Amgen More Undervalued Than Johnson & Johnson

Includes: AMGN, JNJ
by: Takeover Analyst

Given concerns about domestic economic stagnation, I believe that some of the most attractive investments can be found in biotechnology. With inelastic products and relentless innovation, the industry provides an ideal hedge for risk-averse investors. I am currently bullish on Amgen (NASDAQ:AMGN) and reserved on Johnson & Johnson (NYSE:JNJ) (see here).

From a multiples perspective, Amgen is the cheaper of the two. It trades at a respective 14.6x and 10.3x past and forward earnings, while J&J trades at a respective 15.7x and 12.3x past and forward earnings. Although J&J offers a strong dividend yield of 3.5%, gross margins are around 1,310 bps higher at Amgen (82.6%). The Street currently rates both companies a "buy".

At the third quarter earnings call, Amgen's CFO, Jon Peacock, nevertheless noted a significant increase to operating expenses:

Overall, revenues grew 3% in the quarter. Excluding ESAs, product sales grew 13%, reflecting strong growth across the portfolio, particularly on Europe franchises...

Operating expenses grew by 11% compared to the third quarter of 2010. More than half of the increase was driven by the Puerto Rico excise tax for which we benefit from an offsetting foreign tax credit further down. Foreign exchange movements on our international costs and the U.S. health care reform fee.

The balance of the increase in operating expenses, which was explained by research and developments in SG&A, research and development increased 11% year-on-year driven by our late-stage clinical program costs. But quarter-on-quarter, R&D costs declined by $45 million. SG&A increases were driven by investments in the expansion of our international operations and in the launch of XGEVA.

In October, the firm's core products also had poor performance. Neupogen was weak, while Aranesp and Neulasta sales were a complete miss. New products - such as Xgeva and Prolia - may be experiencing strong growth, but shareholder value largely depends on the turnaround of the legacy products. Thankfully, Amgen reached a 7 year contract with DaVita (NYSE:DVA), which will help to de-risk the business and provide virtually guaranteed business. The arrangement is that the former will provide at least 90% of the domestic EPO requirements - this provides greater certainty to Espogen and other products.

Consensus estimates for Amgen's EPS are that it will grow by 1.9% to $5.31 in 2011 and then by 7.3% and 11.8% more in the following two years. Assuming a multiple of 15x and a 2012 EPS estimate of $5.65, the stock could eventually break $84.75 for 44.6%. While I do not believe that this market value will be realized, I am nevertheless attracted to the limited downside or, more precisely, the lack thereof. If the multiple plummets to 11x and 2012 EPS turns out to be 3.5% below the consensus at $5.50, the stock still appreciates.

As for J&J: there is significant concern that the company's Xarelto drug will not meet market expectations. On the other hand, the consumer segment - which includes, LISTERINE, TYLENOL, ZYRTEC, etc. - continues to experience strong demand. Moreover, Zytiga, Edurant/Complera, Incivo, and even Xarelto are performing strongly. Incivo is expected to be introduced in Europe sometime within the next two quarters while Invega Sustenna for schizophrenia continues to drive solid growth.

Consensus estimates for J&J's EPS are that it will grow by 4.4% to $4.97 and then by 5.4% and 7.4% more in the following two years. Assuming a multiple of 15.5x and a conservative 2012 EPS estimate of $5.19, the rough intrinsic value of the stock is $80.456 for 24.7% upside.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in AMGN over the next 72 hours.