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I'll admit it straight off. I just switched from loving to hating Johnson & Johnson (JNJ -2.71%). And that’s despite how the stock rose by over 20% in 2016, a very nice gain for this typically stodgy stock. Unfortunately, that kind of leap poses a highly unpleasant paradox for J&J investors like me. We'd really like to increase our position in this company, but there are too many warning signs that the stock has gotten ahead of itself.
Even with a great company like J&J, there is a time to buy. And that's true even if your focus is only on the company's ultra-safe, growing dividend. J&J's trailing annual dividend yield is only 2.53%, which is close to a 5-year low. When you’re trying to get the best yield possible on your dollars, that's not good news.
But there are several more important reasons why this stock is due for a pause, or even a drop. One reason just hit the news, so let's dive in.
Key Remicade patent struck down, copycat could be launched soon
As of today, Remicade,the company’s biggest revenue generator for years, faces serious potential competition from Pfizer's (PFE -1.00%) copycat drug, Inflectra.
That's because just this afternoon, J&J lost a key court battle to shield Remicade. Specifically, a U.S. District Judge struck down a key patent ruling in favor of Hospira (now owned by Pfizer). J&J said it plans to appeal, but that could take a year or more. Meanwhile, in light of the new ruling, Pfizer could decide to make the somewhat risky move of launching Inflectra in the U.S. That could happen as soon as October 3, 2016, when the drug’s FDA approval allows sales to begin.
If J&J wins the planned appeal, and Remicade’s patent is upheld, Pfizer could be on the hook for big financial damages. But I don’t think Pfizer will hold off on the launch. South Korean company Celltrion has been knocking it out of the ballpark with sales of Inflectra in Europe, since 2015, as part of a marketing pact with Hospira. Seeing how successful Inflectra has been in Europe, it seems likely Pfizer will accept the risk.
Valuation is stretched for earnings only growing at low to mid-single digit rates
J&J is currently trading at nearly 23 times its last 12 months earnings . While that's certainly not nosebleed level, it'sa hefty ratio, especially for a company that has had a growth rate of only 6% since 2012.
It's also high relative to the company's history. J&J has commanded a premium price earnings ratio in the past, but the current trailing P/E ratio is above its historical norms since 2005. Considering just the last five years, J&J’s five year P/E average is 18.6
When J&J raised earnings guidance last quarter to $6.63- $6.73 per share, on projected revenues of $71.5- $72.2 billion, the company also said it did not expect any biosimilar competition for Remicade in 2016. That could change soon, and J&J’s declining HCV revenue is another sore point. Add in headwinds from negative currency movements and a soft global market, and the short-term risks are significant.
Buyback is signaling a warning
In late 2015, J&J announced that its board had approved a $10 billion share buyback plan. Many investors like buybacks, believing the put a floor under a sliding stock’s share price. It’s also a matter of simple math. Reducing the number of shares by 3% will increasing earnings per share by 3%, too, and will tend to bolster short-term prices.
But buybacks can also create an illusion that shares are undervalued, which is why the company decided to buy them back. That’s not always true. It ignores the reality that if the company believed it could generate more earnings by retaining cash, it wouldn’t be buying back its shares in the first place.
What’s even more alarming is that buybacks allow insiders (typically company executives) to exercise stock options without diluting the shares afloat in the market, thus protecting the stock price from dropping. J&J’s buyback appears to be signaling a problem right now. It’s a big initiative, but the number of outstanding shares has gone down very little. J&J has spent around 50% of the buyback, or around $5.0 billion , yet the diluted share count has hardly budged in the last year. The share count for the last quarter, 2016 was 2,794 million, down only 0.6% from last year’s second quarter.
The best things in life are worth waiting for
The big question about J&J isn't whether more stock gains are possible in the future. There’s no doubt about that. The big question is whether investors who exercise patience might get shares at a significantly better price.
Here’s the problem in a nutshell. If Johnson & Johnson's stock price reflected a trailing twelve month’s P/E ratio of around 15, I would be salivating, but that would suggest a price near $100 per share. Since the stock traded today at around $121 per share, and options for safe, growing dividends are few and far between in today’s market, we may not see that $100 price again soon.
Still, with the recent news on Remicade and the other issues, I wouldn’t be surprised it J&J got a haircut. Until then, I’m holding off on buying more.This company is a long-term champion, so I’ll never sell. And if J&J manages to grow earnings more than expected, (the best way to send its P/E ratio closer to its historical norms), you better believe I’ll not only eat my words, I'll switch back to loving it again. In a heartbeat.
