A New Prescription For Your Portfolio Big Pharma may be in flux, but there's still plenty of powerful medicine left for investors. Here, the first dose.
(FORTUNE Magazine) – Pills can be a tough addiction to kick. Especially Big Pills. You know the ones we're talking about: the Mercks, the Pfizers, the Schering-Ploughs. Such feel-good stocks have long been the financial equivalent of Valium, getting us through worrisome stock markets on an even keel. Take Merck, for example--a stock that soared 40% last year in a brutal, tech-bled market. Who couldn't use a Merck in his retirement medicine chest?
Well, just ask any investor who parked his money in this seemingly safe haven at the beginning of the year. When Merck abruptly announced in late June that it would fall short of 2001 earnings targets, the company's stock fell 9% that day. (The stock is now down nearly a third from the start of the year.) There's a phrase for that in the medical world: shock therapy.
As the previous story details, the shortage of new blockbuster drugs in Big Pharma's development pipeline is only the start of its current ailments. Not that we're sounding the death knell quite yet. Blue-chip drugmakers have, after all, returned a remarkable 25% a year to investors over the past decade. The question, really, is one of timing. Says Tobias Levkovich, senior U.S. equity strategist at Salomon Smith Barney: "Now is just not the right time to come running back into these stocks."
So where does that leave investors looking for a fix? With huge scientific advances making the headlines every other week and the demographic trend of a rapidly aging population, it hardly makes sense to shun the drug sector entirely. Rather, says Levkovich, the answer is for investors to look beyond the big do-it-all pill makers and find the more targeted health-care plays.
With that in mind, FORTUNE homed in on four key drug and medical sectors--biotech, genomics, lab research tools, and diagnostic testing--that aren't likely to get tangled up in Big Pharma's current woes. Most of the picks are long-term plays and should be kept in mind only for the aggressive-growth part of your portfolio. These pricey, volatile sectors, we stress, are not for the faint of heart. Still, patient bargain-hunters might see some extraordinary values if they pick up one or more of these stocks on a market swoon. (We've included target purchase prices for each in the accompanying table.) Here is how to protect your portfolio from a pill overdose before it's too late.
THE BIOTECH INDUSTRY
After the dot-com meltdown, the prospect of investing in a speculative sector like biotech is probably enough to send many an investor's blood pressure into a systolic frenzy. But there's good reason to believe that after years of boom-and-bust cycles the Age of Weird Science has finally arrived.
Unlike the dot-coms, the biotech sector--a shorthand way to refer to a vast array of research firms aimed at treating and curing diseases on the molecular level--has already seen three booms and busts since the late 1980s. Many of the companies that had huge valuations but little to show in the way of research and development have already gone out of business. Those firms that survived did so in large part thanks to the promise of their drug pipelines and healthy war chests.
Biotech firms now have more than 350 drugs in clinical development, up from about 130 in 1991. Back then, only two major biotech-originated drugs made it to market--both from industry leader Amgen. Today there are drugs to treat neonatal viruses (from MedImmune), multiple sclerosis (from Biogen), hepatitis (from Chiron), and rheumatoid arthritis (from Immunex). What's more, larger drug companies are showing their own faith in this sector by buying up many of the upstart firms. Well over 100 biotech firms were purchased by big drug companies in the past five years--double the number purchased during the previous five.
To be sure, biotech firms, few of which show profits (or, sometimes, even revenues), remain extremely volatile--moving largely on clinical-trial news and message-board rumors. Witness the Amex biotech index, which, after more than doubling at one point last year, gave nearly all its gains away in the first quarter. It has since rebounded by nearly 60% from its March low. But those willing to stomach the volatility can still land some real values.
One such value that many health-care portfolio managers point to is Genentech (DNA, $55). Shares have fallen 30% this year. But the selloff seems to have had more to do with skittishness over the sector than with the company's fundamentals. In fact, with 17 projects in development, the strongest pipelines in the industry.
Since its founding in 1976, Genentech (a subsidiary of Roche Group that is traded separately) has focused its drug-discovery efforts on cancer and heart therapies. Today the San Francisco company markets nine products, led by breast-cancer treatment Herceptin and Rituxan, a drug used to fight non-Hodgkins lymphoma. Combined, the two medications accounted for about 40% of its $1.7 billion in sales last year.
Among its many drugs in late-stage development are Xolair, a treatment for allergic asthma and seasonal allergic rhinitis, which is expected to be approved by the FDA later this year or early next. Given the size of the market, analysts believe the drug should get off to a fast start, generating $200 million in worldwide sales next year. Genentech also plans to file for FDA approval (this year or next) for Xanelim, a new treatment for the skin condition psoriasis. Some analysts have gushed that the latter could eventually become a $500-million-a-year drug. And these are just a couple of the company's promising drug candidates. "Genentech has products in all the key stages," says Sergio Traversa, a portfolio manager at Merlin Biomed, a New York-based health-care hedge fund that has returned an average 88% a year since its inception in April 1998.
Trading at nearly 60 times next year's earnings estimate of 94 cents a share, Genentech's stock is by no means cheap. (We think a target purchase price of $50 is more palatable.) Still, with the company committed to delivering five new drugs to the market and having a like number in late-stage development by 2005, analysts expect long-term earnings to grow by 25% a year. It's only a matter of time, many believe, before Genentech overtakes veteran Amgen as biotech's most prodigious survivor.
THE GENOMICS REVOLUTION
Ah, the genome. As even your dry cleaner can tell you by now, the mapping of the human genome was a milestone in the history of science, the equivalent of putting a man on the moon. But whether it's an area in which you want to invest is an entirely different question. It's one of the most volatile and speculative areas of the stock market, riddled with companies that may never earn a penny. Frankly, most individual investors may be best off avoiding the sector completely.
That said, the long-term investment opportunities for those willing to take on some risk could be substantial. It's been estimated that by cracking the code scientists may increase the number of molecular "targets" for developing drugs over the next ten years to 10,000, from just 500 today. With these new targets, scientists expect to develop a new generation of therapies that will attack diseases such as cancer at the level of genes and cells. If there are two companies at this very early stage that are likely to emerge as winners, the savviest portfolio managers routinely point to Human Genome Sciences (HGSI, $53) and Millennium Pharmaceuticals (MLNM, $32). Between them they have just one drug on the market and neither is close to turning a profit. But unlike well-known rivals such as gene-mapper Celera Genomics, both of these companies are already well on their way to becoming full-fledged drugmakers, not merely data providers. "They have such a head start on the others," says Faraz Naqvi, co-manager of the Dresdner RCM Biotechnology fund, the category's longtime top performer.
Founded in 1992, Human Genome used its automated sequencing technology to assemble what it claims is the world's largest proprietary gene database (see "Genomics' First Billionaire?" June 25, 2001). It started out providing research support to big drug companies that supplied the firm with near-term licensing fees and the long-term potential for royalty streams. As such, it became the first genomics company to attract the eyes of Big Pharma in 1993, when SmithKline Beecham tapped into its database in a $125 million deal.
Using its strong genomics research platform, Human Genome has developed a promising pipeline of new drugs. It has five products in clinical testing--the most advanced therapy being Repifermin, a wound healer. Last October, GlaxoSmithKline exercised its option to co-develop and co-promote Repifermin, boosting investors' confidence in the drug.
Likewise, Millennium, founded in 1993, built a proprietary technology platform that has allowed it to rapidly identify large numbers of potential drug targets. The value of its technology has been validated by its huge strategic alliances, most notably a $465 million agreement with Bayer in 1998 and a $450 million deal with Aventis in 2000. In its deal with Bayer, the firm agreed to provide an astonishing 225 drug targets in seven disease areas through 2004.
Millennium also has major drug-discovery efforts of its own. It has six products in clinical trials focusing on everything from prostate cancer to asthma. In May the FDA approved its first drug, Campath, for treatment of a form of adult leukemia. While that isn't likely to be a huge seller, analysts estimate that Millennium's cancer-fighting compound LDP-341 could, after an anticipated launch in 2004, become a $1 billion-a-year drug by late in the decade.
Like most genomics stocks, shares of Human Genome and Millennium bounce around like lines on an EKG machine. After falling as much as 75% from their highs last year, both have rebounded somewhat. Now, however, is probably a pretty good time for aggressive investors to start buying while remaining ready to add to their position during the inevitable dips. Naqvi, who's been buying the stocks lately for his fund and his personal account, believes both companies could have several products on the market five to eight years from now, boosting their respective revenue streams to as much as $2 billion or more. When one considers that Human Genome now has about $22 million in sales, and Millennium $196 million, we'd call that a lot of upside potential.
If the sequencing of the human genome was a breakthrough for scientific thought, it was also a triumph for the companies that manufacture the increasingly sophisticated tools of the lab scientist's trade. Technological advances in the ability to analyze genetic data enabled the innovative new strategies that led to this scientific landmark. By making the "picks and shovels" of the rush for genetic gold, industry players like Applied Biosystems (Celera's sister company) also created spectacular returns for investors. But things in this once-booming area have turned ugly.
Back-to-back second-quarter profit warnings by former highfliers Affymetrix and Waters, which make complex and expensive lab instruments, confirmed fears that a full-fledged spending slowdown was in effect. Many investors fled for cover. (Affymetrix and Applied Biosystems are both down more than 70% this year.) All the more reason, says Dresdner's Naqvi, why it's critical "to pick companies where you can have confidence in the earnings stream."
With that principle firmly in mind, one of Naqvi's top picks is Carlsbad, Calif.-based Invitrogen (IVGN, $67), which is fast becoming a dominant player in the market for "reagents." These consumable research products enable scientists to save time, have greater quality control, and more easily reproduce results in genetic experiments. Though massive amounts of raw data on DNA sequences being produced in genomics will yield thousands of new drug targets for researchers over the next few years, the relevance and potential of each target need to be evaluated in order to progress with drug development. In a period of belt-tightening, biotech researchers are cutting down on requests for big-ticket items like $50,000 mass spectrometers. They are unlikely, however, to give up the $500 kits that Invitrogen sells and which make their lives easier and research better. "In a market like this, I'd rather be selling laundry detergent than washing machines," sums up analyst Tim Wilson of Bear Stearns.
Although the reagent business is a rapidly growing market, it previously had no dominant brand name. Invitrogen is quickly assuming that mantle. The company made four key acquisitions in the past two years, the most notable of which is the $1.9 billion purchase of Life Technologies last September. The Life buyout alone tripled Invitrogen's revenue to an estimated $640 million for 2001. It now has a dominant market share in most of its products and is well positioned to make other acquisitions in high-margin niche areas. "This move consolidates two big players," says analyst Jim Patricelli, of Deutsche Banc Alex. Brown. "I think this will prove to be a watershed moment."
The market's initial reaction to the purchase, however, was negative. Invitrogen, a fast-growing and innovative company, was faced with swallowing a bigger, more mature, and slower-growing competitor. Since the merger took effect, though, Invitrogen has moved aggressively to integrate its new parts. Management has begun to sell off non-core businesses and eliminate dogs in the supply chain. The company has already dropped close to 30% of the products in last year's catalog--which accounted for less than 2% of sales. Meanwhile, its bulked-up sales force has been retrained to focus on higher-margin products. There's still a danger that the slowdown could catch up to Invitrogen this fall. But analysts, impressed by the company's rapid reorganization, see Invitrogen regaining its 25% growth rate within the next year. "If that happens," says Wilson, "they're golden."
When it comes to the drab-sounding world of lab-testing stocks, there are two kinds of companies--those that have done well over the past year and those that have soared. The U.S. Bancorp Piper Jaffray Diagnostic Services Index, which tracks the industry, is up 339% since the beginning of 2000. The S&P 500, by contrast, is down 16% over the same period.
It's no mystery that testing is so hot: Investors began to realize last year that companies that process such mundane tests as Pap smears and blood-cell counts are already playing a key role in the much publicized advances in genomics. "In the past labs were there to determine, 'Do you have [a disease] or don't you have it?'" says Bill Bonello, who covers the industry for U.S. Bancorp Piper Jaffray. "Now they're saying, 'Are you predisposed to have it, how should it be treated, and is the treatment working?'" Better yet, unlike most of the pure genomics plays, these are real companies with real earnings and growing revenues.
That leaves just one problem. At this point the stocks are prohibitively expensive. Can testing stocks sustain multiples that would make tech investors cringe? The answer: not likely. But when the overheated sector cools--as it inevitably will--these two companies are positioned to shine.
The first is industry leader Quest Diagnostics (DGX, $72). Out of nowhere, Quest rose 364% last year to earn the title of best-performing stock in the FORTUNE 500. How? While hospitals still handle most tests, Quest's 1999 purchase of SmithKline Beecham's lab assets gave it a dominant share of the outsourcing market. And it also knocked out its most aggressive competitor.
With such a huge reach, Quest can afford to stretch its tentacles into nearly every corner of the business. For example, it's busy bulking up its gene-based testing unit, which is growing 25% a year. And it has just launched QuestDirect in five states, a service that lets individuals get screened for HIV or take pregnancy tests at walk-in centers, then access the results over the Web. And the company continues to dominate its bread-and-butter market for everything from cholesterol screens to blood work ordered by doctors' offices and hospitals across the country. Quest's size, analysts point out, gives it a huge advantage when hammering out contracts with managed-care companies.
Calling current earnings estimates "conservative," Bonello likes the stock at $65, which would give it a P/E of around 28, well below Quest's peak P/E of 45 times forward earnings.
Our second pick is Specialty Labs (SP, $37). The company went public in December of 2000--and in one month of trading still managed to be one of the hottest IPOs of the year. SL's forte is so-called esoteric testing, the kind of complex assays that most hospitals can't perform in-house. In late June, for example, the company announced an agreement for the exclusive U.S. rights to the first genetic test that can measure an individual's predisposition to osteoporosis. Specialty Labs' 3,500 other products include, for example, a test which doctors use to predict whether "drug cocktails" will be effective on certain HIV patients. The company is adding new tests at a rate of 100 per year, many of those developed in-house by a team of 38 researchers.
Not only is esoteric testing sexier, it's also a higher-growth, higher-margin business than drab blood counts. While annual growth of routine testing hovers around 2% to 10%, according to the company, esoteric and gene-based tests are growing at a 30% to 50% clip--and cost around two to three times more. With revenues growing at an annual rate of 20%, investors should feel comfortable paying more for a company like Specialty than for other testing companies, but the current 49 times 2002 earnings is tough to justify. Waiting for a dip is the only way to play this company--and this sector. Our target purchase price is a more conservative $30.