Recently I decided that I've had enough of the foibles and struggles of healthcare giant Johnson & Johnson (JNJ), and that it was time to move on to a new idea. While JNJ still features prominently on many lists of "top healthcare" or "top dividend" stocks, I would suggest that investors might want to think about this a little further. Perhaps there are still valid reasons for owning Johnson & Johnson, but maybe some investors will agree that it is time to give up on the idea that JNJ will live up to our ideas about what it should be.
Recent Stock Performance:
With that in mind, below are the leading reasons that I quit on Johnson & Johnson:
1. Little Leadership:
Name a market in which Johnson & Johnson is really a dynamic force and an industry leader...
That's a big problem; there is a relatively small amount of markets that JNJ still does very well in. Although JNJ has shown an ability to buy its way into attractive markets, it seems to lack the foresight and decisiveness to really maintain that leadership. JNJ was the early leader in stents, only to lose out to better products and marketing from Guidant (now owned by Boston Scientific (BSX)) and Medtronic (MDT). Drug coated stents offered an interesting repeat, where JNJ was among the first, but it saw that lead crumble due to competition from Boston Scientific, Medtronic, and Abbott (ABT).
So to is it in many other areas where JNJ operates. Stryker (SYK), Zimmer (ZMH) and Biomet are fierce rivals in orthopedics, Covidien (COV) has gained share on JNJ's Ethicon Endo business with new product launches, and a host of companies have chipped away at other JNJ businesses, like diagnostics.
To make matters worse, JNJ has been spending steadily less in R&D, from a peak of $7.7 billion in 2007 to $6.8 billion in 2010. Its reductions in R&D have made me to question its durable competitive advantage in the numerous markets it has chosen to enter. Although that amount is admittedly far more than Stryker or Boston Scientific can spend, it does not seem to be paying off for the company. Johnson & Johnson is supposed to be a leader and a wide-moat firm, and yet it cannot grow any faster than its markets and is arguably growing slower than its markets.
2. Bad Deals Have Diluted Capital:
Putting growth aside, JNJ's businesses have a long history of producing exemplary amounts of free cash flow. Unfortunately, management has not always been a great user of JNJ's war chest. Deals for companies like Conor Medsystems, Animas, and Closure don't really look like money well-spent, and even successful deals (like the acquisitions of Cordis, Centocor, DePuy, and Mentor) come with a "but". That "but" is the caveat that the company often paid so much for these deals that the benefits to shareholders have not been that remarkable. I'd argue that management lacks a keen eye for acquisitions, and certainly has not been conservative with JNJ's capital. Lucky for JNJ shareholders, then, that Boston Scientific ultimately emerged victorious in the battle for Guidant, as it seems probable that the deal would have destroyed shareholder value.
3. It All Comes Down To Execution:
Johnson & Johnson could do fine as a "cash cow", investing enough into R&D and M&A to maintain some forward momentum (despite being sluggish) while generating robust cash flow and passing that along to shareholders. Unfortunately, that requires a commitment to execution which management appears to be lacking, as it has "diworsified" JNJ over the last several years. Manufacturing problems and recalls are not just embarrassing, but they are a worrisome sign that management has taken its eye off the ball in many key respects. Recent allegations of kickbacks only add to those problems (assuming they're true), as a JNJ device was recently recalled. The device, called LPS Diaphyseal Sleeve, is used in reconstructive knee surgery. It was recalled because of the potential for fractures, the FDA said. The agency said it has received 10 reports of incidents in which the device has malfunctioned. The affected devices were manufactured by Depuy, JNJ's orthopedic unit, from 2008 to July 20, 2012. A fracture in the sleeve at the joint of it could lead to loss of function or loss of limb, infection, compromised soft tissue or death, the FDA said. The FDA also said the company is not recommending revision or additional follow up in the absence of symptoms of patients with this implanted device.
What's worse is that the board seems to be complicit or at least complacent. In response to one of JNJ's worst years in recent memory (at least from a PR perspective), the board reacted by cutting CEO Weldon's bonus by about half, only to later gave him a 3% raise. Seriously? How did he deserve any sort of bonus? Is there any need to really pay to keep this management team? I happen to think that the Stryker's management could do great things with JNJ's asset base, so I don't see why the board is so willing to reward a CEO who has produced so little to celebrate in recent memory.
4. Where Is JNJ's Moat?
At the end of the day, my issue with JNJ is that it just does not have the moat that people commonly think. I believe that a moat demonstrates a level of excellence that allows for above-market growth and makes it extremely difficult to compete with the company. I just don't see a durable competitive advantage with JNJ.
Stryker has a long record of orthopedic market growth under JNJ's watch, and JNJ has twice lost leadership in the stent market. In addition, small companies like Immucor (BLUD) and Therasense (now part of Abbott) have shown the ability to compete very effectively with this giant. That doesn't sound like a wide moat to me, and where is the innovation? Shouldn't a gee-whiz idea like Intuitive Surgical's (ISRG) surgical robots come from JNJ?
Take the example of Coca-Cola (KO). That's a legitimate moat. Coca-Cola has built a multi-billion dollar business out soda, while Disney (DIS) has gotten a stranglehold on every generation of kids, and McDonalds (MCD) has been the dominant U.S. hamburger restaurant for decades. That is what I view a moat as, and what a moat should be.
It's Not Over, But The Story Has Changed:
The stock's dividend yield is currently hovering around 3.20%, and the dividend payout ratio is a reasonable 62.2% (anything over 50% becomes worrisome; though more mature companies typically have slightly higher payout ratios). Also, take into account a healthy 17.81% Return on Equity [ROE] and an equally impressive 13.25% Return on Invested Capital [ROIC] and you have what amounts to a very solid, safe and "defensive" investment. Indeed its products are widely used, its financials are in good shape, its dividend is very generous (especially by today's standards), and the dividend doesn't appear to be at risk of being reduced any time soon.
I'm not suggesting that JNJ is about to collapse or even slowly fade into the background. As stated above, JNJ is a strong cash flow generator and also generates very strong returns on capital. With such a large amount of re-investable cash, there will always be a hope for better days. The problem, though, is that JNJ just isn't a dynamic player anymore. If you want a company that will produce large amounts of cash, and send a moderate amount of it back to shareholders in dividends and buybacks, JNJ is a fine choice. But if you really want to harness the growth potential of the healthcare market with a top notch operator, JNJ simply does not fit the bill.