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J&J and P&G: A Tale of Two Disappointments

Learn more about where J&J and P&G are going wrong and what they must do to improve from five investment experts.
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NEW YORK (TheStreet) -- The consumer environment remains, inarguably, tough. Consumers, battered and shell-shocked after years of economic uncertainty, clearly remain cautious about opening their wallets and spending on brand name products -- many of which are made by companies such as J&J (JNJ) - Get Johnson & Johnson Report and P&G (PG) - Get Procter & Gamble Company Report.

According to

Goldman Sachs

analysts Andrew Sawyer and Stephanie Whited, sales of big U.S. household consumer names continued to decline in August. Specifically, U.S. measured-channel sales for the household and personal care industry fell 1.3% for the four weeks ended Aug. 7, which was slightly worse than the 0.7% decline in July data, but somewhat better than the trailing three-month average of negative 1.7%.

At the same time, private label competition was outpacing the household and personal care industry, with sales growth of 6%, compared with 9% the previous year. Private label dollar share rose 0.9 points to more than 13%.

But while the economy hasn't yet taken its toll on consumer behemoths such as J&J and P&G, it certainly has had a gnawing effect. P&G missed Wall Street consensus estimates when it reported fourth-quarter earnings on Aug. 3. Analysts expected earnings of 73 cents a share, but P&G reported earnings of 71 cents a share.

So far the Wall Street consensus earnings estimate for the first quarter and full-year fiscal 2011 fall within P&G's guidance ranges. J&J's second-quarter earnings, reported on Jul. 20, were in line with the consensus estimate of $1.21. However, the company slashed its full-year forecast again, after cutting in April. While most would agree that the economy is a major factor weighing down these companies, many would also argue that J&J and P&G are facing problems unique to themselves.

Brian Gilmartin, a

RealMoney

contributor and portfolio manager and founder of Trinity Asset Management, called J&J and P&G "a tail of two different disappointments" -- reflecting a prevailing sentiment in the investment community -- much of which still has the heebie-jeebies regarding P&G's especially pronounced drop during the mysterious Dow "flash crash" that sent the index down by almost 1,000 points on May 6.

TheStreet

spoke with five investment experts to hear their thoughts on where these companies are going wrong and what they must do to improve.

Read on to learn more about where J&J and P&G are going wrong

-- and what they must do to improve; and

click here for actionable investment tips on the two consumer giants.

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Ken Shreve, Manager, TheStreet's Market Movers model portfolio

Where J&J and P&G Are Going Wrong:

J&J --

"Earnings will be negatively impacted by several OTC product recalls and continuing pricing pressure in Europe. In addition, sales of key drugs like epilepsy drug Topamax and Risperdal -- used to treat schizophrenia and depression -- continue to decline due to generic competition."

P&G --

"Put simply, consumers continue to favor lower-cost alternatives to P&G's products. In its latest quarter, higher advertising costs hurt the bottom line."

How to Trade and Invest in Pressured J&J and P&G

What They Must Do to Improve:

J&J --

"J&J needs to continue to do what they've been doing: target emerging markets for growth. In the second quarter, domestic sales in its consumer segment fell 14.3% from a year ago to $1.46 billion, but international sales rose 1.8% to $2.18 billion. It has manufacturing and R&D centers in Brazil, China and India.

"In addition, the company needs to continue to seek out more strategic acquisitions and partnerships. Big pharma has been eyeing biotech in recent years for innovation and J&J is no different. The company announced several deals in 2009:

Acquisition of Cougar Biotechnology boosted its oncology portfolio, especially in the areas of prostate cancer, breast cancer and multiple myeloma.

Acquired all the assets and rights related to Elan's Alzheimer's Immunotherapy Program.

Acquired an 18% stake in Crucell for $440 million. The deal will focus primarily on developing a universal vaccine for the flu.

"J&J's Medical Devices and Diagnostic segment continues to perform well and should be a significant contributor to top-line growth going forward. In this area, J&J recently acquired Micrus Endovascular, a company that develops minimally invasive devices used in stroke treatment."

P&G --

"They need to continue to innovate, which the company is known for doing; more so than J&J. The company must also do better in emerging markets; an area where it's bowed to intense competition in the past. But that's changing under new leadership. Brazil is the primary focus for new CEO Robert McDonald as well as India and parts of Africa.

"P&G investors should feel good about the job new CEO Robert McDonald is doing. He's a West Point graduate so he probably knows a thing or two about battling the competition. In early August, P&G reported earnings. What was noteworthy was that the company increased or maintained its worldwide market share for the first time in 11 years. But expanding market share came at a cost as the company cut prices and advertised."

Stephanie Link, Director of Research & Vice President of Strategy, TheStreet.com

Where J&J and P&G Are Going Wrong:

J&J --

"J&J has been slow to change in a healthcare environment that has been very challenging due to reform and threats from generic drug makers.

"It has struggled recently due to product recalls, margin pressure on its medical device products and from several products that have gone generic. As a result sales and earnings have been decelerating over the last several years. In other words, J&J's problems are more company specific and not necessarily industry issues. Sure, healthcare has had its struggles or challenges this year mainly due to the slowing economy and regulatory reform, but J&J has been slower to react to the changing climate and address its generic exposure. And its product pipeline -- while deep -- is very young and won't fully mature for several years.

"Its quarter fell short of expectations on European drug pricing pressures (an industry wide issue -- although its largest competitor

Abbott Labs

(ABT) - Get Abbott Laboratories Report

didn't feel the squeeze in earnings as it has a better product profile), lower than expected medical technology sales, and volume/pricing/reimbursement pressure. The McNeil recall/OTC issues didn't help, costing the company hundreds of millions -- and, more importantly, created a distraction, in my view. Estimates were lowered after the disappointment.

P&G --

"Nearly all the household products companies posted disappointing earnings in the second quarter, yet P&G posted the strongest in the group in terms of organic growth, gross margin expansion, market share gains and it chose to increase its spending/brand investment by 5% -- to drive future growth. Volumes rose 8% (the fastest in 22 quarters) and accelerated from its March quarter while pricing fell just 1% (no worse than prior quarters) and actually grew 1% in its fiscal 2010.

"It plans on increasing its product flow by 20% to 30% this year and expand into emerging markets, which over the long term will earn it higher market share and growth (it already has a $25 billion emerging market business and will aggressively grow this over the next several years). Guidance was conservative but impressive at 7% to 9% earnings growth (an acceleration from 6% in fiscal 2010) and it also raised its dividend in the quarter (has raised every year on average by 9.5% since 1956). And given the cash it has (it ended fiscal 2010 with $14 billion in free cash flow or 125% of net earnings) it will continue to buy back its shares."

What They Must Do to Improve:

J&J --

"J&J is much better positioned with new management that is dedicated to product innovation and finding new growth -- particularly in emerging market countries. It continues to spend on making its products better and more innovative, resulting in strong consumer demand -- through strong and weak economic times. Its issues in the fiscal fourth quarter were not company specific but rather industry wide, surrounding the weak consumer, and I would argue that as investors dig deeply at the company's financials and compare them to its rivals (

Colgate

(CL) - Get Colgate-Palmolive Company Report

,

Clorox

(CLX) - Get Clorox Company Report

,

Unilever

(UL) - Get Unilever Plc Report

) it is the strongest of the lot.

P&G --

"P&G is in turnaround mode led by a new, aggressive management team dedicated to growth."

Ryan Detrick, Senior Technical Strategist, Schaeffer's Investment Research

Where J&J and P&G Are Going Wrong:

"They haven't done well, but at the same time, the whole market hasn't done well. We're not too different from where we were in November, also specifically since the flash crash. At the same time -- getting to the fundamentals -- there is definitely some concern.

The slowing economy hasn't helped the big cap, blue chip names and for that reason they've underperformed."

How to Trade and Invest in Pressured J&J and P&G

What They Must Do to Improve:

"In terms of investor confidence, things are very similar between J&J and P&G and other blue chip names. You need this market to get out of this range. We are near the upper end of the range, so if the overall market can gain some traction, these names can do well and that could bring confidence to the entire market. 'Confidence' is a good word because there is lack of confidence across the board."

Frank Ingarra, Co-Portfolio Manager, Hennessy Funds

Where J&J and P&G Are Going Wrong:

"What has happened is everyone has been focused on top-line growth. If companies beat on the top line, where they had good guidance, they excelled. Everyone else who didn't, got hammered. J&J and P&G just didn't wow anybody -- then you have that challenge of what's in the pipeline and what's coming off, and that can make some short-term noise."

How to Trade and Invest in Pressured J&J and P&G

What They Must Do to Improve:

"The market has been range bound because of a lack of clarity from Washington. You're not going to see anyone break out until we get through these November elections. So, it's not necessarily just those two stocks that have been underwhelming.

"You can go through any other sector. They've been bouncing between their highs and lows over the last few months. We think that's going to continue to happen until there's some better clarity from Washington to on if they're pro-business or not pro-business. Right now they're leaning not pro-business. With clarity, companies will understand the rules of the game and then maybe start hiring again. And until you get that you're not going to have top line growth and that's not going to help improve the unemployment rate.

"We have four issues from the government right? We have financial reform and how that affects credit; a healthcare bill, which is probably why these two have been getting hammered. We have the possibility of increased taxes. Then with the BP, Gulf of Mexico oil spill -- energy reform is back on the table with carbon credits, which obviously significantly increases costs for companies. We don't seem to have any guidance on these four things, so companies are hoarding cash -- they're not spending it because they don't know the rules of the game.

"Instead, they're acquiring other companies. We're starting to see a pickup in M&A -- because if you can't grow your top line, you want to either defend your market share or find another way to grow -- and that could be through acquisitions in this environment. You make it accretive immediately, so you cut jobs. That just pushes the unemployment rate higher and higher. Right now there seems to be a very negative reinforcement cycle.

"With J&J, people are disappointed in the short-run, but we think they have some great prospects going forward: a very good pipeline, a very good consumer business, even with the market and economy pulling back again."

Brian Gilmartin, CFA, RealMoney Contributor and Founder and Portfolio Manager, Trinity Asset Management

Where J&J and P&G Are Going Wrong:

"They're a tale of two different disappointments. The bottom line with these stocks is there's just not very much growth right now. They're just waiting for the economy and consumer to turn."

J&J --

"J&J has definitely been having some execution problems in terms of their manufacturing ...the recalls. But I think their problems are inherently more fixable than P&G's. They have greater control over the reason for their shortfall.

"They've got three different segments. They've got pharmaceutical, which hasn't been a growth area; consumer, which since 2008 is in the same position as P&G -- and people have cut back on them. The only thing really going for J&J is their medical devices and diagnostics group. Earnings growth has gradually fallen from mid-double digits to low-single digits.

"The forward earnings estimates for J&J are 2% in 2010, 7% in 2011 and 9% in 2012. That's far lower than their historical growth rate. They grew at 19% in 2003, 15% in 2004 and 14% in 2005."

P&G --

"P&G I think is a whole different story -- they're just in the wrong part of the market right now. They're a premium-branded consumer product at a time when consumers don't want to spend for that. Consumers are all about thrift.

"Management has also alluded to that. They're trying to come up with some generic products with lower price points."

What They Must Do to Improve:

J&J --

"My feeling about them is they need to better rationalize expenses; it's a typical conglomerate. In a tough economy, they're just very slow in earnings growth and I think they could help the stock price if they just trimmed some fat -- but they don't seem to be willing to do that. To fix it is to just to cut back on expenses and do a better job rationalizing the income statement.

"Their gross margin in the middle of '08, late '07 was around 71%, 72%; now it's at 69%. Operating income was closer to 30%; it's now at 28%. They're seeing some margin pressure and they're trying to

improve the situation through SG&A (Selling, General & Administrative Expense). SG&A is normally 33%, 32%; they've gotten it to 31%. They may need to cut it further."

How to Trade and Invest in Pressured J&J and P&G

P&G --

"

P&G needs to start thinking of going into a different price point. Their strategy has all been about brand and paying for that brand. Now they're having to compete on price. They're just not used to that. In these developing markets I think they're finally getting that they have to get the pricing right. They're getting volume, but they're having to sacrifice price to do it.

"I think P&G has to wait for the external environment to change before the stock will see P/E expansion."

-- Written by Andrea Tse in New York.

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