Morningstar Advisor - April/May 2010 - 62

Sector Rap

HK: What companies rate the highest in terms of drug portfolio strength? Health-Care Team: The top scorers for Drug

Portfolio Strength, whose drugs range from early-stage candidates to commercialized blockbusters, focus on novel compounds in areas with a strong need for new treatment options. The firms that score highly in this category have ushered ground-breaking drugs to market, developed cutting-edge technology, or introduced novel drug candidates into development that could revolutionize treatment methods, such as Crucell’s CRXL promising drug manufacturing platform and Regeneron’s REGN array of biologics for rare diseases. While our list from 2009 remains relatively intact this year, there were two noteworthy advancements among emerging biotechs: Exelixis EXEL has recently gained steam with the addition of novel PI3K inhibitors to its targeted oncology lineup, and Human Genome Sciences HGSI scored a major victory with favorable trial results for its first-in-class lupus drug Benlysta.
HK: The suspense is killing me. What are some of the firms at the top of the list? Health-Care Team: Our top acquisition target

we have InterMune ITMN, which is a firm focused on the popular therapeutic areas of infectious and rare diseases. And finally, rounding out our top-five targets, we have Celgene CELG, a company whose hematological cancer blockbuster Revlimid and extensive pipeline awards it a leadership position in the blood-related cancer market.
HK: How did the team’s acquisition predictions for 2009 work out? Health-Care Team: The biotech M&A environment was not nearly as active in 2009 as we had predicted based on the financial vulnerability of many small-cap biotechs and the hefty cash balances at pharmaceutical firms. Large pharmaceutical companies instead focused on mega-mergers with their peers, distracting them from smaller biotech acquisitions and eating away excess cash. In addition, as capital markets thawed, several biotechs gained access to cash through partnerships and secondary equity offerings, reducing their vulnerability to potential acquirers.

Last year, Elan ranked first on our takeout list, and Crucell was listed sixth.
HK: What companies do you expect to be most actively looking for acquisitions in 2010? Health-Care Team: As large pharmaceutical companies approach their upcoming patent cliffs, we expect several firms will bolster their growth prospects through acquiring smaller companies. Supported by solid balance sheets and strong cash flows, we expect Big Pharma firms to scoop up several biotech companies as well as a few diversified health-care companies. Those with the most immediate patent threat include Merck MRK, Johnson & Johnson, GlaxoSmithKline GSK, and AstraZeneca AZN. While Merck has largely addressed its patent problems through the acquisition of ScheringPlough, we expect the other companies will make major purchases over the next couple of years. In particular, we believe Astra has finally digested MedImmune and is ready to go back into a more aggressive acquisition mode.

for 2010 is Vertex Pharmaceuticals VRTX. Vertex scored top marks for Drug Portfolio Strength in our study. The firm’s late-stage protease inhibitor telaprevir has the potential to revolutionize the way hepatitis C is treated, and excitement surrounding the drug’s prospects has driven the biotech’s market cap up to $8 billion despite its lack of profitability. Vertex also scored relatively highly for Profit-Boosting Power because we believe telaprevir will bring in several billion dollars in sales if it gains approval. After Vertex, we have Auxilium Pharma AUXL, whose drug Xiaflex is nearing the market for two rare indications. Human Genome Sciences HGSI ranked third on our list this year, moving up from 32nd in 2009, thanks to impressive data for lupus drug Benlysta. Next,

We did see some acquisitions that mirrored our projections. Bristol-Myers Squibb BMY acquired Medarex for $2 billion, gaining rights to the firm’s late-stage melanoma drug, earlier-stage drug candidates, and fully human monoclonal antibody technology. We highlighted Medarex as a possible target in the February 2009 issue of Healthcare Observer. Johnson & Johnson JNJ also made substantial minority investments in two biotech firms ranked highly on our 2009 takeout list. J&J made a $440 million investment in Crucell CRXL, gaining exposure to the firm’s portfolio of marketed and novel, development-stage vaccines, as well as its biologics manufacturing platform. The health-care bellwether also made an almost $900 million investment in Elan ELN and took a majority stake in a newly created Alzheimer’s immunotherapy firm composed of Elan’s leading candidates in this indication. Overall, J&J took an 18% stake in each firm.

From the perspective of which firms have the most capacity to buy, we expect that Johnson & Johnson will make several smaller tuck-in acquisitions in 2010. Besides a net cash position of close to $3 billion as of the third quarter of 2009, we estimate that the company will generate more than $7 billion in cash after dividends in 2010. We expect the firm to quickly put this cash to work through acquisitions. In addition, large-cap biotechs should be increasingly active on the acquiring side of M&A deals. For example, Amgen AMGN noted in January that it is very active in assessing potential acquisitions, and we think that the firm’s $13.4 billion cash balance (as of the end of 2009) allows it to consider some of the largest names on our takeout list, including Genzyme GENZ and Biogen-Idec BIIB. K
Haywood Kelly, CFA, is vice president of equity research at Morningstar.

62 Morningstar Advisor April/May 2010

Morningstar Advisor - April/May 2010

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