Image Shown: J&J continues to face legal liabilities due to talcum powder lawsuits. Image Source: Mike Mozart.
By Brian Nelson, CFA
Johnson & Johnson’s (JNJ) dividend growth story has become much more complicated in recent years. On a price-only basis, shares of the consumer and pharma giant haven’t been nearly as impressive as that of technology names, but the company still has put up a nice 45% price-only return the past five years, further bolstered by a continuous stream of quarterly dividend payments. J&J yields ~2.6% at the time of this writing, and the company reluctantly remains the bedrock of the Dividend Growth Newsletter portfolio, at least for now.
The Split-Up
Before we dig into J&J’s fourth-quarter 2021 results, released January 25, there are few things that investors should note. First, in the next 18 to 24 months, J&J plans to split into two companies, separating its medical device and pharma business its from its consumer products operations. In one company will be Tylenol, Band-Aid bandages and Neutrogena skin care products and the like, while the other company will sell medical devices and prescription drugs.
Though many point out that the separation may be beneficial because it will create two distinct management teams with two distinct operating budgets for these separate business segments, we’re generally not big fans of the news. Instead, the split-up may alienate some dividend growth investors that had liked the resilience of a dividend-paying company with multiple revenue streams from several end markets that have different demand profiles provide. Look at what happened to AT&T (T), for example.
Legal Strategy
Johnson & Johnson has been using a number of legal tactics to cap its exposure to talcum powder lawsuits (claims that its talc products have caused mesothelioma and ovarian cancer). Last year, it created a new subsidiary LTL Management LLC, in which it housed all of its talc liabilities, and then sent the entity right into bankruptcy court protection. It’s too early to assess the effectiveness of how this may shield or limit J&J and its affiliates from the talc liabilities, but such a legal strategy has been used in the past by companies facing asbestos litigation.
Moody’s noted in its October 2021 update that, while the news is a credit negative due to a potential outflow of ~$2 billion related to the creation of LTL Management, there would be no impact on J&J’s Aaa credit rating. J&J has a very healthy balance sheet, and its free cash flow generation remains very robust. Here’s more from the credit rating agency:
LTL’s Chapter 11 filing relates to J&J’s legal strategy for addressing outstanding talc lawsuits, which have steadily increased in number and totaled 34,600 as of July 4, 2021. The Chapter 11 filing is part of a legal mechanism often known as a channeling injunction. Under this process, J&J’s talc liabilities will be channeled into a dedicated trust established for this purpose and overseen by the bankruptcy court. J&J will initially fund the trust with $2 billion of cash, as well as future royalty streams on several specified consumer healthcare products with a present value of over $350 million. Moody’s believes that additional payments to the trust are likely. On top of a recent $2.5 billion talc-related payment to 22 plaintiffs in a Missouri lawsuit, these cash outflows are credit negative. However, J&J’s cash levels stood at over $25 billion as of July 4, 2021, after the Missouri payment.
Despite the cash outflows, the overall level of uncertainty related to J&J’s talc litigation is likely to decline as a result of the LTL Chapter 11 filing and the channeling injunction process. This is because the Chapter 11 filing suspends all talc litigation proceedings in state and federal courts. This eliminates the potential for protracted legal proceedings in multiple venues, as well as the potential for high jury awards. The strategy will eventually cap J&J’s talc-related obligations because all current and future claims will be handled by the dedicated trust. However, the amount that will be required to fully fund the trust remains subject to settlement discussions with plaintiffs and reorganization plans overseen by the bankruptcy court. The uncertain magnitude — despite the likelihood that it will be capped — continues to represent an overhang to J&J’s otherwise strong credit profile.
J&J wrapped up its 2021 with mixed fourth-quarter results released January 25. The company missed a bit on the top line and modestly beat on the bottom line, but new CEO Joaquin Duato seemed to be encouraged by J&J’s positioning for 2022 and beyond, pointing to its strong financial profile and innovative pipeline in the press release. During the final quarter of 2021, J&J generated adjusted operational sales growth of 12.3% and adjusted earnings per share expansion of 12.2% thanks to strength in the pharma division led by in part by key blockbuster drugs and its COVID-19 vaccine.
Management is guiding adjusted operational sales growth and adjusted operational earnings per share growth of 7.7% and 9.2% for 2022, respectively. With all of the moving parts discussed in this article, we’re a bit cautious on whether J&J will deliver on these targets.
Concluding Thoughts
We prefer simple dividend growth stories. Unfortunately, J&J is no longer one of them.
A split of Johnson & Johnson’s consumer products division from its medical device and pharma divisions in the next 18-24 months means that dividend growth investors will have added complexity as a new CEO takes the helm, all the while the board manages its growing talc liabilities during a global pandemic. Shares of J&J haven’t been as strong a performer as other stocks on the market the past five years, but we still like its firm foundation and nice combination of dividend yield and potential dividend growth for now. That may change in the coming months to years, however.
While investors should expect some big changes at the company in the next two years (as it splits up the business and handles talc liabilities with a new CEO), we’re not making any moves to the newsletter portfolios just yet. Shares of J&J remain a top-weighted idea in the Dividend Growth Newsletter portfolio, and we’re sticking with it for now. For “new” money looking for capital appreciation potential in the big cap healthcare and pharma area, the Healthcare Select Sector SPDR ETF (XLV) may be a more attractive relative play (Fact Sheet – pdf).
The XLV is a bet on broad-based innovation within the largest healthcare and pharma names with the most robust drug/therapy pipelines. More risk-tolerant investors may go up the risk chain to consider Vertex Pharma (VRTX), but for more conservative investors, the XLV is a rare “nice-fit” ETF for broader exposure to a healthcare and pharma space, which can sometimes be hit or miss, especially in the riskier biotech arena.
We include the XLV in both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio.
Johnson & Johnson’s 16-page Stock Report >>
Johnson & Johnson’s Dividend Report >>
Tickerized for holdings in the XLV.
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson’s household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.