Johnson & Johnson Is Not Worth The Risk

Mar. 9.12 | About: Johnson & (JNJ)

By Joseph Hogue, CFA

There comes a time for an analyst to eat a little crow and admit he was wrong on a call. Almost eight months after calling Johnson & Johnson (NYSE:JNJ) one of the best boring stocks you will ever own, I am questioning whether the company is worth the risks.

The shares have returned approximately 5.1% annualized over the last 10 years, including the 3.5% dividend yield. This is only slightly above the 5.0% return over the same period for the S&P 500 SPDR (NYSEARCA:SPY) but with significantly more systematic risk. While the company may be able to continue performing over the long-term, significant short-term risks may lead investors to look elsewhere for stability and income.

The company recently announced that the CEO of 10 years, William Weldon, was stepping down to be replaced by Vice President Alex Gorsky. While a change of leadership is certainly needed, I do not know that Mr. Gorsky is the man to turn the company around. Mr. Gorsky is known as a fairly conservative leader and may not be able to make the changes needed to move the company from its path of poor quality control and weak pipeline.

While Xarelto may eventually boost sales, the company has not responded to significant competitor actions lately. Teva Pharmaceuticals (NASDAQ:TEVA) and Procter & Gamble (NYSE:PG) announced last year that they have entered into a partnership to sell over the counter drugs. The move builds off of Teva's strong manufacturing capacity and Procter's infrastructure and brand identity.

The real risk to Johnson & Johnson is legal risks and its weakening grasp on quality control issues. The company had to reorganize its consumer products group in February for the second time in less than a year after a consent decree led to the shakeup of its McNeil Consumer unit. The decree was signed in response to four product recalls from a Pennsylvania plant and gave the government additional oversight at the factory.

The company has had to recall more than 300 million packages and bottles of products over just 15 months.

Beyond the significant headline risks to quality control issues and lack of competitive focus, the industry may be negatively affected by healthcare reform legislation over the next couple of years as regulatory pricing and mandated coverage lower margins.

In late February, even long-term value investor Warren Buffet called the company into question. The Oracle of Omaha told CNBC that he may be ready to sell his stake because JNJ, "obviously has messed up in a lot of ways in the last few years." Berkshire owns roughly 1.2% of the company or about 34 million shares. The risk here is not really downward pressure from sale of the stake but the message it sends to other investors.

The company trades for 12.9 times trailing earnings, which is slightly above most competitors and just above the company's average of 12.6 times over the last eight quarters. Looking at competitors in the space, Teva pays a dividend of 2.1% and comes at a lower price-to-earnings ratio of 9.0 times trailing earnings. Investors looking for higher dividends may be interested in Eli Lilly (NYSE:LLY) with its 5.0% yield. The company has a higher operating margin, 22% compared to JNJ's 19%, and comes at a p/e ratio of just 8.8 times trailing earnings.

Consensus is for earnings per share of $5.10 over the next four quarters. This is only 2% above the last four quarters so even assuming the company can maintain its premium valuation multiple the target 12-month price only approaches $65.28 per share. A discounted cash flow analysis, assuming a terminal growth rate of 2% and a weighted-average cost of capital of 9.8%, brings the value to $66.69 or about 3.7% above the current price. This return may be suitable to those extremely risk averse investors with significant income needs, but it is also assuming no further problems with headline risk. At JNJ, that may be an assumption not worth betting on.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.