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At the end of every year, almost all analysts publish what they think the "themes" will be for the year ahead. In lists of themes for 2012, one theme that shows up time and time again is mergers & acquisitions in the biotechnology and pharmaceutical spaces. Goldman Sachs says so, as does Needham.

It is easy to see why this will happen. Large pharmaceutical companies are facing billions in patent expirations, and anxious investors are looking for them to fill the pipeline with new and innovative therapies. Large cap biotech companies will also become acquirers in 2012, fueled by a desire to "return to the industry's high growth roots."

We have seen this to some extent in 2011, with the purchase of Pharmasset (VRUS) by Gilead (NASDAQ:GILD), and we think 2012 will be no different. So what is the best way to profit from this trend? Rather than buying up a large basket of individual companies, hoping they get acquired, we recommend investors look to two ETF's that can allow them to play this trend from both sides. It is true that the potential payouts are lower than holding a company that gets acquired, that is the trade-off inherent with ETF's. The upside is usually smaller, but so is the downside.

The two funds we highlight today are the First Trust NYSE Arca Biotechnology Index Fund (NYSEARCA:FBT) and the PowerShares Dynamic Pharmaceuticals Portfolio (NYSEARCA:PJP). What makes these two funds appropriate is that through their holdings, they allow investors to capture the potential upside of a rise in drug mergers & acquisitions from both sides. We break down the holdings of these two funds below.

ETF Holdings

Category (% Weight) First Trust NYSE Arca Biotechnology Index Fund PowerShares Dynamic Pharmaceuticals Portfolio
Big 4 Biotech 21.4% 15.38%
Big Pharma N/A 25.02%
Profitable Biotechs 34.61% N/A
Profitable Pharmaceuticals N/A 49.05%
Pre-Commercial & Pre-Profit 43.99% 10.55%

For the record, the Big four biotech firms are Amgen (NASDAQ:AMGN), Celgene (NASDAQ:CELG), Gilead (GILD), and Biogen Idec (NASDAQ:BIIB). We define "Big Pharma" in the United States as Pfizer (NYSE:PFE), Merck (NYSE:MRK), Eli Lilly (NYSE:LLY), Bristol-Myers (NYSE:BMY), Abbott Labs (NYSE:ABT), and Johnson & Johnson (NYSE:JNJ).

These two funds are clearly on opposite sides of the industry, yet both can profit from a coming boom in mergers & acquisitions. The First Trust ETF has nearly 80% of assets invested in smaller biotechs, many of which appear frequently on lists of top takeout candidates. If investors examine the list of companies Goldman Sachs believes have the highest chance of being acquired, this ETF has most of them. The list includes: Alexion (NASDAQ:ALXN), Human Genome Sciences (HGSI), Incyte (NASDAQ:INCY), InterMune (NASDAQ:ITMN), Dendreon (NASDAQ:DNDN), and Vertex (NASDAQ:VRTX). Together, those six companies represent over 26% of the fund's holdings.

In the PowerShares ETF, the situation plays out in a similar way. Close to 60% of assets are held in companies small enough to be easily affordable to the larger drug companies. Many pharmaceutical companies, such as Merck, have openly stated that they will pursue acquisitions to augment their pipelines.

While some investors see this in a negative way, for it will mean paying premium prices for a limited number of viable drug companies, we see it differently. One of the biggest, if not the biggest, concern investors have with "big pharma" is the patent cliff. Estimates are that in the next four years, over $73 billion in sales will be exposed to the patent cliff. With such pressures to revenues, large pharmaceutical companies need to replenish their pipelines with new drugs. Doing so should alleviate investor concern. Thus, we think that stocks of large pharmaceutical companies will rise on the back of acquisitions, as concerns over long-term revenue will begin to abate. That is how these ETF's allow investors to capture the potential upside from a rise in mergers and acquisitions from both sides. Merck has stated that it is going to look towards acquiring drugs in late-stage development. Given the limited number of companies with such compounds, the possibility of bidding wars for smaller pharmaceutical companies, which comprise the majority of the PowerShares ETF, is quite high. Thus, this ETF should benefit from both ends of the deal spectrum.

What about the big four biotechs? All four are in a position to acquire smaller companies in the years to come, although some clearly need to do so more than others. The growth in Amgen's revenue has decreased dramatically, and while new products are slowly ramping up, the company is not growing anywhere as fast as its peers. Furthermore, the company's EPS has been supported by a steady stream of share buybacks, which surpass any of the buybacks in effect at its peers. Below we provide a quick financial overview of the big four biotechs.

Biotech Financials

Amgen Gilead Sciences Celgene Biogen Idec
Market Cap $56.77 Billion $32.13 Billion $29.84 Billion $28.06 Billion
Cash $17.676 Billion $5.482116 Billion $2.579087 Billion $2.86888 Billion
Debt $14.265 Billion $3.893345 Billion $1.546441 Billion $1.064061 Billion
Net Cash $3.411 Billion $1.588771 Billion $1.032646 Billion $1.804819 Billion
5-Year CAGR of EPS 10.4% 31.1% 60.3% 53.1%
5-Year CAGR of Revenue 3.9% 31.4% 46.5% 14.3%
2012 EPS Growth Estimates 9.96% 7.12% 19.05% 7.3%
2012 Revenue Growth Estimates 3.23% 8.33% 12.5% 6%

All of these companies are ramping up their pipelines and expanding. Amgen has Xgeva. Gilead has bought Pharmasset and is expanding its HIV portfolio. Celgene is launching Revlimid and Abraxane into new markets. And Biogen Idec is poised to lead the multiple sclerosis space when BG-12 is approved. Put together, this means that the big four biotechs themselves could be takeover targets.

Mega mergers in the drug industry are not unheard of. Pfizer alone is responsible for two of the largest, including the 2002 takeover of Pharmacia for $56 billion, and the 2009 takeover of Wyeth for $68 billion. The crown, however, goes to GlaxoSmithKline (NYSE:GSK), for the $74 billion merger of GlaxoWellcome and SmithKline Beecham in 2000, creating GlaxoSmithKline. While we do not think that Amgen can be acquired (the premium needed would be far too expensive), even a 100% premium for the other three puts them in the realm of possibility. Should a mega biotech merger or takeover occur, both of these ETFs could benefit.

But what if Wall Street is wrong? What if 2012 is not the year of takeovers? We still think that these ETFs will do well. We have researched the intrinsic value of these two ETFs based on the consensus price targets for their individual companies they hold, and what we have discovered is promising. The weights and prices are current as of the close of trading on Friday, January 6, 2012.

Fair Value of ETFs Based on Reuters Average Price Targets

Company Weight/Present Value in First Trust ETF Weight/Present Value in PowerShares ETF Current Price/Reuters Average Price Target/Upside Value to First Trust ETF Based on Reuters Average Price Target Value to PowerShares ETF Based on Reuters Average Price Target
United Therapeutics 6.02%/$2.09 N/A $48.52/$56.16/15.75% $2.42 N/A
Illumina 5.87%/$2.04 N/A $31.77/$38.58/21.44% $2.48 N/A
Nektar Therapeutics 5.86%/$2.04 N/A $5.73/$12.38/116.06% $4.41 N/A
Amgen 5.59%/$1.94 5.24%/$1.48 $64.76/$64.35/-0.63% $1.93 $1.47
Incyte 5.58%/$1.94 N/A $16.30/$21.93/34.54% $2.61 N/A
Qiagen 5.51%/$1.92 N/A $14.50/$19.18/32.28% $2.54 N/A
Alexion 5.39%/$1.88 N/A $74.45/$75.16/0.95% $1.90 N/A
Biogen Idec 5.39%/$1.88 2.56%/$0.72 $115.50/$125.17/8.37% $2.04 $0.78
Life Technologies 5.26%/$1.83 N/A $42.56/$50.93/19.67% $2.19 N/A
Myriad Genetics 5.23%/$1.82 N/A $21.19/$24.30/14.68% $2.09 N/A
Dendreon 5.23%/$1.82 N/A $12.35/$13.83/11.98% $2.04 N/A
Gilead Sciences 5.22%/$1.82 4.82%/$1.37 $42.78/$48.50/13.37% $2.06 $1.55
Celgene 5.21%/$1.81 2.76%/$0.78 $67.22/$74.65/11.05% $2.01 $0.87
Regeneron 4.99%/$1.74 N/A $65.79/$68.79/4.56% $1.82 N/A
Amylin 4.90%/$1.70 N/A $11.02/$13.68/24.14% $2.11 N/A
Sequenom 4.52%/$1.57 N/A $4.21/$7.03/66.98% $2.62 N/A
Affymetrix 4.04%/$1.41 N/A $4.31/$5.71/32.48% $1.88 N/A
Vertex 4.04%/$1.41 N/A $34.05/$48.05/41.12% $1.99 N/A
InterMune 3.82%/$1.33 N/A $15.05/$30.40/101.99% $2.69 N/A
Human Genome Sciences 2.85%/$0.99 N/A $7.72/$16.88/118.65% $2.16 N/A
Pfizer N/A 5.21%/$1.48 $21.57/$23.19/7.51% N/A $1.59
Merck N/A 5.20%/$1.47 $38.47/$39.52/2.73% N/A $1.51
Eli Lilly N/A 5.04%/$1.43 $39.88/$37.07/-7.05% N/A $1.33
Bristol-Myers N/A 5.04%/$1.43 $34.22/$32.86/-3.97% N/A $1.37
Abbott Labs N/A 4.82%/$1.37 $55.86/$59.35/6.25% N/A $1.46
Johnson & Johnson N/A 4.75%/$1.35 $64.83/$71.63/10.49% N/A $1.49
Prestige Brands N/A 3.29%/$0.93 $11.22/$16/42.60% N/A $1.33
Salix N/A 3.27%/$0.93 $47.87/$51.21/6.98% N/A $0.99
Mylan N/A 3%/$0.85 $21.47/$26.06/21.38% N/A $1.03
Auxillum N/A 2.92%/$0.83 $19.42/$22.07/13.65% N/A $0.94
Akron N/A 2.89%/$0.82 $10.91/$12.75/16.87% N/A $0.96
Jazz N/A 2.81%/$0.80 $45.39/$51.57/13.62% N/A $0.91
Impax Labs N/A 2.8%/$0.79 $20.20/$23.10/14.36% N/A $0.90
Spectrum N/A 2.78%/$0.79 $14.61/$16.80/14.99% N/A $0.91
Allergan N/A 2.69%/$0.76 $87.07/$91.38/4.95% N/A $0.80
Warner Chillcott N/A 2.68%/$0.76 $16.02/$24.56/53.31% N/A $1.17
Medicis N/A 2.66%/$0.75 $32.80/$38.44/17.2% N/A $0.88
Hi-Tech Pharmacal N/A 2.62%/$0.74 $42.24/$32/-24.24% N/A $0.56
Vivus N/A 2.61%/$0.74 $10.16/$11.55/13.68% N/A $0.84
Perrigo N/A 2.61%/$0.74 $96.06/$99.11/3.18% N/A $0.76
Medicines Co. N/A 2.59%/$0.73 $18.25/$22.92/25.59% N/A $0.92
Forest Labs N/A 2.59%/$0.73 $30.60/$35.33/15.46% N/A $0.84
Endo N/A 2.57%/$0.73 $33.80/$43.74/29.41% N/A $0.94
Baxter International N/A 2.53%/$0.72 $50.14/$61.87/23.39% N/A $0.89
Watson N/A 2.37%/$0.67 $63.21/$74.38/17.67% N/A $0.79
Questcor N/A 2.30%/$0.65 $38.95/$41.67/6.98% N/A $0.70
Ending Total 100%/$34.79 (Rounding) 100%/$28.32 (Rounding) N/A $45.99 $31.48

Based on the data above, the First Trust NYSE Arca Biotechnology Index Fund has a value of $45.99, representing upside of over 32% from current levels. And the PowerShares Dynamic Pharmaceuticals Portfolio is worth $31.48, over 11% above current levels. In addition, the PowerShares ETF pays a dividend. The current SEC yield on it is 0.83%.

We think that these two ETFs are the best way to play a coming boom in drug mergers and acquisitions for a reasonable price. The First Trust NYSE Arca Biotechnolgy Index Fund has an expense ratio of 0.6%, and the PowerShares Dynamic Pharmaceuticals Portfolio has an expense ratio of 0.63%. These funds minimize the risk of holding a drug company whose products fail to come to market, and they trade below consensus analyst targets.

Should the boom in mergers and acquisitions occur, these funds will rise as the companies they hold get taken out and investors are placated that the effects of the patent cliff "big pharma" faces can be mitigated. And if there is no increase in mergers and acquisitions, then these funds can rise on the back of the promising fundamentals of their underlying holdings. Either way, 2012 should be a good year for the drug sector. And we think that for the reasons outlined above, these two ETFs are the best way to invest in it.

Source: 2 ETFs To Play A Surge In Biotech/Pharma M&A

Additional disclosure: We hold all the companies mentioned in this article through these two ETFs. In addition, we hold CELG on its own.