Summary
- A sizable portion of litigation costs has been imputed in JNJ's current share price, which I believe is overblown.
- Improving prospects on Medical Device and Pharma segments should re-write the JNJ narrative.
- On a SOTP basis, I think JNJ should trade at $155 per share, an upside of 21% from current levels.
I believe Johnson & Johnson's (JNJ) litigation headlines will continue to dominate the narrative for the stock, at least in the near term. While these litigation concerns are likely overdone, they are likely to remain a significant overhang on JNJ shares in the near term having already accounted for a meaningful portion of the company's valuation discount. One must also consider the possibility of sentiment worsening with further headline risk from litigation updates.
But taking a long-term view, JNJ offers quality at a reasonable price, with encouraging growth prospects led by a recovery in its Medical Device and Pharma segment. Along these lines, I think JNJ shares should trade higher from here, with a potential 21% upside on offer from current levels.
Sizable Portion of Litigation Costs Reflected in the Share Price…
As JNJ's legal woes mount - from talc baby powder lawsuits to the Oklahoma opioid epidemic trials - the market has accounted for a rising litigation costs scenario and then some. On a SOTP basis, I believe at least $20bn of litigation costs may be imputed in the current share price, which appears to be overblown, in the light of the recent Oklahoma District Court ruling on the company's alleged role in the opioid epidemic.
While the verdict was unfavorable, the size of the legal liability of $572 million was substantially lower than the $17.2 billion sought by the state of Oklahoma and against market expectations of legal liabilities of above $1 billion. The damages were based on a 1-year cost of abatement although several state witnesses testifying that the abatement plan would cover for more than 20 years. However, the court ruled that the state prosecutors did not present sufficient evidence to support an equitable abatement beyond a year.
Furthermore, JNJ issued a statement disclosing that they plan to appeal the verdict, which they expect could extend up to 2021. Management's argument appears to have solid legal base, which could potentially overturn or reduce the legal liability: (1) JNJ's opioid-based pain therapies is relatively minimal - comprising less than 1% of total prescriptions in Oklahoma and the US, (2) misapplication of the "public nuisance" law that was historically applied in Oklahoma to settle property cases, and (3) the company is in compliance with state and federal law in the production and market of their products.
In this context, the market is predisposed to overreacting to these situations - estimating legal liabilities beyond a reasonable amount and accounting for a sizable portion of the share price discount. From another angle, while litigation costs have dramatically risen from $145 million in 2015 to $2 billion in 2018, this remains small at only 3% of total operating expenses. Nonetheless, rising litigation costs are offset by a modest rise in the top-line, leading to higher earnings per share from $5.48 in 2015 to $5.61 in 2018. Also, JNJ has a strong balance sheet with cash in hand of $15 billion - along with its strong debt coverage ratios (net debt/EBITDA of 0.2x), JNJ should easily cover a higher than expected legal liability scenario.
