S&P picks: Why the biotech sector looks healthy

Standard & Poor’s Equity Research recently upgraded its outlook for the biotechnology industry to positive from neutral.

Steven Silver, S&P’s biotechnology equity analyst, thinks the industry is positioned for renewed investor interest in 2010, despite lagging the market in 2009. Large-cap biotech names are trading well below historical levels, although S&P Equity Research views the companies’ fundamentals and late-stage pipelines as solid. Silver is encouraged by expected regulatory filings in 2010 for several conditions, including lupus and chronic hepatitis C, since neither disease has seen a new approved treatment in years.

Much of the industry’s underperformance in 2009 can be attributed to uncertainty about potential health care reform legislation. However, the January 2010 election of Scott Brown, a Republican, to take the Senate seat held for 27 years by Democrat Ted Kennedy, changes the outlook for health care reform. Brown’s election not only changed the political landscape in Massachusetts, but for the nation as a whole. The Democrats lost their filibuster-proof supermajority and, in turn, the likelihood of an aggressive health care reform law, according to S&P Equity Research. While health care reform legislation is still likely this year, its ultimate form will likely be scaled back from the grand plans being discussed by Congress as recently as early January, according to S&P Equity Research.

Silver views the renewed debate over health care reform as potentially negative for the biotechnology industry. Here’s why. Currently there is no regulatory approval process for generic versions of biotechnology drugs (biogenerics) whose patents have expired. The health care reform bills introduced last autumn would have created such a regulatory approval process; both would have approved an exclusivity period of 12 years for biotech drug makers before a biogeneric could enter the market. By contrast, President Obama has gone on record as saying a shorter period, perhaps seven years, is more reasonable. The 12-year exclusivity was viewed as a winning scenario for the biotech industry. If the renewed debate over health care reform results in a shorter drug exclusivity period, Silver would view that as a negative for the industry.

However, Silver maintains a positive outlook for drug partnering and acquisition activity, since big pharma and large biotech companies need new products and technologies to bolster their pipelines. Pharma drugmakers face patent expirations between 2011 and 2013 that S&P Equity Research estimates will total more than $100 billion.

In 2009, the biopharma industry focused on consolidation, as megamergers between Pfizer-Wyeth, Merck-Schering Plough, and Roche-Genentech took center stage. Silver notes that in all three cases, the acquired company had pipelines rich with biologic-based candidates, particularly in the case of Genentech. At the time of the acquisition, Genentech was minority owned by Roche. However, a key partnering agreement between the companies was set to expire in 2015, which he believes prompted Roche’s actions.

With fewer acquisitions across the industry, there was a higher incidence of partnering activity in 2009, as many pharma companies streamlined their R&D and sales organizations to focus on fewer therapeutic areas, and sought to acquire rights to individual compounds to fill pipeline gaps. As these recent deals are integrated and as the patent cliff nears, we expect an increase in acquisitions of companies with marketed products or products nearing commercialization, as well as a sustained rate of partnering deals for new growth assets across the sector.

Lastly, Silver is also encouraged by President Obama’s initiatives to expand the FDA’s oversight resources. The agency’s limited staffing and resource capacity has resulted in its being slow to meet action deadlines and cautious in approving new drugs.

S&P Equity Research has strong buy (5-STARS) recommendations, as of March 1, 2010, on Gilead Sciences Ticker:(GILD), Celgene Ticker:(CELG), and Vertex Ticker:(VRTX). (S&P’s STARS recommendations are subject to change at any time, as are its ETF and fund recommendations.)

Investors looking for exposure to the biotechnology industry but who also want to benefit from holding a diversified security may consider mutual funds or exchange-traded funds that invest in biotech stocks. S&P rankings on ETFs and mutual funds incorporate a rigorous analysis of each portfolio’s underlying holdings to assess valuation and risk, and are not based simply on past performance.

S&P has overweight rankings, as of March 1, 2010, on three health-care ETFs that have a top-ten holding in at least one of these recommended stocks. The three ETFs are iShares Dow Jones U.S. Healthcare Ticker:(IYH), Health Care Select Sector SPDR Ticker:(XLV), and Vanguard Health Care Ticker:(VHT).

As for mutual funds, S&P has a top five-star ranking on these funds, both of which have a top-ten holding in at least one of the recommended stocks: T. Rowe Price Health Science (PRHSX) and BlackRock Healthcare Ticker:(MAHCX).

For more access to Standard & Poor’s Equity Research go to www.GetMarketScope.com, or call 1-877-219-1247, or send an email to [email protected].

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