This Is Dividend Stock Johnson & Johnson’s Major Weakness

Although diversification can sometimes be a strength, it can also prove to be a double-edged sword in the long run. Here’s how.

Apr 25, 2014 at 9:30AM

In a previous article on J&J (NYSE:JNJ), I highlighted the company's major strengths -- and it has many, not least of which is its 2.7% dividend yield. Now it's time to focus on its major weakness.

Diversity: A double-edged sword
While J&J's diversity could be seen as a major source of strength for the company, because it provides reduced risk and volatility in the company's sales and profitability, it is not a perfect attribute. By having consumer and medical devices segments in addition to a pharma segment, J&J is less exposed to challenges faced in those divisions; but the company may also miss out on the positive surprises in its segments, too.

Diversification can mean that a company spreads itself too thinly. By this, I mean that it attempts to specialize in a number of areas and business lines; however, it can end up achieving diversification while performing its varied tasks at a sub-optimal level. This can be due to an inefficient allocation of capital. For example, investing too much cash in an underperforming business segment to try and turn it around when the money could be better spent in a different segment that is already highly profitable.

Sector peers
Sector peers, such as Pfizer (NYSE:PFE) and Abbott Laboratories, are attempting to become more specialized than J&J. For instance, pharmaceuticals accounted for 93% of Pfizer's sales in 2013, with the remainder being made up of its consumer health-care segment. Of course, even that specialization still left Pfizer with a revenue decline of 6.5% last year, as compared to J&J's revenue growth of 11%.

While this is only a one-year time period, an increased focus on non-pharma activities does not seem to have hurt J&J in recent years when compared to sector peer Pfizer. However, it raises the question of whether J&J's performance could have been even better were it not for the distraction of less-profitable, but more stable, segments. Indeed, it appears as though Pfizer reached this conclusion and decided to sell off its animal health and nutrition segments in recent years in order to focus time and capital on the most lucrative segment: pharmaceuticals. Could a similar approach from J&J deliver even more profit for shareholders?

Meanwhile, Abbott Laboratories spun-off its research-based pharmaceutical business, AbbVie, on January 1, 2013. In 2013, Abbott Laboratories posted improved sales growth, with the top line increasing by 1.6% compared to 2012. This was higher than the 0.4% sales growth reported in 2012, although clearly the potentially positive effects of the spin-off will take more time to come through. It does, however, show that other companies in the health-care space, such as Abbott Laboratories, are seeking to narrow their specialism in an attempt to stimulate sales and profits.

Looking Ahead
While J&J is currently performing well, as its first quarter update recently showed -- sales up 3.5%, earnings per share up 6.9% versus the first quarter of 2013 -- it could be argued that three separate businesses, as opposed to three segments within the same business, could perform even better, and add even more value for shareholders.

Sure, many investors may argue that a winning formula should not be changed, but if J&J -- or any company -- wants to stay ahead of the competition, it must embrace change and be bold with regard to the changes it makes. Splitting into three distinct entities could maximise profitability, and allow investors in the stock to still access diversification benefits through owning shares in all three entities, while also overcoming what could prove to be J&J's major weakness: spreading itself too thin. 

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Peter Stephens has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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