Johnson & Johnson's Dividend Continues Looking Safe After Latest Baby Powder, Opioid News

Shares of Johnson & Johnson (JNJ) fell 6.2% last Friday following news that the company recalled some of its baby powder in response to a U.S. Food and Drug Administration (FDA) test indicating the presence of very minor levels of asbestos.

As we've previously discussed, the company faces more than 15,000 lawsuits related to claims that its talc-based products such as baby powder caused cancer due to the asbestos they contained. Johnson & Johnson has adamantly denied these allegations.

If the FDA's single-bottle test checks out to be valid (could be a counterfeit product since it was purchased from an online retailer, possible cross-contamination risk in the sample, no asbestos was found by the FDA last month, etc.), then this recall deals a blow to the company's credibility.

From a financial perspective, this news could make it more likely that the healthcare giant will not win as many court battles as it had hoped and will ultimately need to pony up for a larger settlement than investors expected.

Estimating the size of this liability is difficult. Wells Fargo analyst Larry Biegelsen previously wrote a note to clients stating the highest per-case settlement the firm has seen was $280,000 each.

If you conservatively assume J&J settles all 15,500 talc powder cases against it for $1 million each, then the company would be on the hook for $15.5 billion. Based on data from GJEL Accident Attorneys, that amount would be the third-largest settlement of all time across all industries.

Importantly, as of October 10, none of the negative verdicts reached against the company had survived appeals so far, making this outcome appear unlikely.

But the company's legal woes extend beyond its baby powders. Johnson & Johnson is also fighting a number of lawsuits related to the opioid crisis, as we detailed here in May 2019. Earlier this month, J&J supposedly offered about $4 billion to settle all of the allegations against the company.

While this offer has not yet been accepted, it at least provides a foundation for making a ballpark estimate of the opioid-related liability the firm could face. The Wall Street Journal noted that "Wells Fargo had estimated that the opioid litigation could cost the company $5 billion to $10 billion to settle."

Finally, in early October, Johnson & Johnson was ordered to pay $8 billion in damages to man who claimed antipsychotic drug Risperdal caused enlarged breasts, and J&J failed to properly warn of this risk. The man had previously been awarded $680,000 in compensation but was back seeking punitive damages.

Management plans to appeal the amount and believes it will be reduced significantly based on U.S. Supreme Court precedent. More than 13,000 Risperdal lawsuits are outstanding. If you assume claims settle for $500,000 each, then J&J would owe $6.5 billion.

When you add up these potential legal costs, what are the chances they could put Johnson & Johnson's dividend at risk?

Fortunately, Johnson & Johnson's dividend continues to look secure based on the information we know today.

Here are some conservative liability estimates we'll throw out for each legal issue discussed:

  • Talc powder: $15.5 billion
  • Opioids: $5 billion
  • Risperdal: $6.5 billion

Under these assumptions, J&J's total settlement cost would be $27 billion. That's a lot of money and, in aggregate, would represent the second-largest settlement ever, behind only the $206 billion tobacco master settlement agreement reached by four cigarette companies in 1998. 

Even under this draconian scenario, J&J's dividend could survive.

First, none of the products facing litigation materially affect Johnson & Johnson's ongoing earning power. Risperdal lost patent protection in 2008, the firm exited its small opioid-related businesses by 2016, and U.S. baby products account for just 0.4% of firm-wide revenue, according to management.

As a result, the company should continue generating a lot of cash. In fact, Johnson & Johnson remains on pace to produce around $9 billion in free cash flow after paying dividends this year. 

That alone could cover a third of the firm's total liability, and settlements this large seem likely to be paid out over the course of years rather than all upfront.

Even if a large sum was needed immediately, the company holds approximately $18 billion of cash and marketable securities, providing it with excellent liquidity to go along with its AAA investment-grade credit rating from Standard & Poor's. 

If J&J immediately took on $27 billion of debt (rather than use existing cash on hand) to cover these estimated legal liabilities, its net debt to EBITDA leverage ratio would only rise from 0.7 to about 1.6, representing a healthy level that should still warrant an investment-grade rating.

Combined with the company's underlying operations continuing to perform well (adjusted organic sales and EPS growing 4-6% this year), it's hard to imagine a scenario that puts Johnson & Johnson's dividend on the chopping block. 

However, legal uncertainties could continue serving as an overhang on the firm's stock price until more clarity is provided on the size of the liabilities. Large settlements also reduce the flexibility Johnson & Johnson has to meaningfully increase its dividend and make acquisitions. 

But in the grand scheme of things, those issues seem like moderate setbacks that shouldn't affect J&J's long-term outlook. I also don't believe these issues are evidence that the company has lost its way, so I plan to continue holding the shares of Johnson & Johnson we own in our Conservative Retirees portfolio.

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