Make Way for J&J
...it knows how to stay and stay
by Jeff Fischer (TMFJeff)
ALEXANDRIA, VA (Oct. 26, 1998) -- Before Brian wrote his cautious column on Johnson & Johnson last Thursday, I promised that I would share a response to his concerns.
But alas, Brian is holding much of his argument close to his chest until our Dueling Fools column on Johnson & Johnson (NYSE: JNJ), which runs a week from Wednesday. So, I don't have much to defend. Brian did brush on very good points, however, reminding us that two divisions of JNJ's three haven't been growing much. He summed the situation with this:
"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 [my note: and 56% of operating earnings] 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."
Great point, Brian. In fact, you read management's mind.
J&J is the first to admit that it needs to jumpstart its professional product division. The proposed $3.5 billion purchase of DePuy, Inc. is a start. This is a highly complementary acquisition. J&J is a leader in knee replacements and DePuy is a leader in hip replacements. Last year, this combined market was larger than $4 billion and J&J and DePuy combined hold over $1.4 billion in market share. The merged company should be able to take a bigger bite of the overall market. Also, DePuy recently acquired the number two company in the fast-growing spinal implant market. Combined, the two companies split the U.S. and international market for spinal implants evenly and have a combined growth rate as high as the low-double digits.
Brian also mentioned the devastation that J&J has experienced in its stent division. This is true. Market share and sales have plummeted, but J&J is addressing the problem with new, advanced stent products due to be released before the end of this year and in early 1999. The company is refocused on medical device innovation. (Sometimes a giant needs a wake-up call, which is what J&J got.) More on this in the coming Duel. In a nutshell, Brian's stent argument is arriving late. Sales have already taken the big swandive (down as much as 50%) and comparisons next year will be much easier. The company is now more likely positioned to grow this segment rather than continue to have it shrink. Most the damage has been done and through all of it J&J's stock continued to make new all-time highs anyway.
Consumer products: J&J has new products emerging here, too, including Benecol, a cholesterol-lowering dietary supplement that will first be used in margarine and later in other edible products. Another long-awaited product arriving soon is Sucralose, a no-calorie sweetener. Benecol is expected to have sales of $100 million in year one, and Sucralose about $40 million. Even without new products, this division -- though slow-growing -- isn't being smushed as badly as Brian might hint. Weak currencies overseas have taken as much as a 5% bite from sales growth over the past year. The bad currency translations now in the record books make for easier growth comparisons next year. And, again, the stock has continued to make new highs this year anyway.
As for Pharmaceuticals: we covered much of this topic last Wednesday. We'll have more to say on this division in the Duel next week, too.
In summary, I do believe that J&J's valuation is far from modest. At 31 times trailing earnings, the stock is trading at an earnings multiple that is as high as it's been in the past ten years. At 26 times next year's expected earnings, it's at a premium price (however deserved) to the S&P. But, even given this, on the bullish side of the valuation equation is the company's extreme diversity and its ability to unlock value through acquisitions or spin-offs, something which the company might consider.
According to J.P. Morgan, J&J is the second-leading drug company in the U.S., with 6.2% market share, behind only Glaxo-Wellcome at 6.8% and tied with American Home Products at 6.2%. Next is Bristol-Myers Squib with 6%, Merck with 5.9% and Pfizer with 5.3% of the domestic market. Given J&J's size, one shouldn't be surprised if, in order to unlock value, the pharmaceutical division is someday broken apart from the other two divisions. We discussed this one year ago, in fact. This would allow for valuation expansion, essentially creating shareholder value at little cost. Whether this happens or not, though -- ever -- shouldn't matter much to long-term shareholders. This decentralized company is able to grow all of its divisions over time, consistently, and all are great businesses.
Speaking of consistency, yesterday The Washington Post had a good article about incredibly consistent companies over this century. J&J was listed as the fifth-most consistent of all companies on the market when it came to earnings growth. The company has had consistent annual growth in earnings for nearly forty years. For the other consistent companies, you can read the Post article here. (The only problem with the article is the headline: it should have used "Foolish" differently!)
To close this topic: if you have more to add to the JNJ debate prior to next week's Dueling Fools, please visit the JNJ message board.
Mellon Bank (NYSE: MEL). On the message board it's been posted that we need five shares to enroll in Mellon's DRP, despite the literature that stated we need only one share to enroll. Until we hear otherwise from Moneypaper, we'll assume that our registration is a work-in-progress and there are no complications. Not a giant concern either way. We'll get there.
Recent Money Sent. Saturday we sent $40 to buy more Intel (Nasdaq: INTC) and this week we'll send $60 to buy more Johnson & Johnson. Next Monday we add $100 in savings to the Drip Port.
For questions, comments, complaints and ongoing discussion with great Fools, please visit the Drip message boards linked in the top right of this page. Tomorrow, onto our next industry!
Fool on!
--Jeff Fischer
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