Background - my recent views on J&J (JNJ)
My past two JNJ articles reflected my changing views of the deterioration in its non-pharma divisions, namely devices and (iconic) consumer products. On Oct. 19, 2017, I wrote J&J: Unattractive. JNJ was around $140 then versus around $130 today. Subsequently, on April 19, I wrote Johnson & Johnson: Going The Way Of IBM?; JNJ was around $128 then.
Perhaps most relevant is the article I wrote on Sept. 24, 2017, J&J: Thoughts On Sirukumab And Other Problems. This article went into legal issues; two of the summary bullet points said:
- However, repeated guilty pleas for corporate misbehavior challenge that image; several large or even massive punitive judgments in product liability suits may put the credit rating at risk.
- This article documents various financial and reputational risks to the stock.
With regard to talc and asbestos, the catalyst for the recent 10% drop in JNJ's share price, I reviewed the finding of talc in ovarian cancer tissue and summarized my financial analysis in this section of the article as follows:
Again, just making up numbers, say that the number of these cases rises to 6,000 [from the 4,800 mentioned in the Reuters article I referenced]. An average settlement or judgment of $4 million leads to a total liability of $24 billion. This number could be way off the mark, of course, but cancer is cancer - and we are dealing with healthy women to begin with.
What if the real risk here is 8,000 cases X $5 million average per case, or $40 billion? Who needs this risk, even if the odds are that the numbers tossed out in this and prior sections end up being way too high?
Let's start with the talc/asbestos cancer issue.
From 4,800 cases to... many more (?) - in only one year
The PRODUCT LIABILITY section of the Q3 10-Q begins on p. 30. Regarding Johnson's Baby Powder, it says:
Personal injury claims alleging that talc causes cancer have been made against Johnson & Johnson Consumer Inc. and Johnson & Johnson arising out of the use of body powders containing talc, primarily JOHNSONS ® Baby Powder. The number of pending product liability lawsuits continues to increase, and the Company continues to receive information with respect to potential costs and the anticipated number of cases. Lawsuits have been primarily filed in state courts in Missouri, New Jersey and California. Cases filed in federal courts in the United States have been organized as a multi-district litigation in the United States District Court for the District of New Jersey. The Company has successfully defended a number of these cases but there have been verdicts against the Company, including a recent jury verdict of $4.7 billion . The Company believes that it has strong grounds on appeal to overturn these verdicts. The Company has established an accrual for defense costs only in connection with product liability litigation associated with body powders containing talc.
How many more cases? The Reuters report from last week that set off the sharp drop in JNJ shares says 11,700. I do not see that number in the latest 10-Q, but if it's accurate and covers about a 15 month period since the 4,800 number, that's a rate of close to 500 suits per month.
What's the downside to JNJ from Baby Powder litigation?
The problem to me in thinking of investing in JNJ is that it is not calculable. JNJ admits no liability. Note that it has accrued nothing in legal liabilities, only for (relatively modest) defense costs. That said, I will throw out imaginary numbers. Remember, I'm a long-only investor. I just comment on JNJ because the stock has so many interested investors. So, here goes with some total guesswork.
If there are by now about 12,000 cases filed, and I gather these are almost all in the US, then I assume the total number of cases will be 20,000 or more. Several years ago, I saw numbers as high as $10 million for the value of a life lost in US courts. Using that number, and understanding that some cases are cured, what about 10,000 cases (50% acquitals) multiplied by $5 MM per case? That comes to $50 B. But that's US only. And that is a total guess on liability only. It excludes JNJ's legal costs. Probably more important, it also excludes punitive damages if any. Finally, is there not the risk of foreign suits?
I believe it's anyone's guess here. I would think the costs to JNJ range from negligible to very large. In addition to dollar costs, what harm would come to the company if its reputation were indisputably sullied?
Then there are the other known product liability issues that JNJ discusses in the 10-Q and elsewhere. I think they are additional adverse wild cards; I reviewed some of them in my September 2017 JNJ article.
With all these legal matters, I have no opinions of the merits. I am not a lawyer and have not consulted one on these matters. My viewpoint is that of a potential investor thinking of JNJ amongst other possible blue chip, dividend growth stock investments.
JNJ is operating pretty well this year:
A look at 2018 results
The balance sheet shows $64 B in shareholder equity. It also shows $79 B in intangibles plus goodwill. Thus there is approximately -$15 B in tangible shareholder equity. JNJ has gotten there by generously returning earnings to shareholders over many years. Most recently, it expended about $30 B to purchase a smallish Swiss company, Actelion. Actelion's sales generated less than $2.8 B annualized in Q3, showing that JNJ paid a high price for existing sales. That alone raises questions about whether its intangibles and goodwill assets are worth 100 cents on the dollar.
Moving to earnings, Q3 had several moving parts. I'd rather look at 9 month data. This smooths out the "one time" stuff. Here we see yoy comparisons as follows:
- sales up from $56.2 B to $61.2 B
- gross profit up from $38.1 B to $41.1 B
- pre-tax earnings down from $15.1 B to $14.9 B
- but net earnings were up 2% due to a lower tax rate
- diluted EPS up nearly 3% to $4.49 from $4.37.
Note: the drop in pre-tax earnings was due partly to organic increase in R&D spending, but mostly to a $1.1 B write-down for two deals, Alios and XO1. Sales rose partly organically, partly from a full 9 months of income from the Actelion acquisition. Also note, per the conference call transcript, sales growth was 3.6% yoy, but ex-deals was 5.5%. That 5.5% would have been 6.1% ex-currency fluctuations.
So is it valid to annualize $4.49 EPS to $6 and say that JNJ is at 21-22X 2018 GAAP EPS? Probably that's a bit harsh, but writedowns are part of the business. I am wary of the $30 B paid for Actelion and of other intangibles and goodwill, so I would be ready for materially more writedowns in the future. Again, a note: Q2 earnings were harmed by a $0.8 B after-tax charge for "special items."
So, just as a placeholder, I'll be a bit harsh and say that at $130, JNJ is at 21X current-year EPS.
The next question is what JNJ's future growth rate is. Of course, no one knows. I will simply posit that if JNJ grows at the rate of the global economy, which might be 5% per year, then it can handle rising wages and grow EPS at 5% per year. That would bring the stock to a price:earnings:growth rate, or PEG, of 4:1.
I consider that average for high quality stocks in this market.
A word on GAAP
JNJ rides with its US peers in focusing on higher non-GAAP "earnings," but it does not report those numbers to the SEC. Gains and losses from transactions are inherent in JNJ's business strategy. Given an active acquisition strategy, both of marketed products as with Actelion and of pipeline drugs such as with Alios, whatever the accountants identify as amortizable is a wasting asset, and that decline of value must hit the P&L statement. By emphasizing non-GAAP numbers that typically do not include amortization of intangibles, JNJ and its peers would like - in my humble opinion - to suggest that investors ignore much or all of the cost of acquiring assets such as those with finite usable lives such as patent-protected drugs. So I go with GAAP, granted it gives lumpy results. My view is that business is truly lumpy, and GAAP reflects reality better than JNJ's non-GAAP numbers. (Your views may differ.)
At this point, I see JNJ as quite a strong company operationally. It has a stellar pharma division, which is, however, reaching a size where growth rates slow. The device and consumer products have had a spotty record for several years, and bulls can hope for sustained improved performance going forward. I estimate a PEG around 4X, which I consider OK for a blue chip, DJIA (DIA) company.
My view, though, is to consider not just the Baby Powder issue as a wild card, but some of the other products that JNJ discloses as subject to product liability litigation as having significant downside risks. So I proffer my strategy that given potentially large liability risks, JNJ is not attractive yet for me to invest in, and thus I'm staying on the sidelines. But I had a long term long position in JNJ, my views might be different.
Thanks for reading and sharing any views you wish to contribute.
Article completed Wednesday early afternoon with JNJ at $130.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: Not investment advice. I am not an investment adviser.