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Pharma Stocks with the Right Chemistry

The controversy over ImClone Systems' (IMCL) cancer drug, Erbitux, has put the biotech sector in the headlines lately. Investors hunting in this area should look for companies that "already have approved drugs, that are rapidly growing their sales, or...with a significant drug in Phase 3 [trials]", says Standard & Poor's biotech analyst Frank DiLorenzo. His favorite stock in the group is Amgen (AMGN).

Drug stocks such as Johnson & Johnson (JNJ) and Pfizer (PFE) also top the favored list of Herman Saftlas, S&P investment officer covering pharmaceutical stocks.

These were among the comments Saflas and DiLorenzo made in a chat presented on Feb. 26 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL, keyword: BW Talk.

Q: Who do you see as potential biotech takeovers in the coming year?

DiLorenzo: [One company] I cover that I think would potentially be attractive [is] Cephalon (CEPH). I think it's now profitable, has a good line of approved drugs, there are good growth prospects, and I think there's a lot of untapped potential there. Aside from that, I would say in general it's hard to predict which companies, but in the small- and mid-cap arenas, potential buyout candidates would be companies with approved drugs or drugs in Phase 3 [of Food & Drug Administration approval].

Q: Sam Isaly said last night on CNBC Marketwatch that Amgen (AMGN) is the best biotech stock to own for the next decade. Would you agree?

DiLorenzo: Well, if you're going to buy one biotech stock as a core holding, my favorite biotech stock is Amgen, because it's very profitable and has a number of drugs that have blockbuster potential.

Q: Herman, what drug companies does S&P consider best now?

Saftlas: I would say Johnson & Johnson and Pfizer. Johnson & Johnson is the world's largest and most comprehensive health-care company and has one of the best long-term records of consistent sales and earnings growth, a well-diversified position. It has been a leader in creating new blockbusters in both pharmaceuticals and medical devices such as drug-coded coronary stents. These products should make for accelerated earnings growth over the next few years.

Pfizer is also in a relative high-growth mode. Expect earnings growth in the 20% or better area. Again, that's driven by new products such as Bextra, its new second-generation Cox-2 inhibitor for arthritis. Pfizer also has many others: Another one, which is a very strong product, is Spiriva, for a respiratory condition called chronic obstructive pulmonary disease. Those are just some of the big products coming down the pike that should make Pfizer an outstanding performer in earnings per share relative to the overall pharmaceutcal industry. And its p-e ratio is only about 15% above the average, so it's growing much faster than the industry, and its p-e is not that much out of whack.

Some of the other companies that we like are Aventis (AVE) in the European pharmaceutical sector, which also has probably the strongest pipeline among the European companies. This company again should continue to experience rapid growth in the 20% to 25% range over the next few years. Some of its new products include Actonel for osteoperosis, Lantus for diabetes, and Ketek, an anti-infective.

We also like Abbott Laboratories (ABT). [It] has new management that has made several astute acquisitions, including the purchase of Knoll Pharmaceuticals, and that brought them a very promising pipeline of new drugs to treat arthritis and heart disease. [These moves] will provide cost savings and synergies that should total several hundred million dollars over the next few years.

Q: What about Bristol-Myers Squibb (BMY)? Is its pipeline strong enough to combat key drugs going generic?

Saftlas: That's a very good question. Bristol has had a few disappointments -- number one, with its purchase of ImClone Systems (IMCL). There was a meeting today between Bristol-Myers and the FDA on ImClone's Erbitux anti-cancer treatment, I think, and at that point, Bristol would make a determination if it's going to invest further money in ImClone and in this drug. It has already invested $1 billion for a 20% stake in ImClone. It would seem to me that Bristol would try to salvage whatever it can out of this, even if it would involve additional trials.

The company also have a drug called Vanlev, which has a lot riding on it. Bristol originally filed this drug in December, 1999. It was withdrawn in April, 2000, because of adverse reactions in several patients -- the problem was angioedema. The company subsequently did new trials and refiled last December, and it hopes to be approved perhaps by the end of this year or early 2003.

I will note a few other drugs that are very important to Bristol. One is Aripiprazole, a treatment for schizophrenia. Bristol has already gone on record and said that earnings this year will be below last year. It expects earnings in the $2.30 area -- that's down from $2.41 from operations last year. So it's planning for the new drugs to lift earnings in 2003 in the 10% range, and whether that's successful, of course, is yet to be seen.

That's why we maintain a hold rating on this stock -- there are a lot of unknowns. Bristol has also streamlined its corporate structure. It has sold off the Clairol beauty-products division and spun off the Zimmer orthopedic unit, so the company is trying to position itself for growth in pharmaceuticals. Bristol has a decent pipeline, and assuming it succeeds on all its products, the stock would be attractive at this price.

Q: What do you think of Schering-Plough (SGP)?

Saftlas: Schering-Plough is in a bit of a more difficult position. Its main problem is the principal Claritin nonsedating antihistamine, which goes off patent at the end of this year. Schering does hope to somewhat offset this with an enhanced product called Clarinex, which was produced in conjunction with Sepracor, and that's what's known as a single-isomer version of Claritin. And hopefully, that will offset the loss in Claritin over the next few years -- but not this year. This year, there'll be a big hit in Claritin -- and in 2003.

The company does have good growth in Intron A -- this is a Schering product that's used in conjunction with ICN Pharmaceuticals' Ribavirin as the leading treatment for hepatitis C. It continues to grow at a strong rate and should continue so. But it's probably not enough to offset the loss in Claritin.

We rate this stock as a hold. It's severely depressed, down sharply last year, and it continues the sluggish trend this year as well. There are ongoing FDA issues with Schering's plants. I will say that there's the possibility of a takeover or a merger here, which gives that stock some support also.

Q: American Home Products (AHP) looks like it should be a good stock. Do you think so?

Saftlas: Actually, I agree with that. American Home Products is looking better than it has in many years, largely because it has put a cap on its diet-drug litigation liability, and investors are now going to focus more on the new-drug pipeline. The pipeline, I would say, does not have any blockbusters like Pfizer's, but if no home runs, then a lot of doubles and triples -- a lot of strong products whose totality should do very well for American Home Products.

I have American Home rated right now as a hold.... At some point it would be a candidate for an upgrade. By the way, it's changing its name to Wyeth, and it will have a new symbol, WYE -- that's going to take place next month.

Q: Thoughts on Elan (ELN)?

Saftlas: I think despite the catastrophic decline in the stock price, the stock is still no bargain. The company is still under SEC investigation because of questionable accounting practices. There are numerous lawsuits against it. If you strip out all the accounting issues, Elan's earnings could be maybe $1, $1.15 this year, maybe less -- it's difficult to say. One of its new products, an Alzheimer's vaccine, failed recently in clinical trials. The company faces generic competition late this year, early next year, in some cheap products such as Zanaflex and Skelaxin.

But on the other hand, Elan does have a strong position in the neurological sector, and it does have a pipeline. The company should do $1.7 billion in sales this year. So we rate the stock a hold. We think at this price, most of the bad news has already been discounted. But on the other hand, we don't see the earnings visibility at this point sufficient to generate a recommendation of the stock.

Q: What are some small-cap biotech names you like? Also, what category looks good?

DiLorenzo: If I were an investor, I would focus on companies that already have approved drugs, that are rapidly increasing their sales, or I would look to companies with a significant drug in Phase 3. However, if you do look to a company with a Phase 3 candidate and no approved products, if that clinical candidate fails, then the downside could be significant. So for the most part I'm focused on companies with approved products in the next year or so.

[Among] small- and mid-cap biotech stocks [is] Cephalon: The main two drivers there are Provigil, which is a drug used to treat patients who are suffering from excessive daytime fatigue, and Actiq, used to help ease the pain of cancer patients. I think the interesting thing about that company is that it has two drugs that are growing rapidly, so I really like that company because of that.

Another company that I like is Celgene (CELG). It has have a drug, Thalomid, which is primarily used off-label to treat multiple myeloma, and it also has an arrangement with Novartis (NVS), where Celgene receives royalties on sales of Ritalin-based products. Separate from that, it has a good pipeline in the treatment of multiple myeloma and other cancers, and I think if it gets good results in those areas, then we could see the stock go up.

One other company I like that has been beaten down is Enzon (ENZN). The stock has been down because of concerns about a drug it has have that Schering-Plough markets called PEG-Intron. The drug has a multibillion-dollar potential, but the concern is right now there's a manufacturing constraint with Schering-Plough where it might not be able to manufacture enough to meet consumer demand. But I think that has been factored into the stock price. With the recent correction, and considering the growth prospects for PEG-Intron and the growth prospects in treating people for chronic pain...I think it's a good stock. Enzon is rated accumulate, Cephalon is a buy, and Celgene is an accumulate.

Q: You just mentioned Novartis.

Saftlas: Again, it's a leading European drug manufacturer. We see it increasing earnings this year at about 8% or 9%. Novartis is a huge company. It was formed a number of years ago from the merger of Ciba-Geigy and Santos. The new products it has that should drive growth include Gleevec, for chronic myeloid leukemia, Starlix for Type 2 diabetes, and Zometa, an anticancer drug. Gains in these drugs should offset generic erosion in some of the other areas, such as Voltaren, an anti-inflammatory, and Aredia, which also is suffering from generic competition.

Novartis is also involved in other areas such as vision care, consumer products, and animal health, which is a slow-growing business. It also had some disappointments at the FDA -- one was Zelnorm, a treatment for irritable bowel syndrome, and Xolair, an anti-asthma drug. So our overall position on this is a hold.

Q: What about genomics generally? Any thoughts on Human Genome Sciences (HGSI)?

DiLorenzo: We have an accumulate on the stock. It's speculative, highly risky. The company isn't profitable, and I don't expect it to be until 2006 at the earliest. But one thing I do like about the company is that it has a very strong drug-discovery engine.... But it just doesn't have anything late-stage that I think is going to be particularly significant.

Q: Before you leave, Herman and Frank, can each of you give us a quick few names that top your lists?

Saftlas: As I mentioned, we like Johnson & Johnson, Abbott Laboratories, Pfizer, Aventis, and in the specialty area we also like Teva (TEVA) and Mylan (MYL).

DiLorenzo: Right now I have three buys, and those are: Amgen, Genzyme (GENZ), and Cephalon.

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