Monday, September 13, 2010

Johnson & Johnson: An Underleveraged Stock

An article that summarizes thoughts from Whitney Tilson on why Johnson & Johnson (JNJ) should cut the dividend and take on debt to finance a large buy back of its stock.

Tilson asks you to imagine what would happen if Johnson and Johnson cut the dividend in half and used the $3 billion to issue 30-year debt. Assuming a 5% interest rate, $3 billion pays the interest on $60 billion of debt (note that last month Johnson and Johnson issued $1.1 billion of debt, half 10 year at 2.95% and half 30 year at 4.5%).

The $60 billion of debt proceeds could be used to buy back 36% of the current Johnson and Johnson shares outstanding at the current market price. After subtracting the interest payments (partially reduced by income tax savings), Johnson and Johnson's earnings per share would increase 38% assuming no increase in net income.

Personally, I would be in favor of less extreme leveraging but the point being made is a useful one. The scenario described above also works for many other companies right now. Microsoft (MSFT) is an example that comes to mind. The opportunity to do so is directly related to a combination of high FCF yield, an underleveraged balance sheet, and cheap borrowing costs.

When a durable and underleveraged franchise can access low cost financing* then use those funds to buy an 8-10% earnings yield (one that might even grow a bit over time), the difference is to the benefit of continuing long-term shareholders.

This is all in stark contrast to the post on The Danger of Short-Term Debt.

We have a situation now where, at one extreme, there are many sovereign countries and financial institutions that have seemingly too much leverage while, at the other extreme, some very good companies are underleveraged.

Some are even reasonably cheap.


Long JNJ and MSFT

* The four remaining publicly traded U.S. companies with a credit rating of triple-A are Microsoft, ADP, Johnson & Johnson, and Exxon. Johnson & Johnson recently sold 10-year bonds with a nominal interest rate of 2.95%.
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