Outlook 2006: Biotech stock performance hopes focused on small caps after big letdown in 2005

By Ronda Fears

Nashville, Dec. 30 - Volatility is expected to continue in the biotech sector into 2006, but after some big letdowns among the smaller names in the group last year, many are hopeful for the coming year.

In addition, biotech analysts see certain disease areas likely to be a focus among investors, with hepatitis C, staph infections, diabetes, Crohn's and cancer at the top of the list.

"We anticipate better relative value in the mid- to small-cap biotechs compared with the large-caps, given that large-caps have outperformed mid- and small-caps by 30% and 40%, respectively, over the last year," said Merrill Lynch's top biotech analyst, Eric Ende, in a recent report.

"In addition, we believe investors have shunned smaller biotech stocks with binary events in order to avoid a potential year-end blow-up. But we expect risk appetite to improve as the year begins and performance measures are reset."

The Nasdaq Biotechnology Index for smaller companies at year-end 2005 was up about 6% compared to the whopping 42% increase for the Amex Biotechnology Index for bigger names. By another measure, the Burrill Biotech Select Index was up 18.5% for 2005 through Nov. 30 while the Burrill Mid-Cap Biotech Index was up 5.4% for the 2005 period and the Burrill Small-Cap Biotech Index was down 15.7% for 2005 through the end of November.

While some small and medium size biotech companies have fared well, overall the smaller companies were spurned in 2005 as many of those stocks showed negative performance in 2005.

Big Biotechs vs. Big Pharma

With the surge in Amgen, Inc. and Genentech, Inc. in 2005, big biotech players have become an alternative investment to Big Pharmas, what with bigger growth potential, lower generic risk and the licensing deals inked with Big Pharma, not to mention potential acquisitions.

"Big pharma is reacting to its pipeline and investor blues," noted G. Stephen Burrill, chief executive officer of Burrill & Co. "Drug discovery and development costs have risen dramatically over the years and the pipelines are drying up, and there is significant competition from generics. With consumers clamoring for lower prices and at the same time regulators increasing scrutiny and delaying approval [this translates into more costs], it's not a pretty picture for big pharma.

"But the biotech industry with its robust product pipeline is benefiting from the pharmaceutical industry's malaise, as witnessed by the fact that pharma is willing to pay highly for access to biotech's innovation."

Yet, Merrill Lynch biotech analysts warn that it is late in the bull cycle.

"The biotechnology sector is 2.8 years into the most recent bull cycle, which typically last 2 to 3 years," said Merrill's Ende. "The supply of potential equity deals is approaching an all-time high at $8.6 billion with 67% of biotech companies in need of cash, suggesting the potential for a flood of new equity deals in 2006, and valuations have modestly surpassed historical norms."

Merrill's top picks for 2006

Merrill's top picks for 2006 features, not surprisingly perhaps, Amgen among the large-cap names. For mid-caps, the firm likes Protein Design Laboratories, Inc. and Cubist Pharmaceuticals, Inc.

Cubist, Merrill analysts said in a recent report, could find profitability sooner if the use label for its antibiotic Cubicin is expanded. "Expanded Cubicin sales may not yield a hockey stick sales inflection," the Merrill analysts said, but "we project break-even should be reached in mid-06, and the company may have full year profitability in '06 as well."

For a focus on small caps, Merrill's top picks are Theravance Inc., New River Pharmaceuticals Inc. and Keryx Biopharmaceuticals Inc.

Keryx, Merrill's analysts said, has a potential blockbuster drug in its Sulonex. The unpartnered drug, the investment firm says, should be a strong driver for Keryx in 2006 and 2007. "We believe Keryx will be a second half '06 to early '07 story, with enrollment for the 1,000-patient phase 3 trial for Sulonex in diabetic nephropathy to be completed in the second half of 2006, setting up a possible NDA filing in early '07, and launch at year-end '07 or early '08."

Some to sell for 2006

Merrill's top sell names are Imclone Systems Inc., Martek Biosciences Corp. and Elan Corp. plc.

Imclone actually topped the sell list at Merrill, with the biotech analysts saying: "We expect IMCL to receive a $250 [million] milestone payment for Erbitux approval in head and neck cancer in first quarter '06. However, we expect the stock to fall once investors begin to factor in the likelihood that ABGX/AMGN's [Abgenix/Amgen] panitumumab will erode Erbitux's market share and hurt pricing in the colorectal cancer market."

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