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J&J: disappointing leadership but still a money machine [ClearOnMoney]
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J&J: disappointing leadership but still a money machine

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Investment

J&J: disappointing leadership but still a money machine

11 Apr 2011 by Jim Fickett.

Top management's response to the spate of defective products is discouraging, and I will be looking for a better quality holding long-term. Nevertheless, in the short term we may have seen the worst of the news, and earnings seem to have stabilized, so probably the downside risk in the near-to-medium term is not great. The 3.6% dividend remains attractive.

Johnson & Johnson has a lot going for it – good momentum in profits and dividends, diversification both in products and markets, and on the right side of the trend towards increasing medical spending in emerging markets. On the other hand, the long string of recalls, congressional hearings about safety, and escalation of FDA actions points to a significant management failure.

If you have not followed the news on J&J's recall problems, a good starting overview can be found in a recent Business Week article.

The DePuy crisis [a recall of bad hip implants] is one of more than 50 voluntary product recalls that J&J has issued just since the start of 2010, covering brand names that read like an inventory of the family medicine cabinet. Tylenol and St. Joseph Aspirin were recalled for foul odors people said made them sick. Benadryl and Zyrtec were recalled for botched amounts of ingredients. Rolaids were recalled for containing bits of wood and metal. Most of these drugstore stalwarts come from J&J's McNeil Consumer Healthcare unit, which has been plagued by dismaying revelations about the conditions and lax controls at its factories in the U.S. It shuttered one factory in Fort Washington, Pa., for a quality overhaul. Under a Mar. 10 consent decree, that plant and two others—in Lancaster, Pa., and Puerto Rico—will remain under Food and Drug Administration (FDA) oversight for five years.

[The McNeil recalls actually started in September 2009.]

I've held J&J stock since May of last year. Since I bought the price has been both lower and higher, and is now back to where I bought it. For now I'm ahead by the very healthy dividend (currently 3.6%). It seems time for a more careful review.

The worst news: management has lost its way

The CEO, William Weldon, seems to be in denial about the seriousness of the problems:

Johnson & Johnson management, from Chief Executive Officer William Weldon on down, maintains that the company's quality-control issues are aberrations. Any suggestion of a broader malaise, says Weldon, “is just Monday morning quarterbacking. … There's a lot of 'J&J has lost its way,' but I think that everything has been overshadowed by one company [McNeil],” Weldon says. “This is not a systemic problem. This is not an issue around J&J.”

Except the problems don't end with McNeil or DePuy. Over the last 15 months, the company has also recalled contact lenses, syringes filled with prescription medications, hernia devices, and other products made by subsidiaries around the world. In the year ended Mar. 8, 2011, J&J was involved in at least 11 major recalls, as defined by the FDA, almost twice as many as Pfizer (PFE), the world's largest health-care-products company by revenue, or Procter & Gamble (PG), the world's largest consumer-products company. “I'm not familiar with another company that has had this many debacles in a very short period of time,” says Ira Loss, an analyst at investment research firm Washington Analysis who has followed the FDA for more than three decades.

And in a truly bizarre spin on the situation, Weldon says the real problem is not quality, but that people have to do without the products temporarily:

For his part, Weldon most regrets that “there are children who need” the Motrin and other McNeil products absent from drugstore shelves

Given that the FDA has escalated to an unusual level, you would think the company would, by now, be able to show a long list of substantial steps already taken, to impress the public with how they were managing the problem. In Congressional testimony on 30 September 2010, Colleen Goggins, Worldwide Chairment, Consumer Group, said:

Since my prior appearance before this Committee, we have continued to work very hard to address the problems at McNeil. In July, McNeil submitted to the FDA a “Comprehensive Action Plan” (CAP). The CAP applies to all the manufacturing facilities McNeil operates to supply the U.S. market – not just the Fort Washington facility that remains closed. The CAP is part of our ongoing dialogue with the FDA to improve product quality, improve quality systems, and enhance training. Under the CAP, we have engaged leading experts on manufacturing processes, and we have also dedicated Johnson & Johnson’s own experts to our efforts at McNeil.

We are committed to dealing aggressively with the quality and process issues at McNeil, and I believe we are living up to that commitment, although we recognize we still have work to do. As you heard from Mr. Weldon, our employees have dedicated themselves to addressing the quality concerns at McNeil. Johnson & Johnson has directed new personnel and additional resources to the efforts at McNeil.

So they are working hard and filling out lots of papers. But has anything actually changed? She does not say. The impression her testimony creates is that she does not even realize there is a difference between filling out forms and making real changes in the manufacturing process.

After 50-some recalls, it would seem to be clear that the guy in charge of McNeil, Peter Luther, is not exactly an outstanding manager. So what happened to Luther? For too long, CEO Weldon said he had full confidence in Luther. Finally Luther was moved out … to become president of US Consumer Healthcare. The person who replaced Luther at McNeil, Denice Torres, shows no evidence of significant experience in either over-the-counter products or manufacturing. This all indicates that J&J is still not really serious about fixing the quality issues.

The only sign of hope on the management front is that perhaps the board has begun to really pressure Weldon. In December two other managers were promoted to “Vice Chairman” positions, probably both to make succession clearer and to give Weldon a little less leeway.

The somewhat bad news: pharma overall is facing a difficult time

It is well known that the pharmaceutical industry is facing patent expiration on a number of blockbusters, as well as declining productivity in pharmaceutical research. J&J lost exclusivity on one of its biggest moneymakers, Topamax, in 2009, with a resulting drop of about 10% in pharmaceutical sales. The company will face generic competition on another heavyweight, Levaquin, in 2011. In the latter case the loss will probably be 2-3% of pharmaceutical sales. All told, I am not excited about the pharmaceutical business, which is about one third of the company, but neither does it detract greatly.

(Data not otherwise attributed is from the annual reports.

The somewhat good news: growth in emerging markets

It is good news that sales are growing in Asia and South America (“West” means the western hemisphere other than the US and Europe).

But it is not good news that sales continued to drop, in 2010, in the company's two largest markets, the US and Europe.

The best news: earnings and dividends continue to grow

The company would have you think, in the cheery annual report for 2010, that much of the poor performance of the consumer segment is down to economic conditions. That this is not true is clear from comparing revenues at J&J's consumer segment with revenues at two of the large drugstore chains:

Nevertheless, the quarterly sales figures do suggest that the worst is past.

Further, a strong franchise and the ability to keep buying smaller, more productive companies can overcome a great deal of bad news. And J&J has compensated for drops in revenues by thinning the ranks. Earnings have, in the last decade, grown quite impressively (though that growth may be slowing):

The dividend has been increased for 48 consecutive years.

Conclusion

A long-running strong brand is not easily broken. Yet it would be a mistake to think that a top company cannot fall, particularly when management ignores serious problems. Just look at AIG, Arthur Anderson, Lehman, or Sears. I think there is a chance – by no means a certainty, but a chance – that J&J has permanently lost some of the qualities that built a great company, and that a continuing series of quality lapses will drag down performance in the long run. I will be looking for a replacement holding.

On the other hand, the drop in revenues at the consumer division may have halted for now and, even if the company no longer understands its famous Credo, there is no doubt that word has gone out to all managers that recalls are Not A Good Thing. You never know what problems are lurking, but my best guess is that short term, performance will be ok. For now I will hold.