Johnson & Johnson (JNJ - Get Report) sold off this week on fears that opioid litigation in Oklahoma would create a significant headwind for the company. Litigation is nothing new for Johnson & Johnson, however.
The company has been in the headlines recently because of the mounting talcum powder lawsuits. Just on Friday, a New York court ordered J&J to pay $300 million in punitive damages related to the alleged link between the company's products and ovarian cancer. This evolving situation appears to be like many of the others that have led to several sell-offs in recent months, with Johnson and Johnson releasing a statement criticizing the court's decision and likely to appeal.
We live in a world were pharmaceutical companies are targeted as scapegoats for a variety of issues and I think that headlines regarding lawsuits are going to be something that healthcare investors are going to have to get used to.
An Irrational Discount
However, rather than focus on the bad news and allow fear to creep into the equation, it makes more sense to take a deep breath and realize that this is a highly profitable company that maintains one of the top two best balance sheets in the world and offers investors an incredibly reliable dividend, to boot.
In terms of the ultimate impact on the company, this Oklahoma opioid issue remains a speculative one. When J&J shares gapped down, the market appeared to be trading on sentiment, rather than the company's underlying fundamentals. To me, this speculative behavior is a dangerous practice for investors and so I wanted to look past the court room and focus on the company's recent results and balance sheet.
Johnson and Johnson shares hit 52-week highs of nearly $149 late last year. However, J&J was not excused from the Christmas Eve sell-off and the company started the new year trading in the $129 per share range. This means that J&J is up slightly, year to date, yet its $10 per share drop during the month of May has turned it into an under performer relative to the major indexes.
After its recent weakness, Johnson and Johnson shares are trading at just 15.7x earnings. This is well below the company's long-term average price-to-earnings ratio of approximately 18.5x. The potential for litigation should have put some pressure on the company's valuation premium, though a 15% discount to the historical average seems like a bit much.
Focus on The Fundamentals
During the company's most recent quarter, sales were up 0.1%. This essentially flat sales growth figure appears to be due to the strength of the dollar. Management mentioned that J&J had a 3.8% currency headwind during the quarter; 3.9% growth isn't stellar, but it is much better than 0.1%.
The Q1 sales growth figures were in-line with management's full year guidance of 2.5% to 3.5% adjusted sales growth, but only 0.5% to 1.5% operational sales growth with current headwinds factored in. These forex issues are also trickling down to the bottom-line, where management expects to see a $0.20 full year EPS headwind in 2019. This was factored into the company's latest guidance, which is now coming in the range of $8.53-$8.63/share. Johnson and Johnson's 2018 EPS came in at $8.18 so this guidance represents 5% year-over-year growth at the mid-point.
Taking a step back, we see that Johnson and Johnson had a strong year in 2018, posting revenue growth of 6.7% and EPS growth of nearly double that, at roughly 12%. Looking ahead, analysts agree with the company's 5% EPS growth guidance for 2019. They also expect to see 7% bottom-line growth in 2020 and 2021. This means that on a forward basis, using the 2020 EPS consensus estimate, J&J is trading for just 14.4x earnings. To me, this is a potential bargain in the clue chip healthcare space.
Others have called for J&J shares to sink even further. Earlier in the week, Real Money published a rather bearish technical breakdown of Johnson and Johnson which called for a $120 price target with potentially even more downside risk from there.
That price level did serve as support during J&J's talc-related sell-off in 2018, yet I don't think the technicals take into consideration the company's earnings growth since then. In May of 2018, when J&J bottomed out just below $120, the shares were trading for roughly 15.6x trailing earnings. Due to bottom-line growth, that's actually right where we sit today in the $130 price range. Johnson and Johnson shares haven't fallen below the 15x trailing earnings threshold since 2013 and I don't think this opioid issue is going to be a strong enough catalyst to create such strong negative sentiment.
A Blue Chip Stock
Johnson and Johnson is one of only two companies in the world to have a AAA balance sheet (the other is Microsoft). The company has generated nearly $18.5 billion in free cash flow during the last twelve months and its future outlook remains bright.
J&J has a late stage pipeline that includes 30+ Phase III trials which is expected to lead to the creation of numerous blockbuster drugs which have the potential to generate $20+ billion in sales. Management continues to invest heavily in R&D, spending $2.9 billion last quarter. The company's pharmaceutical outlook remains strong. Yet, this doesn't mean that shareholders were forgotten. During the first quarter, the company paid out $2.4 billion in dividends and returned another $900 million to shareholders in the form of buybacks. J&J has used up just 36% of its current $5 billion buyback authorization and I expect to see continued share count reduction moving forward.
So, for less than 16x earnings investors now have access to a highly-diversified, blue chip, cash cow of a company. And while litigation headwinds can be scary, when it comes to Johnson and Johnson, I think it makes a lot of sense to follow Warren Buffett's advice and "be greedy when others are fearful."