The Bad of J&J
...which follows up on the good

by Brian Graney (TMFPanic)

ALEXANDRIA, VA (Oct. 22, 1998) -- After Jeff sang the many praises of our healthcare heavyweight Johnson & Johnson (NYSE: JNJ) yesterday, it's now my turn to drone on about the company's problems.

Just as an aside, let it be known that I am not really Mr. Negative, even though I'll be focusing on the downside of J&J's financials both in this column and in an upcoming Dueling Fools feature with Jeff. I'm not the Fool's resident party-pooper or anything. However, I have noticed lately that co-workers gathered around the water-cooler at Fool HQ curiously tend to stop talking whenever I walk back for a drink.

Even though we're long-term investors here with 20- or 30-year investment horizons, it's important to keep up with the near-term developments affecting our companies and comb through the numbers every quarter or so. Just as termites can eat away the inside of the timbers of the most beautiful house over time and leave no visible damage on the surface, problems can crop up within a company and go undetected for awhile even though everything looks solid and secure on the outside. Vigilance, Fools, is the key word here.

While probably not a termite infestation, a lack of growth in J&J's consumer and professional products units has been bugging the company for the past couple of quarters. But before we call in the Orkin Army for a complete fumigation of our J&J shares, let's pull out our own flashlights and see if we can identify what's going on at the units. Hopefully, the following chart will provide us with some hints (AOL users will need to expand the window):

                          Q397   Q497   Q198   Q298   Q398 
 ($ in millions) 
 Consumer Revenues       1,584  1,618  1,639  1,571  1,587 
 Pharmaceutical Revenues 1,918  1,900  2,092  2,162  2,098 
 Professional Revenues   2,084  2,112  2,052  2,050  2,039 
 Worldwide Revenues      5,586  5,630  5,783  5,783  5,724 
 Net profit margin        15.3%  14.6%  17.5%  17.4%  16.8% 
 Operating margin         21.4%  20.2%  24.8%  23.7%  23.0% 
 Gross margin             68.7%  68.4%  69.3%  68.8%  69.3%

As the table above shows, J&J's pharmaceutical revenues have really driven the company's growth lately, climbing 9% to $2.098 billion in the latest quarter compared to the same quarter a year ago. Not surprisingly, the increase in sales of higher-margin drugs has carried through to the firm's margins, which have also increased over the past few quarters. However, consumer and professional products revenues have pretty much stayed put over the same time-span.

What we have here is a three-cylinder healthcare engine which currently is only firing on one cylinder (pharmaceuticals). While that single cylinder represents 34% of annual revenues and is powerful enough to keep the company moving forward, the progress is slower than it would be with all three pistons churning in unison. In my opinion, J&J's main near-term challenge is to find a couple of sparkplugs to get the other two chambers moving again and provide the company with the extra speed it needs to outperform its competitors.

Of course, our goal is for J&J's stock to return 15.5% annually over the life of the investment. According to Bloomberg, J&J has returned 37.7% over the past year with dividends reinvested, trouncing the market averages. As Jeff noted yesterday, the difference between the Drip Port's dollar-averaged cost and the current market price is 14%. So at first glance, we don't have much to complain about.

And J&J's long-term prospects look pretty bright, too. The company has great brand names, a long history of solid performance, and operates in a healthcare environment where demand for an ever-greater number of services is expected to outstrip supply for the foreseeable future. We're not ready to sell this baby, not by any means.

However, J&J has some near-term challenges to deal with in its professional and consumer products divisions. Execution in the professional products arena has been questionable of late, most notably illustrated by the ugly market share erosion in the coronary stent market experienced by the company's Cordis subsidiary over the last year.

The economics of the professional business is also changing. Accustomed to being a bulk supplier of medical supplies to hospitals, J&J is now faced with an increasing number of bulk purchasers, such as large HMOs and for-profit hospital chains. Those clients will be seeking lower and lower prices from J&J in the future as they attempt to eke out a profit and keep their own shareholders happy. Meanwhile, a new class of painkillers on the horizon has its sights set on taking sales away from Tylenol, which is the cornerstone of J&J's consumer products business.

This is just a quick taste of the downside, of course. In the interests of time (and secrecy), I will put off elaborating on these challenges and others facing J&J until the duel with Jeff, which should be available for your perusal in a few weeks.

For continued discussion, please visit the J&J message board or the Drip message boards, which are linked in the top right of this page.

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10/22/98 Close

Stock Close Change CPB 56 + 1/16 INTC 87 3/8 + 5/16 JNJ 83 1/8 +2 5/16
Day Month Year History Drip 1.03% 4.86% 17.49% 0.06% S&P 500 0.80% 6.04% 11.13% 13.36% Nasdaq 1.66% 0.52% 8.42% 6.83% Last Rec'd Total # Security In At Current 09/02/98 8.027 CPB $52.867 $56.000 09/01/98 9.727 INTC $80.238 $87.375 10/07/98 7.850 JNJ $71.405 $83.125 Last Rec'd Total # Security In At Value Change 09/02/98 8.027 CPB $424.36 $449.51 $25.15 09/01/98 9.727 INTC $780.50 $849.93 $69.43 10/07/98 7.850 JNJ $560.53 $652.53 $92.01 Base: $2000.00 Cash: $186.08** Total: $2138.05

The Drip Portfolio has been divided into 85.474 shares with an average purchase price of $23.399 per share.

The portfolio began with $500 on July 28, 1997, adds $100 on the 1st of every month, and the goal is to have $150,000 in stock by August of the year 2017.

**Transactions in progress:
9/21/98: Sent $77 to buy/enroll in MEL.