Although there's a lot to like about Johnson & Johnson (NYSE:JNJ), the company still has many qualities that might keep savvy investors on the sideline. A positive? The company is a Dividend King. That means the company has raised its dividend in at least 50 straight years, and signals long-term reliability. But slow growth and legal issues have plagued the company over the past decade. After weighing the pros and cons, it's not hard to make the case that the stock is unlikely to outperform a simple S&P 500 index fund over the next decade.
Diversification provides stability
Perhaps the best thing going for the company is how broadly its revenues are spread across products and geographies. Its three business units -- pharmaceutical, medical devices, and consumer -- cover an amazing range of health-related products including pain relievers, skin care, artificial hips, and prescription drugs. The company's sales are also well-balanced geographically, with only half coming from the U.S.
|Division||2019 Sales||% of Sales|
|Medical devices||$26.0 billion||32%|
|Region||2019 Sales||% of Sales|
|Asia-Pacific, Africa||$15.6 billion||19%|
|Western Hemisphere||$5.9 billion||7%|
Although diversification can help when any one unit or geography is struggling, it's hard to achieve impressive growth with so many pieces of the business pulling in different directions. For instance, the pharmaceuticals division grew 3.6% in 2019, but that was almost offset by the 3.8% decline in sales of medical devices. The consumer segment was virtually flat with 0.3% growth. When viewed as a whole, revenue for the year only climbed 0.6%.
Growth may not live up to expectations
Johnson & Johnson has only grown revenue by 3% annually since 2009. Despite that, the stock sits near its decade high valuation as measured by both the price-to-sales ratio and price-to-cash flow ratio. Each is currently trending about 10% above its five year average. Could brighter expectations for the future be why investors are willing to pay a premium for the stock right now?
When management reported earnings in October, they told investors to expect between $82 billion and $82.8 billion in sales for 2020. That's a full $1 billion above what they had estimated in July. It's good news, but achieving even the high end of the new range would only mean 1% revenue growth. Considering year over year sales were down almost 11% in the second quarter, it's understandable if investors see any growth at all as a win.
Analysts expect the recovery to continue. Of 15 analysts covering the company, the average expectation is for $88.7 billion in sales next year. That would be a 7.6% improvement over the latest guidance for 2020. Meeting that upbeat outlook will require growth from several new areas. Of all the groups within the business units, only oncology and interventional solutions -- the company's cardiovascular medical devices -- grew at least 8% in 2019. However, those two units only made up 17% of total sales, not nearly enough to meet the analysts' targets.
Legal expenses keep increasing
One risk that could undermine any growth whatsoever is the myriad of class action suits against the company. Although Johnson & Johnson's legal troubles have been widely publicized, the financial impact has been a moving target.
The company has been faced with significant verdicts only to have them overturned or reduced after aggressively fighting the judgements. For instance, in Missouri, the company was ordered to pay $4.69 billion in 2018 for claims that its talc-based baby powder contained asbestos, leading to ovarian cancer. The judgement was reduced to $2.12 billion in June of this year and management says it will appeal to the U.S. Supreme Court. Another reduced judgement included marking down a Philadelphia jury's $8 billion award for marketing an antipsychotic drug to the elderly and children -- two groups who had not been approved to receive it by the U.S. Food and Drug Administration -- to $6.8 million.
The company has also agreed to pay $5 billion to states and cities suing large pharmaceutical companies for their role in the opioid crisis, as well as $1 billion for deceptive marketing about the longevity and safety of a subsidiary's hip replacements. Although none of the lawsuits threaten the long-term viability of the business, they represent significant uncertainty to future earnings. Just this month, Oklahoma asked its state supreme court to cover the cost of the state's opioid crisis by increasing last year's $465M judgement against the company to $9.3 billion. In a similar move, the Tennessee Supreme Court found that opioid makers and distributors could be sued under the state's "Drug Dealer Liability Act". The law lets innocent third parties seek damages from drug dealers. It's impossible to predict how cases will play out, especially when action can be taken even after a case seems closed, like in Oklahoma.
What can shareholders expect
Management doesn't provide GAAP estimates for its earnings, partly because of the unpredictability of so many legal proceedings. However, one thing that has become predictable is rising legal expenses. In the last half decade, these judgements have had an increasing impact on earnings even after the company's success in getting them reduced on appeal.
|Year||Legal Expenses per Share|
A long history of paying dividends and exceptional diversification may not be enough to make the stock a buy. Johnson & Johnson's legal problems are increasingly eating away at earnings, and the stock -- including those dividends -- has returned only 229% over the past ten years compared to 261% for the S&P 500.
Unlike Pfizer (NYSE:PFE), which changed CEOs in early 2019 and has been busy transforming itself ever since, Johnson & Johnson's strategy and tactics have remained consistent despite the business's big problems. Going by the numbers, and weighing the risks and benefits, I think that investors looking for safe returns are better off in an index fund or ETF that mirrors the overall stock market instead of Johnson & Johnson stock.