Biotech Stocks Will be Fueled by Takeovers in 2011

[Editor's Note: This special report on the biotech sector is part of Money Morning's annual "Outlook" series, which is forecasting the prospects for commodities, U.S. stocks and other top profit opportunities in the New Year. Make sure to watch for upcoming installments in the days to come. Click on the "Outlook 2011" logo to see past installments.]

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While a number of companies are on the verge of hitting the market with exciting new drug products or medical treatments, the biggest 2011 profits for investors in the biotech stocks are more likely to come from mergers and acquisitions  (M&A) than research and development (R&D).

That's because mergers and buyouts in the industry have far outpaced the sector's overall growth rate, which in recent years has been sluggish. Indeed, IMS Health, a leading research and analytical firm serving the pharmaceutical and medical industries, projects only a slight increase in worldwide growth in 2011 - 5% to 7% versus a pace of 4% to 5% this year - with a similarly restrained outlook stretching out to 2015. 

By contrast, virtually every major player in pharmaceuticals worked at least one M&A deal in 2010. That trend is expected to continue, if not accelerate, in the years ahead as drug companies look to broaden product lines, replace revenues lost to patent expiration and expand into emerging markets, where the industry growth rate is much higher in than in the developed nations.

It's also much more economical for big companies to acquire potential new "blockbuster" drugs - those with an annual market potential of $1 billion or more - by buying smaller specialized firms with products already well along in the development "pipeline" than it is to fund the prolonged research, testing and approval process from scratch. A few examples of recent major buyouts include:

  • Johnson & Johnson's (NYSE: JNJ) buyout of California-based medical-devices maker Micrus Endovascular Corp.; its agreement to acquire all rights to Elan Corporation's (NYSE: ELN) Alzheimer's Immunotherapy Program (AIP); and its September announcement of intent to complete acquisition of Crucell NV, a Dutch firm  specializing in the discovery, manufacture and commercialization of vaccines.
  • Pfizer Inc.'s (NYSE: PFE) announced acquisition of King Pharmaceuticals Inc. (NYSE: KG) in order to boost its position in the pain-management market.
  • Bristol-Myers Squibb Co.'s (NYSE: BMY) $2.4 billion buyout of Medarex Inc., a specialist in manufacture of antibody-based drugs, in a bid to broaden its research into treatments for cancer and immunologic conditions such as arthritis, lupus and psoriasis.
  • Abbott Laboratories' (NYSE: ABT) April acquisition of Facet Biotech Corp., a developer of drugs to treat various types of cancer, including chronic lymphocytic leukemia.
Biotech  Stocks Will be Fueled by Takeovers in 2011 Money Morning only the news you can profit from Outlook 2011
The biotech industry is actually much broader than just drugs, therapeutics and medical devices. It also encompasses companies engaged in biological research of technologies for agriculture, bio-fuels and even environmental protection. As an example, Bayer AG (PINK: BAYRY), best known for its aspirin products, actually gets a major stream of revenue from its Crop Sciences Division.

However, pharmaceuticals and medicine dominate the biotech industry - and they are the source of many of the obstacles to strong future growth. Notable challenges include:

  • A number of significant patent expirations, allowing for increased competition from generic drugs. In 2011 alone, pharmaceutical products generating annual sales of more than $30 billion will lose their patent protection. This includes drugs such as Lipitor, Plavix, Zyprexa and Levaquin, which together accounted for more than 93 million 2010 prescriptions in the United States alone.
Still more drugs will lose patent protection in 2012 - and, by 2015, prescription medicines that currently generate annual sales of $142 billion will face generic competition. In spite of the wave of mergers and acquisitions, it's unlikely the industry can bring new products to market that will generate anywhere near the same level of revenue - especially in the blockbuster category, which saw just 14 new entries in 2009, generating combined sales of $50.7 billion. IMS Health sees a further decline in this area, with approval and launch of just five new blockbuster products expected in 2011. 

  • A shift in growth patterns in world markets. A significant portion of the 5% to 7% growth expected in 2011 will come from the 17 countries the industry refers to as "pharmerging markets" - countries like China, India, South Korea, Indonesia, Brazil, etc. Sales growth of 15% is forecast in those markets, many of which are benefitting from increased government spending on healthcare and broader private health coverage for workers. Total sales of up to $180 billion are projected, with $50 million of that coming from China alone, where the growth rate is expected to exceed 25%.
By contrast, growth of just 1% to 3% is forecast for the major European markets and Canada, with 3% to 5% growth predicted in the United States, which is still the world's largest drug consumer with 2011 sales expected to hit $320-$330 billion, up from $310 billion this year.

  • A tougher regulatory environment in the developed countries. The U.S. Food & Drug Administration and many foreign regulatory bodies are becoming more reluctant to grant initial approval for new drugs in the face of numerous recalls and growing safety concerns among the public.
  • Pressure from governments and private insurers to reduce medical and drug costs. Governments in virtually all of the developed countries are pushing cost-cutting measures, including increased use of generic medications, mandatory price cuts for brand-name drugs and elimination of rebates. Private insurers are increasing requirements for pre-authorization of treatments and higher cost-sharing percentages for patients.
  • Shifting government attitudes are also reflected in a reduction of research funding. The New York Times recently reported that the change in power in Congress in the wake of the November elections could result in a 12.3% reduction in President Obama's requested budget of $65.9 billion for non-military medical research and development. Those cuts would reportedly take $2.9 billion from the National Institutes for Health (NIH) and more than $1 billion from the National Science Foundation (NSF).   
  • An increase in demand for specialty drugs and medical products to meet the needs of smaller patient groups, such as those with so-called "orphan" diseases. Such drugs, while often approved by regulators on a fast-track basis, typically have high development costs relative to projected revenues.
  • Rapid growth in demand due to the unmet needs of an aging population. While this represents opportunity and large potential profits for biotech and pharmaceutical companies, it also puts a strain on development budgets and requires reallocation of resources. For example, everything from manufacturing space to marketing budgets may need to be redirected from products where low-cost generics are available to new therapies where patent protection can be maintained.
URCH Publishing, a specialty healthcare publisher, identified six major classes of biomedical research in a recently released report, Pharmaceutical Market Trends, 2010-2014. They are alimentary/metabolism, antineoplastic/immunomodulatory, anti-infectives, central nervous system (CNS) biomarkers, cardiovascular systems and respiratory systems.

I'm not going to waste your time trying to define each class in detail. Rather, I'll just note that key therapies on which many biotech companies are currently focusing include stroke prevention and treatments for various heart conditions, melanoma, multiple sclerosis, breast cancer and hepatitis C. Vaccines for several types of cancer, HIV and other diseases are also being researched, as are numerous therapies using both embryonic and adult stem cells for regenerative treatment of spinal energies, eye diseases such as age-related macular degeneration (which afflicts more than 30 million worldwide) and other degenerative diseases.

From an investment standpoint, the companies doing this innovative and potentially game-changing biotech research offer tremendous opportunity. If a therapy makes it to market and gains medical acceptance, it could join the ranks of the 125 pharmaceutical products that generated more than $1 billion in global sales in 2009, sending the company's stock through the roof.

As an example, the stock of a company called Dendreon Corp. (DNDN) traded for years in a range of $3 to $8 a share with very little activity. Dendreon discovered a prostate cancer vaccine (named Provenge) that "trains" the body's immune system to destroy tumors, but it had a long battle getting FDA approval. Finally, in early 2009, DNDN got the okay to sell the drug, which is expected to have sales of $4.3 billion by 2020. In just 10 days, the stock more than quadrupled to $22 - and it peaked at $57.67 on May 3. It subsequently pulled back with the rest of the market, but still stands above $38 today. 

That clearly illustrates the potential in biotech, but the risks are also quite high. Many of the smaller medical R&D companies - and there are literally hundreds of them in the United States alone - are focused on a single therapy, whether a drug or other type of treatment, or on a single disease. If the therapy fails, or the company runs out of money before testing can be completed, the stock can go bust in a matter of days. And, even if it finds funding, the arduous testing and approval process can drag on for a decade or more, with the stock often languishing at prices under a dime.

That's why it only makes sense to focus on the stocks of companies that have established products in addition to those in the developmental stage, giving them a solid revenue stream to finance research. Look for companies that show quality, but are still on the cutting edge of technology.

If you prefer to try for a home run with a firm still doing tightly focused research or having only a single product, stick with one whose drug or therapy is well along in the development pipeline. That puts it within sight of regulatory approval - or, quicker and potentially more rewarding, makes it a takeover target for one of the pharmaceutical giants. Plus, even if such companies don't get bought out, they're still ripe for usually lucrative licensing agreements with leading distributors.

That's what happened with many of the best biotech investments of the past - and it helps explain how big pharma's Top 10 companies got control of the products needed to roll up total sales of $317 billion in 2009.

Three stocks currently worth considering based on these criteria are:   

Gilead Sciences, Inc. (Nasdaq: GILD), recent price $36.83 - GILD has almost a dozen products, including Truvada, which helps prevent the spread of HIV among those already infected, and a treatment for hepatitis B, a major seller in Asian markets, where the disease is widespread. Gilead has marketing partners or sales units in Europe, Asia, the Middle East, Australia and Latin America, and has consistently topped revenue projections in recent quarters. Earnings per share were $3.41 for the past 12 months, and the P/E ratio of 10.80 is below industry averages.

Neurocrine Biosciences Inc. (Nasdaq: NBIX), recent price $7.90 - NBIX concentrates on neurological and endocrine-related diseases and has eight products in various phases of development and testing. The company has just begun generating revenues from two of its therapies, including one for Type II diabetes, America's No. 1 growth disease. Revenue of $32.9 million is expected for 2010, with growth to $68.8 million, and NBIX posted its first-ever profit of $3.33 a share in the third quarter. What makes it most interesting, however, are its "pipeline partnerships" with Abbott Labs in men's and women's health, GlaxoSmithKine (NYSE: GSK) in anxiety and depression treatment, and Boehringer Ingelheim Chemicals for diabetes - assuring NBIX of needed funding and ample future marketing help.

Cepheid Corp. (Nasdaq: CPHD), recent price $22.70 - A non-drug biotech entry, CPHD makes molecular diagnostics systems for use in gene therapy and DNA analysis. Primary markets are hospitals, emergency rooms and laboratories, though the company's GeneXpert System is also being used by security agencies charged with identifying bio-threats. The company is still operating in the red, but revenues have risen and losses declined for the past two years, and a profit is projected for the first quarter of 2011.
If you go looking for other small companies in biotech, you'll find a wide range with stock prices under $5.00. Many of these have strong potential, but diversification is a must. The best approach is to split your money among a minimum of four low-priced specialty biotech stocks. That way, you can watch three go bust and still come out well ahead if one of them makes good - or gets bought out.

As an alternative, you can get instant biotech diversification by purchasing shares in one or more of the five exchange-traded funds (ETFs) that now focus on the industry. Two of the leading ones are:

SPDR S&P Biotech Fund (NYSE: XBI), recent price $61.25 - This fund attempts to mirror the performance of the S&P Biotechnology Select Industry Index, holding shares of 28 stocks making up that index. It has the lowest expense ratio in its class at just 0.35% and has traded over a range of $47.01 to $62.11 the past year.

iShares Nasdaq Biotechnology Index Fund (Nasdaq: IBB), recent price $90.58 - The most broadly diversified of the current biotech ETFs, IBB holds shares of 126 different companies comprising the Nasdaq Biotechnology Index, though it does not precisely mirror the index at all times. The expense ratio is 0.48% and the trading range over the past year has been $70.00 to $93.53. 

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