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Pharmaceuticals Industry

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We are generally positive on the pharmaceutical industry heading into 2009. We expect the majority of stocks to fair far better in 2009 than they did in 2008, based on a number of attributes.

Firstly, almost all the names in the group are trading at very reasonable valuations. Several of the largest players are trading at PEs below 10x, including Pfizer Ltd. (PFE - Free Report) , 8x), Eli Lilly & Co. (LLY - Free Report) , 9x), Merck (MRK - Free Report) , 9x), AstraZeneca (AZN - Free Report) , 9x) and Wyeth , 10x) based on our fiscal 2009 estimates.

Secondly, expectations are low. Most of the companies are not expected to generate significant revenue growth, and earnings growth is primarily being drive by cost-cutting and share buybacks. Therefore, there seems little downside risk to our financial models, even should the economy continue to struggle throughout the entire year. So we do not see much risk in the names becoming "sneaky expensive" based on massive downward revisions to earnings. Most of the names are dirt cheap based on low expectations -- that presents substantial potential for upside.

Thirdly, the industry's cash position has never been stronger. Pfizer, one of our top-picks for 2009, is sitting on over $30 billion in cash.  Other Buy-rated names, including Bristol-Myers Squibb (BMY - Free Report) and Johnson & Johnson (JNJ - Free Report) , are sitting on $8 billion and $15 billion, respectively. This should allow for a significant deal activity later in the year.

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. 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 entire industry to push higher in 2009 as sentiment on small biotech turns positive perhaps later in the year.

Finally, large-cap pharmaceutical names are paying hefty dividends. That's something all investors should be looking for given the rocky financial markets. Pharmaceutical companies are well-capitalized with financial sound business models. Pfizer's huge dividend of 7% is not only very attractive, it is also safe. Bristol, Merck and Lilly are all yielding 5%. Two of our top-picks for 2009, Johnson & Johnson and Abbott Labs (ABT - Free Report) , are both yielding 3%.

OPPORTUNITIES

We recommend an over-weight exposure to large-cap pharmaceuticals in 2009. For growth funds, our two top-picks are Bristol-Myers (BMY - Free Report) and Abbott Labs (ABT - Free Report) . Bristol is expected to growth earnings by 12% CAGR [compound annual growth rate] through 2012. 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 two very promising candidates, apixaban and saxagliptin, both of which could be blockbusters if approved.

Growth at Abbott is being driven by blockbuster drugs such as Humira for rheumatoid arthritis and the company's drug-eluting stent, Xience. 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.

Our two top-picks for value-focused portfolios are Pfizer (PFE - Free Report) and Johnson & Johnson (JNJ - Free Report) . Both companies are trading around 1X growth (PE/G). Pfizer will struggle to grow the top-line over the next few years, but the company's big dividend and big cash balance should make it a great investment for the long-haul.

Here is one of our favorite stats: Pfizer's $30+ billion in cash is enough to buy Biogen Idec (BIIB - Free Report) , Amylin (AMLN), Forest Labs (FRX), Sepracor (SEPR), Dendreon (DNDN), Arena (ARNA), Onyx (ONXX), OSI Pharma (OSIP) and Elan (ELN) -- all without issuing one share. Watch for Pfizer to put its cash to work in 2009 to help grow that stagnant top-line in the future.

J&J's defensive nature allowed the company to hold up well over the past year. J&J was the third-best-performing DOW stock in 2008 thanks to the reliability and consistency of its medical device and consumer healthcare business. We expect J&J to be acquisitive in 2009 as well, and the pharmaceutical pipeline is among the largest in the industry.

In the large-cap biotechnology market, we remain bullish on Genentech and Biogen Idec (BIIB - Free Report) . Both core businesses remain solid, and both companies have an enormous biologic pipeline and manufacturing footprint. These are two key assets that should allow both Genentech and Biogen to outperform when normalcy returns to the market.

We also favor Amgen (AMGN - Free Report) and Gilead (GILD - Free Report) on a pullback. Large-cap biotech was strong in 2008; that trend should continue in 2009.

WEAKNESSES

Avoid names that are in the opposite position. Stay away from anyone trading on the hopes and prayers of a phase III trial outcome or the decision of the FDA. Now is not the time to be taking on 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. We saw our share of surprise rejections and clinical failures last year, 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.

Finally, do not try to predict which companies are going to be taken out. There are far too many small-cap names, and big pharma rarely comes in to rescue of stocks below $5. We do not recommend trying to catch falling knives such as Amylin (AMLN), Forest Labs (FRX), Arena (ARNA), Sepracor ([url=https://www.zacks.com/research/report.php?t=SEPR]SEPR[/url]) or United Therapeutics (UTHR). Rather, wait for the recovery and buy any one of the above down-and-out names when confidence returns.  Until then, now is not the time to try to be a hero.

Last updated:  January 2, 2009





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