<THE RULE MAKER PORTFOLIO>

Talcum, Drugs, & Shampoo -- Guess Who?

by Rob Landley (TMF Oak)

AUSTIN, TX (May 28, 1999) -- Looking at Johnson & Johnson (NYSE: JNJ) as a pharmaceutical play is a lot like looking at IBM as an Internet play. Yes, J&J has a presence in this wonderful niche and benefits from it tremendously, but the effects are diluted by the large number of other things it does.

Johnson & Johnson is traditionally the least pharmaceutical of all the pharmaceutical companies we're looking at this week. This isn't necessarily a bad thing -- just different. Although less than half of J&J's sales come from its pharmaceutical division, pharmaceuticals are nevertheless the single largest segment of the business as well as the fastest growing. J&J is becoming more and more of a pharmaceutical company as time passes in the same way that most successful stocks in a buy-and-hold portfolio gradually become the largest holdings.

The three main parts of the company are the consumer, professional, and pharmaceutical segments. The consumer part produces literally dozens of well-respected brand name products, including Band-Aid, Mylanta, Tylenol, Neutrogena, Nicotrol, Monistat 7, Immodium A-D, and Pepcid A-C. Notice that I didn't have to tell you what any of those were -- you've seen the commercials. It also produces Reach toothbrushes, Stay-Free, Carefree, and Sure & Natural feminine hygiene products, and the products everyone immediately associates with the J&J name: baby and adult shampoos.

The professional segment of the business produces stuff used in hospitals: surgical instruments and supplies, diagnostic and cardiology products, sutures and mechanical wound closing products, and orthopedic joint replacements. Some consumer-like items such as disposable contact lenses are grouped here, as well as some pharmaceutical-like items such as products for wound management and infection prevention.

Finally, we get to the pharmaceutical division. While literally none of the products listed in J&J's 10-K are likely to be familiar to anyone but medical professionals or their patients, J&J produces a wide range of allergy, anti-infective, anti-fungal, anti-anemia, central nervous system, contraceptive, dermatology, gastrointestinal, and pain management medications. Stated simply, doctors in hospitals sell a lot of little bottles from these guys.

The trick here is to think of Johnson & Johnson as an integrated whole. The company that makes Band-Aids and Tylenol for individuals also makes sutures and prescription drugs for hospitals. Individual consumers know and trust the J&J name through the consumer division, but doctors know J&J even better through the myriad professional products they use every day, as well as the pharmaceutical products they prescribe to their patients.

While J&J doesn't have the level of consumer marketing power focused behind other companies' prescription products like Viagra, Rogaine, or Claritin, it has a very strong brand name among the doctors who write the prescriptions. This focused and consistent market presence is extremely effective. Just as Cisco would rather market itself to Internet Service Providers than put random commercials on television for the general public, Johnson and Johnson has remained quite successful by creating a brand name directly for medical professionals. A strong and trusted consumer brand name helps end-users accept Johnson and Johnson pharmaceutical products, but it is not the driving force behind the sale of them.

Still, the pharmaceutical division is the "light" part of the business that attracts this portfolio. It is where the profits are, and where the growth is. Here's the sales breakdown by division from the first quarter:


($ in millions)  Sales   % of Total  Growth
Consumer        $1,728   26.0%        5.4%       
Professional     2,434   36.7%       18.6%
Pharmaceutical   2,476   37.3%       18.4%
  Total          6,638  100.0%       14.8%

As you can see, top-line results were healthy across all divisions. Just looking at the sales mix, the pharmaceuticals division doesn't look particularly more important than either of the others. But take a look at the operating profits results:


($ in millions)  Operating Income   % of Total  Growth
Consumer         $223                13.6%      14.9%       
Professional      455                27.7%       5.6%
Pharmaceutical    967                58.8%      16.9%
  Total         1,645               100.0%      11.9% 

Not only did pharmaceuticals produce the most raw income and the highest rate of growth, they also produced the highest net margins. In the most recent quarter, the pharmaceutical division produced $967 million of the $1.6 billion combined net operating profit from the three segments, almost 60% of the total! That's more than half the profits from less than half of the sales. In comparison, the Professional division produced $455 million, and the consumer division a paltry $223 million. The growth rates of the net profits tell a similar story: Pharmaceutical was up 16.9%, Consumer redeemed itself with a second place 14.9%, and Professional came in the loser at only 5.6% annual growth.

Johnson & Johnson could be viewed as a healthy, diversified company with fairly strong growth across the board. Or it could be viewed as a pharmaceutical company with a diversified support infrastructure for its pharmaceutical products. That excellent stability and superior performance are what got it into our original MoneyHeavy paper portfolio (see Rule Maker Step 1), but that same dilution of the lightest, highest-margin part of its business is what kept it from being a Rule Maker.

Looking at J&J's first quarter results on the Ranker, the main problems are on the balance sheet. Compared to the year-ago period, total debt doubled while cash declined. The result was a decline in the cash-to-debt ratio from 1.78 (above our standard of 1.50) to 0.65. The Flowie fared a little better with a slight decline to 1.69, but is still well above our benchmark of 1.25. Improvement on the ratio of cash-to-debt and the Flowie would dramatically improve the company's current score of 32.

In the long run, we believe that a pure pharmaceutical play like our picks Pfizer and Schering-Plough will outperform a more diversified pick like Johnson & Johnson. However, they'll give us a rougher ride along the way, with more uncertainty and volatility. Since we've diversified within our portfolio by selecting several different companies in different industries, we didn't feel the need to select individually diversified companies. But use your own judgment, Fool. Since our purchase of Pfizer in February of last year, we've achieved a good return of 30%, but over the same period, Johnson & Johnson has actually been the winner with a 33% return, not including dividends. We encourage you to think Foolishly about the companies you pick, rather than blindly echoing our selections.

- Oak.

05/28/99 Close

Stock Change    Bid
AXP   +4 3/16   121.06
CHV   -  1/2     92.50
CSCO  +1        109.00
EK    -1 3/16    67.63
GM    +  1/2     69.00
GPS   +1 13/16   62.56
INTC  +  15/16   54.06
KO    +  3/8     68.50
MSFT  +2 5/16    80.69
PFE   +3 1/8    107.00
SGP   +  3/4     45.06
TROW  +1         38.63
XON   +1 1/16    79.88
YHOO  +14 5/8   148.00

                  Day     Month  Year    History
        R-MAKER  +1.65%  -6.59%   4.70%  32.48%
        S&P:     +1.59%  -2.50%   6.23%  31.43%
        NASDAQ:  +2.12%  -2.84%  12.67%  49.47%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
    2/3/98   48 Microsoft     39.13     80.69   106.18%
   6/23/98   34 Cisco Syst    58.41    109.00    86.61%
    5/1/98   55 Gap Inc.      34.37     62.56    82.03%
    2/3/98   22 Pfizer        82.30    107.00    30.01%
   2/13/98   44 Intel         42.34     54.06    27.70%
   2/17/99   16 Yahoo Inc.   126.31    148.00    17.17%
   5/26/98   18 AmExpress    104.07    121.06    16.33%
    2/6/98   56 T. Rowe Pr    33.67     38.63    14.71%
   2/27/98   27 Coca-Cola     69.11     68.50    -0.88%
   8/21/98   44 Schering-P    47.99     45.06    -6.11%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.88    24.15%
   3/12/98   15 Chevron       83.34     92.50    10.99%
   3/12/98   20 Eastman Ko    63.15     67.63     7.09%
   3/12/98   17 General Mo    72.41     69.00    -4.70%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   48 Microsoft   1878.45   3873.00  $1994.55
   6/23/98   34 Cisco Syst  1985.95   3706.00  $1720.05
    5/1/98   55 Gap Inc.    1890.33   3440.94  $1550.61
    2/3/98   22 Pfizer      1810.58   2354.00   $543.42
   2/13/98   44 Intel       1862.83   2378.75   $515.92
   2/17/99   16 Yahoo Inc.  2020.95   2368.00   $347.05
   5/26/98   18 AmExpress   1873.20   2179.13   $305.93
    2/6/98   56 T. Rowe Pr  1885.70   2163.00   $277.30
   2/27/98   27 Coca-Cola   1865.89   1849.50   -$16.39
   8/21/98   44 Schering-P   2111.7   1982.75  -$128.95

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon       1286.70   1597.50   $310.80
   3/12/98   15 Chevron     1250.14   1387.50   $137.36
   3/12/98   20 Eastman Ko  1262.95   1352.50    $89.55
   3/12/98   17 General Mo  1230.89   1173.00   -$57.89

                              CASH     $70.09
                             TOTAL  $31875.65

Note: The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it adds $2,000 in cash (which is soon invested in stocks) every six months.

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