Recently I made a change to my portfolio. After several years of patient ownership, I decided that I had 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.
With that in mind, here are the leading reasons that I quit on Johnson & Johnson:
1. Little Leadership
Quick – name a market in which Johnson & Johnson is really a dynamic force and an industry leader.
That is a big problem; there is relatively little that JNJ still does very well. Although JNJ has shown an ability to buy its way into attractive markets, it seems to lack the foresight and follow-through 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 eerie repeat – JNJ was was among the first, but 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.
Making 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. That is admittedly far more than Stryker or Boston Scientific can spend, but it does not seem to be paying a lot of dividends 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 arguably is growing slower than its markets.
2. Bad Deals Have Frittered Away Capital
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 shepherd of that cash. 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. Lucky for JNJ shareholders, then, that Boston Scientific ultimately “won” the battle for Guidant, as it seems probable that the deal would have destroyed value for shareholders.
3. It's All About Execution
Johnson & Johnson could do fine as a “cash farmer”, investing enough into R&D and M&A to maintain some sluggish forward momentum while harvesting robust cash flow and passing that along to shareholders. Unfortunately, that requires a commitment to execution and management that JNJ appears to be lacking. Manufacturing problems and recalls are not just embarrassing, but they are a worrisome sign that management has taken its eye off the ball in a lot of key respects. Recent allegations of kickbacks and fraud only add to those problems (assuming they're true).
What's worse, 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 … and then gave him a 3% raise. Seriously guys? 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 management of Stryker could do great things with JNJ's asset base, so I do not see why the board is so willing to reward a CEO who has produced little to celebrate in recent memory.
4. Where's The Moat?
At the bottom line, my issue with JNJ is that it just does not have the moat that people commonly think. To me, a moat means a level of excellence that allows for above-market growth and makes it extremely difficult to compete with the company. Where is that with JNJ?
Stryker has a long record of orthopedic market growth under JNJ's very nose, and JNJ has twice lost leadership in the stent market. Moreover, 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 real moat. Coca-Cola has built a multi-billion dollar business out of flavored sugar water, while Disney (DIS) seems to get a stranglehold on every generation of kids and McDonalds (MCD) has been the dominant U.S. hamburger restaurant for decades. That is what a moat is supposed to be.
It's Not Over … But It's Different
I am not suggesting that JNJ is about to collapse or slowly fade into the background. As I said, JNJ is a strong cash flow generator and the company does generate very strong returns on capital. With such a large amount of reinvestable cash, there will always be at least the hope of better days.
The problem, though, is that JNJ just isn't a dynamic player. If you want a company that will produce large amounts of cash, and send a fair bit 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.