Johnson & Johnson - What The Hell Are You Doing?

I feel the need to invoke Vince Lombardi when I think about Johnson & Johnson these days - that is, "what the hell is going on out there?!?!"

JNJ, a company known for it's time-tested and valuable brands, has announced what is, by my count, the eighth in a recent stream of recalls for popular over-the-counter drugs like Tylenol and Benadryl. Some of the recalls have been tied to unpleasant smells in the product, others to small metal bits, and others tied to product being stored on pallets that had nasty chemicals on them.

Not surprisingly, these recalls are affecting sales as at least some consumers are deciding to stay well clear of any OTC product with "Johnson & Johnson" prominent on the label. Although the print media seems to be taking on a certain amount of breathlessness in talking about the "tens of millions of dollars in sales" that the company is losing, a little perspective is in order. 

The consumer business does not "drive the bus" at J&J from a revenue standpoint (it contributed $3.8B of $15.6 billion in the last quarter), and it contributes even less as a percentage of total operating income. So, losing "tens of millions" due to these US recalls is not even 1% of the company's quarterly total. 

Nevertheless, the Consumer division a reliable generator of cash flow and it is a cornerstone of the company's brand value. Unlike the company's drug business, generic competition isn't so much of a threat and the R&D burdens are quite a bit lower. In other words, it is a fantastic business ... so long as you don't screw it up.

What is odd about this series of recalls to me is that ... well, it has been a series of recalls. Any one big screw-up is somewhat understandable - a machine breaks, throws shrapnel into the product, and a production batch has to be recalled. Fine, that happens.But a series of mistakes like these have to make you wonder if shortcuts are being taken and if the company has pushed "efficiency" too far.

Here's an odd thing - the recalls seem to be stemming from different facilities. That means one of two things. Either the company is hitting an improbable string of bad luck and a number of things are just happening to go wrong at the same time, or perhaps there is a systemic quality control problem. Clearly that would be a serious issue for the company, and one that the FDA would be sure to investigate extensively.

Maybe there is a third option as well - in response to the first recall (or two ... or three), it would not surprise me if JNJ HQ sent out memos to all plants instructing the managers to triple-check *everything* that was going on. As anybody who has worked in a manufacturing facility or even just a large organization can attest, if you go looking for problems, you will find some. 

Predictably, analysts and other commentators are lining up to call for the CEO's head, but I think that's silly. If Weldon needs to be fired, it is because of how the pharmaceuticals business has stagnated, how Abbott stole the march on drug-coated stents, and how the company has made a series of iffy (if not stupid) acquisitions in the device business. It is not as though Weldon has been ordering people to ship bad product or is personally contaminating them. For him to resign (or get fired) over this strikes me as Japan-style apology-quitting and I think that's a waste of talent.

Of course, if more information comes out that he signed off on irresponsible shortcuts in quality control to save money, he should go. Likewise, if Weldon isn't made to pay a price in terms of his bonus I'm going to be very annoyed as a shareholder. But to fire a CEO when the company is in the middle of a crisis makes about as much sense as firing a general when you're still in the middle of the battle. All it does is sow more chaos into a chaotic situation.

In any case, I will say this - Weldon needs to get his butt in a make-up chair and shoot a mea culpa ad to go up in prime-time on all channels. JNJ needs to be front-and-center saying, in effect, "we know you have trusted us for many years, and we have badly abused that trust with these mistakes. We are taking steps to fix it now, and we will do anything we can to see that it doesn't happen again".

What's an investor to do?

Oddly enough, the market hasn't reacted all that badly to this string of recalls. Maybe that's due to the oil spill or the economy or some other distraction. I mean, normally I think the idea of eight recalls of well-known brands that are in every supermarket and pharmacy, made by a universally-recognized company, would be a prominent news story. Then again, maybe it's also because nobody has been hurt - a recall due to smelly pills may not meet the current bloodthirsty standard for news.

As I said, the whole Consumer business is only a modest contributor to operating income, so even a nasty sales drop for products like Tylenol isn't going to really hurt earning much at all (if at all). Moreover, since it doesn't seem that anybody has been hurt by the products, the lawsuit risk would appear to be controllable as well.

I've owned JNJ for a while now because, faults aside, it is still a high-quality name operating in three very attractive businesses. Moreover, it produces solid cash flow, invests large sums into R&D, pays a decent dividend, and is certainly not overvalued. Companies of lower quality than JNJ have survived even bigger foul-ups, so I see no reason to alter my fundamental thesis or models on this one. I own JNJ and would still recommend others buy it.

Disclosure - I own shares of JNJ