Shares of Johnson & Johnson (JNJ) dropped 10% on Friday, shedding $40 billion in market value to mark its worst trading day since 2002.
The cause was a Reuters article claiming that insiders at J&J knew for decades that its baby powder "sometimes tested positive for small amounts of asbestos" without disclosing the issue to regulators or the public:
"A Reuters examination of many of those documents, as well as deposition and trial testimony, shows that from at least 1971 to the early 2000s, the company’s raw talc and finished powders sometimes tested positive for small amounts of asbestos, and that company executives, mine managers, scientists, doctors and lawyers fretted over the problem and how to address it while failing to disclose it to regulators or the public."
This worried the market because as of September 2018 Johnson & Johnson faced 11,700 cases related to its baby powder containing asbestos, which is a proven carcinogen that women are now claiming has given them ovarian cancer (vast majority of these cases).
For more background information on this issue, please review the article we published in July 2018 reviewing the claims made against Johnson & Johnson here.
If there is strong evidence the company's talc products did indeed contain asbestos and management turned the other way, not only would Johnson & Johnson's public image take a big hit, but the company could be more likely to face a multibillion dollar settlement.
Naturally, J&J has vehemently denied these latest allegations. The company quickly responded with a statement calling the Reuters story "one-sided, false and inflammatory."
Here are the three main counterarguments Johnson & Johnson laid out:
The article ignores that thousands of tests by J&J, regulators, leading independent labs, and academic institutions have repeatedly shown that our talc does not contain asbestos.
The article ignores that J&J has cooperated fully and openly with the U.S. FDA and other global regulators, providing them with all the information they requested over decades. We have also made our cosmetic talc mines and processed talc available to regulators for testing. Regulators have tested both, and they have always found our talc to be asbestos-free.
The article ignores that J&J has always used the most advanced testing methods available to confirm that our cosmetic talc does not contain asbestos. Every method available to test J&J’s talc for asbestos has been used by J&J, regulators, or independent experts, and all of these methods have all found that our cosmetic talc is asbestos-free.
With such an unusually large drop in the company's stock price, especially given J&J's status as a safe haven investment, some income investors are worried if the firm's dividend could end up in trouble over this news.
First, note that this legal process is likely to be drawn out over many years. Of the claims that have made it to trial thus far, some juries have failed to reach verdicts, while many have sided with Johnson & Johnson. The company is also appealing the cases it has lost, most notably the $4.7 billion lawsuit announced this summer.
And according to Citigroup analyst Amit Hazah, Johnson & Johnson has thus far won every court case it has appealed.
So understand that the Reuters article is not cold hard proof of Johnson & Johnson's guilt. Your guess is as good as mine regarding the ultimate outcome of all these cases, but it is far from being determined at this stage.
However, as conservative investors, we can at least try to ballpark an adverse outcome to see if J&J and its dividend could survive if the firm were to lose the thousands of cases filed against the company.
Quantifying legal liabilities is difficult enough for industry insiders, and even more challenging as an outsider looking in. However, we can look to history as a guide regarding the type of settlement Johnson & Johnson could face.
Here are the three largest drug lawsuit settlements of all time, according to consumer justice attorneys Saunders & Walker:
GlaxoSmithKline: $3 billion in 2012 for selling antidepressants for uses unapproved by the FDA
Pfizer: $2.3 billion in 2009 for illegally marketing a pain killer
J&J: $2.2 billion in 2009 for promoting certain drugs for unapproved uses by the FDA
What if we expand beyond the drug industry to look at all of the largest class action lawsuits and settlements?
Philip Morris, RJ Reynolds, and two other tobacco companies: $206 billion in 1998 to cover medical costs for smoking-related illnesses
BP: $20 billion in 2016 for Gulf of Mexico oil spill
Volkswagen: $14.7 billion in 2016 for cheating emission tests on its diesel cars
Enron: $7.2 billion in 2008 for defrauding shareholders prior to bankruptcy
Worldcom: $6.1 billion in 2005 for accounting scandal
American Home Products: $3.8 billion in 2000 for selling a diet drug (fen-phen) that was associated with potentially fatal heart valve damage
American Indian Trust: $3.4 billion in 2011 for the federal government mismanaging funds in land trust accounts dating back to the 1800s
Dow Corning and Bristol-Myers Squibb: $3.4 billion in the mid-1990s for producing silicone gel breast implants that exposed women to autoimmune and connective tissue disorders
Cendant: $3.2 billion in 2000 for accounting fraud
Tyco: $3.2 billion in 2007 for accounting fraud
With 11,700 claims against the company, it's hard to say where J&J's potential settlement would fall on this spectrum. However, whether one looks at just drug-related lawsuits or settlements across all types of companies, almost all of the biggest suits ended with less than $5 billion in damages.
While the number of claims against J&J could rise, for now let's assume the company decides to settle all 11,700 cases for $1 million each. Wells Fargo analyst Larry Biegelsen wrote a note to clients stating the highest per-case settlement the firm has seen was $280,000 each, so using $1 million seems quite conservative.
In that scenario, Johnson & Johnson would be on the hook for $11.7 billion, the fourth largest settlement of all time (and the largest drug settlement by more than $8 billion).
Could the firm afford to make such a payout without jeopardizing its dividend?
It certainly looks like it. Through the first nine months of 2018, Johnson & Johnson generated about $16 billion in operating cash flow and spent $2.4 billion on capital expenditures, leaving $13.6 billion in free cash flow, which funds the dividend.
The firm paid out $7.1 billion in dividends during this time (a reasonable 51% payout ratio), leaving it with $6.5 billion in retained cash flow that could be used for acquisitions, share repurchases and debt reduction (plus any legal liabilities).
In other words, if the company was on the hook for a legal settlement of $11.7 billion related to its body powders containing talc, over half of that liability could have been funded with just the usual cash flow J&J generates after paying dividends through the first three quarters of 2018.
Johnson & Johnson also has $19.4 billion in cash and marketable securities on its balance sheet. With such low financial leverage, management could easily tap into this reserve to help service a large legal liability.
Source: Simply Safe Dividends
But what if consumers stop buying J&J's body powders as negative headlines increasingly dominate the press?
The company's powders fall under its "Baby Care" segment, which accounted for just 2.2% of company-wide revenue through the first nine months of 2018. This division contains other types of Johnson-branded products as well, so talc products are an even smaller driver of J&J's overall business.
Simply put, even if demand fell off a cliff for Johnson & Johnson's body powders, the firm's free cash flow generation is unlikely to materially decline thanks to the company's well-diversified business.
This case also seems unlikely to indicate that J&J's other product lines could have quality control or other issues that result in future liabilities. The thousands of lawsuits against the company relate to talc products that were sold over many decades. According to Reuters:
Asbestos, like many environmental carcinogens, has a long latency period. Diagnosis usually comes years after initial exposure – 20 years or longer for mesothelioma. J&J talc products today may be safe, but the talc at issue in thousands of lawsuits was sold and used over the past 60 years.
Manufacturing processes, technology, knowledge, and the quality of raw materials have all improved significantly over the last 50 years. It's hard to make a case that the procedures followed half a century ago have any bearing on a company's current quality control efforts or corporate culture.
Johnson & Johnson has established itself as a very conservative operator over time, and this news does not seem like it should change that sentiment given what we know today.
Healthcare companies work to solve complex problems that also tend to be very sensitive in nature. Unfortunately, legal liabilities are a part of business for virtually every major medical company as perfection is often impossible to achieve across the thousands or millions of unique people being served.
Johnson & Johnson's stock could remain in the penalty box until more is known about the company's potential liability related to its talc powders. And even then, the potential billions of dollars directed towards legal matters is money that J&J can no longer invest in growth initiatives to increase its earning power over the next few years, which could remain a lingering disappointment for investors.
Fortunately, given J&J's diversification, excellent free cash flow, and strong balance sheet, as well as the size of historical settlements in the healthcare space, the firm's ultimate liability seems very unlikely to threaten the safety of its dividend or its long-term outlook for profitable growth. Regardless, Johnson & Johnson's recent stumble serves as a reminder of the importance of maintaining a well-diversified portfolio.
