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While it is easy to visualize what pharmaceutical firms or medical device firms produce, the life science segment seems a little hazier to investors. We do not encounter its products in daily life, nor do we usually see them in the doctor's office. Life science firms produce equipment and consumables (such as tests and reagents) for use in research, applied markets, and diagnostic labs. Research customers come from government and university laboratories as well as from the development arms of large pharmaceutical and biotechnology companies. Life science products also trickle down into the applied market for use in forensics, agriculture, and environmental testing. These firms also make products for molecular diagnostics to detect mutations or strains of viruses, like the H1N1 flu. While we don't currently have any 5-star calls in our life science coverage universe, we still view the market as attractive and have outlined our broad expectations for 2011 as well as our view of potential mergers and acquisitions targets.

Weak Overall Health-Care Spending Will Persist in the Near Term

A broad consumer pullback in health-care spending didn't spare life science firms with exposure to health-care end markets, especially those with diagnostic test offerings. The suppressed demand is likely to linger for several more quarters as high unemployment figures, loss of COBRA benefits, and general macroeconomic uncertainty are unlikely to dissipate quickly. We believe physician visits and lab testing will remain low until the insurance coverage and employment situation improves, though some industry giants like Becton Dickinson (BDX) have reported stabilization in demand the last few quarters. On the upside, the health-care reform provision that eliminates a deductible for preventative services in 2011 should be a catalyst for the industry, and we anticipate lab volume to pick up starting in the first quarter.

Pharmaceutical Research Spending Should See an Uptick Due to Pent-up Demand

We anticipate Big Pharma's demand for discovery tools will continue to be tight, but the situation looks marginally better than in early 2010. After a wave of megamergers in the past year, pharmaceuticals firms embarked on massive restructuring programs, closing manufacturing sites and cutting research staff. However, given the constantly evolving technological requirements for drug discovery and development, the average research equipment is becoming aged. This sets up the possibility that Big Pharma could choose to ramp up its investment in capital equipment, particularly as investor focus turns away from patent cliffs and onto new drug introductions. While we are not incorporating sizable growth from this end market into our projections, even lukewarm but improving demand from Big Pharma positions life science firms well for 2011.

We are being conservative on our view of the National Institutes of Health (NIH) budget for this year. The NIH, which provides funding to researchers, has requested $32 billion in funds for the fiscal year, though congressional budget proposals could cut funding levels.

Emerging Markets Will Provide Long-Term Growth

A shift of manufacturing to low-cost regions has coincided with a greater sales push toward emerging markets, and local sourcing should aide these efforts. Life science firms have increasingly looked toward Asia for growth prospects. With rising middle classes, growing emphasis on food, water, and air quality, and the expansion of health-care spending (especially with China's health-care reform package), Asia/Pacific has the potential to generate strong double-digit annual growth in the coming years for the industry.

A Look at the Deal Environment

The availability of cheap debt financing in 2010 accelerated the pace of transactions and afforded buyers flexibility to pay a premium for attractive targets; no major deals in this space came at a bargain. In March 2010, Merck KGaA (OTCPK:MKGAY) acquired life science and biopharmaceutical tool provider Millipore for around $6 billion, representing about a 45% premium to Millipore's stock price before acquisition rumors started in late February 2010. In December, Thermo Fisher (NYSE:TMO) spent $2 billion to acquire chromatography competitor Dionex. In February 2011, diagnostics giant Beckman Coulter (NYSE:BEC) agreed to be acquired by conglomerate Danaher (NYSE:DHR) in a deal valued at $7 billion, a 26% premium to our fair value estimate.

We think that Thermo Fisher will remain an active acquisitor in this space. We continue to recommend Thermo's shares as its long-term competitive dynamics and growth trajectory (both revenue and earnings) remain compelling despite the lukewarm overall demand. The firm's superior access to customer channels, the one-stop shop value it provides to customers, and the leading exposure to emerging markets should yield above-market long-term revenue growth. Meanwhile, an ongoing commitment to operational improvement, increasing sourcing from low-cost regions, operating leverage, and robust share buybacks should generate strong earnings momentum once top-line growth returns.

We see two firms in our coverage universe as attractive acquisition candidates. Mettler Toledo (MTD presents a good case of a firm with attractive instrumentation and leadership positions. The firm holds a lead in the laboratory balance equipment and pipette market, with a third of sales outside the U.S. and half of that in China. Industrial conglomerates are likely to be interested in the firm given its strong presence in applied as well as health-care end markets. Mettler Toledo's stock price has risen considerably over the last year and has a market capitalization of $5 billion; that could make it less appealing in terms of price.

Myriad Genetics (NASDAQ:MYGN) is one of our favorite companies in the genetic/molecular diagnostics space, and it is trading into deep 4-star territory. Myriad brings an opportunity to participate in the personalized medicine wave, with tests that help physicians predict an individual's cancer risk and tailor therapies to current cancer patients. Big Pharma has heavily invested on this area and could have an interest in bundling a diagnostic test with a specific drug treatment. Other diagnostic firms could also step in to grab Myriad's intellectual property in this area, though pending litigation on its patents could be deemed a risk to acquisition moves.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Putting Biotechs Under the Microscope