It’s been a year to forget for Johnson & Johnson (NYSE:JNJ). Two sets of legal issues have damaged the company’s image. JNJ stock has taken a hit as well, and has now fallen nearly 8% over the last three months.
From one standpoint, the declines make some sense. Johnson & Johnson could be facing billions of dollars of legal liabilities. And it’s too simplistic to argue that lawsuits are the only reason JNJ stock has stalled out in recent years.
But from another viewpoint, the pressure looks extremely excessive. Multi-billion-dollar exposure is nothing to sneeze at, but Johnson & Johnson has a market capitalization of well over $300 billion.
I believe that both points have some merit. It’s worth remembering, however, that legal problems are far from the only reason JNJ stock looks relatively cheap at the moment.
Are the Legal Risks Facing Johnson & Johnson Overblown?
At this point, the legal risks that JNJ is confronting are no secret. The company is being sued over claims that its talcum powder contains asbestos, which in turn may lead to ovarian cancer. J&J was ordered to pay $72 million to a single plaintiff back in 2016 (that judgment was later overturned on a technicality), and more recently lost an appeal over a $4.7 billion award to 22 plaintiffs.
Meanwhile, the company’s opioid business faces challenges as well. A judge in Oklahoma awarded his state $572 million in a judgment in August. That case may open the door to personal injury suits. Given the tremendous reach of opioid-related tragedies, Johnson & Johnson may have to shell out billions of dollars as a result of its role in the crisis.
The legal risks are real. Mallinckrodt (NYSE:MNK), a major producer of opioids, has seen its market capitalization shrink from $15 billion four years ago to $200 million now, although it’s had other problems also. Privately held Purdue Pharma has filed for bankruptcy as part of a broad legal settlement. And a December 2018 Reuters article which disclosed that JNJ knew about the talcum powder issue “for decades” sent JNJ stock down 10% in a single day.
That said, the market capitalization of Johnson & Johnson stock now has dropped by some $50 billion since the day before the Reuters article was released. But the company is still valued at $340 billion. J&J historically wasn’t a major producer of opioids, and it’s not yet proven that talcum powder does contain asbestos in quantities large enough to cause cancer. (The science remains somewhat unclear, though evidence of a link to cancer is mounting.)
There is a case that the legal worries are priced into Johnson & Johnson stock at this point, given the $50 billion reduction in its market value. Indeed, Wall Street seems to agree: the average price target for JNJ is $149, about 15% above its current levels.
For investors who believe J&J’s legal exposure will prove to be manageable, there’s an intriguing contrarian case for the stock. The market may be too focused on the short-term issues facing Johnson & Johnson. That suggests that once those issues are resolved – in almost any fashion – investors’ focus will return to the company’s underlying business. In that scenario, JNJ stock, which trades at 14 times the average forward earnings estimate, would probably rebound.
That said, legal issues aren’t the only reason that JNJ stock has been pressured. While JNJ is better known for its consumer businesses, Johnson & Johnson at its core is a pharmaceutical company. Pharmaceuticals drove 61% of its adjusted pre-tax income in 2018, and Medical Devices brought in 29% of its pre-tax income. The Consumer segment contributed just 10% of its earnings.
And pharmaceutical stocks are struggling. It’s true that J&J doesn’t have the generic issues pressuring the likes of Teva Pharmaceutical (NASDAQ:TEVA) or Lannett (NYSE:LCI). And it has some winners in its portfolio, particularly in immunology and oncology.
But that doesn’t mean that the P/E multiple of JNJ stock should be 20 or higher. Pfizer (NYSE:PFE) trades at less than 13 times its forward earnings. Its deal with Mylan (NYSE:MYL) is a factor, but valuations across the sector are under pressure. Merck (NYSE:MRK), perhaps the best large-cap drug maker out there at the moment, trades at just 15 times analysts’ average 2020 EPS estimate.
JNJ probably still merits a premium to its pure-play pharmaceutical peers. Its consumer business, including its contact lens unit, is valuable. The high valuations of Alcon (NYSE:ALC) and The Cooper Companies (NYSE:COO) show what investors will pay for contact lens operations, But, again, investors are clearly more cautious toward the pharmaceutical industry at the moment for reasons that go beyond company-specific legal risks.
The Case for Johnson & Johnson Stock
To be clear, that doesn’t mean Johnson & Johnson stock is a short or even a sell. Its valuation is reasonable. A nearly 3% dividend yield helps the cause as well. The legal liabilities will be resolved at some point, potentially removing an overhang from the stock.
But it’s too simplistic to believe that legal issues alone are causing investors to overreact. JNJ is facing risks, and there are reasons why Johnson & Johnson should have a relatively low valuation. And with its legal issues swirling, investors should at least consider PFE and MRK as alternatives.
Over time, JNJ stock will likely rise. But it’s not a slam dunk winner. Indeed, the stock has significantly underperformed the market over the past decade. Between its legal issues and the risks to Big Pharma, I’d bet it could very well underperform over the next decade, too.
As of this writing, Vince Martin has no positions in any securities mentioned.