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By Grant Zeng, CFA

The Biotech industry as a whole continues to underperform the market so far this year. As of May 26, 2009, both the AMEX Biotech Index and the broader NASDAQ Biotech Index declined 6.8% (AMEX Biotech has 20 biotech companies while NASDAQ Biotech Index includes over 130 component companies), while the Dow Jones Biotech Index declined 3% (which includes 33 companies).

At the same time, both the NASDAQ Composite and S&P 500 have achieved positive returns. NASDAQ has made a gain of 11% as of 5/26/09 and the S&P 500 has gained 0.8%, while the Dow Jones Industrials reached a negative 3.5% return.

This constitutes a sharp contrast with last year when the Biotech industry as a whole achieved much better performance than the market. In 2008, all three biotech indices outperformed all three major market indices by a large margin. The three major indices declined as much as over 40% (34%, 41% and 38% for Dow, NASDAQ and S&P 500 respectively). While the NASDAQ Biotech Index declined only 12.6% and the AMEX Biotech Index was down 17.7%, the Dow Biotech Index actually had a positive 3.7% return in 2008.

This can partly be explained that when the recession gets deeper, even large-cap biotech companies will feel the pinch, while the smaller ones are still struggling with survival. Usually large-cap biotech companies, like large-cap pharma ones, have more resources to withstand economic downturns and financial crises than smaller biotech companies which have limited revenue and cash reserves. The current economic and financial environment has exerted negative impact on even large-cap biotech companies when patients curtail their out-of-pocket expenses.

Valuation is attractive though. The industry's average P/E (TTM) ratio has declined to 16x from a historical 35x to 40x. The five-year PEG ratio is less than 1 at 0.97, according to Yahoo Finance. But big pharma and biotech companies still face three major challenges: patent expiration, low research and development productivity, and generic competition.

We expect continued M&A activity in the remainder of the year after a series of mega deals in the first five months of the year. We believe the current market environment in the Pharma/biotech industry is favorable for M&A activity. With very active M&A's in the pharma/biotech sector, investors have every reason to speculate on buyout targets. Opportunity also exists in companies with decent pipeline which may attract big pharma or biotech companies for partnerships.

OPPORTUNITIES

Our best picks at this point include Myriad Genetics (NASDAQ:MYGN), Onyx Pharmaceuticals Inc. (NASDAQ:ONXX) and AMAG Pharmaceuticals Inc. (NASDAQ:AMAG), Dendreon (NASDAQ:DNDN) and 3SBio Inc. (NASDAQ:SSRX). We have different reasons for a BUY rating for each of the four companies, but all of these companies have one thing in common -- strong balance sheets, which eliminates immediate financing needs.

Both MYGN and ONXX are already profitable. MYGN is a molecular diagnostic company. The company's molecular diagnostics business has been very strong and continued to grow impressively in fiscal third quarter of 2009 (ended March 31), and the outlook is bright even at the current economic environment. Our price target is $50.

Our BUY call on ONXX is based on strong performance of its cancer drug Nexavar partnered with Bayer Healthcare. Nexavar has been approved for kidney cancer and liver cancer, and sales remained strong in 1Q09 and will continue their momentum in the coming quarters. With profits at its back, ONXX recently in-licensed two cancer drug programs, while continuing to expand Nexavar labels.

With a cash balance of $467 million and no debt as of March 31, 2009, ONXX is well positioned for long-term growth. The company is also cooperating with Bayer for Nexavar, which makes it a potential and meaningful buyout target by Bayer. Our price target is $37.

For AMAG and DNDN, both are late-stage development companies. AMAG filed an NDA for its lead drug Feraheme (Ferumoxytol) in December 2007. Feraheme is indicated for the treatment of iron deficiency anemia, and we expect the FDA approval to come by the middle of 2009. AMAG is not profitable yet, but with Feraheme approval at its fingertips, the company should enjoy strong growth in the coming years. The balance sheet is strong. As of March 31, 2009, the company had $195 million in cash, cash equivalents and investments and no long-term debt. Our price target is $62.

DNDN's lead product candidate Provenge is indicated for the treatment of prostate cancer. The company reported positive results from its IMPACT phase III trial in April 2009 and will file a sBLA to the US FDA in fourth quarter of 2009. We estimate that the FDA will approve Provenge in 1H10. Our price target is $25.00.

We also have a Buy rating on 3SBio Inc. SSRX is an integrated, China-based biotech company focused on developing and marketing therapeutics for nephrology, oncology and cancer supportive care. The company's flagship product EPIAO is the number 1 brand in the Chinese EPO market. Its second lead product TPIAO has gained rapid physician acceptance for thrombocytopenia, and is making a meaningful contribution to the company's top-line growth. A recent deal with US-based AMAG Pharmaceuticals Inc. will boost its expansion into IV Iron market. Our price target is $10.

WEAKNESSES

We continue to be negative on SurModics Inc. (NASDAQ:SRDX), Alkermes (NASDAQ:ALKS) and Celera Group (NASDAQ:CRA) based on financial performances from the most recent quarter ended March 31, 2009. The recession has finally taken a toll on both top line and bottom lines of these companies, and the outlook is not optimistic.

We also suggest investors avoid small biotech firms with weak balance sheets, particularly those which need immediate financing. Even with a promising pipeline, these small biotech firms may suspend operations and may be forced into survival mode without immediate new funds until current financial market and economic situations improve. We continue to suggest investors to avoid Genta Inc. (OTC:GNTA), Cell Therapeutics Inc. (NASDAQ:CTIC), Decode Genetics (DCGN) and Cyclacel (NASDAQ:CYCC). All these tiny biotech firms have great pressure for further financing in the next 6 to 12 months, and they have entered into survival mode in order to save cash.

Source: Biotech Opportunities: Look for Decent Pipeline, Big Pharma Partnerships