Is Biotech's Health Improving?

S&P's fundamental outlook for the industry is neutral. But it has buy recommendations on some with novel therapies and strong patents

The S&P 1500 Biotechnology subindustry index recently saw its relative strength ranking move up one notch, from 3 to 4, indicating that its trailing 12-month price performance is now in the top 30% of all subindustry indexes in the S&P 1500 (a ranking of 5 would place it in the top 10%). Year to date through Mar. 28, the S&P Biotechnology index rose 0.8%, vs. a 10.3% decline for the S&P 1500.

During 2007, this subindustry index fell 2.6%, compared with the broader market's climb of 3.6%. Take a look at the accompanying chart. As a reminder, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's long-term mean relative strength.

There are 10 large-, mid-, and small-cap companies in the S&P 1500 Biotechnology subindustry index covered by S&P equity analysts. Seven stocks have a favorable STARS ranking: Celgene (CELG), Cephalon (CEPH), Gilead Sciences (GILD), PDL BioPharma (PDLI), Regeneron Pharmaceuticals (REGN), and Vertex Pharmaceuticals (VRTX) are each ranked 4 STARS (buy); while Genzyme (GENZ) carries a 5 STARS (strong buy) recommendation.

No Major Catalyst

Steven Silver follows biotechnology issues for S&P Equity Research Services. His fundamental outlook for the biotechnology subindustry is neutral, reflecting S&P's view of a lack of major catalysts for earnings growth over the next 12 months, and higher regulatory and clinical uncertainty weighing on investor sentiment and risk tolerance. S&P sees a conservative and overwhelmed Food & Drug Administration contributing to a slower industry pipeline. Silver sees no immediate impact from legislative pressure for biogeneric drugs and lower drug prices, although he sees the issue gaining momentum as President Bush has requested FDA authority to approve biogenerics in his 2009 budget proposal. Thus, Silver views favorably companies with novel therapies and strong patent protection.

Silver expects long-term M&A trends to remain positive, particularly in drug partnering. S&P sees smaller companies remaining attractive to both Big Pharma and large biotech firms seeking new products and technologies to bolster slowing pipelines and expiring patents. However, Silver believes the environment has been dampened for large-cap deals, as evidenced by Biogen IDEC's (BIIB) inability to find a buyer in late 2007. S&P expects IPO activity in biotechs to remain sporadic. In 2007, most leading biotechs initiated large share buyback programs, leveraging their robust operational cash flows.

S&P sees small-cap biotechs conserving cash to delay raising capital until late-stage drug candidates near approval and provide potential for a higher valuation, thereby lessening dilution. Several outfits have outsourced their clinical programs to better manage corporate headcount and operating expenses. Cancer therapeutics remains the primary growth impetus, in S&P's view, and Silver sees the prospects for autoimmune and inflammatory treatments remaining positive as well. All told, S&P expects the competitive environment for treatments for most key diseases to intensify.

Given S&P's view of continuing volatility for unprofitable, small-cap names, Silver recommends that investors concentrate their core biotech holdings on established, profitable companies with solid growth prospects on an absolute and relative basis. S&P believes a strong pipeline and prior pipeline successes are key factors, as such companies have resources to pursue new indications and broader labeling for their marketed products. For smaller firms, Silver would seek those with diversified, late-stage pipelines, or with at least one major near-term catalyst, such as a recently approved drug or positive late-stage clinical trial candidate.

So there you have it. Despite the biotech group's improving relative strength, it appears as if the overall fundamental outlook does not support this optimism.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of 5 (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (3/28/08)
Coal & Consumable Fuels Peabody Energy BTU 3 $51
Computer Hardware IBM Corp. IBM 5 $115
Construction & Engineering Fluor FLR 4 $140
Construction & Farm Machinery Manitowoc MTW 5 $39
Diversified Metals & Mining Freeport-McMoRan Copper FCX 3 $97
Fertilizers & Agr. Chem. Monsanto MON 3 $114
Industrial Gases Air Products APD 3 $91
Internet Retail AMZN 3 $70
Marine Kirby Corp. KEX 4 $56
Oil & Gas Drilling Noble Corp. NE 5 $48
Oil & Gas Equip. & Svcs. Baker Hughes BHI 5 $67
Oil & Gas E&P Swift Energy SFY 5 $45
Railroads CSX Corp. CSX 4 $57
Soft Drinks Coca-Cola KO 5 $61
    Before it's here, it's on the Bloomberg Terminal.