J&J's Stockholders Win
Updated: Nov 21, 2021
I was sad to hear that my old company, Johnson & Johnson, has decided to spin off its consumer health and over-the-counter (OTC) medicines businesses. Those businesses house the company’s iconic brands, most notably Johnson’s Baby, Band-Aid, and Tylenol. These are the products all of us most associate with J&J. The smell of Johnson’s Baby Shampoo is something that brings back parents’ memories of their first months of parenthood. “I am stuck on Band-Aid” (written by Barry Alan Pincus, better known as Barry Manilow) is one of the all-time great ad jingles. And CEO Jim Burke’s handling of the Tylenol crisis in 1982 remains a fixture in business school curricula and the gold standard example of corporate crisis management. These businesses are J&J.
It’s been that way since the very beginning. When the company made its initial public offering in 1944, J&J was best known for its surgical dressings—products treated with sterilizing technology critical to modern wound care. Today we take sterilizing technology for granted, but it was novel in the late 1800s when brothers James, Edward, and Robert first formed Johnson & Johnson and set out to mass produce sterile gauze. Their products, sold under the “Johnson & Johnson” brand name, would become crucial in saving American lives on the battlefields of WWI. The Band-Aids that we stash in our medicine cabinets and First Aid Kits that we see at every pool lifeguard station originated from these early sterile gauze products.
When I was at the company, we referred to the “Johnson & Johnson” cursive as “the trustmark.” And it really is that. If I handed you a bottle of clear gold syrup and told you to slather it over your 3-month-old baby’s head, you’d think twice. But if that bottle had the word “Johnson’s” on it, you’d open the cap, smell the familiar scent, and massage a dime-sized drop of that liquid gold onto your infant’s head without any concerns. That’s trust!
Our communications professionals and trademark lawyers zealously guarded the trustmark. This went so far as requiring special committee approval for “Johnson’s” “J&J” or “Johnson & Johnson” to appear on the label of any product, in the name of any division or subsidiary, or on the side of any building worldwide. The Johnson & Johnson name never appeared on any of the prescription drugs or medical devices, and that was very intentional. Johnson & Johnson is a name the company wanted to have the public associate with the warm feelings of mother and baby, not the scary therapeutic areas of schizophrenia, HIV, and cancer, and definitely not opioids. When you have a name that commands that kind of trust, you do whatever it takes to protect it, even if it means keeping it out of the reach of your most profitable businesses. The trustmark also acted as somewhat of a shield when Big Pharma was being attacked as a cabal of greedy snake oil salesmen. Having a name that most people don’t associate with pharmaceuticals was a way to distinguish J&J from the usual suspects and avoid sitting next to them at a Congressional subcommittee hearing. Former J&J CEO Ralph Larsen once said, "It gives us a wonderful image that most companies would kill for.”
So, my brow reflexively furrowed when I read that once consumer products and OTC are spun off, the remaining pharma/medical devices company will keep the name Johnson & Johnson. After all, the corporation has made an affirmative decision to cast off all of the products that carry the legacy Johnson & Johnson brands. I’m sure some licensing arrangement will be negotiated for the consumer products of the spun-off company to use the trustmark, but it will be strange for the old company to still be called Johnson & Johnson and traded under the ticker symbol “JNJ.”
“Our Final Responsibility Is to Our Stockholders”
Breaking up is hard to do, and last week’s decision is the culmination of many years of debate between the company and the investment community. Investors have publicly suggested breaking up J&J on multiple occasions just over the past decade. Every time, the suggestion was met with a full-throated defense by the CEO and CFO of the “One J&J” diversified healthcare company model that had served the company’s stakeholders well and rewarded the stockholders handsomely over the long term. The language that investors used in their arguments for spinning off one of the three business segments or breaking the company into three typically included terms like “unlock shareholder value,” “pure play companies,” “better asset allocation,” “management focus,” “lack of synergies,” and “sum-of-the-parts analysis.” All of these were parried by management (including me), passed off as stock phrases of sell-side analysts and MBAs who just did not get the intangible value of the company’s breadth, culture, and history and the power of the trustmark. And we pointed to the legendary Credo as the ultimate defense.
The J&J Credo, originally written by General Robert Wood Johnson, J&J’s then-Chairman and Johnson family patriarch, right before the company went public famously says that the company’s “first responsibility is to the patients, doctors and nurses, to mothers and fathers and all others who use our products.” Its second responsibility is to “our employees who work with us throughout the world.” Its third responsibility is to “the communities in which we live and work and to the world community as well.” And the company’s “final responsibility is to our stockholders.” The last line of the Credo reads, “When we operate according to these principles, the stockholders should realize a fair return.” Much has been made of General Johnson’s decision to put the stockholders at the bottom, but the ranking has stayed the same, even during the few times when the Credo was amended and the heyday of shareholder primacy.
What the Stockholders Want…
The headline of the company’s press release reads, “Johnson & Johnson Announces Plans to Accelerate Innovation, Serve Patients and Consumers, and Unlock Value through Intent to Separate Consumer Health Business.” It goes on to use a number of the buzzwords that sell-side and hedge fund types go gaga over, like “pursue more targeted business strategies,” “more targeted investment opportunity,” “focus capital allocation,” “increase management focus,” and “align corporate and operational structures.” There’s lots of talk in the announcement about innovation, patients, and consumers, but not much about employees or communities, probably because this move has little to do with those stakeholders, even though the spin-off will no doubt impact them (the employees in particular).
But those buzzwords do characterize business and financial strategies that today’s investors truly believe are in everyone’s best interests. Investors want to be able to assess and put a price target on each of the company’s three business segments separately. Research analysts typically specialize in one of pharma, medical devices, or consumer health, not all three or even two of the three, so it’s always been difficult for them to cover a three-headed monster. And investors these days prefer having targeted investment choices over conglomerated choices. They would rather order their healthcare investment lunches à la carte than take the three-course prix fixe served by J&J. More than anything, investors want “above market growth,” especially in earnings per share (EPS) and total shareholder return (TSR), which means having more of a craving for pharma (high risk, high reward) than consumer and OTC (slow and steady, but low reward). That’s why you’ll hear nothing but praise about the J&J consumer/OTC spin-off plans from people in the investment community.
For those who see executive compensation as the ultimate driver of corporate decisions (I’m not in that camp), J&J’s executives did exactly what they get paid to do. Regardless of where the Credo ranks stockholders’ return on investment, J&J’s board of directors set up an incentive system more aligned with the interests of the stockholders than the interests of the rest of the stakeholders combined. J&J CEO’s pay mix (at target) is 75% in the form of long-term incentives (LTI). (The pay mix for the other executive officers is about 70% in LTI.) Of the LTI, 60% is awarded in the form of performance share units (PSU), 30% in stock options, and 10% in restricted stock units (RSU). PSU payouts are based on hitting targets for the growth of EPS, TSR (relative to competitors), and the stock price. (Prior to February 2020, one-third of PSU payout was based on operational sales growth.) The value of the stock options and RSUs are purely tied to the stock price. Part of the executives’ annual bonus payout is also based on EPS growth.
… the Stockholders Get
The headline for me is that the stockholders, after 77 years of dwelling in the cellar, have climbed into second place, or maybe even a tie for first in the hierarchy of J&J’s corporate stakeholders. It’s a tough pill to swallow after having spent years, both while at J&J and in the roles I’ve had since, pontificating about the elegance and genius of the Credo and insisting that this is the right way to manage a corporation. In fact, on a webcast just a few weeks ago, I held out J&J as the G.O.A.T. example of how corporate purpose and stakeholder governance—not shareholder primacy—are the keys to long-term success. I’m not sure I can do that anymore, at least not when talking about the company in the present tense.
I have no doubt that this was a tough decision—maybe even the toughest ever—with a lot of soul searching for J&J’s board of directors, a group of experienced stewards with a great appreciation of the rich history and iconic status of the company in the pantheon of American corporations. I hope at least some of the board members were stubborn hold-outs and took a lot of convincing. Frankly, I wish the board had gone through the process, slept on it, and in the morning said, “Sorry stockholders, but we’re not letting go of our consumer products because that’s who we are.”
After Alex Gorsky steps down as CEO and eventually relinquishes the Executive Chairman position, spinning off the consumer and OTC businesses will be his legacy. It may turn out to be a brilliant and courageous move where everyone wins. It may end up being seen in hindsight as a tragic capitulation to the pressures of Wall Street. One way or another, Mr. Gorsky and today’s J&J board will own it. That’s why they “get paid the big bucks”: to make tough, risk-adjusted decisions based on their collective wisdom and business judgment. Whether company alumni cry or cheer isn’t a factor for them. Change, even when it’s obvious that it needs to happen, can make traditionalists uneasy, and clear-eyed business decisions are not always popular with romantics (like me).
Innovation, disruption, and changing consumer preferences are always challenging corporations, including the oldest and most successful ones, to make decisions on when to keep playing and when to move on. IBM eventually decided to get out of the typewriter business and later sell off its personal computing business. GE stopped making lightbulbs and now decided to break up entirely. And we all know what happened at Kodak and Polaroid. But the spin-off of J&J’s consumer health business feels different. Imagine The Coca-Cola Company spinning off Coke and the rest of its carbonated beverages, The Walt Disney Company sending Mickey, Minnie, Donald, Goofy, and Pluto packing, or Levi Strauss & Co. no longer making denim jeans. Well, the day for J&J to say goodbye to its consumer health and OTC businesses has come. Even though I’ll still see (and buy) my beloved J&J consumer and OTC products on store shelves wherever I go, it will take a long time for me to get used to the Johnson & Johnson parent without Johnson’s Baby.