Both companies are struggling and the market is overvaluing them

Johnson & Johnson (NYSE:JNJ) posted a profit decline?in the?third quarter. It’s suffering from a boatload of self-inflicted wounds — demonstrating just how difficult it is for a long-time market leader to adapt to change. Would drug-maker Forest Laboratories (NYSE:FRX) be?a better bet?

The health care industry used to be so cozy and profitable. R&D money led to patented products with high prices. Profits went into giving doctors fancy vacations, touted as science seminars,?so they’d prescribe their patented products to patients.

But that cozy world is gone forever. Here are three reasons why:

• Pharmacy Benefit Managers (PBMs) — they negotiate with drug companies on behalf of corporate health plans — now decide which drug to prescribe, not doctors.
• Generic pharmaceutical makers make off-patent drugs at much lower prices and they always get the PBM nod of approval.
• Biotechnology companies are much better at developing new drugs than the pharmaceutical R&D labs that keep spending more and more money for fewer and fewer blockbuster drugs.

Companies that used to prevail in the good ol’ days are now threatened by all these changes. And it seems that often, they just decide to punt by finding a merger partner and hoping that cost-cutting will help fix their basic problem — an inability to adapt to change.

Tuesday’s third-quarter financial report from Johnson & Johnson reflects some of these problems. Its profit was down 6% thanks to product recalls in its implants and stents, more competition from generic drugs and the costs of an acquisition — its $21 billion acquisition of?medical device maker Synthes will close in June — all this bad news dwarfed the?benefits JNJ got from higher foreign sales.

The good news for JNJ shareholders is that the company beat expectations. The 6% drop in ! net inco me to $3.2 billion yielded adjusted EPS of $1.24 — three cents?ahead of analysts’ estimates. But J&J fell just $20 million short of the $16.02 billion in sales that analysts?were expecting. Nevertheless, those revenues were up 7% — but half of that came from “favorable currency exchange rates,” according to Associated Press.

With all these problems, would investors be better off owning Forest Labs? In?a word, no. In Tuesday’s?second-quarter report,?Forest disappointed investors. Its?net income fell 13% to $249.8 million on a 7.3% rise in revenue to $1.17 billion. But its adjusted EPS of?91 cents a share was eight cents below expectations — although it beat revenue forecasts by $10 million.

Does this mean you should avoid both stocks? Yes. Here’s why:

• Johnson & Johnson: No growth, but strong margins; expensive stock. While JNJ’s revenues have dropped 0.5% to $64.4 billion in the past 12 months, net income has climbed 8.7% to $11.4 billion — creating a strong 17.7% net profit margin. Its PEG of 2.22 (where a PEG of 1.0 is considered fairly priced) is expensive, however, on a P/E of 13.1 and expected earnings growth of 5.9% to $5.25 in 2012.
• Forest Laboratories: Good growth, high margins; but plunging profit forecast. Forest Labs’ revenues climbed a decent 5.4% to $4.5 billion in the past 12 months, while net income jumped 53.4% to $1.19 billion — yielding a whopping net profit margin of 25.1%. Its PEG is undefined, though, because its trades at a P/E of 8.8 and its earnings are expected to plunge 67% to $1.22 in fiscal year 2013.

Just because an industry is big and important doesn��t mean you should invest in it. Johnson & Johnson and Forest Labs appear to be saddled with too much baggage to make the agile moves needed to earn an attractive return on their shareholders�� investment.

As of this writing, Pe! ter Coha n did not own a position in any of the aforementioned stocks.