2 BioPharma Stocks to Avoid, 1 to Buy

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

While I am generally bullish on the healthcare sector, there are a few expensive producers that have limited growth prospects within the industry. Fortunately, the Street has become overly bearish on the sector due to the string of patent cliffs. Investors who look towards a company's pipeline and momentum for guidance will be well positioned to pick the winners.

Pfizer's (NYSE: PFE) Risk/Reward Is Better Than Merck's (NYSE: MRK)

From a multiples perspective, Pfizer is more attractive than Merck. It trades at 11.2x forward earnings versus 12.9x for its competitor. Both offer dividend yields of around 3.5% and 30% reduced volatility against broader indices. But, in my view, only Pfizer is meaningfully undervalued.

Over the last 5 quarters, Pfizer has consistently beaten analyst expectations - ultimately, by an average of 7%. In contrast, Merck has beaten expectations by only an average of 2.3%. Yet, over the last six months, Merck has generated a return of 25%, which outperformed Pfizer by around 900 bps. I expect the market to even out this return differential as Pfizer's superior pipeline kicks in.

Which brings me to my second point: Pfizer has excellent products. Its Zyvox antibiotic was recently shown to be effective in combating a lethal form of tuberculosis. Negative side effects were also meaningfully reduced with lower dosing. Chantix similarly met primary and secondary endpoints in helping depressed patients stop smoking. And even though Inlyta just barely missed its Phase III primary endpoint in treating advanced kidney cancer, the research still provides a strong foundation for subsequent attempts. It is this kind of performance that will allow shares to elevate as drugs are brought into the market.

While Merck has several catalysts, like a treatment for osteoporosis that was shown to increase spinal density in a Phase II trial, growth potential looks relatively weak (all things considered). Analysts forecast only 4.8% annual EPS growth over the next 5 years, which is a weak turnaround from flat earnings over the past 5 years.

Johnson & Johnson (NYSE: JNJ) Likely To Underperform

In my view, J&J is also likely to underperform. While it is relatively strong on the balance sheet, with a debt-to-equity ratio of 0.3x, future growth opportunities are quite limited. Analysts forecast the company growing EPS by 6.7% annually over the next 5 years. This implies 2016 EPS of $6.66, which, at a multiple of 16x translates to a future stock value of $106.56. Discounting backwards by 8% yields a present value of $72.52. This in-line with the current market assessment.

While third quarter EPS of $1.25 was $0.04 ahead of expectations, outlook is relatively weak. Moreover, EPS still declined 7%. From the introduction of a 2.3% excise tax on medical devices as a result of the healthcare law to increasing competition, J&J has had to downsize in recent years. Consumer sales have also been weak, with a decline of 4.3% in the recent quarter.

I am also hesitant due to the company's $19.7 billion acquisition of Synthes in 2Q 2012. This manufacturer of implants for broken bones will help the company capitalize in demand in China and India, but limited money from patients and an uncertain insurance market could make for some negative earnings surprises.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Johnson & Johnson. Motley Fool newsletter services recommend Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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