Johnson & Johnson
Bull's Rebuttal
by Jeff Fischer ([email protected])

If you look closely enough at any $100 billion company -- no matter how healthy it is -- you're certain to find imperfections. With Johnson & Johnson, the imperfections are easy to spot because they're on the surface. And that's good. These are blemishes that the company recognizes and is treating. Being an overly diligent Fool, however, Brian is focusing on the blemishes. That's akin to being with a wonderful, lovely partner but focusing on the one small blemish on his or her forehead.

Brian didn't focus on the most profitable part of the business (pharmaceuticals, where J&J has more U.S. market share than any company but one). Instead, he heartily attacked the weakest part: the stent market represented by J&J's Cordis division. Market share in this division plummeted instantly and severely, signifying two things: 1) the damage is already done and the stock is still making new highs because J&J is so diversified. And 2) the fact that the competition could grab market share instantly means that switching costs are extremely low, so with the introduction of new products J&J could steal market share right back.

That's exactly what the company hopes to do. Having been burned, management has a renewed focus on innovation in its professional product division. The company's promising Mini Crown stent will be available soon, and a heparin-coated version of this innovative stent should be available next year. The heparin-coated version virtually eliminates the problem of subacute thrombosis in patients. Cordis is also working on radiated stents, which greatly reduce retenosis in patients -- 30% of patients experience this otherwise.

So, just as Guidant stole market share from J&J in a wink, J&J has the possibility of stealing at least some of it back. And next year, year-over-year sales comparisons will be much more favorable following a very weak 1998. Still, stents represent less than 2% of J&J's profits, so the company isn't in serious danger even if it doesn't regain market share soon. (It will likely take a few years.)

As for other professional products, the $3.5 billion acquisition of DePuy Inc. is a bone-solid match. DePuy had $770 million in sales last year, primarily in hip replacements, while J&J's orthopedic division had $630 million in sales focused on knee replacements. The combined hip and knee market is some $4 billion, and the combined entity of J&J's orthopedic division and DePuy Inc. has $1.4 billion in sales, for a 35% market share. Plus, the synergy of this new combination puts J&J in a position to grab more market share in orthopedic replacements.

Brian also mentioned the consumer product division. The few small, specific products that he addressed aren't significant enough to merit more study here in my opinion -- the profits are insignificant in light of J&J's size. Brian's larger point, though, is that J&J is losing its innovative edge.

Yet, the company will spend $2.2 billion on research and development this year, up a whole $1 billion since 1993, making it again among the top ten companies (top few really) in terms of dollars spent on research and development. Brian himself pointed out that 36% of J&J's 1997 revenue came from products introduced in the last five years. And this shouldn't change much in the future. The company continues to spend to innovate and develop new products, including the new Acuvue bifocal contactlenses, Sucralose artificial sweetener, and drugs for Alzheimer's and MS, to name just a few.

As for valuation, J&J isn't cheap, but it's less expensive than its peers, which, collectively as of October 1, traded at 1.6 times the P/E of the S&P 500, and at 1.44 times the P/E of the S&P on 1999 earning estimates. J&J traded at just 1.3 times and 1.19 times the S&P on these measures, respectively. (Remember that these stocks usually trade at a considerable premium to the market.) J&J, at 26.8 times 1999 estimates, is at less of a premium than its peers. Still, if the stock isn't great for an outright purchase here (long-term, it probably is), J&J is still near perfect for a Drip Portfolio. Aside from sustainable sales and earnings growth, the company's margins and dividend payment continue to grow.

Finally, Brian mentioned potential changes in the U.S. healthcare policy: like any "feared event," the potential for serious change is probably overblown.

Brian did a great job finding the Achilles heel on this giant winner, but management knows it's there, too, and is working to cure it. Meanwhile, investors have apparently already gotten through the worst of it, and all the while they saw their stock chart new highs. Long-term, shareholders are probably strapped down for a very healthy ride as 65 years of consecutive sales growth stretches into the year 2000 and beyond.

Next: The Bear Responds