Once upon a time, back in the 1960s, corporations and investors got excited about a new form of organization: the conglomerate. It seemed like a good idea at the time because cyclical companies could buy counter-cyclical companies and smooth out their earnings—in theory, at least.
But investors do not care much about conglomerates anymore, as they have come to stand for mediocre results and unfocused leadership. And those who do want the diversification formerly provided by conglomerates can simply buy mutual funds or exchange-traded funds.
Management at Johnson & Johnson (JNJ, Financial) has taken note. In November 2021, it announced its intention of spinning off the Consumer Health division. That’s the division that got the company started 135 years ago, with products such as band-aids and the now troublesome baby powder.
The divestment was expected to take 18 to 24 months, which would put its full execution into roughly the second half of 2023. In its call with analysts about second-quarter 2022 earnings, the company reported it had named the CEO and chief financial officer. It also indicated the spinoff’s new name and market positioning would be announced in the coming months.
That would leave the company with two of its existing divisions, Pharmaceuticals and Medical Devices. They are company's biggest revenue generators.
The foundational Consumer Health division makes the smallest revenue contribution to the company. It is a mature island in a company focused on the high risks and rewards of the pharmaceutical and medtech industries.
Johnson & Johnson executives believe investors are not seeing the full worth of the company because of the consumer division. And it is not the only market giant feeling this way.
Merck & Co. Inc. (MRK, Financial) has disposed of its consumer health care division, while GlaxoSmithKline PLC (GLAXD, Financial), Pfizer Inc. (PFE, Financial) and Sanofi SA (SNY, Financial) are following the same path.
What does all this mean for current investors?
First, and as noted, investors generally do not care about this kind of diversification anymore. Instead, they would rather do their own diversification through individual stocks or through mutual funds.
Shareholders who hold Johnson & Johnson shares at the time of the spinoff will see the value of their shares decline by the amount of the consumer health valuation, but will also receive shares in the new company (which will go public at the same time).
Theoretically, this should all be a wash, but of course, Mr. Market will have a say in the matter. In the best-case scenario, investors will show increased interest in both companies and drive up the share prices. On the other hand, if Mr. Market does not like what he sees, the price of one or both will fall.
In the long run, though, this should be positive for shareholders. In its spinoff announcement, the company listed four ways in which the separation should create value for all stakeholders:
- Increase management focus, resources, agility and speed.
- Focus capital allocation according to the objectives of each independent company.
- Give each company a more compelling financial profile.
- Enhance growth and value creation through better alignment of corporate and operational structures.
The announcement also noted, “The New Consumer Health Company would be expected to benefit from a strong investment grade profile and balance sheet that would allow it to build on its long history of innovation and maintain and extend its leadership position across important and growing categories.”
A study by McKinsey & Company noted that spinoffs can, and should, be good for all parties. In “Achieving Win-Win Spin-Offs,” the authors wrote, “For a spin-off to truly succeed, both ParentCo and SpinCo (and their investors) should end up in a place better than the one where they started. Indeed, our empirical research suggests that spin-offs outperform by supporting the long-term growth and value-creation opportunities of both entities.”
But the devil is in the details, of course, and the McKinsey people argue that management can create win-wins by managing four steps correctly:
- Quickly increase revenue growth. In other words, spinoff management has to know how it will create new value before the company goes out on its own.
- Optimize the operating model by having in place a strategy that will help drive growth. Increasing the marketing budget, for example.
- The time and attention of leadership. This is one of the core strategies involved in spinning off part of a company.
- The right culture and talent. As the authors wrote, “We observed that the leaders of the most successful spin-offs didn’t approach this question as a zero-sum exercise. Instead, they took the time to assess the cultures and capabilities each company would require to succeed in the long term.”
From my reading of materials related to the spinoff, I believe Johnson & Johnson should meet each of these criteria. The fact that it is taking at least 18 months, and as many as 24 months, suggests management knows it must address multiple complex issues.
In particular, the new consumer health company should get the management time and attention it needs. It will no longer need to share that attention with two other divisions that generate more revenue. Note that even as a spinoff, this is still a giant in the industry, generating billions of dollars in revenue each year. It also owns four megabrands and dozens of lesser brands. Few new entities go out into the world as richly armed with products as this one.
Finally, the company has taken controversial action to try to rid itself of the baby powder problem. In a move designed to get some protection from roughly the 38,000 lawsuits it faces, Johnson & Johnson hived off those liabilities to a separate subsidiary.
Through a series of complex legal maneuvers, it then declared the subsidiary bankrupt and offered $2 billion in compensation. Many consumers were outraged by the action, but it has gone ahead and apparently is being hashed out.
Conclusion
It may come as a surprise that Johnson & Johnson is about to spin off the division that got it started in 1887. But even though it will operate with a new name, this separation may give it a chance to grow more robustly and broadly.
For shareholders, holding two new companies rather than one old one may present short-term challenges. However, in the long run, investors should come out ahead.
