The pharmaceutical industry is entering a period of substantial change in 2009. Most of the names in the industry are facing significant patent challenges in the years to come. U.S.-based firms are facing foreign exchange headwinds, as well. Revenue growth is non-existent, and earnings growth is being driven primarily by mergers, cost-cutting and share buybacks. Knowing that investors rarely pay-up for this type of manufactured earnings growth, we struggle to see a broad-based out-performance for the large-cap pharmaceutical sector in 2009.

Valuations, however, are attractive, with several of the largest players trading at PEs below 10x, including: Pfizer (PFE, 7.5x), Eli Lilly (LLY, 8.1x), Merck (MRK, 8.3x), Sanofi (SNY, 7.5x), AstraZeneca (AZN, 7.6x) and GlaxoSmithKline (GSK, 9.3x) based on our fiscal 2009 estimates. Attractive valuations, along with big dividend yields, should protect investors against significant downside risk even if the economy continues to languish well into the second half of the year.

Additionally, expectations are low. Knowing that most of the companies are not expected to generate significant revenue growth, and that cost-cutting initiatives have generally out-paced guidance and financial modeling, any bit of revenue upside could lead to select out-performance at times during the year.

M&A activity remains the wildcard for investment in the sector. We have already seen three significant mega-deals so far in 2009, with Pfizer’s $62 billion acquisition of Wyeth (WYE) leading the way. Roche’s $46 billion takeover of Genentech and Merck’s (MRK) $42 acquisition of Schering-Plough (SGP) prove that companies are desperately seeking for ways to grow the top-line while cutting-costs all at the same time.

Big pharmaceutical names are keenly aware of their patient situations, and ARE turning to deal-making for the answer. Most of the industry’s largest players are sitting on significant cash balances, and Pfizer, Merck and Roche all proved that capital is available for the top players. We expect more deals to come.

Buy-rated names, including Bristol-Myers (BMY) and Johnson & Johnson (JNJ), are sitting on $9 billion and $14 billion, respectively. Given the difficult cash-raising environment during the second half of 2008, most small to mid-sized biotech firms are eager to partner with pharmaceutical companies in 2009.

According to a recent analysis by the Wall Street Transcript, 25% to 35% of all publically traded biotech firms are sitting on less than six months’ cash. That has created a frenzy within the sector to form alliances and strike deals. The recent emphasis has been on cancer biotech firms heading up to and now post the American Society of Clinical Oncology (ASCO) meeting. J&J just recently announced its intensions to acquire Cougar Biotech (CGRB) for approximately $1.0 billion in cash.

Asset prices for early-to-mid stage product candidates are very cheap, and pharmaceutical companies are now willing to look at phase I and phase II candidates in 2009 — something most managements have been hesitant to do in the past. This should create a much better environment for the biotech industry to push higher in 2009, as sentiment on smaller names has clearly turned positive.

OPPORTUNITIES

We have three `Buy-rated’ names within the large-cap space: Bristol-Myers, Johnson & Johnson, and Abbott Labs (ABT).

For growth funds, we recommend Bristol and Abbott. Bristol is expected to grow earnings by 12% CAGR through 2013. That’s tops in the industry. Growth is sustainable with a product suite heavy in attractive areas such as biologics, cancer and cardiovascular drugs. The late-stage pipeline includes three very promising candidates, belatacept, apixaban and Onglyza (saxagliptin), all of which could be blockbusters if approved. We expect an FDA action on Onglyza later this month.

Bristol is also sitting on nearly $10 billion in cash, and has made it clear they are interested in acquiring biologic assets in 2009. The company came up short last year in their bid to acquire ImClone (they lost to Eli Lilly), however rumors earlier in the week were that the company was in talks to establish a stake in Elan Pharmaceuticals (ELN). Regardless, we think Bristol already has an excellent biologic platform, and would view any move to enhance their position with small-to-mid sized strategic acquisitions as a plus.

Growth at Abbott Labs is being driven by blockbuster drugs such as Humira for rheumatoid arthritis and the company’s drug-eluting stent, Xience. Plus, Abbott has also been highly acquisitive over the past few years, most recently paying $175 million to pick up Ibis Biosciences, a subsidiary of Isis Pharmaceuticals (ISIS), to enhance the company’s position in molecular diagnostics for infectious disease. New products at Abbott that could offer blockbuster sales include TriLipix, which Abbott recently announced AstraZeneca would co-promote in the U.S., and ABT-874 for T-cell driven autoimmune diseases such as psoriasis and Crohn’s disease.

Our top-pick for value-focused portfolios is Johnson & Johnson. The company is trading around 1X growth (PE/G) and sitting on $14 billion in cash. Much like Abbott, J&J has been highly acquisitive over the past year, most recently paying $1.1 billion to acquire medical product maker Mentor Corp. in December 2008 and $1.0 billion for cancer biotech firm, Cougar Biotechnology in May 2009. We expect that J&J will continue to look for acquisition targets in both pharma and medical devices throughout the year.

The big opportunity to out-perform in 2009 is to own the names that are going to be acquired. We have no crystal ball, but names that certainly look attractive and fit the model for a large pharmaceutical company to gobble them up include Biogen-Idec (BIIB), Amylin Pharmaceuticals (AMLN), Vertex Pharmaceuticals (VRTX), Acorda Therapeutics (ACOR), Osiris Therapeutics (OSIR), Auxilium Pharmaceuticals (AUXL), OSI Pharmaceuticals (OSIP) and Elan Corp. All of these companies have what big pharma is looking for — novel compounds with potential blockbuster sales levels at reasonable valuations.

Our top-pick for biotech continues to be Biogen-Idec. Rituxan and Avonex continue to dominate the top-line, but with Tysabri expectations significantly lowered and a late-stage pipeline that boasts seven phase III candidates, we think Biogen is set to out-perform expectations in the years to come. Biogen also possess an enormous biologic manufacturing footprint — a key asset that could help attract interested suitors during the year.

On the small-cap, or riskier front, we would point investors towards Acorda Therapeutics, with its phase III multiple sclerosis candidate, Fampridine-SR. Finally, two biotech firms are the center of the obesity market, Arena Pharmaceuticals (ARNA) and Vivus Inc. (VVUS), will be looking to do deals in the second half of the year, and both could fetch a hefty premium over their current price if the phase III data continues to look strong for their respective candidates.

WEAKNESSES

We continue to recommend avoiding names that offer little growth or opportunity for a take-out. These include companies developing “me-too” type drugs on hanging on the hopes and prayer’s of an FDA approval. Now is not the time to be taking on unnecessary risk. The number of new entity approvals was 24 in 2008, up from 18 in 2007, but the number of rejections and delays was also up.

Throughout 2008 it seemed as though just about every FDA action (PDUFA) date was pushed back and delayed. In 2008, we saw our share of surprise rejections and clinical failures as well. Drug development is a risky business; the success rate on new drugs from preclinical to approval is less than 5%.

Stay away from companies that are all ideas and no assets. Above we discussed some key measures to hang your hat on: cash, dividends, pipelines and strategic assets like biologic manufacturing. If your target company has none of these, now is probably not the best time to roll the dice.

Run from any company looking for money or looking to raise money in the next year. Interest rates on direct financing loans are going to be through the roof, and stock prices are down so big that share offerings will be painfully dilutive. Unless the company is looking to partner with large-cap pharma, expect out-of-cash small-cap biotech to remain out-of-favor.

Above we listed several names that could potentially be taken-out by large-cap pharmaceuticals at some point during the year. In contrast, owning the name doing the acquiring is often a sure-fire way to see quick under-performance. Pfizer’s stock dropped by 25% shortly after announcing the Wyeth acquisition.

We would be cautious on three names in particular: Sanofi, AstraZeneca and Eli Lilly, as these are the three largest players in the sector that are likely to “go shopping.” We continue to believe the acquisition of Wyeth by Pfizer simply creates an even bigger struggling company. Wyeth is not the saving grace for Pfizer. Both companies have significant patent expirations in the years to come, and both companies have been severely lacking in their R&D productivity over the past few years. We recommend avoiding both names.

Our “counter-point” idea for those seeking a contrary investment is to short Amgen (AMGN). Results over the past few quarters demonstrate the challenging environment for Amgen, specifically with its key products, Aranesp and Enbrel. Management believes that the first quarter represents a trough with respect to product sales. That may be true, but we struggle to see what re-accelerates Amgen’s top-line in the second half of the year from the trough.

Management’s revenue guidance of $14.4 to $14.8 billion looks high to us, and seems to include significant inventory stocking on key product and/or a big upfront licensing deal for denosumab. We are hesitant to model either. Amgen should be able to meet its EPS target of between $4.55 and $4.75, but with the top-line most likely staying weak, we struggle to see how the stock moves higher.

In our opinion, buying Amgen now means you are supremely confident of denosumab approval in October 2009. Denosumab may just be a surefire blockbuster for Amgen, but there are still three major phase III programs ongoing with the drug, and betting that the FDA will give the thumbs up to a drug like complex biologic drug like denosumab — on time, on first-cycle — is something we are not comfortable recommending.Zacks Investment Research

Last 5 posts by Zacks Market Commentaries

• Switched Digital Video Thriving - Analyst Blog - February 9th, 2010
• Boeing Progressing on 747-8 - Analyst Blog - February 9th, 2010
• Atmel Beats Expectations - Analyst Blog - February 9th, 2010
• Aeropostale Lifts Guidance - Analyst Blog - February 9th, 2010
• Label Expansion for AZN Drug - Analyst Blog - February 9th, 2010