Johnson & Johnson
Bear's Den
by Brian Graney ([email protected])

Johnson & Johnson is one of those brand names that seems to be everywhere. Its Band-Aid brand is the default name for adhesive bandages, much like Kleenex is the default name for tissues and Jacuzzi is the default name for hot tubs. J&J has about half of the $42 million annual market for baby lotions, and its Tylenol non-prescription pain reliever is the market leader with a roughly 22% share. Heck, even the Motley Fool's own soccer team sports a Johnson & Johnson first aid kit -- which has been used quite extensively this season, I might add.

So let's give my worthy opponent Jeff his due and admit up front that J&J is a great company. The firm has great brand names, 65 straight years of sales growth under its belt, and operates in a healthcare environment where demand for an ever-greater number of services is expected to outstrip supply for the foreseeable future. Jeff has reason to be proud of this Drip Port holding, whose stock has returned roughly three times the gains of the S&P 500 index with dividends reinvested over the past 12 months.

I'm going to assume here that Jeff has at least commented on J&J's pharmaceuticals business, whose more than 90 drugs represent 34% of the firm's annual revenues and over 50% of annual operating profit. The list of recent successes is long, including the anemia treatment erythropoietin (which J&J sells as Procrit in the U.S.) and the hyper-popular Propulsid treatment for nocturnal heartburn. J&J's Reminyl drug for Alzheimer's disease is being touted as a blockbuster, and its Benecol cholesterol-reducing "nutraceutical" is supposedly the best thing since sliced bread.

Unfortunately, the drug unit is only part of the company. It's the other two parts of J&J's business -- the professional and consumer products units -- that concern me from an investor's point of view.

As I stated in a recent Drip Port column, J&J's drug sales increased 9% between the third quarters of 1997 and 1998, while sales of the company's professional and consumer products went nowhere. Remember, the professional and consumer products divisions account for 66% of J&J's annual sales and roughly half of its yearly operating profits, so they can't be tossed away from the investing equation like the paper wrapper of a Band-Aid.

Like a good general, I'll attack the weakest part of J&J's defensive line first, which I feel is the professional products unit. Lumped under this grouping are several J&J subsidiaries, including its Ethicon medical and surgical products business, its LifeScan unit, which sells the SureStep blood glucose monitoring system for diabetics, and its much-maligned Cordis division, which develops coronary stents and related products. Let's continue the "weakest first" strategy, then, with a look at Cordis.

J&J acquired Cordis Corp. in 1996 and instantly benefited from the company's breakthrough coronary stents, which are small, tube-like devices typically used during angioplasty procedures to reopen vessels near the heart and keep them open. A year-and-a-half after the product's release, Cordis had sold $1 billion worth of the tiny devices, taking a commanding 90% lead in the stent market. But in the fall of 1997, former Eli Lilly unit Guidant Corp. introduced a competing stent. A mere 45 days later, Guidant had a 70% share of the stent market at J&J's expense, according to a recent Wall Street Journal article. Other stent offerings from Boston Scientific and Arterial Vascular Engineering soon followed, driving Cordis' market share even lower. The upshot: analysts expect Cordis will be left with about an 8% share of the estimated $1.4 billion stent market this year.

To understate, it seems Cordis has had a few execution problems. First, it misjudged how much demand was out there for stents. Then, it shot itself in the foot by not developing new stent features to compete with the more advanced devices offered by its new rivals. Instead of the $1.25 billion in revenues this year J&J could have garnered had it kept its 90% market share, it will end up with about $112 million in stent revenues, by my estimate, with its 8% share. That's a big difference, understating once again.

Unfortunately, this isn't the only instance of market share erosion the company has encountered recently. In the consumer products arena, J&J's Nicotrol over-the-counter patch to help individuals stop smoking saw its sales drop by about $13 million, or 23%, in the year ending March 29, according to Information Resources Inc. Meanwhile, sales of SmithKline Beecham's Nicorette gum and NicoDerm CQ patch jumped 16% and 49%, respectively, over the same stretch. These advances occurred despite the fact that J&J's Nicotrol product was approved for OTC use a full month before its rival's offerings, underscoring again J&J's recent problems holding onto lucrative monopolies.

Instances of slow innovation are becoming more apparent at the company. Take J&J's facial cleansing strips, which were introduced probably much too late to compete effectively with already entrenched products from Andrew Jergen's Biore unit and Unilever's Pond's subsidiary. Then there is the missed opportunity represented by the popularity of nutritional cough and cold remedies such as zinc-based lozenges, which rival Warner-Lambert quickly acted upon with its Hall's Zinc Defense line, to the detriment of J&J's Tylenol line.

And what is one to make of J&J's virtual neglect of the booming pacemaker and defibrillator segment of the medical products market? According to analysts, certain new types of defibrillators are expected see sales growth in the 25% to 30% range over the next few years, with annual worldwide sales expected to reach $1.2 billion. Unfortunately for J&J, those nice growth rates will be sacrificed unless the company allocates "catch-up capital" to acquire a market leader like Medtronic.

These recurring instances of innovation lapses are reducing the future growth prospects of J&J's professional and consumer products businesses. A lack of innovation isn't a good trend for a firm like J&J, which admits on its website that 36% of its 1997 revenues came from products introduced in the last five years. Take away the innovation, and you take away a good portion of J&J's growth down the road. And we haven't even talked about what the changing economics of the U.S. healthcare industry means for J&J, or discussed the firm's current market valuation. But before we can get into those topics, we must allow Jeff some time for a Foolish rebuttal.

Next: The Bull Responds