Johnson & Johnson: Starting To Look Interesting Again

Summary:

• Johnson & Johnson continues to grow, albeit at a very modest GDP + pace.
• The company closed the Abiomed deal already, while maintaining balance sheet integrity.
• Forward multiples of 15 times earnings and low leverage looks very reasonable.
• The Johnson & Johnson baby talc powder overhang has come to life again after a recent court ruling, probably grabbing quite some attention this year.

In November, I called Johnson & Johnson (NYSE:JNJ) a steady growth play after the company announced a $16.6 billion deal for Abiomed at the time. There were, however, many moving parts, including this deal, the spinoff of the consumer health business, and JNJ’s attempt to isolate talc powder liabilities, making the situation quite fluid.

Nonetheless, I called Johnson & Johnson a steady long-term growth play at a very reasonable valuation.

A Recap

Ahead of the pandemic, Johnson & Johnson was a $150 stock which posted $82 billion in sales in 2019, on which it posted adjusted earnings of $8.68 per share, albeit that GAAP earnings came in quite a bit lower. Johnson & Johnson guided for modest growth in sales and earnings, as the resulting 16–17 times adjusted earnings multiple looked very modest, with net debt only posted at $8 billion.

With dividends trending at $4 per share, backed by a 58-year dividend track record, I was a happy buyer around the $140 mark, but ever since, shares have been trading pretty much rangebound between $160 and $180 per share.

2021 sales rose in a convincing manner, with Johnson & Johnson sales up 13% to nearly $94 billion, with adjusted earnings up 22% to $26 billion, equal to $9.80 per share. Growth was driven by double-digit sales in the core pharmaceutical business, which measured $52 billion in sales. Medical device sales grew in the high-teens, with revenues reported at $27 billion, while consumer health sales were growing just very modestly to $15 billion.

The company guided for mid-single digit increases in sales and earnings for 2022, albeit that the strong dollar proved to be a gradual and increasing headwind. Through the third quarter, Johnson & Johnson guided for earnings to just surpass the $10 per share mark. Deleveraging meant that Johnson actually ended the third quarter with $2 billion in net cash, with shares trading around 17 times earnings at $170 per share.

There were 3 items, however, which changed the thesis a bit. In November, Johnson & Johnson announced a $16.6 billion deal to acquire Abiomed, which despite a multi-billion dollar deal tag is equivalent to just 3-4% of Johnson & Johnson’s own valuation. The deal is set to add merely a billion dollars in sales, adding about 1% to Johnson’s sales base, as the goal is really to drive growth. Pro forma net debt of $15 billion was still reasonable, but there were more items.

The idea to spin off the consumer health business into the company called Kenvue was creating some uncertainty, but overall should be pretty neutral. However, the deal appears to be part of Johnson´s attempt to isolate lawsuits with regard to talc products and baby powder, as the process has seen quite a few hurdles to date.

Stuck

Starting the year around the $180 mark, Johnson & Johnson shares have fallen to $162 at the moment of writing, even as the overall market has seen a solid start to the year.

The company closed on the Abiomed deal just days ahead of Christmas 2022, marking quite a quick turnaround. The fourth quarter results were a bit soft, with sales down 4% and change on the back of a strong dollar and reversal of Covid-19 induced sales. This meant that full year sales rose just a percent to $95 billion, with adjusted earnings up more than 3% to $10.15 per share.

GAAP earnings came in at $17.9 billion and adjusted earnings at $27.0 billion. Roughly half that difference is explained by a $4.3 billion amortization charge, but there were many and significant other costs, some of them which I am happier to adjust for than others, which means that the adjusted earnings should be taken with a small grain of salt.

For 2023, the company guided for 4% operational sales growth, with sales seen at a $97.5 billion midpoint amidst some currency headwinds, even as the dollar has recently given up some growth. Adjusted earnings are expected to rise by low single-digits as well, seen around $10.50 per share.

Johnson & Johnson ended the quarter and year with some $16 billion in net debt, translating into very modest leverage ratios. Based on the forward-looking estimate, multiples have fallen from about 17 times anticipated earnings to 15 times, on the back of higher expected earnings and a fall in the share price. While debt is completely under control post the Abiomed deal, the issue of lawsuits has risen again.

The Third Circuit Court of Appeals ruled against the intended usage of using bankruptcy to shield the company from the talc lawsuits, after the company aimed to use the “Texas two-step” in an attempt to shield the company from nearly 40,000 individual lawsuits. Pegging the potential liability to a specific number is very hard to do. The $6 move lower in the JNJ share price in reaction to the deal subtracts about $15 billion from the market value, a substantial amount, as investors clearly take these concerns seriously, with the realistic liability unknown. This comes after a Missouri court awarded a mere 22 women a more than $2 billion settlement last year already.

Warming Up

While buying into lawsuits typically is ill-advised, the situation seems manageable and priced-in for the case of Johnson & Johnson, although it is very hard to price in the cost of these lawsuits if they are granted by a judge or jury. Even if compensation needs to be paid, the amount and timing of such payments will be very hard to accurately predict, as the market takes the matter seriously, as seen in the share price reaction.

With leverage being very modest, even if Johnson & Johnson is liable to pay out tens of billions of dollars in compensation, the 15 times forward multiple looks very reasonable. The quarterly $1.13 per JNJ share dividend supports a near 3% dividend yield, perhaps not enough to compete with risk-free rates, but certainly a decent yield given a strong track record here.

All of this means that I am gradually warming up to Johnson & Johnson stock here, and looking to add more in the $150s, if selloffs take the stock that far down in the coming period.

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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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