The Sum Of JNJ's Parts: Medical Devices

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Johnson & Johnson (NYSE: JNJ) is a massive and diversified healthcare focused company. The company has a long history of doing multiple things well. While it has three main divisions, its medical device group is one of its two main growth engines.

Success is in the DNA

Johnson & Johnson is well over 100 years old. It has survived good times and bad, for the past 70 years part of its success has come from an adherence to a company “credo.”

Created by Robert Wood Johnson, a member of the company's founding family, the document underpins the company's strategic framework. The credo speaks to the many obligations the company wishes to live up to and the strategic framework provides a guide for meeting those self imposed obligations.

Broad diversification is one of the key components of the company's approach. To this end, Johnson & Johnson is actually a holding company, with over 250 operating companies underneath it. Management believes this diversification gives it the ability to work across product categories to benefit customers and to react quickly to fast changing trends.

Another key is a long-term focus. This has allowed the company to navigate turbulent healthcare markets and should serve it well as this industry faces increasing demands for change. The company's dedication to research and development is a prime example of its long-term view of the world. Spending billions on R&D, the company claims that two-thirds of its growth over the past decade has been created from internal efforts.

At the end of the day, the Dow-30 component prides itself on providing products across the “full continuum of care—prevention, diagnosis and treatment.” With facilities in 60 countries and products being sold in over 200, Johnson & Johnson claims to “touch more than one billion people around the world every day.” That's impressive and is a testament to this more than 100 year old company's long term success.

Medical Devices

The company operates in three areas, pharmaceuticals, medical devices, and consumer products. The company's medical devices segment is in the process of absorbing the largest acquisition in the company's history. That should help push performance over the longer term.

The medical devices division, in which the company also includes its diagnostics segment, provides products in areas such as orthopedics, neurosurgery, general surgery, vision care, diabetes care, infection prevention, cardiovascular care, and aesthetics. That's an impressive list that, with the mid-year purchase of Synthes is even more robust than it was just a year ago.

Synthes

In the middle of 2012, JNJ completed the acquisition of Synthes for $19.7 billion in cash and stock. Synthes is being integrated into the company's DePuy business, to create DePuy Synthes.

Synthes is one of the largest makers of products to treat skeletal injuries, such as screws, plates, and bone grafts. DePuy is probably best known for its joint reconstruction products, among others that it offers. Although JNJ had to divest its DePuy trauma business in order to acquire Synthes, the acquisition added 7.9% to the medical device group's top line in 2012, clearly more than offsetting the lost revenue from the divestiture.

One of the nice things about the addition of Synthes is that its products are used in emergency situations, which, by definition, aren't elective. This should protect its products from both economic vagaries and, to some extent, the shifting healthcare environment. That's a nice counterbalance to the joint products for which DePuy is known, which are generally elective in nature.

So far, JNJ reports that everything is going smoothly, with the customer and sales integration process actually ahead of plan. That said, the expectation is that manufacturing integration will be more complicated and take longer.

Bigger than DePuy Synthes

The list of products noted above goes well beyond skeletal repair and joints. In fact, while DePuy Synthes is a large and important part of the medical devices group, there are plenty of other well-known brands there, as well, including Acuvue, and OneTouch, and  brands that only medical professionals might know well.

So while the DePuy business accounted for over 20% of the group's revenues in 2011, and will account for even more now that it has merged with Synthes, the division has a diverse lineup of leading products. Several segments, in fact, contributed a similar percentage to the top line as DePuy in 2011. All of the products are used primarily by physicians, nurses, therapists, hospitals, diagnostic laboratories, and clinics. That said, certain products, including diabetes monitors and contact lenses, are also used by individual consumers.

This division accounted for about 40% of 2012 sales and is the largest medical technology business in the world. Management believes that it holds a number one or number two position in over 80% of the markets in which it participates. This group is clearly a core business that is both broad and deep.

Investing in the Future

Research and development spending is a key factor in Johnson & Johnson's long-term success as a company. While the drug business consumes the lion's share of R&D spending, the company still invested about around $3.5 billion in its medical devices group over the last two years. That's a huge amount of money and helps explain why JNJ owns so many leading brands.

Some examples of recent product introductions include the OneTouch Verio Glucose testing platform. The company describes it as “the first diabetes care device to alert and display high/low patterns to deliver meaningful and actionable insights to help patients better understand and manage diabetes.” Harmonic Ace+ Shears are another recent launch.

Looking to the future, the company's purchase of Calibra Medical should result in the introduction of a insulin patch, providing an “easy-to-administer, meal-time dosing solution” for diabetics. In 2013, DePuy Synthes is planning to introduce the Attune Knee System, “which is designed to help patients who are not completely satisfied with current knee replacement systems achieve their optimum performance.” That's actually a bigger issue than many doctors would have patients believe.

Pruning

The Synthes acquisition required JNJ to divest one of DePuy's business units. It did this to, in the end, become a bigger and better company. However, there are times when Johnson & Johnson makes the decision to get out of a business because its prospects have dimmed. For example, the company recently announced that it was “initiating an exploratory process to evaluate strategic options for its Ortho Clinical Diagnostics (OCD) business.” While there are no clear indications of what the outcome of this review will be, management seems to be telegraphing a sale.

The willingness to add businesses and sell businesses is yet another attribute of JNJ's long-term success. The decentralized structure makes this process fairly easy to accomplish, leaving top-level management to act almost like portfolio managers.

Overseas Expansion

One of the key drivers for Johnson & Johnson is growth in foreign markets, and the medical devices division is no different from the others in this regard. Unlike the company's other two divisions, however, the medical devices group has been growing strongly on both the domestic and international sides of the business. That said, international sales are already larger for this group than domestic sales, so foreign markets will become increasingly important as time goes on.

Competition? Or Not...

While JNJ is a big player across all of its products, one company stands out as a near clone, Novartis (NYSE: NVS). This company has operations in the pharmaceuticals (branded and generic), eye care (surgical, ophthalmology and consumer products), consumer products, and diagnostics areas. While it doesn't have medical devices, there is so much overlap between the two companies that they are key competitors.

Interestingly, Novartis, like JNJ, has had production problems in its consumer unit. Those problems resulted in the closure of one U.S. plant in 2012 and led to a 19% sales decline in the company's consumer health business and an operating income decrease of 93% at the unit. It is now paying third-party manufacturers to make key products Excedrin, Lamisil, and Triaminic so the over the counter drugs don't disappear from store shelves.

This exposes a key difference between the two companies because that one U.S. plant isn't the only one experiencing problems. While Novartis appears to be managing the issues, Johnson & Johnson's problems look to be fading, suggesting that it is better able to handle such difficulties. Still, investors looking to buy a broadly diversified healthcare company without a medical devices group have a solid option with Novartis.

Medtronic (NYSE: MDT) is a major competitor that is focused only on medical devices. This company's key areas of focus include cardiac rhythm disease management, cardiovascular diseases, spinal care, neuromodulation, diabetes products, and surgical technologies. One key theme in all of these is that the company is working to treat chronic medical conditions. From pace makers to insulin pumps, it has a focus around a specific type of end customer.

This is a notable difference between JNJ and Medtronic. While it's hard to say this gives either company an edge, it is clear that chronic illnesses are likely to be on the increase as the baby boomer generation ages. So, Medtronic's niche will be a growing one. Like JNJ, acquisitions have played a big role at Medtronic recently, but so, too, have product recalls. Unlike JNJ and Novartis, however, when Medtronic does a recall, it could mean major surgery for its end customers. So this is a pretty big issue to watch at the company.

Still, Medtronic is an important, pure play medical device maker with an interesting focus. Investors looking to avoid pharmaceuticals and consumer products would do well to consider it. Of course, combining it with Novartis would create a two-stock portfolio that was roughly equivalent to JNJ. Buying all three, meanwhile, would provide even more healthcare diversification.

Key Growth Driver

Johnson & Johnson is a massive player in the medical devices space. This group has been growing nicely in recent years and coupled with what looks to be a resurgent drug segment, should help to drive the company's performance over the next few years.


Reuben Gregg Brewer has no position in any stocks mentioned. The Motley Fool recommends Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and Medtronic. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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