Big changes are afoot in the medical device industry, and Johnson & Johnson (NYSE:JNJ) is in the driver's seat. When the largest among medical device companies makes a move, the industry tends to stop and pay attention.
J&J has witnessed its operational performance completely flip-flop over the past decade. In the 1990s and 2000s, medical device growth was strong whereas pharmaceutical growth was hit-and-miss. Nowadays, we're observing the opposite, with J&J bringing seven blockbuster drugs and 14 novel medicines in total to pharmacy shelves since 2009, and medical device growth traipsing along at a meager 1% as of the most recent quarter.
Why medical device growth slowed dramatically
What's wrong with the medical device segment? It likely boils down to three key factors.
First, competition among medical device makers is much fiercer than it was one or two decades ago. As competition has grown and the innovative processes used by medical device makers has shortened, it's placed downward pressure on industry giants like Johnson & Johnson. You can almost draw parallels between the pricing pressure on devices and the commoditization of electronics used in computers and cell phones.
Second, as pointed out by The Wall Street Journal, surgeons are now mostly salaried employees of healthcare companies. Prior to being salaried, surgeons strongly lobbied for medical device use, but have since had their demands quelled or device makers' product prices pressured, by healthcare companies looking to save money.
Last, at least within the U.S., the Patient Protection and Affordable Care Act, better known as Obamacare, has stymied spending on optional surgical procedures. We've witnessed cost uncertainty under Obamacare that's caused some consumers to hold off on elective surgical procedures, and similarly constrained hospital spending on new equipment and devices due to uncertainty surrounding surgical demand and the ability of consumers to pay their bill.
Johnson & Johnson's plan to fix its ailing device business
All told, J&J's medical device weakness has demanded action, and the company released its plans to get its once-prized business growing at a strong pace yet again.
As reported on Tuesday, Johnson & Johnson is planning to lay off approximately 3,000 people from its medical device division -- this equates to 6% of all medical device jobs and about 2.5% of J&J's global workforce. Its diabetes care and vision care segments are in the clear, with the layoffs strictly coming from orthopedics, surgery, and cardiovascular. The layoffs should result in savings of between $800 million and $1 billion annually, which the company believes is achievable by 2018. If all goes to plan in 2016, according to FierceMedicalDevices, J&J believes its restructuring efforts may result in $200 million in cost savings this year.
Johnson & Johnson isn't planning on pocketing the entire difference, though. It'll be using a portion of the savings to promote innovation and launch new medical devices. J&J has previously stated its intentions of filing for marketing approval of 30 new medical devices by the end of 2016, and it's already more than halfway there.
There will also be charges associated with Johnson & Johnson's medical device retooling. The company anticipates booking $2 billion to $2.4 billion in charges stemming from its decision, including $600 million in initial restructuring charges in the fourth quarter of 2015. Nonetheless, J&J doesn't foresee these costs in any way affecting its $10 billion share repurchase program or altering its fiscal 2015 profit forecast.
Grading Johnson & Johnson's plan
The prospect of saving money should provide for higher margins, at least temporarily, and allow for J&J to boost its investments in high-growth opportunities in its medical device franchise. Innovation is what helps keep commoditization from truly crushing device makers' margins. But how does this move really stack up?
Personally, I think we're looking at a necessary move in order to satiate Wall Street and investors for the time being, but we're far from a fix. In other words, I'm giving this a "B-minus."
The bright side is that, at least on paper, J&J's long-term outlook for medical devices is healthy. Globally, we're seeing improved access to medical care, and with very few exceptions, life expectancies are on the rise. As we get older, our reliance on medical care to maintain reasonably good quality of life grows. J&J's knee replacement products, spinal implants, and even robotics are all expected beneficiaries of this process.
But this process is going to take time. We're probably looking at a process that will take one, two, or even three decades before medical device growth is booming because of an older global population and improved access to medical care. In the meantime, J&J is going to have to make do with what it has, namely partnerships and a focus on potentially high-growth segments.
One way Johnson & Johnson is looking to kill two birds with one stone here is by partnering with Google's life science division known as Verily, a subsidiary of Alphabet (NASDAQ:GOOG)(NASDAQ:GOOGL), to develop advanced robotic surgical assistants. The idea is to combine J&J's knowledge of medical devices with Alphabet's ability to master machine learning to change the future of surgery as we know it. A robotics platform would presumably command high margins because of its precision, and it has rapid growth potential.
Divesting non-core assets is another near-term solution to emphasize higher growth device segments. Last year, J&J announced the sale of Cordis, a developer of vascular technology, to Cardinal Health for $2 billion. Ridding itself of non-core assets helps boost its already impressive cash pile, and it gives the company all the more reason to invest in innovation as well as consider acquisitions in higher growth areas such as robotics and trauma.
To be clear, I believe J&J has a lot going its way as a whole, and I'd suggest conservative investors and retirees consider adding J&J to their portfolios. However, when it comes medical devices I simply don't see a quick turnaround for the company in the near to intermediate term.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. The Motley Fool owns shares of and recommends Alphabet (A shares) and Alphabet (C shares). it also recommends 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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