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Shares of Johnson & Johnson (JNJ) hardly moved in Monday's trading session following the announcement of the acquisition of Aragon Pharmaceuticals. While the deal is an excellent addition to the firm's oncology drug business, and I like the overall business prospects, I remain on the sidelines on the back of the premium valuation.

The Deal

Johnson & Johnson announced that it has entered into a definitive agreement to acquire Aragon Pharmaceuticals. Johnson & Johnson will pay $650 million for the privately-held pharmaceutical discovery and development company.

Aragon has a leading product candidate, ARN-590, currently in Phase 2 development for castration resistant prostate cancer. Dependent upon a successful outcome of this product candidate, Johnson & Johnson will make additional contingent payments of $350 million based if Aragon reaches its predetermined milestones.

All other existing activities of Aragon will be transferred into a new company which will be spun off and will not become part of, nor owned by, Johnson & Johnson. The new company will be called Seragon Pharmaceuticals. Peter F. Lebowitz, who is Johnson & Johnson's Global Therapeutic Area Head, commented on the rationale behind the deal,

The acquisition of Aragon further enhances our leadership in prostate cancer drug development. Prostate cancer is one of our main areas of focus, and we are pleased to be adding ARN-509 to our portfolio.

The transaction has already been approved by the board of directors of both companies. The deal is subject to normal closing conditions including regulatory approval and is expected to close in the third quarter of this year.

Valuation

Johnson & Johnson ended its first quarter with $21.7 billion in cash, equivalents and short-term investments. The company operates with $15.9 billion in total debt, for a solid net cash position of around $5.8 billion, giving it plenty of liquidity to make these kind of deals.

The company generated annual revenues of $67.2 billion for 2012, up 3.8% on the year before. Net earnings rose by 12.2% to $10.9 billion. Trading around $86 per share, the market values Johnson & Johnson at $242 billion, or its operating assets at $236 billion. This values the firm at 3.5 times last year's annual revenues and 21-22 times annual earnings.

Johnson & Johnson currently pays a quarterly dividend of $0.66 per share, for an annual dividend yield of 3.1%. There is little room for spectacular dividend hikes, after the company recently hiked its dividend by five cents per quarter, currently paying out 68% of last year's profits.

Some Historical Perspective

Long-term investors in Johnson & Johnson have seen decent returns. Shares rose from $50 in 2003 to highs of $70 in 2008. Shares fell back towards the $50 mark in 2009, to recover towards $70 in 2011. Shares have already risen more than 20% so far in 2013, trading hands at $86 per share, after peaking at all time highs of $90 in recent weeks. Between 2009 and 2012, the company has increased its annual revenues by a modest cumulative 8-9% to $67.2 billion. Net earnings fell by 11-12% in the meantime to around $10.9 billion.

Investment Thesis

Investors reacted somewhat favorably towards Johnson's acquisition of Aragon Pharmaceuticals. Four years ago, the company already acquired the Zytiga cancer drug when it acquired Cougar Biotechnology for $1 billion. The drug has been a huge success, used by more than 60,000 patients. Zytiga generated first quarter revenues of $344 million, up 72% on the year before.

Still, a potential market entrance of ARN-509 is not likely for a few more years. Unlike Zytiga, ARN-509 has the potential to help as well for patients in whom cancer has not spread yet. Combining both technologies and drugs could ease the pain from competition arriving in 2016 when generic drugs will impact Zytiga's sales.

If approved, the potential new ARN-509 drug would have market exclusivity until 2028. Johnson & Johnson is still awaiting late-stage trials to assess the methods of usage of ARN-509, including the possibilities of whether it would be used in combination, or sequentially, with Zytiga.

The acquisition, with total potential deal value of $1 billion, is just a drop in the bucket for a firm like Johnson & Johnson. The acquisition of Aragon is a perfect addition, boosting its drugs pipeline in the growing oncology cancer market. The firm has a good track record and knowledge about the market with its Zytiga drug. While short-term oncology revenues will be solid, the firm needs a replenishment for the long-term future.

The acquisition is excellent, diversifying Johnson's operations, while the firm maintains a solid balance sheet. These kind of deals bolster future revenue and earnings growth, allowing the company to pay a fat dividend yield of 3.1% in the meantime, despite shares trading near all-time highs.

While I like the deal, and the overall company, I am not a buyer around all-time highs. Given the significant run-up in the shares so far in 2013, and a premium valuation, I would be a buyer on significant dips.

Source: Johnson & Johnson: Aragon Pharmaceuticals Is An Excellent Addition For Its Oncology Unit