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Taking a Wild Ride with Biotech

The Franklin Biotechnology Discovery Fund (FBDIX) isn't for the weakhearted. Given its focus on biotech -- a notoriously volatile sector -- the yearly returns of the $475.9 million portfolio have fluctuated wildly. After skyrocketing 97.9% in 1999, the fund rose 46.6% the following year, and then dropped 20.5% in 2001. Last year, the portfolio plummeted 42.5%, close to the decline in the Nasdaq's biotech stock index.

Such performance swings should be expected from an industry that still suffers growing pains (see BW Online, 2/5/03, "Selective Healing in Biotech"). Most biotech outfits aren't yet profitable, and bringing a drug to market can be a long, arduous, risky, and expensive process.

Managed by Evan McCulloch since its September, 1997, inception, Franklin Biotechnology Discovery is one of the longest-running "pure" biotech portfolios around. For the five-year period ended December, 2002, the fund posted an average annualized return of 8%, vs. 4.3% for the handful of biotech funds in Standard & Poor's universe with five years of operating history. Standard & Poor's assigns it an

overall ranking of 3 STARS based on the portfolio's risk and return profile. S&P notes that the sole focus on biotech makes this portfolio very risky. The fund's standard deviation, a measure of volatility, is much higher than that of funds invested broadly in health care.

Palash Ghosh of S&P's Fund Advisor recently spoke with McCulloch about investing in the sector and the fund's strategy. Edited excerpts from their conversation follow:

Q: The Nasdaq Biotech Index plunged 45.3% in 2002. Why did biotechs perform so poorly?

A: Several factors contributed to the sector's weak performance. The bulk of these events occurred in the first and second quarters of the year. We witnessed many company-specific disappointments -- so many, in fact, that this became a "sector trend" unto itself.

Q: What kinds of disappointments precisely?

A: There were a number of negative Food & Drug Admininstration-driven events, such as delays or outright rejections of new products. There were also numerous drugs that failed in clinical trials. Some companies faced manufacturing problems. The sector suffered as a whole due to the scandals at Elan (ELN) and ImClone Systems (IMCL).

Q: What are your largest individual holdings?

A: Out of 49 positions as of Dec. 31, 2002, our top 10 holdings were Amgen (AMGN), 12.6% of the fund; MedImmune (MEDI), 7.7%; IDEC Pharmaceuticals (IDPH), 5.6%; Gilead Sciences (GILD), 5%; Genzyme (GENZ), 4.3%; Biogen (BGEN), 3.3%; Serono (SRA), 3.1%; Millennium Pharmaceuticals (MLNM), 2.7%; NPS Pharmaceuticals (NPSP), 2.6%; and Neurocrine Biosciences (NBIX), 2.6%.

Q: Given that Bristol-Myers Squibb (BMY) was badly hurt by the Erbitux/ImClone fiasco, did it dissuade big drug companies from entering into partnership arrangements with biotechs?

A: I think initially Big Pharma did indeed step back from entering into deals with biotechs, but this hesitation was short-lived. In fact, just recently, we saw Pfizer (PFE) signing a couple of huge deals, including a $400-million agreement with Neurocrine Biosciences to develop Indiplon, Neurocrine's insomnia drug.

We expect to see many more similar arrangements between Big Pharma and biotechs. Recognizing that product pipelines at pharmaceutical companies are still fairly weak, we think the terms of these partnership agreements will become increasingly lucrative for biotech firms. [Johnson & Johnson (JNJ) announced on Feb. 10 it will acquire biotech outfit Scios (SCIO) for about $2.4 billion to boost its drug pipeline.]

Q: Biotech stocks typically have strong fourth quarters, as they did in 2002. Why is this?

A: In the fourth quarter, we have a plethora of major medical conferences and investor forums. The biotech sector is very "catalyst-driven."

Q: A new FDA Commissioner was appointed in October. Will this lead to an acceleration of drug approvals in 2003?

A: I think we'll see an increase in drug applications and approvals this year, but this is partially because several prominent new drugs were delayed in 2002. [According to the Biotechnology Industry Organization, the FDA approved 20 new biotech and biotech-related drugs in 2002. The FDA also cleared 15 new indications for previously approved products last year].

Q: What are some of the prominent new drugs you expect to come to market in 2003 from any of your holdings?

A: MedImmune has a nasally administered flu vaccine, FluMist, which it acquired when it merged with Aviron in early 2002. This drug has been delayed since the summer of 2001, when the FDA expressed concerns about its efficacy and safety. That hurt Aviron's stock price, allowing MedImmune to buy it rather cheaply.

FluMist was again delayed in 2002, due to some more efficacy concerns. Finally, in December, 2002, an FDA Advisory Committee recommended approval for FluMist. We have, however, been positive on FluMist all along, and we believe it will come to market in a few months. I don't think this will be a blockbuster drug, but I expect it to generate annual sales in the neighborhood of $400 million to $500 million. It will be an important growth driver for MedImmune for the next several years. [MedImmune has partnered with drug giant Wyeth (WYE) to market FluMist]. MedImmune's lead compound is Synagis, which is used to treat respiratory syncytial virus in infants. This is a $700 million drug.

We have a small position in ICOS (ICOS), which has an interesting impotence drug called Cialis that was recently approved in Europe and may be approved in the U.S. later this year. This is a situation we'll be watching very closely. Cialis has some advantages over Pfizer's Viagra and will be co-marketed by Eli Lilly (LLY). Keep in mind that Viagra is currently doing about $1.5 billion of business annually.

One of the most intriguing drugs on the horizon is Fuzeon, an HIV drug belonging to Trimeris (TRMS) and its European partner, Roche. Fuzeon has had some very good Phase III clinical data, and HIV doctors are excited about it. It will likely be launched in March, and Trimeris should start seeing profits on it by 2005. Fuzeon should see annual sales of about $500 million to $600 million. However, Trimeris is going to have some problems in manufacturing the drug on a large scale, so they may face some capacity constraints for a few years.

Q: Amgen is the fund's largest position. What's the outlook for its rheumatoid arthritis drug, Enbrel?

A: We're extremely bullish on Enbrel, which we believe could generate annual revenues of several billion dollars over the long term. Not only do we think that Enbrel has a great deal of growth left in the rheumatoid arthritis field, we also think it's the long-term winner among biologics for psoriasis. [Amgen's Enbrel, Johnson & Johnson's Remicade, and Genentech's (DNA) Raptiva may be approved to treat psoriasis in the next year. Biogen's injectable drug Amevive was approved for psoriasis on Jan. 30.] This would make Amgen's $16 billion price tag for Immunex seem like a bargain.

Q: IDEC Pharmaceuticals, a top 10 position in your fund, markets the cancer drug Rituxan. What is the outlook for this drug?

A: Rituxan is a genuine blockbuster -- it just exceeded $1 billion in annual sales. We think it will continue to grow. What's interesting is that while IDEC has a large position in our fund, the drug's co-marketer, Genentech, has a very small weighting. Genentech trades at a p-e that's nearly four points higher than that of IDEC. This baffles us, and, as we're very value-conscious, we have a much larger weighting in IDEC.

Q: What kind of annual earnings growth are you forecasting for the profitable biotech stocks this year?

A: We're projecting 21% earnings growth for the biotech sector, compared with a figure of about 12% for Big Pharma. On a p-e basis, biotechs trade at a 50% premium to Big Pharma, but much of that's due to incorporating the higher earnings-growth rates for biotech. On a p-e-to-growth basis, biotechs actually trade at a significant discount to the big drugmakers.

A biotech stock typically becomes profitable two to three years after it launches its flagship drug. We expect that a host of companies -- including Trimeris, CV Therapeutics (CVTX), United Therapeutics (UTHR), InterMune (ITMN), and Cubist Pharmaceuticals (CBST) -- will reach profitability by 2005.

Q: Do you expect to see much merger-and-acquisition activity in biotech in 2003?

A: After the big three biotech mergers were announced at the end of 2001, the most notable being Amgen and Immunex, we thought 2002 would witness a huge wave of M&A activity. But it didn't happen, and that surprised us, since we need to see more consolidation in the industry.

In biotech you basically have two types of companies: Ones with no products but lots of cash, and companies with no cash but with a product. Thus, it makes sense for these two types of companies to merge. I expect to see some mergers this year, particularly from the big biotechs, which have large reserves of cash.

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