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The following segment was excerpted from this fund letter.
Johnson & Johnson (NYSE:JNJ)
J&J is currently our largest position and a long-standing holding. The majority of the group’s sales comes from its collection of pharmaceutical franchises, but a large majority (~45%) comes from its collection of medical device businesses and its consumer brands.
Here’s how JNJ make and spend a dollar of revenues: As of 2021, about 55 cents of that dollar comes from its pharmaceutical sales – sales of drugs to pharmacies and distributors – while 30 cents come from the sale of medical devices, such as surgery equipment and orthopedics. The rest of that dollar in sales comes from sales of JNJ’s consumer brands such as Listerine mouthwash, Nicorette nicotine tablets and Neutrogena cosmetics.
To make that dollar, however, JNJ typically spends about 25 cents to make the products themselves and another 27 cents on marketing and general administrative functions. This leaves JNJ with about 48 cents on the dollar in profit.
The pharmaceutical industry is a research intensive one and investments in R&D – along with typical capital expenditures into manufacturing – take their own share of revenues. JNJ spends about 16 cents in R&D for every dollar of product sold, along with another 4 cents in investments into property, plant and equipment. Taking all this together, Johnson & Johnson pockets roughly 25-30 cents of cash profit per dollar sold of its pharmaceutical, medical device, and consumer products; all, of course, before interest and taxes.
The economics differ slightly by business segment, and this is worth noting: JNJ’s pharmaceutical business has on average contributed about 52% of group sales over the last half decade but has contributed to two thirds of the operating profit. Compared with this, the Medical Devices business made an average operating margin of 30% in the 5 years before COVID, with the Consumer business making margins just over 10%.
Aside from the high degree of margin stability the group has exhibited over the last two decades, the business also runs efficiently on its capital base, with returns on invested capital – treating R&D spend as a capitalized expense – of a commendable 20% to 25%. This stability, high ability to produce returns on capital invested in the business, and its decent cash conversion profile, make this a high-quality business.
Healthcare businesses of course come with plenty of risks – and we have seen JNJ pay some hefty fines in previous years for product liability issues; and the pharmaceutical business faces some near-term headwinds as a couple of its most important patents roll off and leave them open to cheap generic manufacturers. However, longer-term, JNJ’s history of innovation, its institutional memory and knowledge base should ensure its ability to top up its pipeline of pharmaceutical franchises well into the future.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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