How Johnson & Johnson Really Makes Money

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Tylenol, Listerine, Band-Aids, Neutrogena, Stayfree, Splenda, Visine, Reach, Bengay, Purell, Rogaine, Motrin, Rolaids, and Nicorette.

You may know that Johnson & Johnson (NYSE: JNJ  ) makes all of these famous brands. But what may shock you is that these brands represent a very small part of J&J's business.

Its consumer goods cohorts Procter & Gamble (NYSE: PG  ) and Kimberly Clark (NYSE: KMB  ) make their money exactly where you think they would -- from brands like Tide, Head & Shoulders, Huggies, and Kleenex.

Not so with J&J. Believe it or not, consumer brands like the ones I listed above account for only about a quarter of J&J's sales. And these sales convert to a bite-sized 15% of J&J's pre-tax profits.

Where the money's at
Johnson & Johnson is called a virtual health-care mutual fund for good reason; it has a passion and proficiency for all things healthcare. The consumer goods division is the smallest of three health-related segments-- the other two being pharmaceuticals (39% of profits) and medical devices (46% of profits).

The general public is the ultimate consumer of all of these segments, but marketing is only primarily targeted at you and me in the consumer goods segment. The other two segments market to the health care professionals and organizations that we trust to make those brand decisions for us.

That's why we've all heard of Tylenol and Band-Aids, but most of us haven't heard about Johnson & Johnson's top pharmaceutical brands (Remicade, Procrit, Levaquin, Risperdal Consta) or top medical devices brands (Cordis, DePuy, Ethicon).

As investors, there are two important takeaways from this surprising product mix.

The takeaways
While P&G and Kimberly Clark can rely indefinitely on the moats they've built with their brands, Johnson & Johnson can only do so for the consumer division (assuming its recent recalls are a temporary blip). Like Boston Scientific (NYSE: BSX  ) , Baxter (NYSE: BAX  ) , and Stryker in the medical devices area, J&J must keep replenishing its patents pipeline, either through research and development or through acquisition. And like its competitors Pfizer (NYSE: PFE  ) and Abbott Labs (NYSE: ABT  ) , the same is true for pharmaceuticals.

The proof? In the past 12 months, Johnson & Johnson spent over 10% of its sales on R&D, and a significant chunk on acquisitions. And last year, a quarter of its sales came from products introduced in the past five years.

What this means for investors is that it's more dangerous to project trailing earnings and cash flow numbers for Johnson & Johnson than it is for, say Procter & Gamble. You have to be sure that J&J's pipeline of drugs and devices in testing and future acquisitions can replenish expired patents and grow the business.

The second takeaway is that Johnson & Johnson has no real one-on-one comparable. It's kind of a highly functional and well-integrated Frankenstein of P&G, Pfizer, and Boston Scientific. Luckily, Johnson & Johnson breaks down its three segments in its financials, so it's possible to compare each segment individually. For example, you can see that over the last three fiscal years, the consumer segment grew profits by 80% (largely due to its purchase of Pfizer's consumer health care business), pharmaceuticals shrank 7%, and medical devices grew 26%.  

Unfortunately, my two takeaways result in more work for you as an investor. But the work is worth it on a quality company like Johnson & Johnson that is trading at reasonable-to-cheap multiples. If it slips under $60 a share again, it makes for a very compelling opportunity.

Anand Chokkavelu owns shares of Pfizer. Pfizer and Stryker are Motley Fool Inside Value picks. Johnson & Johnson, Kimberly Clark, and Procter & Gamble are Motley Fool Income Investor recommendations. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Johnson & Johnson.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

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  • Report this Comment On October 07, 2010, at 2:20 PM, goalie37 wrote:

    Excellent article. JNJ is a great company, but it does require a little extra work on the part of the shareholder.

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