Image Source: J&J
Shares of J&J have settled into the high-$120s at the time of this writing, well below our ~$150 fair value estimate. We’re going to stick with J&J in both the Dividend Growth Newsletter portfolio and Best Ideas Newsletter portfolio at this time.
By Callum Turcan and Brian Nelson, CFA
On August 26, an Oklahoma judge ruled that Johnson & Johnson (JNJ) had to pay $572 million to the state over its role in the opioid crisis in America. In particular, District Judge Thad Balkman noted that “Johnson & Johnson’s misleading marketing and promotion of opioids created a nuisance” that compromised the health of thousands in Oklahoma. Johnson & Johnson and its Janssen subsidiary will contest the ruling. J&J responded:
The judgment disregards the Company’s compliance with federal and state laws, the unique role its medicines play in the lives of the people who need them, its responsible marketing practices and that since launch, DURAGESIC®, NUCYNTA® and NUCYNTA® ER have accounted for less than one percent of total opioid prescriptions in Oklahoma as well as the United States.
“Janssen did not cause the opioid crisis in Oklahoma, and neither the facts nor the law support this outcome,” said Michael Ullmann, Executive Vice President, General Counsel, Johnson & Johnson. “We recognize the opioid crisis is a tremendously complex public health issue and we have deep sympathy for everyone affected. We are working with partners to find ways to help those in need.”
Though J&J believes it has “strong grounds” to appeal the ruling, the cost of that judgement was markedly less than what the state’s plaintiffs were seeking (as much as $17 billion) and came in at the low end of consensus estimates (~$5 billion), sending shares of J&J up initially after the news. In this context, we’re viewing this as a positive development (relatively speaking) as evidence that the sell-off in shares of J&J over the past few months is somewhat overdone. J&J possess the free-cash-flow profile to handle any legal liabilities while continuing to make good on its dividend commitments.
When it comes to valuation, we view potential opioid-related liabilities in a similar fashion as that of potential talc-related liabilities. Here’s how to think about potential contingent liabilities within the valuation context relative to recurring expenses, the latter having a magnifying impact, while the former but a one-time adjustment to intrinsic value; from our December 2018 note on J&J:
It’s important to differentiate one-time legal exposure such as talcum product liability from events that permanently increase continuing operating expenses, the latter having cascading implications on the company’s value into perpetuity. Said another way, one-time impacts are generally one-for-one reductions to the company’s equity value and are different than increased operating expenses, which can have a greater impact by reducing forward-looking free cash flows for years and years into the future. It’s certainly not a good situation for J&J to be in, but its legal exposure to claims regarding its talcum powder products, including potential securities class action lawsuits, appear to be manageable.
We’re not worried about J&J’s financial health in the context of potential contingent liabilities such as those related to the opioid crisis or talc-related lawsuits. J&J has one of the few triple-A rated credit ratings in the world (meaning it is one of the best credits out there), and the company has tremendous financial flexibility. Here is what Moody’s said a couple days after the Oklahoma ruling, affirming the top credit rating at the firm, but revising the outlook to negative:
…J&J’s Aaa rating continues to reflect an excellent business profile and outstanding financial flexibility including annual free cash flow after dividends in excess of $9 billion and cash on hand above $15 billion…
…Several upcoming catalysts will help Moody’s assess the magnitude of J&J’s legal exposures and the potential to negatively affect the Aaa rating. These include the first bellwether trials in the Multi-District Litigation in Ohio federal court opioid proceedings, a decision on which expert testimony can be used in federal talc lawsuits, and the outcome of an appeal of a Missouri talc verdict. At the same time, settlements of legal exposures could provide greater clarity into J&J’s exposures, but the timing of any settlements is difficult to predict.
As Moody’s noted, J&J had roughly $15.3 billion in cash and marketable securities at the end of June 2019, and while the firm holds a long-term debt position of $27.7 billion, the company remains a free-cash-flow generating powerhouse. J&J has already hauled in roughly $8 billion in traditional free cash flow during the first six months of the year. Shares of J&J have settled into the high-$120s at the time of this writing, well below our ~$150 fair value estimate. We’re going to stick with J&J in both the Dividend Growth Newsletter portfolio and Best Ideas Newsletter portfolio at this time.
Related: TEVA, MNK, ENDP, CAH, MCK, ABC
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Callum Turcan and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.