Johnson & Johnson Focusing on Quality Over Quantity

On May 22, Johnson & Johnson hosted an all-day analyst day for its medical device business. This meeting didn't really offer any major surprises, but did highlight management's intention to run this business with a focus on returns and scale and an understanding of where the company can (or cannot) likely earn attractive returns for shareholders. All told, this update was not especially bullish for Covidien or Intuitive Surgical , but it may stoke ongoing speculation as to additional areas where Johnson & Johnson may look to shrink or expand via M&A.

Devices still a growth opportunity
One of the biggest takeaways from Johnson & Johnson's presentation came early on. The company continues to expect the global device market to grow around 3% to 6% a year through 2018. Relative to the company's recent performance (roughly flat in 2013, down in 2012), simply keeping pace would be a big improvement. Management also made it clear that growth is going to come largely from emerging markets, as they expect development market growth on the order of 2% to 4%.

A one-two punch
Management made repeated references to the importance of scale and synergies in its operations, and it is well worth noting that general surgery and orthopedics are about 70% of the MDD business.

On the surgery side, Johnson & Johnson kicked up its R&D spending by about a third two years ago. The company is starting to see results in terms of new energy, stapling, and biosurgery products. A new fibrin sealant patch (Evarrest) should make life more "interesting" for Bard, while the company's new Harmonic Ace+ shears look like a fit competitor to Covidien's Ligasure line. All told, Johnson & Johnson's focus on energy and stapling is not going to be a welcome development for Covidien, as Covidien has been reaping the benefits of better innovation in these categories over the past two years.

Johnson & Johnson also announced that it is developing a robotic surgical system that will be smaller and more mobile than Intuitive Surgical's da Vinci. It's not really surprising that Johnson & Johnson would be interested in surgical robotics, particularly given rumors that Covidien and Stryker are interested (or have been) as well and the cost of acquiring Intuitive Surgical. While management was dutifully respectful to what Intuitive has accomplished with the da Vinci, they also believe that further adoption in general surgery will be limited by cost issues and a lack of clinical superiority. That this is where a rival system can offer value.

While it is of course easy to talk about doing something (I can claim that I can dunk on Blake Griffin), actually doing it is a different matter. Even so, I would argue that the risk of future competition to Intuitive Surgical has now moved beyond the theoretical stage. Johnson & Johnson's capabilities in terms of R&D funding and surgical marketing make it a significant potential rival.

On the ortho side, I didn't hear as much that seemed new. Johnson & Johnson is likely to be a beneficiary of any sales disruptions that result from the Zimmer-Biomet merger and the company believes it has meaningful cross-selling opportunities stemming from its trauma business. Management did acknowledge "ambitions" to grow its lower extremity business, and as an owner of Wright Medical Group I would be more than happy to see an acquisition here (and I do believe there were would be significant synergies from such a transaction, as Wright would bring quality lower extremity and biologics, while J&J could immediately upgrade the sales effort.)

Heigh-Ho or heave-ho for the smaller businesses?
If general surgery and orthopedics are dual Snow Whites, the rest of MDD are dwarfs by comparison. Management sounded skeptical of the prospects of developing a third major business line from its existing operations and may instead look to divest some of them.

In the diabetes business, management is looking to bring the Animas Vibe insulin pump to the U.S. as well as the Calibra insulin patch. If these products don't take off, I could see Johnson & Johnson considering an exit; its insulin pump business trails Medtronic and Insulet, and it lacks a continuous sensor product.

In cardiology, management acknowledged a lack of scale, but acquiring a cardiac rhythm management or stent business is undesirable given the lack of growth in those businesses (JNJ exited stents a few years back.) That affirms yet again that an acquisition of Boston Scientific is unlikely, and management likewise sounded skeptical of the opportunities in transcatheter valves given the level of competition. Structural heart products sounded more interesting, though, as did ventricular assist devices. The atrial fibrillation and electrophysiology businesses are growing nicely as well.

Aesthetics and vision care are likewise small businesses for the company. Acquiring Allergan as a white knight could add scale to both operations, but it sounds more likely that Johnson & Johnson would prefer to avoid large expensive deals. Instead, it may consider buying businesses that Valeant would have to sell off in the event of a successful bid.

The bottom line
The most bullish takeaway from Johnson & Johnson's MDD analyst day may be that management is keenly focused on returns, scale, and sense, not on empire-building. Getting bigger for its own sake or entering a market just because it is hot and offers growth is no longer on the table, and that should be good for long-term shareholder returns.

Given the company's increased scale and R&D focus on general surgery and orthopedics, management should be able to lift growth back into the neighborhood of 3%. Matching the high end of industry growth guidance (i.e. 6%) may be out of reach, however. All things considered, it was a good update for Johnson & Johnson but maybe not such good news for Covidien or Intuitive Surgical.

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Stephen D. Simpson, CFA owns shares of Wright Medical Group. The Motley Fool recommends Covidien, Intuitive Surgical, Johnson & Johnson, and Valeant Pharmaceuticals. The Motley Fool owns shares of Intuitive Surgical, Johnson & Johnson, Medtronic, and Valeant Pharmaceuticals. 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.

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