Summary:
- Johnson & Johnson has seen solid second-quarter results, triggering a modest hike in the full-year guidance.
- This looks quite compelling, as progress is made with the Kenvue Inc. exchange offer.
- All this is still overshadowed by continued concerns on the talc asbestos litigation, something which likely will continue to linger for a while.
yuelan
In May, I offered an update on shares of Johnson & Johnson (NYSE:JNJ) following the IPO of its consumer health business Kenvue Inc. (KVUE). Despite the fact that the offering can be described as a success, it was the attached $50 billion enterprise valuation which is not a game changer for Johnson & Johnson.
The split is set to increase exposure to the faster-growing pharmaceutics and medical device segment, although the talc litigation overhang (and its concerns) largely remain with Johnson & Johnson. With the business posting resilient growth and liabilities remaining with Johnson & Johnson, I do not think this is a game changer, although overall valuations remain reasonable here.
Setting The Base Case
Johnson & Johnson is not just a household name for consumers across the globe. It has been a very decent and steady value creator for long-term investors as well, driven by a strong positioning, modest usage of leverage, and sound capital allocation skills.
For the year 2021, the company grew sales by 13% to $94 billion, aided by easier comparables as the pandemic hurt substantial parts of the business. Adjusted earnings grew to $26 billion, for earnings of $9.80 per share.
The key pharmaceutical business was the largest segment, with $52 billion in sales, complemented by a $27 billion medical device segment and another $15 billion consumer health business, now spun off as Kenvue. With earnings power pegged around $10 per share, a $160 valuation worked down to a reasonable multiple at 16 times earnings.
The thesis changed a bit in 2022 as the company announced a $16 billion deal for Abiomed and announced the spinoff of Kenvue, but the worst news was that of emerging lawsuits for asbestos related to talc in baby powder products.
While the operating performance was rather flattish in 2022, the company guided for 2023 sales to advance in a modest fashion to $97.5 billion, with earnings seen at $10.50 per share. Net debt of $16 billion was modest, but prevailing legal worries on talc/asbestos continued to cast a shadow, and despite the concerns I was happy to initiate a position in the mid $150s early this year.
2023 – Solid So Far
In April, Johnson announced solid first quarter sales, which were reported up by 5.6% to $24.7 billion, with constant currency growth coming in at 9%. Earnings fell a bit in absolute terms, although that on a per-share basis, earnings were up a penny to $2.68 per share. That said, a small GAAP loss was reported following a $6.9 billion litigation expense being taken.
The company spun off Kenvue around the same time, as Johnson sold 173 million shares at $22 in the consumer health business (ahead of the green shoe option), raising $3.8 billion in gross proceeds. With shares trading at $26 in the immediate aftermath of the offering, Johnson held a remaining 1.7 billion shares, which were valued at $45 billion, while Johnson offloaded $7.7 billion in net debt to Kenvue as well.
With Johnson & Johnson commanding a $441 billion enterprise valuation at $162 per share in May, the $56 billion interest in Kenvue (defined as the gross proceeds from the IPO, the remainder of the stake in Kenvue and net debt assumed by its former daughter) indicated that Kenvue was valued at 13% of Johnson’s own valuation. As Kenvue was responsible for 16% sales of Johnson, accompanied by subpar margins, that looked quite fair.
While I believed that shares of Kenvue looked a bit rich on a standalone basis, that was not the case for Johnson & Johnson, whose shares still looked appealing in my eyes, despite liability concerns.
A Blowout Quarter
After shares have stabilized in a $155-$165 trading in recent weeks, they have risen sharply to $170 per share, levels last seen in January, as the company posted strong second quarter results.
Second quarter sales rose by 6.3% to $25.5 billion, as the dollar headwinds dissipated a bit, but Johnson was hit by further demand retreat in items which benefited from the pandemic. The company grew adjusted earnings by 8% to $2.80 per share, as the results still include the consolidated Kenvue numbers. That will change, however, as the company intends to split off the shares in the form of an exchange offer in the coming periods, subject to market conditions.
Looking at the segments, it was the largest pharmaceutical segment which reported a modest 3.1% increase in sales to $13.7 billion, with MedTech revenues up as much as 12.9% to $7.8 billion (aided by the Abiomed deal on top of a generic solid performance) while the consumer health business posted a resilient 5.4% increase in sales.
Amidst these results, the company hiked the full year guidance in a modest fashion (after doing so already alongside the first quarter earnings report). Full-year sales are now seen at $99.3 billion (at the midpoint), with adjusted diluted earnings now seen at $10.65 per share.
No 10-K filing was made yet, as net debt came in around $20 billion in the first quarter, but that is ahead of the IPO of Kenvue, as there is no reason to expect a huge change in this debt load (other than debt assumed by Kenvue) given a rather uneventful but decent second quarter.
What Now?
The truth is that I am a bit surprised by the strong share price reaction in response to the second quarter results. Shares of Kenvue have fallen from $26 at the time of the IPO to $24 now, which means that Johnson’s stake is now worth a couple of billion dollars less.
While the full-year outlook has been raised, Johnson has done so in a minor way, so perhaps investors are just upbeat that no bad news on the talc liabilities has hit the newswire. Other immediate triggers could that an exchange offer for Kenvue is imminent. Following this move, Johnson will no longer consolidate the results of Kenvue, which is no major impetus to me (as most liabilities remain with Johnson), a news item perhaps overlooked by some other investors.
It seems that investors act relieved on better news regarding the talc product liability claims. On the conference call, it became apparent that 60% of the 100,000 claimants regarding the talc situation were in favor of a plan outlined by Johnson to settle, but the whole situation remains rather cloudy, resulting in an uncertainty overhang on Johnson here going forward.
Still holding a Johnson & Johnson position which I averaged at $155 earlier this year, I am confident enough to hold onto this position. Sitting on decent 10% gains, while the performance is largely in line with expectations (perhaps a bit better) while Kenvue is lagging a bit and no clarity is yet seen on the talc asbestos claims, I anticipate that shares will muddle through here.
Therefore, I see no reason to alter a modest long position in this long-term value creator, although some further clarification on the liability situation would be welcome and is needed to bring the $200 mark in sight for Johnson & Johnson.
Analyst’s Disclosure: I/we have a beneficial long position in the shares of JNJ 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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