Johnson and Johnson Isn't Quite as Cheap as Morgan Stanley Thinks It Is

Morgan Stanley analyst David Lewis recently increased Johnson and Johnson's weighting from equal weight to overweight and raised his price target from $145 to $170.  However, a move to $170 doesn't appear to be justified by current fundamentals.
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Last week, Morgan Stanley boosted Johnson and Johnson’s weighting to overweight from equal weight, signaling a strong bullish sentiment on the shares heading into 2020.

Analyst David Lewis raised Johnson and Johnson’s  (JNJ) - Get Report price target from $145 to $170, pointing towards upside of roughly 16.5% from today’s $146 levels.

Lewis also said that Johnson and Johnson is “the most under-owned stock in healthcare.”

Now, there is a difference between being under-owned, and undervalued, which I appreciate. However, with a price target of $170, Lewis also appears to believe that Johnson and Johnson shares are cheap.

The stock is under owned because of continued legal threats surrounding the company’s talcum powder and potential links with asbestos and ovarian cancer. Johnson and Johnson is also embroiled in the opioid crisis, which also has the potential to weigh heavily on the company’s balance sheet.

However, Lewis argues that these threats are already priced into the stock. He believes that continued growth in the pharmaceutical segment will bolster the price-to-earnings multiple on the stock. He also noted that the company’s operations are more balanced now than they have been in the past, with both consumer and medical devices performing well in recent quarters.

Citing continued multiple expansion owing to the relative discount that Johnson and Johnson shares currently trade at when compared to the broader markets, Lewis is confident in J&J’s potential to outperform moving forward.

Morgan Stanley points out that historically, Johnson and Johnson trades at a premium to the market, not the other way around. However, I think it’s fair to say that the broader markets are overvalued at this point (the capital appreciation that we’ve seen in the markets throughout 2019 has certainly not been matched by the underlying performance of sales and earnings growth) and with that in mind, I don’t think it makes sense to use one irrational benchmark to arrive at another.

Instead of comparing Johnson and Johnson to the broader markets, then, I prefer to compare the stock to itself.

Johnson and Johnson’s current trailing twelve-month price-to-earnings ratio is 16.8.

This is below the stock’s 20-year historical average price-to-earnings ratio of roughly 18.5. However, it is above the stock’s 10-year historical average of 15.5.

More recently, throughout the last five years, Johnson and Johnson shares have traded in a fairly tight range. Shares have bounced off of the 15 times earnings mark several times. We’ve also seen the stock hit upside resistance in the 18-19x range. Every time the stock has traded up to the upper end of this range, a sell-off has come shortly thereafter.

It appears as though the market just doesn’t have an appetite for Johnson and Johnson, surrounded as it is by so many legal issues, to trade too far above its 10-year average.

Assuming the stock stays range bound, it appears as though the current rally may have legs left to rise to the 18-19x range. However, to reach $170/share, Johnson and Johnson would have to trade for 18.6x the current analyst consensus EPS estimate for 2020 earnings of $9.12/share.

This means the stock would have to maintain a forward multiple at the top of its current range. Forward multiples are typically discounted relative to trailing ones due to the speculative nature of future results. Given that Johnson and Johnson’s earnings-per-share growth in 2020 is expected to be below the stock’s long-term average, I don’t see the justification for an above average premium.

Now, all of this isn’t to say that Johnson and Johnson won’t continue to generate significant wealth for its shareholders. Without a doubt, this is a wonderful company to own. It’s an iconic name in the healthcare space, and legal headwinds or not, I don’t see that changing anytime soon.

With that in mind, it’s worth mentioning that I bought the stock twice in recent months. In the $130 range, I thought there was significant enough of a margin of safety available to justify adding to my position. However, after the recent 15% rally, I think that this margin of safety has been reduced significantly.

The company continues to face significant legal headwinds. And the headline risk overhang surrounding healthcare reform that we’re likely to see throughout the upcoming election season is looming large. Without a surprise earnings-per-share performance to the upside in 2020, investors would be relying on further multiple expansion to hit Morgan Stanley’s $170 target. 

To me, this stock is hovering slightly above fair value at the moment. I don’t expect for shares to rise that far in the short-term, and if they did, I think they’d be overvalued.