Geoffrey Meacham, Ph.D.
Analyst, JP Morgan
Biotechs underperformed the broader market in 2006 with the BTK index up 10.8% versus 13.6% for the S&P500. For 2007, our sector view is modestly positive as M&A activity, above-market revenue, and earnings growth should drive outperformance. However, the changing political environment and crowding therapeutic competitive landscapes are risks.
In 2007, the large caps should see revenue and EPS growth of 14.7% and 23.5%, forecasts that have clear upside potential. Celgene (CELG), Biogen Idec, and Genentech have, in our view, the strongest revenue and EPS upside potential in the group.
There were ten announced biotech acquisitions in 2006, up from eight in 2005 and we expect M&A trends to continue in 2007 as big pharma and to a lesser degree big biotech uses their currency. With S&P earnings decelerating from 14.4% in 2006 to 9.1% in 2007, growth in the biotech sector looks comparatively good.
Strong product launches (e.g., Revlimid, Atripla, Tysabri, Vectibix, and Lucentis) and Phase III data (e.g., Vectibix for colorectal cancer, Revlimid for multiple myeloma, tenofovir for hepatitis B, Tolevamer for C. difficile-associated diarrhea, Remodulin for PAH, MDX-010 for metastatic melanoma, AGI-1067 for atherosclerosis) should continue to drive fund flows in the sector, in our view.
The changing political landscape, including concerns over reimbursement, pricing pressure, and follow-on biologics, should remain a sector overhang, though real action is unlikely to occur prior to the next election cycle. Ironically, ample access to capital is making biotech therapeutic markets more competitive and driving more intra-industry competition. Gilead, Genentech, Celgene, and MedImmune seem competitively well positioned, whereas Genzyme and Amgen, Millennium Pharmaceuticals (MLNM) and OSI Pharmaceuticals do not. The following are our top picks:
Large Cap Biotech
Biogen Idec ($49.75/Overweight): We see upside potential in Biogen Idec shares driven by a better-than-expected launch of Tysabri and better operational leverage than is currently implied in Street consensus. We expect the Tysabri re-launch to accelerate throughout 2007. While third quarter Tysabri sales were modest, our 2007 Tysabri forecast is $357 million.
Biogen Idec did not announce a major investment in external R&D in the fourth quarter, hence, a healthy upside to fourth quarter 2006 EPS should not be surprising. Our EPS forecast for 2007 is $2.58. Looking forward, we expect Biogen Idec to continue external investments in R&D, to the tune of $200–300 million. We note, however, that the R&D spending level has flexibility, Biogen Idec remains valuation sensitive to therapeutic assets that are available, and we do not expect a major M&A transaction that is noncore or materially dilutive.
In spite of the recent “Dear Doctor” letter indicating PML risk for Rituxan in lupus patients, we believe that the Rituxan franchise is intact. In our view, Rituxan remains an extremely safe therapy whose safety and tolerability profile is well characterized with nearly a million patient exposures. Overall, we do not see significant downside to our 2007–2008 Rituxan forecasts of $2.61 billion and $3.11 billion respectively, with growth largely coming from the RA setting.
In addition, Biogen Idec shares are still undervalued, in our view. Trading at 19x our 2007 EPS estimate of $2.58, Biogen shares are still discounted compared to the large-cap biotech peer group, which trade at 31x. With high expense expectations and low Tysabri expectations, we believe Biogen Idec is well positioned to deliver top- and bottom-line upside in 2007.
Biogen Idec’s growth prospects are heavily dependent upon governmental regulatory processes and approvals. Also, if additional safety issues emerge with Tysabri, a negative impact on valuation may occur. We would also point out that additional risks that could adversely impact Biogen Idec’s valuation include the following: failure to achieve regulatory approval for additional indications for current and anticipated future products, changes in government and private reimbursement, slower than expected adoption of newly launched products, the introduction of competitive products, changes in intellectual property status (patents), and any other risks associated with investing in biotechnology securities.
Celgene ($58.04/Overweight): Celgene continues to be one of our favorite names in large-cap biotech despite 2005–2006 performance of +144% and +77%, respectively, versus 25.1% and 10.8% for the BTK index in the same periods. We expect that the next legs of Revlimid growth will come from the European launch of Revlimid in multiple myeloma (EMEA action expected the first quarter of 2007), and increasing off-label use in chronic lymphocytic leukemia (CLL) and non-Hodgkin’s lymphoma (NHL). For fourth quarter Revlimid sales, we are once again, almost Street-high at $145 million. Looking to 2007, we are formally assuming Revlimid U.S. sales of $739 million. However the range is quite broad at $689–$967 million.
What is widely ignored is the company’s mid-stage pipeline, which features CC-4047 for small cell lung cancer, myelofibrosis, and sickle cell anemia where pivotal programs are beginning in 2007; CC-10004, an oral TNF-a inhibitor for moderate-to-severe psoriasis (Phase II data expected in mid-2007) with potential in RA; and an advanced placental stem cell program. Visibility on these programs, which are not in our model, as well as Revlimid in CLL and NHL should continue to increase in 2007, highlighting the value conferred in Celgene’s IMiD franchise as well as the blockbuster opportunities for Revlimid beyond multiple myeloma and MDS.
Revlimid gross margins of 95%+ have transformed Celgene’s P&L since its market introduction as seen by gross margins, which have increased from 79% in the fourth quarter of 2005 to 85% in third quarter of 2006. Now that the European infrastructure for Revlimid commercialization is largely built, we see margin expansion on the operating side looking to 2007. Our operating margin assumptions for 2007–2008 of 41% and 46% look conservative as do our 2007–2008 EPS forecasts of $1.00 and $1.44 (excluding European sales of Revlimid).
Although Celgene is currently trading at 58x our 2007 EPS estimate of $1.00, versus the group at 31x, EPS is expected to top 81% (large cap group: 24%). Accordingly, Celgene’s P/E/growth ratio of 1.7x is still attractive, in our view compared to the peer group average of 1.8x (P/E/growth ratio calculated using four-year EPS CAGR).
We identify three primary risks to our overweight rating. First, Thalomid or Revlimid sales could fluctuate from quarter to quarter due to competition with other drugs, such as Millennium’s Velcade. Second, additional data from Revlimid clinical trials, either for multiple myeloma or MDS could come in below expectations and have a significant negative impact on Celgene shares. Third, there is headline risk associated with the generic thalidomide in the U.S.
Incyte (INCY/$6.19/Overweight): For 2007, we view Incyte as holding significant potential for investors given its broad and maturing pipeline of clinical candidates. Few biotech companies of Incyte’s size can boast the potential of having six candidates in the clinic for six different indications by the end of 2007. Incyte is anticipated to have Phase II trials ongoing for its sheddase inhibitor for cancer, CCR2 antagonist for MS, CCR5 antagonist for HIV, and its 11beta-HSD1inhibitor for type 2 diabetes. In addition, Phase I trials are expected to be under way with two yet undisclosed candidates for both cancer and inflammatory disorders.
Beyond the $800-million deal that the company signed with Pfizer in November 2005 covering its CCR2 program, except MS and one other undisclosed indication, Incyte has retained all rights to the other products in its pipeline. We therefore believe there could be further opportunities for the company to sign licensing deals during 2007 or if it chooses, take some of the products forward itself. With more than $425 million in cash, cash equivalents, and marketable securities, we believe the company has greater financial flexibility to determine when such deals should be made.
We believe that Incyte is presently undervalued. We anticipate that valuation will continue to be tightly correlated with the success/failure of the company’s early-stage pipeline, but the company’s current cash position ($5/share) should sufficiently allow it to continue development and meet short-term debt obligations.
Risks to our rating include the failure of Incyte’s CCR2 receptor antagonists and/or the failure of Pfizer to develop these products, resulting in reduced milestones and royalty payments. The failure of the company’s earlier-stage programs also represents a long-term risk.
Shire (SHP LN/1092p/Overweight): Shire is our long-term top-pick as it is in the midst of a robust product cycle, which supports mid-teen’s five-year earnings growth with the potential for significant upside. The company is launching two products currently (daytrana for ADHD and elaprase for Hunter syndrome) and is expected to launch five in 2007 (NRP104 for ADHD, mesavance for ulcerative colitis, dynEpo for anemia-related to chronic renal deficiency, SPD465 for ADHD, and SPD503 for ADHD). We expect these products to contribute over half of Shire’s revenues by 2011.
We foresee increased focus on the human genetic therapies (HGT) business, as it will likely be the next major value driver after the launch of NRP104 and Mesavance in the first half of 2007. By 2011, we estimate HGT will contribute 25% of Shire’s total revenues, up from our projected 14% contribution in 2007.
Our current five-year low-teen’s revenue growth estimate is predicated on conservative assumptions for new products. We estimate there could be $1 billion in revenue upside by 2011. If half of the potential upside is realized, revenue growth would increase to the high teens.
Shire is trading at a 7% premium to its European mid-cap biopharma and a 4% premium to its U.S. specialty pharma peers on 2008 IBES consensus earnings.
In our view, Shire is one of the few European mid-cap biopharmaceuticals companies capable of generating mid-teens earnings growth over the next five years without exerting heroic efforts. Hence, we believe additional premium to peers is warranted.
Risks to our rating include: earlier-than-expected generic competition for Adderall XR, regulatory delays for new product approvals, and disappointing new product launches.
United Therapeutics (UTHR/$53.66/ Overweight): We view United Therapeutics as a top mid-cap biotech pick for 2007. We believe United trades at an unwarranted discount to its peer group given continued superior bottom-line performance and our expectations for further outperformance. Following a difficult 2006 (-21%), we believe the company’s shares are poised for substantial upside in 2007, driven by above-consensus Remodulin growth and thus EPS outperformance, as well as positive inhaled Remodulin pivotal results mid -year.
We expect Remodulin will continue to exhibit strong growth, where our 2007 estimate of $180 million is ahead of consensus, driving EPS outperformance. We view the Remodulin franchise as underappreciated. We believe any lingering concerns regarding increased sepsis risk with IV Remodulin should be mitigated when the CDC issues its definitive report, which should be in line with a “Dear Doctor” letter sent out in late November, which the CDC reportedly signed off on.
We view the Remodulin franchise as well positioned, where we expect SQ/IV Remodulin will drive near-term growth, followed by inhaled Remodulin, which should drive medium- to long-term growth in the PAH market.
United’s P&L continues to offer significant EPS leverage driven by tight expense control and a minimal share count. The levered P&L backbone has historically allowed United to deliver significant EPS upside, where key value driver Remodulin’s gross margins are in the order of 90%. Indeed, United recently increased its P&L leverage with the buy back of 1.8 million shares of common stock, in addition to committing to buy an additional 2.2 million shares in the next two years. We expect United will remain committed to strict control of the P&L.
We value United shares using a forward earnings multiple that we believe appropriately accounts for the significant leverage in the model. United is currently trading at 21x our 2007 EPS estimate of $2.55 (pro forma), a significant discount to the profitable biotech mid-cap peer group and not fully reflective of the company’s significant EPS growth potential over the next few years.
We identify three primary risks to our Overweight rating. The primary near-term risk is the clinical risk associated with the ongoing Phase II/III trial of inhaled Remodulin.
Should the trial not reach statistical significance, additional studies would need to be conducted, leading to a delay in the timeline for the drug reaching the market. The same risk applies for Phase II/III trials of oral Remodulin, which also have the potential to be registration studies. Should United choose to file in these indications, the company faces regulatory risk when the FDA decides on the drug’s application.
The third risk associated with our rating is commercial risk, as United markets Remodulin in a highly competitive space against more experienced and better-funded biopharmaceutical companies, and could miss Street consensus forecasts for quarterly financial performance.