Johnson & Johnson CEO Bill Weldon's painful year

FORTUNE -- What started last year as a series of small drug recalls at Johnson & Johnson exploded this summer into a full-blown crisis in quality control. But for months there was nary a peep from CEO Bill Weldon.

It wasn't until late August, after McNeil Consumer Healthcare, the division of J&J (JNJ, Fortune 500) that makes over-the-counter drugs, had instituted eight recalls, that Weldon emerged, granting multiple interviews in which he promised to rectify McNeil's quality problems. He told Fortune that he had created a new position: an operations chief who will oversee quality across J&J and report directly to him. Weldon also said the company had been busy inspecting facilities at all of its 250 operating companies, adding, "This is not a systemic problem at J&J." [For a diagnosis of what went wrong, read "Why J&J's headache won't go away."]

That assertion was quickly undercut. About a week after Weldon proclaimed McNeil an anomaly, the company issued two more recalls -- both in divisions completely separate from McNeil. One was for contact lenses made by Vision Care, and the other involved hip implants made by DePuy.

Meanwhile, Weldon's plan to install a new quality czar has rankled some staffers, who say he is resurrecting a concept that was dismantled under his watch. According to four former employees, J&J had a corporate compliance group that oversaw all of the different companies, but it was drastically cut down in 2007. The group, helmed by Corporate Compliance Officer Brenda Davis, conducted tough biannual audits of J&J's operating companies and helped set up "management action plans" for improving quality control. Davis, who left the company in 2007, did not respond to requests for comment. A J&J spokesperson declined to comment for this article.

"The whole idea was creating a Hawthorne effect: If people know they're being watched, they'll do better," says one former J&J executive. After the group was cut, he says, some divisions lost their focus on quality. "The heads of the operating companies let their hair down."

Weldon told Fortune that the company had made "significant investments" in refitting McNeil's factories -- one of which will be shuttered until next year -- increasing automation and hiring third party experts to assess the company's manufacturing processes. He also said J&J had begun implementing a company-wide quality plan a year and a half ago, which resulted in the creation of the new corporate compliance team. "My expectation of this group is that, as good as we do manufacturing at J&J, we'll take it to a completely new level," he says.

But corporate image experts say Weldon needs to make a grander gesture to restore faith in the brand. "At this point, it's no longer about the specific incidents, but the underlying process," says Daniel Diermeier, a professor at Northwestern's Kellogg School of Management. "That requires a pretty heavy push driven beyond just appointing another person."

J&J announced in July that the McNeil recalls will cost the company some $600 million. That's a small dent in J&J's $62 billion in annual sales, but analysts fear that the highly profitable McNeil business could suffer from permanent reputational damage. "The steady drip is at a modest pace eroding investor confidence," says Les Funtleyder, an analyst at Miller Tabak.

Weldon, who has kept a low profile for the majority of his eight-year tenure, must now fight to salvage not just McNeil's reputation -- but his own. Surveys of business executives conducted by CoreBrand show that favorability ratings of J&J's management have dropped from 88.3% in 2006 to 80.9% last quarter. That's a significant decline, according to Jim Gregory, the branding firm's CEO. "There's something not right here that needs attention," Gregory says. "[Weldon] needs to change it -- or there needs to be a change of management."

J&J employees often speak of Weldon's predecessors -- James Burke and Ralph Larsen -- in hushed tones, rehashing stories of how those vaunted leaders managed through crises. Weldon has not engendered that sort of veneration. But his supporters point out that the CEO has faced a very different sort of challenge: A decade of slowing growth for the entire healthcare industry.

The Brooklyn-born son of Broadway stage workers, Weldon is known internally as a tough competitor who hates to lose. He joined the J&J's sales force straight out of college -- the CEO told Fortune in 2002 [see: "Can J & J keep the magic going?"] that he wanted to be a doctor, but couldn't afford to go to medical school -- and was named head of J&J's device-maker Ethicon Endo-Surgery in 1992. At the time, Ethicon was a small player in the surgical device industry, which was dominated by rival U.S. Surgical. Weldon took U.S. Surgical head on by aggressively investing in Ethicon's business, and over the next few years the company's market share grew from 9% to over 50%.

When Weldon became CEO of J&J in 2002, the company was living large off high-margin drugs like Topamax, which treats migraines and epilepsy, and antipsychotic medication Risperdal. Those blockbuster drugs have lost their patent protection in recent years and J&J's lucrative drug-coated stent has ceded much of its market share. The company has battled pricing pressure and weakened demand during the recession.

As J&J's sales growth slowed, turning negative last year for the first time in decades, Weldon fought back with layoffs -- the biggest cuts in J&J's history and acquisitions. His dealmaking record is mixed. Before he became CEO, he spearheaded the successful $12 billion purchase of Alza, which made Concerta, an attention deficit disorder treatment that is still a breadwinner for J&J. His purchase of Scios, a biotech, was less fruitful, as the company's heart-failure drug was later linked to medical problems.

Analysts say J&J lucked out when it lost a bidding war for device-maker Guidant, which was bought by Boston Scientific (BSX, Fortune 500) for $27 billion, a deal that Fortune derided as a bomb. [See: "The (second) worst deal ever."] Shortly after that, Weldon purchased Pfizer's consumer health unit for $16.6 billion. Critics balked at the high premium, but the buy is now viewed as a prescient move by the CEO, who expanded the company's roster of stable consumer brands before the recession hit. "That looks smart for J&J, and dumb for Pfizer," says Miller Tabak's Funtleyder, who gives the company "a solid B" for its performance over the last decade.

J&J's stock remains well-liked by analysts, largely because of its best-in-class balance sheet (it recently issued 10-year bonds with the lowest yield ever) and diversified business model. Since the end of 2002, the stock has returned about 3.5% annually; worse than the S&P 500's 5% return, but slightly better than the S&P 500 healthcare index because of its high dividend yield.

Organic growth, however, has been elusive in recent years. David Lewis, an analyst at Morgan Stanley, says he recently downgraded the stock after he realized that J&J has derived almost all of its operating leverage since 2006 from cuts to R&D and savings from the Pfizer Consumer Health acquisition. J&J's annual revenue has jumped by about 70% since 2002, but its headcount has increased only 7%. Weldon has boosted sales per employee at a faster rate than rivals such as Procter & Gamble (PG, Fortune 500), Pfizer (PFE, Fortune 500), or Medtronic (MDT, Fortune 500).

Though the company is famously diversified, Lewis says, "it's deriving its growth from similar mechanisms to large pharma." Referring to J&J's higher-than-average valuation, he adds, "You have to ask yourself: Why are we paying the same historical premium?"

Though some corporate image pundits have called for the CEO to resign, insiders say Weldon is unlikely to depart before next year, when he will be 62, the age at which J&J leaders typically retire. In fact, two former executives say Weldon may stick around even longer. He has reportedly told his board, one says, that his two younger heirs apparent, Sheri McCoy, the head of J&J's pharmaceuticals sector, and Alex Gorsky, the head of medical devices, aren't prepared to assume his role.

One of the executives, who declined to be named because he still works in the pharmaceutical industry, says Weldon's lack of a clear replacement is a huge "blind spot." Says the other: "At this stage in the game, orderly succession should be in place." Over the last few years, a number of high-ranking J&J staffers have left well before retirement age, including former pharmaceutical chiefs Joseph Scodari and Christine Poon.

According to former employees, there is also talk of replacing Weldon with a high-profile outsider who comes from the world of medical devices or consumer products. One name that's been bandied about: Susan Arnold, the former P&G executive who was widely considered a CEO candidate and left shortly before COO Bob McDonald was picked for the job. If Arnold, who did not respond to requests for comment, were picked to run J&J, she would be the first outsider to run the company in its more than 120-year history.

Update: J&J responds

Shortly after this story posted, a PR person from J&J responded, saying, "The product recalls by DePuy Orthopaedics and Johnson & Johnson Vision Care are unrelated to the manufacturing and quality issues being addressed at McNeil Consumer Healthcare. When product recalls become necessary, they reflect our commitment to do what's in the best interest of those who use our products."