A Time of Innovation

In the long term, I would expect biotech to continue to innovate and be associated with stellar top-line growth prospects in health care. That said, this year the biotech group is down primarily due to disappointments from the FDA. It doesn't necessarily have to do so much with the FDA not approving drugs as it does with the FDA clamming up in this post-Vioxx environment and issuing what we call approvable letters. It almost seems as if the FDA will only approve a cancer drug on its first cycle approval and for indications that are less severe.

Buys: Adolor (ADLR); Array BioPharma (ARRY); Avalon Pharmaceuticals (AVRX); and Exelixis Inc. (EXEL)

Top Pick: Adolor Corporation

Why Adolor: Adolor is a late-stage biotechnology company that has a string of very significant catalysts in front of it for the second half of the year. Its lead product is Entereg. Entereg negates the gastro-intestinal side effects associated with opiates. Entereg, in the chronic setting, goes after chronic opioid-induced bowel dysfunction (OPD). About four million to five million Americans who have this condition are not responsive to standard remedies.

Phase Two studies had very impressive results, increasing the quality of the life of these patients. Phase Three data, due toward the end of September, are expected to be positive and to serve as a significant catalyst for the company. The next catalyst is the FDA decision on the lead indication for Entereg. The lead indication is a condition called post-operative ileus (POI), and this is the acute setting for the drug. The particular application is for patients undergoing bowel surgeries. The data show an improvement in gastro-intestinal function and shorter hospital stays.

Overall, totality of the data set was very impressive. An FDA decision is expected in early November, and the drug is expected to be approved.

Finally, the last key catalyst for Adolor should occur before the year's end. It's basically visibility on the combo program. Adolor is evaluating the potential of combining the active ingredients in Entereg with Vicodin.

This has a billion-dollar potential because the company owns 100 percent of the rights to the combo program. (For the Entereg product, Axolor has a relationship with GlaxoSmithKline in which Axolor gets slightly less than 50 percent of U.S. profits plus mid-double-digit royalties for sales outside the U.S.)

—–

William Tanner

Leerink Swann

212-446-6766

[email protected]

Outlook: Across the board, the market is tough right now. There are a lot of geopolitical concerns. Inflation has been a problem. These and other factors make people flee to stocks that are more stable than biotech.

That said, I have been covering this sector for 10 years, and you definitely see the industry maturing. There are more companies that are profitable, and more companies that have drugs on the market. There are also more companies that are closer to getting drugs on the market. So biotech is definitely maturing.

The real question comes down to separating the winners from the losers — figuring out which companies are going to be successful and which ones are going to blow up. This year, we have already had several blowups. So that's going to kind of shake people's confidence from time to time. People talk a lot about mergers and acquisitions and all the M&A activity in the group. It's been fairly well known that pipelines of big cap pharma companies are probably not adequate for them to maintain decent earnings growth going forward. They will have to go out and license drug candidates' products and/or acquire biotech companies.

From a regulatory perspective, the FDA has become much more risk adverse and much more concerned about safety. That's probably a net negative for everybody that's developing drugs since agencies can require companies to do a lot more clinical testing which takes time and costs money.

Finally, a lot of biotech companies are developing drugs for the treatment of cancer. You have to worry whether the ability of the system to actually pay for these extremely costly therapies will, at some point, break the system or will there be downward price pressure on the products.

Outperforms: Amgen (AMGN); Biogen Idec (BIIB); Genentech (DNA); and Genzyme Corp. (GENZ)

Top Pick: Genentech

Why Genentech: The company has demonstrated the greatest R&D capabilities, and it is the most innovative. As for financial performance, it expects to grow earnings from 2006 to 2010 at a compounded annual growth rate of at least 25 percent. Most of the companies in the sector with decelerating growth can probably expect long-term growth rates closer to the mid-teens.