Is Johnson & Johnson A Strong Buy Candidate?

| About: Johnson & (JNJ)

By Renee O'Farrell

The pharmaceutical industry is just like horse racing. The companies are the stables, the drugs are the horses and the methods the drugs can be used are like the different types of races or events. It is certainly just as competitive - and no wonder. There is a lot of money to be had for producing a "winner," and it seems like only the top handful of companies ever produce those winners, barring the occasional long-shot. And, like horse racing, there are a lot of lawsuits alleging shady practices.

A good example of this is healthcare giant Johnson & Johnson (NYSE:JNJ) suing several drug manufacturers for, allegedly, planning to market generic versions of Bystolic, a hypertension drug developed by Forest Laboratories (NYSE:FRX) and Johnson & Johnson's Janssen Pharmaceutica NV, before the patent expired. Forest Labs is also named as a plaintiff in the matter. The suit claims that the pair have a patent on Bystolic that does not expire until December 2021. They claim that, as a result, when Watson Pharmaceuticals (WPI) filed a new drug application with the FDA for its generic version of the drug it was allegedly violating that patent. Johnson & Johnson and Forest Labs also filed suit against Amerigen Pharmaceuticals, Glenmark Pharmaceuticals, Hetero USA and Torrent Pharmaceuticals, and others, for the same allegations.

Johnson & Johnson, the company that makes Splenda, Tylenol, Motrin and Concerta among other brands, seems to be on the right side of the legal divide lately. It escaped being named in the lawsuits filed by outreach organization Community Catalyst in early March. Community Catalyst filed suit against several big name pharmaceutical companies, like Pfizer (NYSE:PFE) and Merck (NYSE:MRK), alleging that when these companies issue coupons that allow consumers to buy premium drugs for pennies on the dollar, often to the expense of generic substitutes, it raises insurance premiums and causes them to max out their benefit caps more quickly.

Johnson & Johnson also recently gained EU approval for its $21.3 billion deal to buy the Swiss medical devices company Synthes. The approval is expected to come before the EU's original deadline, which was set for April 26. If approved, which it is rumored to be, it will be the largest deal in Johnson & Johnson's history. The deal is important because medical devices and diagnostics accounted for over 40% of Johnson & Johnson's turnover in 2010 and the acquisition will allow the company to more effectively compete in that arena.

Yet, in spite of being able to avoid such legal issues, Johnson & Johnson is really only moderately-positioned. The company managed to grow its revenue by almost 4% compared to the same quarter last year, but that fell short of its industry's average of 4.3% for the same period. Further, in spite of the modest increase in revenue, Johnson & Johnson's profit margins shrank. In turn, net operating cash flow flew almost 10% and its net income fell dramatically, decreasing almost 89%, from $1.94 billion to $218 million. Moreover, Johnson & Johnson's numbers aren't just low compared to its historical performance - the company's performance is low compared to its peers.

Johnson & Johnson is currently trading at roughly $65 a share with a $2.28 dividend (3.50% yield). At this price, the company is trading at just 12 times its forward earnings, which is significantly lower than its peers' average forward price to earnings ratio of roughly 17. When that happens, the difference is usually owing to a market inefficiency or a stock that has poor growth prospects. In this instance, I think that Johnson & Johnson is plagued by a combination of the two. However, I doubt the news of Johnson & Johnson's acquisition of Synthes is included in its growth estimates. The news could be a game changer.

According to Yahoo Finance, analysts expect the company's earnings will grow by just 2.20% this year, versus expectations of 39% for the industry. Next year is no better. Analysts predict Johnson & Johnson's earnings will increase by 6.50% while expecting its industry to grow almost 22%.

That said, Johnson & Johnson did manage to return roughly 11% over the last 52 weeks, outpacing the market by almost 2%, and it looks like the company is expected to pick up the pace after next year. In spite of the large differences in expectations over its income this year and next compared to its industry, analysts say that its earnings will grow by an average of 5.80% per annum over the next five years, versus 6.88% for its industry - only a marginal difference.

The company's outlook in other areas is decent as well. For instance, analysts say this stock will go for somewhere between $64 and $90 a share within the next year - so upside is generally expected. In other words, Johnson & Johnson is an "OK" stock. I'd recommend it as a buy but I think its price will fall lower before it goes back up, so I am going to say this one is a hold, for now, but keep it on your watch list. The price could swell dramatically after the Synthes acquisition is finalized.

Johnson & Johnson competitor Pfizer is also on my list of stocks to watch. The company is in a stronger position than Johnson & Johnson. It was able to grow its gross profit margin almost 85% from the same quarter last year. It also has a better net gross profit margin than Johnson & Johnson, but it didn't have the same revenue success. In fact, its earnings actually fell 3.5%, which pushed its earnings per share south. Pfizer also lacks the same earnings growth estimates of Johnson & Johnson. Analysts say that Pfizer's earnings will grow at a rate of less than 3% on average a year over the next five years - hardly show-stopping.

However, in spite of that, Pfizer really doesn't look that bad. According to Yahoo Finance, analysts give the company a one-year target range of $19 to $30, which isn't too bad considering Pfizer is currently trading at just under $22 a share and pays an 88 cent dividend (4% yield). Over the last 52 weeks, the company has gained almost 10% in share price, which is definitely encouraging including its dividend. Pfizer is also priced lower than Johnson & Johnson, with a forward price to earnings ratio of over 9.

I like Pfizer. It has solid numbers and a good outlook. The company recently partnered with Emergent Biosolutions (NYSE:EBS) to develop SBI-087, an autoimmune drug that is being developed as an aid in rheumatoid arthritis, systemic lupus erythematosus and other autoimmune diseases. The deal is encouraging. It lets Pfizer do what it does best - bringing pharmaceuticals through testing to market and everywhere in between - while playing off of Emergent's experience in autoimmune therapies.

It all sounds good but, again though, Pfizer has that lawsuit pending against it from Community Catalyst. I'm sure the suit will take a few years to actually come to a verdict - that's how these things usually go - but it is hard to say how a negative verdict could affect the company. As such, I like Pfizer as a shorter-term, wait-and-see sort of position. It is on my watch list. I am much more encouraged about Johnson & Johnson.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.