Image Shown: Johnson & Johnson’s embattled ‘Baby Care’ segment performed poorly during the third quarter of 2019. Image Source: Johnson & Johnson – IR Presentation.
By Callum Turcan
Johnson & Johnson (JNJ) was back in the news Friday October 18 when the company announced it was voluntarily recalling “a single lot” of its embattled Johnson’s Baby Powder product in the US due to alleged asbestos contamination risks. The US Food and Drug Administration tested a single bottle from this lot, according to Johnson & Johnson, with the federal regulator noting that sub-trace levels (no greater than 0.00002%) of chrysotile asbestos had been detected in the bottle. Johnson & Johnson plans to vigorously contest these allegations and maintains that its talc products don’t contain asbestos.
Please note that we think these legal hurdles are a lot more manageable for Johnson & Johnson than its share price action over the past year would indicate, and we continue to like the company in both the Best Ideas Newsletter and Dividend Growth Newsletter portfolios. We will go over this in greater detail after first covering the legal issues facing the firm’s talc-based baby powder products and how it concerns Johnson & Johnson as a whole. Shares of J&J yield ~2.9% as of this writing.
How We Got Here, an Overview
As baby powder is a talc-based product, it’s essential that the mining operations where the talc is sourced aren’t contaminated with asbestos. Talc is a hydrous magnesium silicate mineral and has a score of 1 on the Mohs Hardness scale. The mineral is often sourced from open pit mines, including those in the US, and comes with a wide variety of industrial and consumer uses. From paint and plastics to ceramic and cosmetic uses, talc can be used as a filler, coating, pigment and dusting agent.
When it comes to baby powder, talc is used because it’s good at absorbing moisture and reducing rashes. However, talc can contain asbestos in its natural form. As asbestos is a carcinogen, the FDA doesn’t allow any asbestos in cosmetic products and more broadly, the world has aggressively moved away from using asbestos (which decades ago was a common building material, but now is considered worldwide to be a major health risk). There are some nations that still use asbestos as a building material, but there are ongoing global efforts to cut down on its use. Brazil banned asbestos mining in 2017, but Russia continues to be a major supplier.
Back in 1976, a cosmetics manufacturer’s trade council known as the Personal Care Products Council declared that all talc-based products should be asbestos free. However, the FDA generally does not test cosmetic products for safety concerns before allowing those products to hit the shelves (save for color additives, which are tested).
Asbestos can make its way into talc-based products when the miner (the source of raw talc) targets talc ore deposits (specifically talc-carbonate ore bodies) near where bodies of asbestos ore are located. Testing the raw talc product can be used to ensure that major cosmetics companies, including Johnson & Johnson, aren’t using contaminated raw materials. Johnson & Johnson created the first baby powder from crushed talc for widespread commercial use back in the late 1800s, spawning the once popular and now embattled Johnson Baby Powder product.
Why Johnson & Johnson
The FDA likely tested the firm’s Johnson Baby Powder product due to several major lawsuits recently going against Johnson & Johnson, including a $4.7 billion judgement in 2018 that involved a St. Louis jury handing down a ruling that stated that the firm’s tainted baby powder products gave the plaintiffs (in this case, 22 women and their families) ovarian cancer (again, it’s not the talc that’s the problem per se, but the alleged presence of asbestos in the talc-based products).
More recently, Johnson & Johnson has lost similar cases in New York and New Jersey. The US Department of Justice has launched an investigation into the company for allegedly knowing about the risks posed by its talc-based products (particularly its Johnson Baby Powder product) in the form of heightened asbestos contamination risks, but declining to properly inform the public (consumers, regulators, etc) about these risks. Johnson & Johnson has had some legal victories on the appeals side of things, but it’s clear that this controversy is going to continue weighing on shares of J&J for some time.
Significance
At first glance, the legal problems facing Johnson & Johnson seem worse than they are and here’s why: For starters, the size of these judgements are very likely to be reduced (assuming they aren’t overturned) by future court cases and the possibility for a wide-reaching settlement. Johnson & Johnson’s strategy from the start has been to vigorously defend its brand and its talc-based products, but that doesn’t mean a settlement is out of the question. We see Johnson & Johnson’s current legal strategy largely about positioning itself in the event there is a wide-ranging settlement, and given the sheer number of lawsuits facing the company (and past legal rulings, keeping the firm’s success when appealing these rulings in mind), that appears like a fairly plausible strategy.
As an aside, Johnson & Johnson has reportedly offered to pay $4.0 billion to settle more than 2,000 lawsuits levied against the company in the US from local and state governments concerning its alleged role in the opioid epidemic according to the Wall Street Journal. There’s arguably precedent for the company pushing back at first against major legal and liability issues like these before ultimately agreeing to a deal in the end.
What We Think
On October 15, we published a piece (link here) covering Johnson & Johnson’s latest earnings which included yet another guidance boost for fiscal 2019. However, the firm’s legal troubles have gotten in the way of that potential upside. Here’s a key excerpt as to why we think Johnson & Johnson can handle its legal woes:
“Johnson & Johnson has come under pressure from mounting lawsuits and potential legal liabilities stemming from its alleged role in the US opioid epidemic (this year the firm lost a court case in Oklahoma and was ordered to pay ~$0.6 billion), that the company’s talc-based baby powder products allegedly cause cancer (the firm lost a major court case on this issue in July 2018 and was ordered to pay $4.7 billion), and that Johnson & Johnson’s antipsychotic drug RISPERDAL allegedly causes abnormal growth of breast tissue in males (with the firm very recently getting hit with an $8 billion judgement).
We would like to stress that while the headline figures look menacing, most of these judgements will likely be brought down in the future. More broadly, Johnson & Johnson has the capacity to take these hits while still representing a quality investment. Unless these rulings cause a fundamental change in Johnson & Johnson’s ability to conduct business, they have a much smaller impact on the fair value estimate than at first glance. Our September 2019 article covered this topic in greater detail.
As of this writing, Johnson & Johnson’s market capitalization stands near $340 billion and the company had $17.9 billion in cash and cash equivalents on hand at the end of the third quarter (according to its IR presentation). The firm’s net debt load stood at $11.3 billion at the end of this period. We see Johnson & Johnson’s net debt load and legal liabilities as very manageable given the company’s strong free cash flow profile. From 2016-2018, its annual free cash flows averaged $17.3 billion, hitting $18.5 billion last fiscal year. Additionally, please note Johnson & Johnson’s stellar investment grade credit rating. While Moody’s Corporation (MCO) revised the firm’s outlook to negative back in August 2019 following the opioid case ruling, its senior unsecured credit rating was still reaffirmed at Aaa.
The company’s Dividend Cushion ratio of 2.4x supports a nice dividend growth trajectory in the face of these hurdles, especially as underlying demand for Johnson & Johnson’s products remains quite strong (particularly for its medical devices and pharmaceutical offerings). When putting foreign currency and legal headwinds aside, Johnson & Johnson’s core businesses are performing quite well.”
Additionally, please note that Johnson & Johnson, as of this writing, has not yet published its 10-Q filing with the SEC for the third quarter of 2019. It isn’t uncommon for publicly-traded companies to put off filing their 10-Q for a few days after posting their quarterly earnings reports.
Concluding Thoughts
We continue to like Johnson & Johnson and think the market hasn’t given the firm any credit for its numerous guidance boosts this fiscal year and strong free cash flow profile. Our team of analysts continue to monitor this issue, and we will keep our members posted of any key updates.
Household Products Industry – CHD, CL, CLX, ENR, HELE, JNJ, KMB, PG
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Callum Turcan does not own shares in any of the securities mentioned above. Johnson & Johnson (JNJ) is included in Valuentum’s simulated Dividend Growth Newsletter and Best Ideas Newsletter portfolios. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.