Life Science Stocks: A Growing Market in 2010

It took more than four years, a double mastectomy, and multiple other surgeries—as well as radiation treatments and bad reactions to ineffective chemotherapy drugs—before Christine Hanson's breast cancer was brought under control by Dr. Mark Fesen in Hutchinson, Kan. By then, cancer had spread to her lungs, liver, and brain.

Through a port implanted in her chest nearly five years ago to reduce stress on her veins, Hanson, the mother of three children not yet in high school, has been getting weekly infusions of cancer-treatment drugs Avastin and Abraxane, which have put her cancer into remission. What if doctors had a detailed road map of the kinds of drugs and therapies that Hanson's genetic makeup makes her most receptive to, instead of having to arrive at treatments through the costly—and sometimes painful—method of trial and error?

That's the promise of the nascent field of personalized medicine, where treatment is prescribed based on an understanding how an individual's body is genetically predisposed to welcome or resist certain compounds. The day when customized treatment is widely available may soon be within reach, thanks to technological advances being made by life science tools companies. They develop and market protein-separation devices and other instruments that will eventually provide researchers with the knowledge needed to precisely target the best treatment for life-threatening illnesses.

After bureaucratic delays this year that frustrated investors, the awarding of $10 billion to the National Institutes of Health under the Obama Administration's stimulus program over the next two years is likely to give a big boost to life science companies' earnings as the money funds a fresh wave of research.

Genome Sequencing for $1,000 or less It's been less than seven years since completion of the momentous Human Genome Project, which took 13 years and an estimated $3.8 billion to map humanity's genetic material. Sequencing an individual's DNA currently costs about $50,000 and there's a road map to get it down to $1,000 within three to five years, say equity analysts who cover the industry.

At $1,000, it would still be more expensive than the average home computer, but that's the price point below which personalized medicine is considered far more economically viable. The lower the cost of genomic sequencing, the greater the shift analysts expect to see in the allocation of research funds toward the consumer market, says Timothy McCandless, an analyst at Bel Air Investment Advisors in Los Angeles. The dramatic drop in costs over the past five years has already sparked demand for applications in other areas such as agriculture, where genetic information can be used to breed more drought- and pest-resistant crops and livestock prized for certain types of meat. The push toward biofuels also makes the technology relevant for energy applications.

Drug companies have been reluctant to embrace personalized medicine because it's easier to sell a less-targeted drug to a broader population than to market more narrowly applied drugs to smaller populations.

When Merck (MRK) voluntarily pulled its blockbuster arthritis drug Vioxx from the market in 2004 in the face of mounting evidence of side effects such as heart attacks, it served as a catalyst to get other pharmaceutical manufacturers and the U.S. Food & Drug Administration (FDA) to think more seriously about the viability of personalized medicine, says McCandless.

To be clear, several years of increasingly fine-tuned diagnostic and clinical research will be needed before personalized medicine are available to the extent that it might quickly identify the optimal treatment for Christine Hanson's breast cancer. The process remains in a stage akin to batting practice before an actual baseball game, says Jonathan Groberg, an analyst at Macquarie Research Equities.

"The tools are there to find the [genetic] information. It's finding the information that's relevant," he says. Then a huge education effort will be needed in order for doctors to know what to do with the genetic analysis that becomes available, he adds.

Sequencing Tools The drive to slash the cost of genomic sequencing to $1,000 has focused attention on advances under way in next-generation sequencing. Companies such as Illumina (ILMN), Life Technologies (LIFE), Helicos BioSciences (HLCS), and Roche Holdings (RHHBY) provide various sequencing tools that may help lead to a breakthrough.

Isaac Ro, an equity analyst at Leerink Swann, sees Illumina as the industry's foremost innovator, with a reputation for identifying and commercializing "the next big thing." The company's next major opportunity probably will involve its 20% equity stake in privately held Oxford Nanopore in the United Kingdom, which is developing an electrically based sieve for isolating mutant nucleotide sequences in DNA. The new technology would eliminate the need for tagging and optical amplification that make genomic sequencing take so long. "If it bears fruit over the next 12 to 24 months, it could provide Illumina with big upside [earnings potential]," says Ro, who believes Oxford Nanopore is in the lead to reach the $1,000 price point.

But Groberg at Macquarie questions how much demand there may ultimately be for sequencing. Once the desired information has been found, he says, "there are cheaper and more targeted ways" to identify it. Single-cell cancer research, for instance, uses flow cytometry, a laser technology, to funnel and examine microscopic particles within a cell. He believes that 2010 will be the year of targeted research, the key to which will be how to validate all the data collected and decide what's useful.

His strongest buy ratings for 2010 are for Affymetrix (AFFX), Life Technologies, and Waters (WAT). Investors have grown irrationally pessimistic about micro arrays, the silicon-based slides that Affymetrix makes and that allow multiple genetic tests to be run on a single sample at one time, Groberg says. A lot of the NIH funding in 2010 and 2011 will go to academic and government research centers, which provide 70% of Affymetrix's sales, he says. The company has retooled its cost structure and will benefit from micro arrays, which he says will grow more than people realize next year. The stock now trades at 0.7 times estimated 2009 sales and Groberg believes the company's market cap can double to $700 million next year.

Groberg considers Life Technologies reasonably valued as 2010 begins, with exposure to trends such as regenerative medicine, stem-cell research, and other kinds of advanced genetic research that require more sequencing information. Ultimately the company will be able to move into more applied markets.

stellar gross margins at Waters Waters will benefit from new products related to mass spectrometry, which helps researchers better understand how proteins function within cells and can illuminate the basic cellular pathways by which cancer spreads. Groberg believes investors are overly bearish about the company's exposure to the pharmaceutical market, where many expect mergers to prompt cuts in research and development spending.

Waters also has the potential to increase earnings over the longer term, after the incremental $10 billion in NIH funding has run out, according to Ro at Leerink Swann. With a gross margin of more than 50%, one of the highest in the industry, Waters' revenue is expected to grow by 5% in 2010.

The company is also positioning its Acquity business, which makes high-performance liquid chromatology instruments that separate compounds into key constituents, for higher profit margins by moving the unit to Singapore next year. Ro predicts Acquity's margins can eventually expand by 2% to 3%, but he expects improvement of only about 0.5% in the first year after factoring in the negative currency translation. Ro's 2010 earnings forecast is $3.88 a share, compared with the consensus estimate of $3.74. Share buybacks with the substantial free cash flow the company generates will further increase earnings per share, he adds.

While the extra $10 billion that will be funneled from the stimulus funding into research grants is significant, the market's anticipation that the funding will end in 2011 could work against life science stocks, some pros believe. That's why Jeffrey McCormack, a portfolio manager of the Manning & Napier Life Sciences Fund (EXLSX), would prefer to find factors that will allow life science companies to achieve sustainable growth beyond 2011.

As the global economy improves next year, these companies will be able to continue to expand their customer bases on both an end-market and geographic basis, McCormack believes. Their revenues should grow two to three times faster than the rate of global growth in gross domestic product, he predicts.

Uses in nonmedical Industries Although the future medical research prospects are lucrative by themselves, some analysts see a much bigger opportunity in applications across such other industries as environmental monitoring, water treatment, food safety, and forensics—all driven by stricter global regulation.

"These technologies' ability to differentiate and quantify compounds in a quick, cheap, and efficient manner makes them applicable to lots of other industries," says McCormack. "Early applications were in life sciences where the compounds in question were drugs. As we move forward, the compounds are air, water, and food, and you're trying to find the elements that don't belong or that we need to remove."

Two companies that McCormack thinks will benefit from the longer-term economic recovery and broader application of life science technologies are PerkinElmer (PKI) and Pall (PLL). PerkinElmer has a large environmental health business that generates more than half its total revenue and the company can take advantage of growing demand for stricter procedures to guarantee the safety of food produced in the U.S. and imported from overseas.

Pall is a major producer of filtration devices used in the biotech drug industry and in water treatment systems. About 70% of its revenue comes from outside the U.S., where water infrastructure is being developed more quickly than in the U.S. McCormack thinks Pall will be able to increase its annual revenues from emerging markets by at least 10% over the next five years.

If you're less confident about the prospect of a strong economic recovery, you may feel more comfortable with Millipore (MIL), says Ro at Leerink Swann. Half of its business is in less-cyclical filtration products used to produce biotech drugs. The company is expected to deliver good earnings growth for the next five years, no matter how the overall economy fares, he says. The other half of Millipore's revenue comes from reagents and sequencing kits.

"If you believe biotech drugs over the next five years will see a more prevalent position, [Millipore has] the best basis for that theme," says Ro. And because switching costs are high, biotech clients aren't likely to replace Millipore's filtration devices with cheaper alternatives. The fact that its products are applied universally across drug manufacturing processes means Millipore's growth is less reliant on a single drug, which makes the company an attractive acquisition target, he says.

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