Johnson & Johnson (NYSE:JNJ) recently announced the settlement of its Risperdal case with the DOJ and 45 states for approximately $2 billion. The company will plead guilty to one count of criminal misdemeanor, and expressly denies the civil allegations.
Quantifying the settlement in terms of market cap, it amounts to 0.76%. On a per share basis, it amounts to 71 cents. The amount had been previously reserved and the settlement won't change financial results. But the question arises, what about the reputational damage?
The last time I looked at the issue (in October 2011), my take was positive:
I'm working on an article on the topic. Briefly, the risk of serious injury to consumers from the recalled products was remote, and the company has complied with FDA required corrective action. The loss of market share is reflected in current earnings, and can be recovered over time with judicious advertising and promotional efforts.
The Risperdal case involves off-label marketing of an anti-psychotic drug, something for which other drug companies have been prosecuted, with the cost running in the $1 to $2 billion range. That can quantified as less than 1% of market cap, or 2% of shareholders' equity. I see an ethical issue in shades of gray.
Meanwhile, publicly available surveys on reputation show JNJ retaining its position as one of the most admired companies in the United States.
Standing on the Fortune List of Most Admired Companies
JNJ has seen a steady erosion of public respect vs. its peers, as well as against other large companies. Specifically, in 2009 the company was #5 overall, and 1st among Pharmaceuticals.
For 2013, they have slipped to #23 overall, and 4th among Pharmaceuticals.
Here's Warren Buffett on the issue:
It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.
In point of fact, JNJ has had a number of issues that have been eroding their standing, and at times management appeared utterly clueless about the damage that was occurring. A good reputation is an important business asset, as the Oracle of Omaha knows.
Quality Control Issue
Reuters did an analysis of JNJ product recalls, and found over 20 for the period from July 2009 to February 2012.
Just scanning the list, Tylenol, Motrin and Benadryl appear repeatedly. These are household names, and it's difficult to believe that some of the brand equity hasn't been destroyed.
Change of Management
William Weldon retired as CEO in December 2012. From Wikipedia:
He spent his entire working life at J&J. He joined J&J as a sales representative for the McNeil Pharmaceutical division in 1971 and eventually became the head of J&J's Ethicon Endo-Surgery business in 1992. He became the head of J&J's pharmaceutical operations in 1998 and then became J&J's CEO in 2002. As CEO, Weldon engineered some of the largest acquisitions in J&J's history including the purchase of Alza and Pfizer's consumer-health product line. In 2009, he earned a total compensation of $22,830,834, which included a base salary of $1,802,500, a cash bonus of $12,831,146, stock awards of $2,762,532, option awards of $5,238,069, and other compensation of $196,587. In 2011, the New York Times named him on its list of "The Worst C.E.O.'s of 2011" for the increased number of Johnson & Johnson product recalls under his leadership. Additionally, as of 2013, his story is a case of study at the Leadership & Corporate Accountability course at Harvard Business School as an example of unethical leadership in business. Weldon retired as chairman of Johnson & Johnson on December 28, 2012 and was reported to receive $143.5 million in retirement pay.
Venomous material on both Weldon and JNJ is easily located on the internet.
I watched Weldon do an interview with Maria Bartiromo on CNBC while the recall debacle was developing, and formed an impression of cluelessness. He didn't seem to get it.
The company is fully valued by my preferred PE5 method. Using S&P's estimates for 2013 and 2014, together with three years' historical results, 5 year average EPS will be $4.68. Applying a multiple of 20 on that metric, typical of high quality/iconic firms, a value of $94 emerges, by year end 2014. The stock is trading at $93 as of this writing.
It should be noted that EPS in 2011 and 2012 were weak. As such, a metric that looks back to them may underestimate what a forward-looking market will pay for future earnings.
The dividend has increased steadily for many years, most recently by 8%. At a $93 share price, it yields 2.8%. The payout ratio is 60%, at the current dividend rate and using TTM earnings.
The financial information is developing favorably here. Buying at today's prices, an investor has a reasonable expectation of receiving an increasing flow of dividend income. Modest capital appreciation over time is probable, subject to the risk of further reputational damage caused by inadequate quality control and ethical insensitivity.
I would resist the temptation to chase this one higher. It's priced for superior performance both this year and next, which has not yet occurred. I question the wisdom of paying iconic prices for tarnished merchandise.
I'm long Jan 2015 77.5 LEAPS calls, against which Apr 2014 90 calls have been sold. The position acts very much like a put, in that I'm bearing the chance of loss if the shares are below $90 at the first expiration.
On more than one occasion, I've been sitting in a doctor's office, waiting to see the great man, when a pharmaceutical salesperson comes in and is immediately admitted to his presence.
At one time, I worked for a healthcare organization, and developed the impression that the psych nurses were functioning as "med cops." Their mission was to make sure that the chemical shackles remained in place.
I don't like this Risperdal thing, or the similar offenses by other industry players. Investors in the aggregate seem to view the issue as more in light shades of gray than black and white. After all, everybody does it, and they pay their fine, and go on their way.
Here, similar to investing in tobacco companies, a portfolio focused on dividend growth stocks should include key players, without excessive concentration in any one name or the industry as a whole.