3 Things About Johnson & Johnson Smart Investors Know

If you've ever been inclined to pop a Tylenol or use a Band-Aid, you've used Johnson & Johnson's (JNJ -0.96%) products. There's a good chance that you use more than one of them every day. But there's a lot more to the company than its consumer health goods, and it has quite a lot to offer for investors of all stripes.

Still, J&J isn't the perfect investment. Smart investors should understand that there are three things in particular that are critical to know about this stock before buying shares. Let's take a look at each.

1. J&J's attempt to mitigate damage from billion-dollar litigation failed

Even the best companies get into legal trouble sometimes. When trouble crops up, watch the situation closely to see if it reveals some sort of enduring mismanagement or serious wrongdoing that might warrant a reassessment of the stock and its worthiness to remain in a portfolio. 

Johnson & Johnson faces significant possibility of damages from billion-dollar-plus class-action lawsuits brought by those claiming to be harmed by its talcum powder, which was shown to be contaminated for several years with cancer-causing asbestos despite the company's denials. In early 2021, J&J set aside $3.9 billion to cover its legal costs related to these lawsuits. Unfortunately, the actual costs will ultimately prove to be higher, as at least 38,000 people are now involved in these years-long lawsuits.

In an effort to get out of paying some of the settlements, J&J attempted to transfer the liability for the settlements to a shell company in late 2021 that then filed for Chapter 11 bankruptcy protection. The idea was that the shell company would use the bankruptcy to better manage the costs that would arise and to protect J&J shareholders from the brunt of the damages. Federal courts denied this effort in early 2023.

On April 5, Johnson & Johnson announced that it reached a settlement worth $8.9 billion with its counterparties. Under the terms of the settlement, it will pay the settlement out over the next 25 years. The shell company also filed for bankruptcy protection again, so there could still be more to come with regard to this story.

The terms of the settlement will result in less cash being available to use for acquisitions, paying down debt, or paying out dividends. J&J has $23.5 billion available in cash and equivalents, so it can afford to pay. But looking at the broader picture, smart investors should be asking whether it would have been cheaper, in the long run, to simply remove the asbestos contamination from its talc products when the issue was first noticed internally and brought to the attention of management, way back in 1971.

2. J&J's stock is underperforming, and the size of its business makes growth harder

Johnson & Johnson's stock price is down about 10% over the past year. Reasons for this include the above-mentioned lawsuits, the current bear market, and some uncertainty surrounding the impending spinoff of its consumer health division into a separate public entity later this year. The dip in its share price pushed its dividend yield to 2.76%, a bit above its 10-year average of 2.54%. The above-average yield might suggest a buying opportunity, but it isn't right for everyone.

Canny investors will look at past performance and note that, while the stock has generated a healthy total return of 165% over the past decade, that rate falls below the S&P 500's total return of 217% over the same timeframe. A big reason for the above-mentioned spinoff J&J is working to complete is that the company's underperforming consumer division is weighing down the smaller and better-performing segments as well as J&J's largest and best-performing pharmaceutical segment.

Another reason for the lag is investor perception that J&J has gotten too big to perform as well as it used to. With a top line of $94.9 billion and a bottom line of $17.9 billion in 2022, J&J needs to add billions of dollars in revenue or earnings just to generate the growth rates the market expects of growth stocks. For most businesses, adding $1 billion in earnings in a year would be a major accomplishment that'd send shares soaring. For J&J, such a gain doesn't move the growth needle like it used to. So don't buy it just because its shares are cheap, as your money would probably grow faster in an index fund.

3. New legislation might constrain J&J's ability to hike drug prices 

Johnson & Johnson makes the majority of its revenue from its pharmaceutical segment, which also happens to be highly regulated. These regulations -- and changes to them -- can make a big difference in terms of J&J's ability to generate profits. Unfortunately, key regulations recently changed.

As part of the Inflation Reduction Act, the Centers for Medicare Services now have the ability to levy a fine against companies that hike the prices of their drugs faster than the rate of inflation. J&J's competitors like AbbVie have already been notified that their price hikes will lead to penalties at some point in the next few years. More importantly, the company will no longer have the option of raising its drug prices annually beyond a certain point without the potential for a penalty. 

The rule changes may not be as concerning for its medicines approaching the loss of their exclusivity protections. But for newer medicines, especially expensive ones like those in its oncology portfolio, the impact over the life of a drug patent could be significant. Investors will need to pay attention to this new wrinkle and see if the company ends up being singled out as a violator under the new standards.