Seriously, Should JNJ Break UP?

With 238 subsidiaries and 118, 700 employees, JNJ is one of the most complex enterprises in the world. Its $64 billion in annual sales is larger, for example, than the gross domestic product of 117 countries. If JNJ were a country it would be the 60th largest in the world. 

Managing this complex of an enterprise is hard. The science of management has, over the years, developed good strategies for directing complexity, and two of them that JNJ mentions in its annual report are decentralization and convergence.

Decentralization is a strategy to push decision-making down to the lowest level of the organization. Convergence is, we think, a buzz word. It is supposed to mean the practical meshing of technologies to deliver better consumer care. Like drugs + biologics + surgical tools + surgical implants = higher market shares, better pricing and better consumer service all around.

So, how’s JNJ doing – decentralizing and converging?

Actually, things were looking pretty good until 2005.

Then operating efficiencies, we think, began to slip. It may be a temporary aberration. It may, however, be a sign that this elephant isn’t as quick of step as it could be or, more importantly, should be to remain at the top of the medical game.

The ultimate form of decentralization is a breakup. Kick a few of these baby JNJs out of the nest. Force them to eat what they kill. Some will starve, but some will feast very well―like a herd of baby JNJ raptors set loose in the jungle.

Anyone remember the breakup of Ma Bell? That was a transformational event that marked an upswing in innovation and wealth creation in the communications industry.  Could that happen for JNJ? We think it could. Would it benefit the medical technology industry? Much as Ma Bell’s breakup benefited the communications technology industry, Pa JNJ’s breakup could deliver a jolt of entrepreneurism to the medical technology industry.

Changing Employee Productivity

JNJ’s operating numbers are interesting, and there are clear signs of really outstanding management. There is also evidence that the complexity of this enterprise has begun to gum up the works.

JNJ has roughly 119, 000 employees working all over the world. As a group, they generate about $537, 000 of sales each. That’s good. By comparison, the average McDonald’s employee generates about $59, 000 of sales. But, then again, the average General Motors (GM) employee generates $613, 000 in sales. McDonald’s, like JNJ, is part of the Dow 30 and is one of the most solid corporations in the world. GM, however, is essentially bankrupt. 

So, how much does each JNJ employee cost?

Here are the numbers from 1995 to 2005.  The record is impressive.

Source: SEC filings

In the decade from 1995 to 2005, JNJ’s sales per employee almost doubled. In 1995, the average employee generated about $229, 000 of sales. By 2005 that number had risen to almost $437, 000. Impressively, the profit earned on those sales rose as well, from about $62, 000 (27% of sales) to approximately $170, 000(39% of sales)! 

Finally, as a measure of employee productivity, the return on assets per employee rose from 28.8% in 1995 to 33.9% in 2005! 

Then things began to change.

In 2006, 2007 and 2008 the numbers turned the other way.

Source: SEC filings

Employee productivity is now less than it was in 1995―if we look at each employee’s return on assets employed. Each JNJ employee in 2009 is supported by $715, 000 in assets―up almost 4x from 1995 when it took $217, 000 in assets to support each employee. That, we think, is the core of the issue.

The number of employees actually declined between 2006 and 2008, which we interpret as management’s attempt to keep productivity levels from slipping. In 2006, JNJ’s return on assets per employee fell to 29.5% and it has continued to decline through 2008. The operating profit per employee rose in these last three years (to $200, 000, up from $170, 000) but as a percentage of sales per employee, it is down (37% vs. 39%). 

The Baby JNJs

In 1984, when AT&T divided into eight “baby bells, ” its asset base was $125 billion, about 50% larger than JNJ’s today. Its employee base, at one million people, was about nine times larger than JNJ’s. 

The market value of AT&T in 1983 was about $50 billion. One hundred shares of AT&T were worth about $6, 000.  Fifteen years later (October 1999), Motley Fool estimated that the value of 100 shares of pre-breakup AT&T had increased to $12, 444.27, up 107%. Last year, the combined market value of AT&T, Verizon, Qwest, Lucent, and Avaya (the remains of the 1984 “Baby Bells”) was $211 billion, an increase of 322% from 1984.

Source: Wikipedia

Like AT&T in 1984, JNJ is not a collection of interchangeable, modular pieces. Because of that, convergence of the various technologies within JNJ hasn’t delivered higher growth or profits. For example, where is the convergence between DePuy and Cordis?  Or Oral Care and Ethicon? Or Neutrogena and LifeScan? It’s hard to see the synergism, for example, between Listerine and JNJ’s Prescription Pharmaceuticals.

A breakup of those business segments could well, as it did with AT&T, unleash higher growth and innovation.

Source:  www.jnj.com

Are the Parts Worth More Than the Whole?

Each “Baby” JNJ would be a substantial company reporting between $1 billion and $24 billion in annual sales and trade, we expect, on all the major global stock exchanges.  That’s right, Vision Care, Skin Care, Oral Care, Cordis, LifeScan…each of the business segments that we identified above as a “Baby JNJ’ is generating more than $1 billion in annual sales.

Analysts have pondered the hypothetical value of JNJ’s parts from time to time. Usually they conclude that the sum of the parts is not much different from the whole―at least as currently valued on the New York Stock Exchange. 

Using Wachovia’s Larry Biegelsen’s estimates (and he’s probably the most knowledgeable JNJ analyst on the Street right now), here is what a hypothetical sum-of-the-parts JNJ valuation might look like.

So, in Wachovia’s analysis JNJ’s parts combined would be worth between $51 and $53 per share. JNJ’s stock is trading at around $52.60 per share right now. So, the difference between the sum of JNJ’s parts and the intact company is not much of a difference at all.

Of course Wachovia is assuming, conservatively so, that there’d be no substantial change in growth or operating profit assumptions if the Baby JNJs were spun off. 

We recall that one observer of the AT&T breakup noted it created a “near-chaos of opportunity which has made the total communications marketplace one of the most exciting ever to exist in this nation of opportunity.”

We don’t know that that would exactly occur if a dozen Baby JNJs were unleashed, but we do think that JNJ shareholders have had to pay a price for JNJ’s size. Baby JNJs, we think, could reach out in new directions and apply their core technologies, experience and expertise in new ways and in new markets.

Would JNJ actually break up? No…we’re making a hypothetical case. But still, we think, a good one.