Nobody seems to like health care anymore. And that sentiment has weighed on shares of Johnson & Johnson (NYSE:JNJ), the world’s most valuable health care company. JNJ stock has fallen over 17% from its highs and now trades at a 52-week low.
The recent decline has come despite generally solid news from Johnson and Johnson so far this year. Earnings haven’t been stellar, but they’ve been good enough. Regulatory and legal concerns surrounding opioids have risen, but J&J posted a big win on another legal front last month.
And so the decline in JNJ of late seems a bit overwrought. Investors still are getting one of the world’s great businesses at a very reasonable valuation. A recent dividend hike pushes the yield to an attractive 3%. Short-term volatility may continue, and industry challenges may persist. But even acknowledging those risks, Johnson and Johnson stock looks simply too cheap.
The Risks Facing JNJ Stock
The recent weakness in JNJ does perhaps have some justification. While consumers may know Johnson and Johnson best for its brands like Tylenol, Listerine and Benadryl, the consumer business isn’t J&J’s bread and butter. In 2017, per the 10-K, the Consumer segment generated not much more 10% of adjusted pre-tax profit.
It’s the pharmaceutical business, and to a lesser extent medical devices, that are the real drivers here. And both businesses look relatively challenged at the moment. President Trump is set to unveil a speech calling for lower drug prices. Regulatory and legal pressure remains intense, with J&J facing potential liability for opioids, as Lucas Hahn detailed last month.
On medical devices, reimbursement pressures and cost controls have trickled down to device manufacturers. Even the consumer business faces a threat from Amazon.com, Inc. (NASDAQ:AMZN), as Hahn pointed out.
Across the board, then, there are potential obstacles to Johnson and Johnson’s growth. And looking at peers for each of the businesses, a relatively muted valuation perhaps isn’t surprising.
Pharmaceutical rivals Pfizer Inc. (NYSE:PFE) and Merck & Co., Inc. (NYSE:MRK) are trading at 11x and 12x forward earnings, respectively. Medical device leader Medtronic PLC (NYSE:MDT) trades at 16x, though I like that stock long term. Consumer stocks like Procter & Gamble Co (NYSE:PG) and Kraft Heinz Co (NASDAQ:KHC) trade at multiyear lows amid competitive concerns.
Given the widespread pressures here, and the market’s sentiment toward similar stocks, the relatively muted valuation assigned JNJ stock at the moment doesn’t seem outlandish. In fact, a ~15x multiple to the midpoint of 2018 EPS guidance seems reasonable based on how the market is valuing J&J’s rivals.
The Bull Case for Johnson and Johnson
That said, I still see JNJ as too cheap. A 3% yield, even amid rising Treasury yields, could bring in demand at these levels, particularly given that JNJ just raised that dividend by 7%. As noted, I like MDT at 16x, and both PFE and MRK look attractive at their own muted valuations.
Meanwhile, J&J has an arguably stronger product pipeline, notably in oncology. Pharmaceutical revenue has grown nicely of late, including an 8%+ rise in 2017, albeit with some help from acquisitions.
Legal concerns surrounding exposure to both opioids and talcum powder allegedly tainted with asbestos have pressured JNJ stock. But the talcum powder exposure appears minimal, as an analyst has argued, and J&J also is coming off a win surrounding its discontinued Pinnacle hip implants.
Q1 earnings last month beat estimates and showed continued growth. A cost-cutting plan should help margins and profits going forward. Tax reform benefits are driving R&D and capex investments which should help revenue.
And yet, at 15x earnings, JNJ is pricing in something close to zero growth — or significant legal and/or regulatory liability. That seems far too negative. Johnson and Johnson still has room to grow earnings going forward. The dividend was just raised for the 56th consecutive year.
Health care may not be the safe, defensive sector it once was. But Johnson and Johnson remains the most valuable, and most successful, company in that industry. At a valuation near its historic lows from a multiple standpoint, investors are paying a discount price for a quality stock. No matter what the near term looks like, that’s generally a good way to drive strong long-term returns.
As of this writing, Vince Martin has no positions in any securities mentioned.