Johnson & Johnson Q1 Earnings Preview: More Pain Ahead?

Summary:

• In this article, I provide a brief overview of Johnson & Johnson’s 2022 performance and take an updated look at the company’s balance sheet, including its debt following the Abiomed acquisition.
• I discuss the company’s recent earnings performance and the likelihood of an earnings beat on Tuesday, when J&J reports its first quarter results.
• I explore the question of whether JNJ stock should possibly be considered “3M 2.0” or whether fears of potentially devastating litigation costs are overblown.
• I model the impact of the now significantly higher talc litigation expenses on JNJ’s DCF valuation, taking into account that the new reorganization plan is apparently strongly supported by claimants.

Introduction

I first covered pharmaceutical, medical devices and consumer health giant Johnson & Johnson (NYSE:JNJ) in January, when I compared it to Swiss-based healthcare giant Roche Holding AG (OTCQX:RHHBY, OTCQX:RHHBF). I concluded that the U.S.-based company is a better dividend growth stock for several reasons, even though I also think Roche is an impressive and well-run company.

More recently, I published an article that focused on the upcoming initial public offering (IPO) of JNJ’s Consumer Health division, which will be named Kenvue (KVUE). In it, I pointed out the fact that contrary to popular belief, JNJ will not be getting rid of most of its talc liabilities through the Kenvue IPO. Quite the contrary – JNJ will retain all of its talc liabilities in the U.S. and Canada, which make up the bulk, and Kenvue will only be responsible for the remainder. In addition, I explained how JNJ plans to limit its talc liabilities in the U.S. and Canada and why I believe the Kenvue transaction was likely a necessary step in that process.

Johnson & Johnson will report its first quarter results on April 18 before market open. So in this update, I’ll outline what to expect from JNJ on Tuesday – not just in terms of earnings, but also in terms of talc litigation. After all, the company recently announced that its subsidiary LTL Management LLC has re-filed for voluntary Chapter 11 just a few months after it became known that the approximately $2.4 billion litigation-related cap might no longer apply.

Johnson & Johnson’s Performance In 2022 And A Brief Look At The Balance Sheet

Johnson & Johnson is sometimes referred to as a healthcare mutual fund of sorts – and rightly so, given its broadly diversified portfolio across three main businesses: pharmaceuticals, medical devices and consumer health (see my original article for a portfolio deep-dive). For this reason, and because of JNJ’s savvy and conservative management, the company regularly beats earnings estimates (Figure 1). I suspect this is a key reason why so many investors hold JNJ stock as an anchor position in their portfolios. The company is growing earnings like clockwork, with an average annual growth rate of 7.3% over the past twenty years – only in 2020 did the company report declining earnings when most elective surgeries had to be postponed due to government mandated measures to contain the spread of SARS-CoV-2. However, as shown in the FAST Graphs chart in Figure 2, JNJ’s earnings recovered in 2021. Overall, I consider the company’s earnings growth very acceptable – after all, it’s a $430 billion company with a very long history.

Given the current inflationary headwinds, I believe adjusted earnings growth of 4% in 2022 is very acceptable for such a giant and confirms JNJ’s strong position. The company’s earnings growth last year was largely due to volume growth (+6.9% year-over-year on a net sales basis), as JNJ noted a negative contribution from pricing of about 80 basis points (p. 22, 2022 10-K). Currency effects are not included in the adjusted figure (-5% year-over-year from a net sales perspective).

Free cash flow (FCF) was significantly lower than 2021 and also 2020, but this was largely due to working capital related effects, so FCF can be expected to mean-revert going forward. JNJ completed the acquisition of Abiomed Inc. in late 2022, and its FCF contribution will certainly be positive (three-year average unadjusted FCF of $250 million), but hardly significant. JNJ’s capital expenditures were about 10% higher in 2022 compared to 2021, but it is important to understand that the healthcare giant is also growing through acquisitions. At the same time, the company is divesting underperforming assets, so it is actually able to maintain a pristine balance sheet, unlike Unilever (UL, OTCPK:UNLYF), for example (see my comparison with Procter & Gamble, PG). Of course, one cannot directly compare a health care company with a food and personal care company, but the comparison is still helpful in illustrating JNJ management’s obvious knack for profitable acquisitions and the proper and timely integration of the acquired units.

Besides Apple Inc. (AAPL) and Microsoft Corporation (MSFT), JNJ is the only company in the U.S. with a long-term credit rating of Aaa and a stable outlook. It seems worth noting that the recently completed $16.6 billion acquisition of Abiomed (plus potential future considerations) has not negatively impacted Moody’s outlook on JNJ’s credit rating. However, and very understandably in my opinion, the setback related to the talc litigation discussed in my previous article was credit negative, but the rating agency still maintained its stable outlook. The JNJ subsidiary’s renewed bankruptcy filing comes with a nearly fourfold increase in commitments (from $2.4 billion to $8.9 billion) to settle all current and future talc lawsuits in the U.S. and Canada, and was also deemed credit negative by Moody’s Investors Service. However, the agency currently maintains its stable outlook and Aaa rating.

At the end of 2022, JNJ reported net debt (including operating lease liabilities) of $17.4 billion. So, the company could theoretically pay down all of its debt in less than a year with free cash flow if it hypothetically suspended dividend payments and share buybacks. Note that this figure already includes the debt incurred in the Abiomed acquisition. Excluding $11.2 billion in short-term debt, i.e., focusing on JNJ’s long-term debt and current portion at the end of 2022, the company’s weighted-average interest rate is 2.99% – very reassuring, as this translates to an interest coverage ratio of about 25 times free cash flow (before interest and adjusted for stock-based compensation). Assuming that JNJ refinances the aforementioned $11.2 billion at 4%, the company’s interest coverage ratio would decline to 17 times adjusted free cash flow before interest.

Johnson & Johnson’s debt maturity profile, as shown in Figure 3, is quite balanced and should be viewed in the context of the strong and reliable free cash flow. It should be noted that the figure does not include the portion mentioned above, which is expected to be refinanced long-term in the near future. Even after paying the dividend, JNJ typically has about $9 billion remaining for acquisitions and/or debt repayment, so the company could theoretically pay down its debt as it matures. Looking at the weighted-average interest rates calculated for each three-year bucket, and considering the $11.2 billion soon to be refinanced, JNJ will of course be negatively affected by the current interest rate environment, especially if rates remain higher for longer. However, the impact will remain very manageable due to the generally low leverage, top-notch credit rating, and reliable free cash flow.

Can JNJ Be Expected To Beat Earnings On Tuesday?

JNJ routinely beats earnings estimates, not only on an annual basis, as shown above, but also on a quarterly basis (Figure 4). In 2020, when the global economy was largely in hibernation due to the pandemic and most elective surgeries were postponed, analysts were obviously more conservative – but so was JNJ’s management. Granted, the company reported lower earnings this year, but I think management did a good job of navigating the environment and communicating developments in a conservative manner. From that perspective, it’s reasonable to expect JNJ to beat expectations on Tuesday. Given the weaker U.S. dollar in recent months, the exchange rate will provide a tailwind to reported earnings – after all, 49% of JNJ’s 20222 top-line was generated outside the United States. Given that JNJ’s 2022 (and 2021) profit growth was largely due to volume growth and not really price increases, I think the company could potentially surprise with an earnings beat thanks to price increases on its high-demand products.

I also think negative surprises are unlikely from the perspective of sales and earnings per share (EPS) revisions. Both the sales and EPS revision trends for the first quarter of 2023 have been negative over the past six months, but only to a rather insignificant extent. On an annual basis, analysts have slightly increased their 2023 EPS estimate over the past six months. In my opinion, the analyst scorecard published by FAST Graphs does a very good job of underscoring the low probability of an earnings miss. Predicting EPS accurately is difficult even on an annual basis, let alone a two-year basis. However, with the exception of 2020 (who saw the pandemic coming?), analysts’ expectations were very closely met on a two-year-forward basis (Figure 5). I don’t know many companies with such a high-quality analyst scorecard – Merck & Co. Inc. (MRK), however, is another notable positive example.

Update On J&J’s Talc Litigation – What To Expect Going Forward

Given the rather substantial sell-off – for such a world-class company – since the start of the new year, I think it is clear that the market is not really focused on earnings and cash flows at the moment, but on the ongoing talc litigation. As detailed in my previous article, JNJ hit a roadblock earlier this year when a U.S. appeals court rejected the company’s bankruptcy strategy to isolate the talc lawsuits from the rest of the company. JNJ stock lost about 17% in three months, which is definitely a lot for this type of company. Investors likely feared that JNJ could turn into a sort of “3M 2.0” as it faced unpredictable and potentially devastating charges related to its allegedly cancer-causing talc-containing products. It should also be remembered that JNJ is also involved in several other product liability claims and lawsuits – Note 19 on page 84 et seq. of its 2022 10-K provides a good overview, but of course focuses on talc-related litigation.

Since my last article, important news has emerged related to the talc lawsuits. The company’s subsidiary, LTL Management, which was essentially formed to handle all current and future claims in the U.S. and Canada, has re-filed for Chapter 11, with the difference that $8.9 billion is now being allocated to the matter. Interestingly, JNJ speaks of “an increase of $6.9 billion over the $2 billion previously committed” and did not mention the previously allocated $350 million present value of certain royalty revenue streams. It is therefore reasonable to assume that the actual amount committed to settle all current and future claims will be approximately $9.3 billion. This is, of course, a substantial sum, but considering that the commitment is payable over 25 years, it will not materially impact JNJ’s free cash flow, which currently exceeds $20 billion annually. However, this figure does not include claims from outside the U.S. and Canada, as I detailed in my last article. Those will be handled by JNJ’s Consumer Health spin-off Kenvue.

The market understandably breathed a sigh of relief and looked past the rather staggering figure – likely because JNJ reported that it “has secured commitments from over 60,000 current claimants to support a global resolution on these terms” which has significantly reduced uncertainty on the matter. In stark contrast, 3M (MMM) management recently noted that its 2023 guidance does not include potential litigation costs related to earplugs and PFAS (see this article for a detailed discussion). Morningstar estimates 3M’s litigation exposure at approximately $19 billion in its most recent analysis:

Our survey of prior environmental and product liability cases leads us to assume that a midteen billion-dollar liability is more likely, though 3M’s own legal expenses bring legal-related costs meaningfully higher. For 3M’s Combat Arms earplugs litigation, we earmark a liability of just over $4 billion based on inflation-adjusted comparable cases and the number of cases pending.

Joshua Aguilar on March 2, 2023 – Senior Equity Analyst at Morningstar

If JNJ is successful with its bankruptcy maneuver, the cost of about $9 billion is definitely much easier to digest than the potential $19 billion liability that 3M faces. After all, the materials science company is fairly cyclical and generated a three-year average of $5.6 billion in unadjusted free cash flow. Moreover, the company is significantly more leveraged and is rated only A1 by Moody’s. Importantly, the rating agency recently changed the outlook from stable to negative:

Although Moody’s expects 3M’s underlying operational performance to remain strong through 2023, the company is facing significant and growing risk from product liability litigation (Combat Arms) and environmental liabilities associated with its history of PFAS production

David Berge on February 27, 2023 – Senior Vice President at Moody’s

Therefore, I think it’s inappropriate to call JNJ “3M 2.0” – even if the company fails to cover its talc-related liabilities also through this new Chapter 11 filing of LTL Management. Foreseeable litigation expenses are much lower at JNJ, and the company has a much better standing with the rating agencies, has a much healthier balance sheet, and has largely non-cyclical cash flows. I think it is reasonable to conclude that litigation is a “cost of doing business”, and investors should be careful not to discount these costs when determining an appropriate cost of equity when valuing the stock using a discounted cash flow analysis.

JNJ’s earnings call on Tuesday will definitely be interesting to follow, particularly because management will likely be confronted with several questions related to LTL’s renewed Chapter 11 filing. Considering that management has reiterated that it believes “that these claims are specious and lack scientific merit“, the increase from $2.4 billion to $9.3 billion could be taken as a sign of desperation – what if the company fears even higher litigation cost? There are also lawyers who still oppose the maneuver, claiming that JNJ’s move was made in bad faith, and the group even questioned the claim that JNJ’s latest offer is supported by over 60,000 claimants.

It should be noted, however, that JNJ has won most of the talc-related jury trials to date, so I think there is a good chance that the parties will settle based on the significantly increased commitment. Also, I think – and I don’t mean to disparage the people who have health issues and are taking action against JNJ – it’s important to look at both sides of the coin, i.e., the incentives of the law firms involved. At some point, the risk-reward ratio (please excuse the term in this context) becomes less and less favorable, especially when adding the time factor into the equation. I believe that with this latest move, JNJ management has underscored that it wants to put to settle issue that has plagued the company and its stock since at least 2018. The apparent significant support from claimants is definitely reassuring, and I think management will provide more information on Tuesday that could further improve investor sentiment. JNJ stock is already up nearly 10% from its recent low, but I think there is more upside in the near term given the increasingly confident sentiment around litigation.

Conclusion – And The Impact Of The Increased Commitment To JNJ’s Valuation

JNJ will report its first quarter results on Tuesday, April 18. Given management’s excellent track record and analysts’ somewhat conservative stance in recent months, it is reasonable to expect the company to beat adjusted EPS estimates as usual. However, and quite understandably, the focus right now is on the talc litigation and LTL Management’s renewed Chapter 11 filing. The market hates uncertainty, so the significant support from claimants was probably the main reason for the recent improvement in investor sentiment. 75% of plaintiffs must support the reorganization plan – the exact number is not known, but the apparent support of over 60,000 is a strong sign that the plan will work as expected.

Investors apparently did not mind the nearly fourfold increase in litigation expense, or have already expected a substantial increase. Having a sizable position in JNJ myself, I am among those who favor a “once and for all” solution, even if it may come at a rather high price (again, please do not misunderstand my words). I think the cost of litigation should be viewed in the context of JNJ’s strong and largely non-cyclical free cash flow. Assuming an evenly distributed payout over 25 years ($370 million p.a.), the impact on the fair value of JNJ stock is insignificant. Consider that JNJ currently generates free cash flow of about $20.5 billion per year after accounting for stock-based compensation. If the company maintains 3% annual growth – which is a conservative estimate based on past performance – and we assume a 7% cost of equity, the discounted value of cash flows generated over the next 25 years declines by 1.4% when we include the currently expected talc litigation expense (Figure 6). This is already largely insignificant, but it is important to remember that discounted cash flow calculations typically include a terminal value – given that JNJ expects to spread its talc litigation payments over a 25-year period, including a terminal value would reduce the impact by about 50 basis points to 0.9%.

When I wrote my last article, JNJ stock was trading close to $150, which I think is a compelling valuation. As the stock approaches $170, I no longer consider JNJ a buy and therefore changed my rating to “Hold”. However, I should add that I already own a sizable position, and if I put myself in the shoes of someone looking to open a position, I would still consider the current valuation (16 P/E, 4.7% FCF yield, 2.7% dividend yield) to be quite acceptable. My long-term positive outlook on the company has not changed, and I think the Kenvue spin-off will help both the RemainCo and the Consumer Health business, which is currently treading water.

As always, please consider this article only as a first step in your own due diligence. Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there is anything I should improve or expand on in future articles, drop me a line as well.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of JNJ, UNLYF, MMM, RHHBF, PG, MRK either through stock ownership, options, or other derivatives. 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.

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