in healthcare, medical devices, and consumer health, are an essential part of many dividend growth investment portfolios. The company boasts a remarkable long-term dividend history supported by robust earnings and cash flow, a strategic approach to acquisitions, and extensive diversification across its product lines. These factors form the foundation of a compelling investment case for JNJ, making it a staple for investors seeking reliable income and growth.

As a long-term investor, I prioritize diversifying my portfolio not only across the eleven Global Industry Classification Standard (GICS) sectors but also within various economic regions. Within the healthcare sector, Roche Holding AG (OTCQX:RHHBY, OTCQX:RHHBF) stands out. Although JNJ is the larger entity with a market capitalization of around $470 billion, Roche remains a significant player with a market cap of approximately $268 billion. In 2021, JNJ reported nearly $94 billion in sales while Roche achieved around $63 billion in sales, excluding royalties and additional revenue. Established in 1896, the Swiss firm has navigated through two world wars, the Great Depression, and various recessions, much like JNJ, which originated in 1886. Unlike Johnson & Johnson, Roche is predominantly family-controlled, with the Hoffmann family and their associates holding the majority of voting shares in RHHBF.

Both companies are recognized for their consistently increasing dividends. In this article, I will evaluate which of the two represents the superior long-term investment, particularly in terms of growing earnings that can support living expenses during retirement. Nevertheless, I will also highlight why I believe both stocks are excellent choices for investors. Additionally, I will address key risks associated with investing in the pharmaceutical sector, particularly concerning JNJ and RHHBY, to provide a well-rounded discussion. Those who are already well-versed in the operations of these companies may opt to skip directly to the concluding portion of the article.

As an important note, my comparison of the two corporations is based on their most recent annual results from 2021. This discussion will touch on certain metrics that can yield misleading interpretations when assessed through a trailing twelve-month lens or based on quarterly balance sheets.

Understanding the Strength of Johnson & Johnson and Roche Holding AG

In-Depth Analysis of Johnson & Johnson’s Business Segments

Johnson & Johnson operates through three primary business segments: Consumer Health, Pharmaceuticals, and Medical Devices.

The Pharmaceutical segment contributed significantly to JNJ’s revenue, accounting for 56% of net sales in 2021, amounting to $52.1 billion. This segment is home to blockbuster medications such as Stelara (ustekinumab, targeting interleukins 12 and 23, $9.1 billion, +19% YoY), Remicade (infliximab, targeting TNF-α, $3.1 billion, -15% YoY due to biosimilar competition), and Tremfya (guselkumab, targeting interleukin-23, $2.1 billion, +58% YoY). Further, oncology treatments like Darzalex (daratumumab, a therapy for multiple myeloma, $6.0 billion, +44% YoY) and Imbruvica (ibrutinib, a therapy for B-cell cancer, $4 billion, +6% YoY) along with cardiovascular drug Xarelto (rivaroxaban, an anticoagulant, $2.4 billion, +5% YoY) and treatments for neurological disorders such as Invega Sustenna (paliperidone palmitate, a schizophrenia treatment, $4.0 billion, +10% YoY) showcase the breadth of its portfolio.

While I won’t delve deeply into the specifics of the drug portfolio in this article, it’s clear that JNJ’s reliance on well-established blockbusters is pivotal, demonstrated by a solid growth rate of 14.3% YoY and an 11.1% two-year compound annual growth rate (CAGR), reflecting the pandemic’s influence. The long-term growth outlook appears promising, albeit tempered by a limited number of significant late-stage candidates in its pipeline. Nonetheless, JNJ remains a broadly diversified pharmaceutical player, with a significant revenue share stemming from biologics, which are generally more resilient against sharp sales declines once they lose exclusivity compared to small molecule drugs.

Notably, biosimilars represent the “generics” of biologics, possessing proven comparable properties and efficacies to the original macromolecules. However, they differ from generic small molecule drugs, which tend to be easier to synthesize and typically involve less complex efficacy studies, marketing, and generally higher acceptance rates. For instance, my research—including insights from Coghlan et al. (J Pharm Sci 2021 110 1572)—indicates that Humira (adalimumab), AbbVie’s blockbuster biologic, remains in high demand despite the introduction of biosimilars in Europe since 2018 (e.g., Amgevita, Amgen (AMGN), Hulio, Viatris (VTRS), Hyrimoz, Novartis (NVS)). Importantly, JNJ possesses the financial capacity to acquire promising smaller pharmaceutical firms, enhancing growth potential within its pharmaceutical division. The earnings before tax (EBT) for this segment in 2021 stood at $18.2 billion, translating to a robust 35% margin.

The Medical Devices segment ranks as JNJ’s second-largest, generating $27.1 billion in sales for 2021, accounting for 29% of total sales. This segment encompasses surgical instruments and devices (36% of segment sales, +19% YoY), orthopedic products like artificial hips and knees (32% of segment sales, +11% YoY), vision-related products including surgical devices and contact lenses (17% of segment sales, +20% YoY), and interventional solutions (15% of segment sales, +30% YoY). This segment experienced a 17.9% YoY sales growth, primarily attributed to the recovery in 2020 when many elective surgeries were postponed due to the pandemic. However, a two-year comparison indicates only a 2.2% growth, highlighting the impact of lockdowns and containment measures against SARS-CoV-2. The segment’s EBT margin in 2021 was 16%, indicative of continued recovery, though it was influenced by inventory-related effects from supply chain challenges and a $700 million charge for in-process research and development (IPR&D), contrasting with a 2019 EBT margin of 28%.

Lastly, the Consumer Health segment contributed 16% to total sales in 2021, amounting to $14.6 billion. This segment’s sales are well-distributed across various categories, including 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 boasts popular brands such as Tylenol, Neutrogena, Aveeno, and Band-Aid. Overall, this segment saw a 4% increase in sales compared to the previous year and 2.5% growth over a two-year period. Despite a 9% EBT margin in 2021, performance appears relatively stagnant, with weak revenue growth suggesting that JNJ has not aggressively pursued price increases relative to competitors. The decline from nearly 15% EBT margin in 2019 to 9% in 2021 can be attributed to $1.6 billion in litigation expenses related to talc, inflation, and increased marketing costs. If we adjust the 2021 EBT for these legal expenses, the margin would approach 20%.

Looking ahead, JNJ’s stakeholders will benefit from the company’s decision to spin off its Consumer Health segment in 2023, with preparations already underway for Kenvue Inc.’s initial public offering (KVUE), pending the sale of shares received. Post-spinoff, JNJ’s litigation-adjusted EBT is expected to decline by approximately 11%, or 5% when excluding 2021 litigation expenses from consideration.

Geographically, JNJ maintains a strong diversification strategy, with 50% of 2021 sales generated in the U.S., 25% in Europe, 18% across Asia-Pacific and Africa, and 6% in the Western Hemisphere (excluding the U.S.). This solid geographic diversification helps mitigate the effects of the Drug Price Negotiation Initiative and the Inflation Reduction Act (Morningstar adjusted its fair value estimate by 1.8% to account for these challenges), while also exposing the company to foreign exchange risks.

Investors appreciate JNJ for its consistent performance, mainly driven by its broad diversification and strong margins. The company’s adjusted operating profit margin remains stable at approximately 26%, which compares favorably to Roche (see Appendix). Furthermore, operating profit effectively translates into cash flow, evidenced by a stable and slightly positive excess cash flow margin (1% ± 3% over the last six years). The average normalized free cash flow margin stands around 23%, based on a four-year average.

JNJ’s status as a large, mature company results in relatively slow growth. Over the past decade, sales and adjusted operating income have grown at an average rate of about 3%, based on five-year average growth rates. Nevertheless, the company consistently generates a substantial return on invested capital (ROIC) that exceeds its weighted average cost of capital (comparison to Roche, see Appendix). This is complemented by excellent cash flow conversion, resulting in a solid cash return on invested capital (CROIC), which remains well above the current 6.6% Capital Asset Pricing Model (CAPM)-derived cost of equity. JNJ has successfully optimized its cash conversion cycle over the years, primarily through improved inventory management and extended payment terms with suppliers.

In summary, JNJ is rightly viewed as a well-diversified (in terms of products and geographical reach) and highly profitable company (apart from the Consumer Health segment). However, it remains a large, mature entity that tends to exhibit slow growth. Known for its successful acquisition strategy, JNJ’s reliable ROIC, CROIC, and effective working capital management reflect the successful integration of acquired businesses. The upcoming Kenvue spinoff is expected to enable management to focus on enhancing its drug pipeline to sustain solid growth in its Pharmaceutical segment while continuing to support the recovery of Medical Devices, thereby reinforcing the company’s leadership position in this sector.

Examining Roche Holding AG’s Business Structure and Performance

Roche, which I previously analyzed in an article from late 2021, is organized into two main reportable segments: Pharmaceuticals and Diagnostics. Similar to JNJ, the Pharmaceuticals segment is Roche’s largest, generating CHF 45 billion in 2021, excluding approximately CHF 3 billion in royalties and other revenue, which accounts for 72% of total sales. The Diagnostics segment contributed 28% to Roche’s 2021 sales, nearing CHF 18 billion, although it represented only 21% of total sales in 2019. The Pharmaceuticals segment experienced a 1% growth in sales in 2021, while the Diagnostics division surged by 29% in the same year. This performance highlights Roche’s resilience and diversification, as it has capitalized on extensive testing for SARS-CoV-2-related RNA fragments and surface antigenic proteins. For instance, Roche markets the COBAS 6800/8800 test system through its Diagnostics division, which can analyze 8,800 samples within a 24-hour period.

Delving into Roche’s Pharmaceuticals segment reveals a strong emphasis on antibody-based cancer therapies. The oncology sub-segment generated sales of CHF 20.5 billion in 2021, with leading products including Perjeta (pertuzumab, targeting HER2-positive breast cancer, CHF 4.0 billion, +2% YoY), Tecentriq (atezolizumab, used for treating non-small cell lung cancer, CHF 3.3 billion, +21% YoY), Avastin (bevacizumab, for colorectal, lung, and renal cell carcinomas, CHF 3.1 billion, down 39% YoY), and Herceptin (trastuzumab, for HER2-positive breast cancer, CHF 2.7 billion, down 28% YoY). The modest growth of Perjeta is attributed to its approval back in 2012, while the significant declines in sales for Avastin and Herceptin stem from heightened competition from biosimilars and alternative therapies that have entered the market since their initial approvals in the U.S. (2004 and 2008, respectively). Nonetheless, Roche’s dedicated focus on oncology, particularly antibody-based therapies, underscores the pivotal role of its subsidiary Genentech, which has continued to drive innovation since its acquisition in 2009.

A key takeaway with Herceptin is its status as an early personalized therapy, which aligns with Roche’s current strategic focus. Coupled with its strong diagnostics segment, Roche is positioning itself to become a leader in personalized medicine, particularly in the realm of personalized cancer therapy, through collaborations with firms such as Adaptive Biotechnologies (ADPT), BioNTech (BNTX), and Vaccibody.

Beyond oncology, Roche’s Pharmaceuticals segment also encompasses immunology and neurology, which contributed 19% (+2% YoY) and 14% (+27% YoY) to sales, respectively, in 2021. Key therapeutic agents include Actemra (tocilizumab, targeting interleukin-6, CHF 3.6 billion, +25% YoY; also approved for COVID-19 treatment) and Ocrevus (ocrelizumab, an anti-CD20 therapy for relapsing forms of multiple sclerosis, CHF 5.1 billion, +17% YoY). Another noteworthy medication is Hemlibra (emicizumab, a treatment for hemophilia A, CHF 3.0 billion, +38% YoY), showcasing Roche’s diverse yet oncology-centric portfolio.

Overall, Roche derives approximately 80% of its Pharmaceuticals segment’s sales from biologics. Given that this segment contributes over 70% of Roche’s total sales, it is reasonable to argue that Roche is better insulated from sales declines linked to generic competition compared to Johnson & Johnson. However, it is crucial to recognize the highly competitive nature of the biologics industry, especially in oncology, which necessitates ongoing vigilance (as discussed in my analyses of Merck’s Keytruda/pembrolizumab and Bristol Myers Squibb’s Opdivo/nivolumab, as well as AbbVie’s Enbrel/etanercept and tezepelumab).

Under current market conditions, Roche’s Pharmaceuticals segment has faced challenges from new therapies (Keytruda, Opdivo) and biosimilars (e.g., bevacizumab, trastuzumab, rituximab), leading to a decline in operating profitability from over 43% in 2019 to 34.5% in 2021. I have a strong appreciation for Roche’s focus on biologics and its Genentech subsidiary, which has solidified the company’s status as a market leader. However, the concentrated emphasis on oncology, particularly given the competitive landscape presented by Keytruda and Opdivo, raises some concerns. Nevertheless, the expected peak sales for Tecentriq, Ocrevus, and Hemlibra are promising, projected at CHF 9 billion, CHF 8 billion+, and CHF 5.5 billion, respectively.

The Diagnostics segment is divided into five sub-segments, with Core Lab (which includes immunoassays, clinical chemistry, and custom solutions) being the largest, accounting for 42% of segment sales (+21% YoY). The Molecular Lab (focusing on pathogen detection and donor screening) follows with 27% of segment sales (+21% YoY). Point of Care, which includes SARS-CoV-2 rapid tests, contributed 15% of segment sales, demonstrating remarkable growth of nearly 137% YoY. Diabetes Care and Pathology Laboratory together represent 16% of segment sales, posting a 5% YoY increase. The profitability of this segment is understandably lower than that of the Pharmaceuticals division, with an average operating margin of 16% over the past three years. The significant growth in SARS-CoV-2 diagnostics greatly influenced the YoY margin expansion of over 400 basis points in 2021, and it’s plausible that Roche’s Diagnostics division’s success during the pandemic played a role in the selection of Thomas Schinecker as the successor to the current CEO, Severin Schwan, in March 2023.

Roche enjoys similar geographic diversification to JNJ, with only 42% of its sales coming from the U.S. This suggests the company is less vulnerable to the Inflation Reduction Act, although it faces higher exposure to exchange rate fluctuations from a U.S. investor’s viewpoint. In 2021, Europe accounted for 26% of sales, including Switzerland, which generated a mere 1.2% of total sales. Japan contributed 8%, while the rest of Asia (including China) constituted 16%, and the remainder of the world (Latin America, North America excluding the U.S., Africa, Australia, and Oceania) contributed 8%.

Like JNJ, Roche’s sales have generally grown at an average of approximately 3% over the last decade, a trend unsurprising given its size and maturity. However, operating profit growth has lagged slightly behind, averaging around 2% over the past ten years, based on five-year average growth rates. Roche’s profitability is comparable to that of Johnson & Johnson, with an average adjusted operating margin of 29% versus JNJ’s 26% (see Appendix). The pandemic-related tailwinds have contributed to Roche’s profitability outpacing that of JNJ.

Roche’s conservative management approach, combined with a focus on organic growth instead of acquisitions, results in a generally higher ROIC compared to JNJ, averaging ten percentage points more (see Appendix). Roche’s excess cash margin also exceeds that of JNJ. The company allocates 28% of normalized operating cash flow to capital expenditures, compared to JNJ’s 11%, highlighting Roche’s emphasis on effective portfolio management. Consequently, while nFCF margins are similar, Roche’s CROIC remains significantly superior to that of JNJ, well above the CAPM-derived cost of equity of 5.0%. This low estimate underscores the limitations of the CAPM theory, as it inadequately captures the complexities of calculating the cost of equity based solely on stock volatility as a risk measure.

I believe investors should anticipate a cost of equity of at least 8% for both Roche and JNJ, given the evident risks tied to their drug pipelines, litigation, execution, integration of acquisitions, and competition from generics and biosimilars. With 42% of Roche’s sales generated in the U.S., the company faces moderate exposure to the Inflation Reduction Act and the Drug Price Negotiation Initiative (Morningstar projects U.S. sales declines of 1% in 2023 and another 1% in 2025). Just like JNJ, Roche is subject to multifaceted currency risks, as nearly 99% of its sales are derived from outside Switzerland, despite earnings and dividend payments being reported in Swiss francs. When the Swiss franc appreciates, earnings decrease, although the dollar amount received by U.S. investors increases, impacting the payout ratio simultaneously.

From a working capital perspective, Roche’s cash conversion cycle is notably longer than that of JNJ. However, I hesitate to label its working capital management as inferior. Large U.S. firms are often managed more efficiently yet aggressively regarding working capital, and Roche’s potentially more complex diagnostic device manufacturing processes could contribute to this difference. Importantly, Roche has consistently improved its working capital management over the years (comparison to JNJ, see Appendix).

Overall, Roche presents numerous attractive qualities as an investment. Like JNJ, Roche’s growth has been steady, albeit somewhat slow. Its superior profitability metrics in terms of ROIC and CROIC are noteworthy, yet the company’s concentrated focus on oncology raises some concerns due to the competitive nature of that field. Nevertheless, Roche’s strong position within this segment is evident, as it combines its expertise in oncology biologics through Genentech with the development of companion diagnostics, making a solid investment in the future of personalized cancer care. I appreciate Roche’s strategy of prioritizing biologics over small molecule drugs, which should mitigate the impact of competition as treatments reach their loss of exclusivity (LOE).

Evaluating JNJ versus Roche: Which is the Superior Income Investment?

Having detailed the specific attributes of both companies, it is essential to assess their qualities from the perspective of income investors