Johnson & Johnson — 3 Pros, 3 Cons

by Tom Taulli | April 27, 2011 2:05 pm

As expected, Johnson & Johnson (NYSE:JNJ[1]) has agreed to purchase Swiss-American medical device maker Synthes.  The price tag: a hefty $21.3 billion, which consists of a blend of cash and stock.  The deal is actually J&J’s largest in its 125-year history.

Wall Street likes the transaction.  Over the past week, as rumors of the deal slinked through the market, the stock price of J&J has gone from $59 to $64. 

But will the acquisition really be a positive?  And will J&J’s stock continue its momentum?

Let’s take a look at the pros and cons of the stock:

Pros

Diverse platform.  J&J is a leader in healthcare, which sets it apart from purer-play drug companies like Pfizer (NYSE:PFE[2]) and Merck (NYSE:MRK[3]).  For example, J&J has a massive consumer business, which includes skin care, oral care, over-the-counter products and baby care.  But it also has a high-profit pharmaceutical business, with products in immunology, pain management, oncology and oncology.  And of course, J&J has a thriving medical devices and diagnostics business. 

The Synthes deal.  The new acquisition is a leader in the market for surgical devices, with a focus on orthopedic devices.  Actually, it has twice the market footprint of its main rival, Stryker (NYSE:SYK[4]).  What’s more, Synthes has juicy operating margins of roughly 35%. 

However, the valuation is a bit steep, coming to about 18 times earnings.  But high-quality companies like Synthes always come at a premium.

 Solid financials. J&J is a cash machine.  In the last quarter, the company posted sales of $16.2 billion and earnings of $3.5 billion.  J&J also sports an AAA-credit rating.

Cons

Quality issues.  Since 2010, J&J has issued more than 50 drug and device recalls as the company has experienced problems with its manufacturing system.  This has been a major distraction and a hit to the company’s reputation.  Also, the efforts to pull off the Synthes deal may suggest even less focus on solving its quality-control problems.

Drug pipeline.  As is the case with all the major drugmakers, J&J will have a variety of major drugs that will lose their patent protection.  The result will be a spike in competition from its generics rivals, meaning margins are likely to fall.

Regulation.  A hot-button topic in the U.S. budget battles is healthcare.  Expenses continue at a rapid rate and there is talk about cutting government programs.  No doubt, these moves can put pressure on J&J.

Verdict

J&J has proved to be a good acquirer, and its approach has generally been to give much autonomy to its various units, which allows for more growth and innovation.

And, in the case of the Synthes deal, it should be transformative.  The company is in a fast-growing market and should help improve margins for J&J. 

At the same time, the company is trading at an attractive valuation, with a price-to-earnings ratio of 14, and the dividend brings in a yield of about 3.4%. 

When looking at all these factors, the pros outweigh the cons on the shares of J&J.

Tom Taulli’s latest book is “All About Short Selling[5]” and his Twitter account is @ttaulli[6].  He does not own a position in any of the stocks named here.

Endnotes:
  1. JNJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=JNJ
  2. PFE: http://studio-5.financialcontent.com/investplace/quote?Symbol=PFE
  3. MRK: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRK
  4. SYK: http://studio-5.financialcontent.com/investplace/quote?Symbol=SYK
  5. All About Short Selling: http://www.amazon.com/All-About-Short-Selling/dp/0071759344/ref=sr_1_1?s=books&ie=UTF8&qid=1302184310&sr=1-1
  6. @ttaulli: http://twitter.com/#!/ttaulli

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