J&J's New Baby

As other divisions stumble, consumer products--bolstered by a $16.6 billion addition-- provide a security blanket

By Arlene Weintraub

It's not a personal thing, but J. Neal Matheson spends a lot of time obsessing about bad breath. Matheson is chief technology officer for Johnson & Johnson's (JNJ ) consumer health unit, home to such iconic brands as Johnson's Baby, Band-Aid, and, most recently, Listerine. J&J nabbed the world's No. 1 mouthwash a year ago when it bought Pfizer's (PFE ) consumer health unit for $16.6 billion--its biggest acquisition ever. With Listerine in its portfolio, along with other Pfizer brands such as decongestant Sudafed, Bengay, and Rolaids, J&J's consumer business is, without doubt, the freshest-smelling division in an otherwise troubled company.

The consumer teams from Pfizer and J&J are scientific soulmates, says Matheson. Their shared mission: to keep their storied brands up to date by constantly tweaking the ingredients, redesigning the packaging, and finding whole new uses for the contents. At J&J's consumer research headquarters in Skillman, N.J., Matheson whips out a paper showing how Pfizer won the right to pitch Listerine as much more than a breath freshener simply by running some inexpensive clinical trials. "Halitosis, plaque, gingivitis...kills germs between teeth, kills germs at the gumline," he reads from a list of Listerine's advertising claims, excitement rising in his voice. "It's beautiful." Annual retail sales of Listerine, age 112, have jumped 61% in the last five years, to $877 million, according to market research firm Euromonitor International.

Gingivitis is hardly the first thing that comes to mind when most investors think of J&J. They're more likely to remember the litany of woes that have hit the company recently. J&J's pharmaceutical division has suffered a series of stumbles, made worse by a dearth of innovative products. As a result, its stock is down 3% so far this year, while the Dow Jones industrial average is up 10%. Meanwhile, J&J's medical device unit has failed to come up with a strategy to expand into high-end heart products. In January, 2006, J&J's effort to buy Guidant Corp., a maker of cardiac devices, ended in disappointment when J&J CEO William Weldon declined to match Boston Scientific Corp.'s (BSX ) $27 billion bid.

The sting of defeat didn't last long, though. Just three weeks later, Pfizer suddenly put its consumer unit on the block, and Weldon sprang into action. "We opted out of Guidant because we couldn't bring value to shareholders at the price that was being pinned to it," he says with a shrug. "The consumer health-care group at Pfizer brought tremendous value."

Weldon can be excused for feeling smug about the way these two deals turned out. Granted, nobody expects the new, expanded consumer business to be able to match the profit potential of expensive, life-sustaining heart devices. Nevertheless, J&J recently announced first-quarter sales of $15 billion, up 16% from the previous-year period. And profits, excluding special charges, jumped 14%, to $3.4 billion. The Pfizer deal provided a mighty lift, pushing J&J's consumer revenues that quarter up 48%, to $3.5 billion. J&J is now telling Wall Street that the Pfizer merger will allow it to squeeze $500 million per year out of its cost structure and that the company will break even on the transaction in 2009--a year earlier than expected. Meanwhile, Boston Scientific is struggling to turn Guidant around and has lost 20% of its value in the past year.

A JOURNEY INTO J&J'S CONSUMER PRODUCTS division shows how a subtle power shift inside the health-care giant has brought much-needed stability. It also lifts the curtain on a mysterious alchemy J&J uses to spin cash out of relatively simple innovations in product design, packaging, and marketing. J&J's total revenues are on track to rise at least 12% this year, to about $60 billion. Consumer products make up 24% of the total, compared with 18% prior to the Pfizer deal. J&J has already staked out its turf in America's medicine cabinet, but now it seems poised to crowd out Procter & Gamble Co. (PG ) J&J produced 400 new products last year, and the acquisition pushed it to the top of 22 consumer categories. Some of its oldest family members are charting double-digit sales increases, including what J&J playfully calls "the pink line"--the baby potions that come in pink bottles. For Weldon, such brands are annuities. "If you invest in them and you bring technology and innovation to them," he says, "they just keep paying back."

The command center for J&J's consumer operation is on the sprawling Skillman campus, which appears, seemingly out of nowhere, off a remote two-lane road dotted with farmhouses. In the center of the town, population 5,000, convenience stores are loaded with the latest versions of Tylenol, Reach toothbrushes, and other products being developed just down the road.

Matheson, a scientist with a background in skin care, came to J&J from P&G in 1994 with a mandate to transform a scattered and somewhat disorganized research group into a launchpad for products consumers would rush to purchase. Back then, the unit was bringing in just $4.8 billion a year in sales, and growth was languishing below 1% a year. To gain a foothold in the skin-care market, J&J bought pimple-potion purveyor Clean & Clear and RoC, a French maker of anti-wrinkle creams, followed by soapmakers Neutrogena and Aveeno.

J&J has a long tradition of preserving the independence of operations it acquires. But that created problems. There were scientists all over the world--from Skillman to Paris, home of RoC--who weren't always in sync with each other or with the people who could turn their discoveries into products. "There were gazillions of ideas," recalls Matheson, a young-looking 60-year-old whose voice sometimes dwindles to a whisper when he wants to emphasize a point. "The question was: How would we get those ideas to market?"

Matheson put together small teams of up to a dozen scientists and charged each with tackling a cosmetic challenge. There's an acne team, which does nothing but think up ways to help teens zap zits, and a pigmentation team that dreams up products to help even out skin tone. Each group gathers input from marketing and development folks, who help define target audiences and rush products to drugstore shelves. And Matheson encourages the teams to partner with small, forward-thinking companies--a departure from how things were done at his old stomping grounds. "Procter has huge teams that do everything inside," Matheson says. "We're much more outward-looking." (A spokesman for P&G notes that 40% of its products now include input from the outside, up from less than 10% in 2001.)

J&J'S new system has helped erase wrinkles on aging brands, such as Neutrogena. For decades, that name evoked little more than amber, transparent soap, but under Matheson, the brand is expanding in unexpected directions. Most recently, Neutrogena has created an at-home version of something called microdermabrasian--a skin-smoothing procedure that can cost up to $200 at health spas. At the same time, J&J's "suncare" team--including scientists from Skillman, Los Angeles, France, and Brazil--cooked up a three-ingredient cocktail called Helioplex that promises to offer broader and longer-lasting protection than standard sunscreens, so beachgoers don't have to keep slathering themselves. Last year, J&J put Helioplex in several products, including Neutrogena's sunscreens and anti-aging lotions. Neutrogena, which J&J bought in 1994, has grown 56% in the last five years. It now has worldwide sales of $1.6 billion.

The Pfizer scientists J&J brought on board have mastered a formula for printing money from minor breakthroughs. In 2001, Pfizer introduced Listerine PocketPaks, a unique formulation of fast-dissolving breath strips that sparked a $100 million-a-year industry. The melt-in-your-mouth film has become a new drug delivery platform for such brands as Pfizer's Sudafed. And, says Matheson, J&J is considering expanding it to other over-the-counter drugs.

The beauty of innovations like PocketPaks is that they don't cost a fortune to pull off. And even just adding a claim--saying, for example, that Listerine can prevent gingivitis--enables a company to drive demand for the product, much as adding a new use to the label of a drug can widen the pool of patients who take it. But there's one important difference: The U.S. Food & Drug Administration is much more lenient with consumer products, as long as they contain already approved ingredients. In fact, when companies run trials to prove claims on balms and cosmetics, it's usually not because the FDA requires them, but rather because they need the studies to support advertising messages and gain street cred with physicians, who then recommend the products to patients. A skin-care study might cost $5,000, Matheson estimates. An over-the-counter drug trial would be a little more, perhaps $50,000. Developing a new formulation, such as PocketPaks or Helioplex, could run up a tab of $10 million. Still, that's pocket change compared with the $1 billion it costs on average to develop a new prescription drug.

ON A CRISP APRIL DAY, 1,800 J&J INVESTORS stream into a Hyatt hotel across the street from J&J's New Brunswick (N.J.) headquarters. The crowd, mostly retirees, has made the pilgrimage to the company's annual meeting, a rollicking event that's sort of like a rock concert crossed with a shuffleboard tournament. As Weldon takes the stage and begins ticking off J&J's accomplishments, he's interrupted by applause. For the 45th year in a row, he tells the gray-haired audience, the company is increasing its quarterly dividend, this time by 10.7%. J&J is one of only five U.S. industrial companies with an AAA bond rating, and its free cash flow is at an historic high of $11.6 billion. Retired retail exec James K. McIntosh, when asked why he has held his J&J shares for 40 years, says simply: "Where would the populace be without J&J?" A moment later, a slide pops on the screen revealing that a single share purchased for $37.50 in 1944, when J&J went public, would be worth $950,000 today, including stock splits and dividend reinvestments.

J&J's critics, however, say far too much of the company's ebullience rests on the success of its consumer products business. Beyond those comfortable perimeters, the company faces serious challenges. In the pharmaceutical arena, the FDA is considering strict new limits on J&J's anemia drug Procrit, which brings in $3 billion in sales a year. An additional $7 billion could fall off the top line when J&J's schizophrenia drug Risperdal and its epilepsy and migraine treatment Topamax go generic in 2008 and '09, respectively. There are few potential blockbusters in J&J's pipeline to replace them. And sales of J&J's heart failure treatment Natrecor, which it picked up in a $2.4 billion acquisition four years ago, have sagged in the wake of studies suggesting it might increase the risk of death. Analysts expected the drug to be bringing in annual sales of $1 billion by 2007. They now estimate the company will struggle to sell more than $100 million of it a year. And there are federal and state probes into marketing practices related to some of the company's drugs, heart stents, and orthopedic products.

Meanwhile, recent studies have sparked worries that drug-eluting stents can cause blood clots in some patients. That has curbed demand for the tiny metal tubes, which J&J invented in 1994 as a way to prop open clogged arteries. Last year, the company paid $1.4 billion to acquire stentmaker Conor MedSystems, which was positioning its stent as a safe alternative to rival products because it releases drugs in a precise, measured manner. But in May a trial of Conor's most advanced stent failed. J&J stopped developing the product and pulled it from Asia, Latin America, and Europe, where it was already on the market.

THE CONOR DEBACLE, ONE OF THE MOST embarrassing in J&J's recent history, helps explain the tremendous affection Weldon and his crew have for the consumer division. It acts as a kind of security blanket. The consumer unit posted operating profit margins of 14% last year--not bad, but well below the 30% J&J typically earns on drugs and devices, which are protected by patents. Yet historically, powders, lotions, soaps, and other lifestyle products have been a much safer haven for manufacturers. Besides the fact that consumer products are lightly regulated, they rarely spark liability lawsuits. More important, their sales don't fall off a cliff when generic competitors enter the fray. But mostly, consumer brands are safe because they have intrinsic value for consumers, who willingly hand over those extra bucks for Tylenol rather than buying the store-brand version in a bland-looking box. "You don't have to deal with the volatility that you have in pharmaceuticals and devices," Weldon says. "It's the consumer making a choice and then moving forward."

Despite J&J's recent stock swoon, the company remains one of the strongest long-term performers in the health-care sector. It has returned 149% to shareholders over the past 10 years, beating both the Dow, which has gained 124%, and the Standard & Poor's (MHP ) 500 Health Care Index, which is up 118%.

To some influential investors, the company's sliding shares represent a buying opportunity. This year, Warren Buffett's Berkshire Hathaway Inc. (BRK.A ) doubled its stake, to 48.7 million shares, according to a May 15 filing with the Securities & Exchange Commission. Buffett's policy is to stay mum on specific investments, but some of his followers say most likely it's the Band-Aids and Baby Oil that are drawing him to the stock, not the stents and drugs. "Buffett loves consumer businesses with staying power," says Frank Betz, a partner at Carret Zane Capital Management in Warren, N.J., which manages private portfolios that hold both Berkshire and J&J shares. "Yes, J&J has hit some speed bumps, but look at it over the long run. There's never been a bad time to own J&J."

On May 17, an invitation-only crowd of more than 800 young adults lined up in New York's trendy SoHo neighborhood to celebrate, of all things, toothpaste. The party launched a "pop-up store" that J&J ran for six weeks to promote its tooth-whitening brand, Rembrandt. The multimedia-crammed space didn't actually sell the product. Instead, to build buzz for Rembrandt as the whitener of choice for the hip and youthful, it hosted makeover parties, book readings, and concerts. Among the opening-night guests were up-and-coming actresses Rashida Jones and Sophia Bush. "They were trendsetters--boutique owners, actors, models. No suits," says Carmen Nestares, 32, part of the new generation of J&J brand managers, who are coaxing the centenarian to think beyond old-fashioned marketing techniques such as print and TV advertising. Was the Rembrandt store a departure for the traditionally buttoned-up J&J? "Totally," she says.

In staging such events, J&J is just now catching up to its rivals, who long ago embraced alternative techniques such as viral marketing. Just before Valentine's Day, J&J's Rembrandt team placed an ad on YouTube that featured a young couple kissing passionately for 30 seconds. It was so racy that the video site relegated it to its adult section. Word spread on blogs, prompting viewers to click on the ad 180,000 times. "Next thing we knew, it popped up everywhere," says Colleen Goggins, a 26-year veteran of J&J who has been worldwide chairman of the consumer unit since 2001. She adds with a mix of delight and trepidation: "We couldn't control it."

For products with few special powers--and let's face it, not all consumer products are legends in their own time--success lies in surface details. In 2006, J&J opened a satellite office in New York staffed by designers who spend their days devising fresh ways to serve up decades-old products, from how they're packaged to how they're displayed on store shelves. "It's no longer a situation where we work so hard on the product and then just throw it into a standard package," says Marc Robinson, who came over from Pfizer to serve as J&J's group chairman for consumer healthcare, over-the-counter, and nutritional products. The new unit designed Band-Aid Brand Interlocking Pods, a package with separate linked compartments for carrying different sized bandages.

Sounds simple, but marketing experts say such variations on old products can make all the difference on shelves populated with umpteen first-aid tapes, ointments, and sprays. "In what's become an overcrowded marketplace, companies need to own a point of difference," says Lee Sucharda, president of Design North, a packaging consulting firm in Racine, Wis.

It will also help J&J achieve the ambitious growth targets Weldon sets for his top executives. Unit managers are constantly weighed against internally designed "composites" made up of competitors in each of J&J's three major industries, consumer, pharmaceuticals, and medical devices. The consumer composite includes the usual suspects: skin-care giant Loreal; over-the-counter drug rivals Novartis (NVS ) and GlaxoSmithKline (GSK ); and über-competitor P&G. The goal is to outpace the composite on a top- and bottom-line basis. By boosting sales 55%, to $9.8 billion, and operating profits 37%, to $1.4 billion, since 2001, J&J'S consumer group has stacked up pretty well, Goggins says. But before the Pfizer opportunity popped up, Goggins worried about the future: "We would have certainly grown organically, but not in any way, shape, or form could we have achieved what we can achieve [with Pfizer] as quickly."

AT SHANGHAI FIRST Maternity & Infant Health Hospital, newborns with tiny inner tubes around their necks float in warm baths. After a 15-minute soak, the babies get massages from their moms, courtesy of J&J, which sponsors this center and more than 700 like it to teach Chinese parents the art of therapeutic touch. In the massage room, a smiling mother adorns a giant pink J&J poster, and a display cabinet showcases a dozen J&J baby shampoos and lotions. New father Zhuang Jun, a 32-year-old software engineer, says he and his wife plan to use J&J products for their baby girl. His wife was already using the company's products anyway. "I listen to what my wife says," he explains.

If J&J can crack the code, that baby with the inner tube around her neck will soon be swishing Listerine and slapping on J&J's sunscreens. The real test of any company's strategy is in places like Shanghai, where people are just now cluing in to the concept of consumer choice. Last year, J&J's overseas sales in the consumer unit grew nearly 11% to $5.2 billion, while U.S. sales inched up just 4% to $4.6 billion.

To garner insights on how to tailor products to local markets, J&J expanded a consumer research center in India in 2004, and it has just broken ground on a similar center in Shanghai. "We expect the number of upper- and middle-class families in India and China to double in the next five years," says Goggins, who is always devouring market research so she can better understand overseas opportunities. "That's a lot of people with newfound income."

In locales where Unilever PLC and P&G have flourished for years, J&J is still in kindergarten--and prone to stumbles. When it introduced a line in India called Johnson's Kids a few years ago, parents weren't interested, reports Aneesh Issar, who worked for J&J in Mumbai for three years. "Buying something just for kids wasn't perceived by the masses to be a necessity," says Issar, who is now a senior manager for RocSearch, a marketing research firm in Noida, India. One of the products was a menthol powder that J&J pitched as being comfortably cooling. "It was perceived as burning rather than cooling," Issar says. Trying to create a children's market, he admits, "was a little premature." J&J dropped the kids' line.

As J&J feels its way through foreign territories, Pfizer is helping it plug some holes in its geographic reach. J&J, for example, has never been a big player in Mexico, whereas Pfizer has. Building an operation there from the ground up, says Goggins, "takes time and it takes money. When you have the kinds of relationships Pfizer has with the retailers, health-care professionals, and consumers, it just makes life easier." As a result of the Pfizer merger, overseas sales of over-the-counter drugs and nutritionals (primarily the J&J sugar substitute Splenda) jumped 183% in the first quarter.

In January, at an integration kickoff soiree J&J execs threw for their new Pfizer colleagues, partygoers came across a striking exhibit. It featured 24 illuminated columns, each labeled with an hour of the day. Atop each column were a handful of products consumers might use at that hour: 7 a.m., Reach toothbrush (J&J); 11 p.m., Sudarub Vapour Rub (from Pfizer, sold overseas only); and so on. Each column poses a challenge for the combined J&J-Pfizer consumer team to ponder. At 11 p.m. it asks, "How Can We Help People Rest Assured?" The display, now on the consumer floor of the New Brunswick headquarters, is a perfect depiction of J&J's grand plan: to hook consumers regardless of where they are or what they're doing. "The consumers are king and queen," Matheson says. Serving at their pleasure is more important than ever as J&J's other divisions struggle to find their way.

With Bruce Einhorn in Shanghai

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