As Predicted, More Biotech Buyouts

When I wrote about the Merck (MRK) deal to acquire Sirna Therapeutics (RNAI) on 10/31 and predicted more biotech deals were coming, I didn’t realize it would only take a week and a half. Last night, Genentech (DNA) announced plans to acquire Tanox (TNOX) for $20 per share in a deal worth more than $900 million. The all-cash tranasaction is expected to close by the end of the first quarter.

Tanox is not a company that has gotten much attention on Wall Street, in terms of product potential or as a possible buyout candidate. Like I said in my last piece, it is very tough to know which of these small and mid cap biotechs will get bids. It appears there are some royalty synergies with this deal, which explains in part why DNA targeted them.

On another note, shares of Genentech have been flatlined for a while now (see the chart below) and are beginning to not look as overvalued as they have in the past. While a 30 forward P/E would rarely be considered extremely cheap, further weakness in DNA shares might allow for an attractive entry point for a firm that can grow earnings north of 20 percent per year.

CVS/Caremark Deal Creates Pharmacy Powerhouse

Many investors are scratching their heads after the announcement of a blockbuster deal that would, if approved, combine CVS (CVS) and Caremark Rx (CMX) into a pharmacy goliath with a $40 billion market value and $90 billion in sales. Caremark has been very active in the M&A game in the past but this deal in particular surprised a lot of people. There are obvious synergies between a PBM and an actual pharmacy and it will be interesting to see exactly how the deal turns out, both for customers and for shareholders.

What exactly was the motivation for such a deal? Several ideas come to mind. First, Wal-Mart’s recent decision to price a 30-day supply of generic drugs for as little as $4 is a real threat to the likes of CVS, Walgreen’s (WAG), and Rite Aid (RAD). By merging with Caremark, CVS opens up new, stronger avenues to compete with Wal-Mart (WMT). For one, they can enhance their mail order prescription business (mail order script fills have stronger margins than retail fills). Second, now when Caremark works with corporations and customers on benefit program management, they can steer clients toward CVS retail stores or one of their own mail order pharmacies.

Cost synergies seem inevitable with this deal as well. Computer systems can be made far more efficient with the company adjudicating the claims and the pharmacy filling the scripts on the same team. Cash collections will also likely be improved since the pharmacies and the PBM will not be trying to squeeze each other for their own cash flow gains.

All in all, the combination of bricks and mortar pharmacy, mail order pharmacy, and pharmacy benefits manager makes logical sense. The size and scope of the deal, along with its associated integration, might have made some leery in the past to make it happen. However, Caremark has shown a willingness to make game-changing deals (they acquired AdvancePCS, a large competing PBM several years ago and it proved a very successful transaction).

It will be interesting to see what, if any, response Express Scripts (ESRX) and Medco Health (MHS) decide on. I could also imagine that many Caremark shareholders will be upset with this deal and might even vote against it. Will they be able to halt the deal entirely? Perhaps, but it’s too early to tell. Caremark and CVS will definitely have to sell the deal to naysayers though, and do so convincingly.

Merck Paying $1B for Sirna, More Deals Likely

Pharmaceutical giant Merck (MRK) is clearly looking for ways to boost growth. It’s no secret that big pharma companies face increasing competition from generic drugs and pressure to keep rising healthcare costs in check. Small to mid size acquisitions of biotechnology companies are a solid way for companies like Merck, Pfizer (PFE), and Glaxo SmithKline (GSK) to strengthen their product pipelines.

On Monday we learned that Merck is paying more than $1 billion for Sirna Therapeutics (RNAI). It’s is quite possible that they overpaid. After all, MRK is paying $13 per share in cash, a premium of more than 100 percent over Monday’s closing price. However, overpaying by a couple hundred million dollars isn’t a big deal for a company the size of Merck if several of Sirna’s products eventually reach the market.

There is no doubt that deals like this one will continue. I am generally leery of trying to predict which firms will get taken out next. So, I would suggest that biotech investors pick stocks that have solid fundamentals, not just those that some speculate could get a bid from big pharma.

As for the pharma companies themselves, I like Pfizer at current levels ($27 per share). It trades at a discount to most of the other pharmaceutical companies and yields well over 3 percent. Pfizer has done mid size deals before and likely will do so in the future. In fact, I made a ton on a company called Esperion Therapeutics when it was bought out by Pfizer for $1.3 billion.

With a hefty yield and a below-market multiple, conservative, defensive, income-oriented investors should take a look at PFE. A recent analyst downgrade has knocked the stock down a buck.

Full Disclosure: I own shares of Pfizer personally, as do some of my clients.


Time to Cover Express Scripts Short

Two months back I wrote that shares of Express Scripts (ESRX), a leading pharmacy benefits manager, were bloated at $93 each. A P/E of 30 for the company was simply unsustainable. Today ESRX is down nearly $10 to $74 per share after issuing an in-line earnings report. Although I would not do a complete 180 and go long quite yet, I do think it is time for ESRX shorts to be covered for a 20% gain. Where should the money go? I’m interested in taking a look at Aetna (AET), which is down more than 20% today to $36 per share.

A Healthcare Opportunity For Investors?

If you look at the fundamental outlook for the healthcare industry over the next couple of decades you can’t help but be impressed. After all, the demographic shifts our country is going to see as the baby boomers retire is quite compelling. From an investment perspective, leading companies serving our aging population stand to profit tremendously.

However, the current market climate for such stocks is quite interesting; healthcare stocks are getting hammered with investor interest lackluster at best. We know big pharma is facing severe headwinds. But insurance firms are down, as are medical device companies, not to mention the brutal sell-off in biotechnology in recent weeks.

It’s true that any government-led reform to the healthcare sector could be negative for these companies to a certain degree. Right now, cost containment within Medicare and Medicaid is pretty much non-existent. If policy makers took firm action to bring costs down, pricing pressures would compress profit margins for essentially all healthcare firms.

However, how likely is such broad reform? And even if it does occur, will it completely cancel out all the incremental business gained from the aging boomer generation? I think these are important questions to ask when analyzing the sector and I suspect there are some excellent values beginning to surface, and prices could certainly continue falling in the short-term as governmental involvement is always more of a concern during election years.

Loyalties Aside, ESRX is Bloated

Shares of my former employer, Express Scripts (ESRX), a leading pharmacy benefits manager in the U.S., are going to fall a few points this morning. Earnings reported last night were 2 cents above expectations but the momentum traders wanted more.

Express Scripts had beaten estimates by a fairly wide margin in recent periods, and bulls were undoubtedly hoping for another “beat and raise” quarter. They got the “beat”, but not the “raise”.

Full year guidance remained at $3.10 to $3.22 per share in earnings. ESRX rarely misses guidance, so they will be fairly conservative. They don’t raise guidance often, and when they do, it’s usually only once per year.

At $93 per share, the stock was trading at 30 times 2006 earnings coming into the latest report, historically an astronomical multiple for a PBM company. It’s true that accretive acquisitions are boosting growth rates above competitors like Medco (MHS) and Caremark (CMX), but 30 times earnings for ESRX is too rich, in my view.

As a result, profit taking is in order, and investors have already begun that process this morning.

Cramer Pump Sends NMTI Up 34% After Hours

Nothing really surprises me anymore, but today’s action in NMT Medical (NMTI) is absolutely ludicrous. NMTI is a micro cap medical device company that closed today’s regular session at $17 per share.

Tonight on CNBC’s Mad Money show, Jim Cramer led off the hour-long episode by recommending NMTI, saying it could go to $100 if their new migrane product is approved. If the trials fail, his downside projection was $10 a share. Given the risk/reward he sees, Cramer pumps the stock for several minutes and the stock quickly jumps over 33%, or $6 per share, to $23 and change.

The reason I bring this up is because NMT Medical is one of 10 stocks featured on Peridot Capital’s 2006 Select List, published earlier this month. Thanks to many individual investors who were silly enough to put in a market order to buy, simply based on Cramer’s recommendation, I was able to sell a decent chunk of stock at between $23.09 and $23.75.

First of all, if you purchased our 2006 Select List and are lucky enough to be holding shares of NMTI right now, I strongly suggest taking some profits tonight in after-hours trading, or on Monday if the mark-up holds early next week. There is no fundamental reason for the stock to be up at all, let alone more than 30 percent.

It is true that the company’s devices could be a huge hit if they prove effective, but human trials have not been completed. This stock is very speculative, as was noted in our report, and is not for every investor. In fact, we tabbed it the lone “speculative pick” in the group of 10 companies we profiled in the report. Please trade with caution, especially if you are a fan of Cramer’s show. These are very dangerous waters for retail investors.

Another interesting twist is that NMT, not NMTI, spiked $5 during Cramer’s show, as investors bought the wrong stock with a similar ticker symbol. NMT is a municipal bond fund that closed at $15, but some people paid $20+ for it in after-hours trading. Another example that if you’re not careful, you can lose 25% of your money on a trade within minutes.

Genentech’s Q3 Highlights Healthcare Cost Issues

There is little arguing that the rising cost of healthcare is one of the biggest issues hampering the U.S. economy. Next year, average health insurance premiums are expected to surpass $14,000 per family. That will represent one-third of the average household income in this country. The main reason for such staggering costs are prices for prescription drugs. Drug expenditures, which were $12 billion in 1980, hit $179 billion in 2003. That’s an average increase of 12.5% per year, more than 4 times the historical rate of inflation.

Investors need look no further than the Genentech (DNA) Q3 earnings report to see exactly how crazy drug prices have gotten. Genentech’s newest and second-best selling drug, Avastin, costs a whopping $140 for a day’s supply. That equates to $4,400 per month and $53,000 per year. Should a drug for colon cancer really cost 20% more per year than the average household income in the United States? I bet very few could argue it should.

The argument for limiting the costs of prescription drugs centers around the idea that limited profit potential will result in less research and development, and therefore fewer novel therapies for the world’s most lethal diseases. Without the ability to make a significant profit, proponents of a healthcare free market say, drug makers will lose the incentive to discover new drugs for cancer, heart desease, etc.

However, a simple analysis of Genentech’s third quarter income statement shows that this theory, while it makes sense in economic terms, simply isn’t true when you actually look at the numbers. Here are some key facts from DNA’s latest earnings release:

* Genentech’s drug mark-up (retail price versus manufacturing cost) is 662%

* Only 38% of the drug company’s profit is reinvested into research and development, and net profit after tax actually surpasses total R&D expenditures

* Drug company net profit margins are nearly 20%, higher than any other major industry

And the one that is important to understand when hearing the debate on spiraling costs for prescription drugs:

* If retail prices for Genentech’s drugs were reduced by 50% effective immediately, the company would still be able to spend the same amount it does today on R&D and would have more than $400 million left over in excess profit every year

BioCryst Rally Warrants Trepidation

Shares of biotech firm BioCryst Pharmaceuticals (BCRX) have caught fire lately after worries over a potential Avian Flu pandemic have flooded media outlets. The stock is up 80 percent to $17.65 already this month and has tripled in the last three months, giving the company a market cap of nearly half a billion dollars.

To say this violent move to the upside is based on speculation would be a dramatic understatement. The excitement over BCRX comes from a flu vaccine that the company actually scrapped in 2002 after it failed late stage clinical trials. However, with Avian Flu worries running rampant, the company has decided to bring back the drug and test it on bird flu. Early indications show it might have some kind of positive effect, but it’s way too early to conclude the drug, Peramavir, would be successful in preventing the spread of Avian Flu.

Investors, though, haven’t really focused on the downside (an ineffective drug brought back into testing only to get shelved again), but rather only on what it could do, become heavily useable in case a pandemic of Avian Bird Flu does sweep the globe. What happens if Avian Bird Flu goes the way of SARS, and in several months we never hear of it again? Or what happens if BioCryst’s drug shows to not work, or not work any better than drugs that have already been approved by the FDA for the flu (TamiFlu from Gilead, for instance)?

There is no doubt that BCRX shares have momentum right now as individual retail investors gobble up shares while the media hypes the potential death toll from an Avian Flu pandemic. Such momentum could drive the stock higher in the short term, with $20 or $25 very feasible. However, for BCRX to maintain its current share price for the longer term, after the hype dies down, a lot of things need to go perfectly, most of which the company and investors can’t control. If that doesn’t happen, remember that BCRX was a $3 stock in April of this year.

Spiraling Healthcare Costs

I just got a notice in the mail from United Healthcare. My premium will be going up by 21 percent on November 1st. That’s right… 21 percent in a single year. Although politicians campaigned on the issue, and Bush and Kerry continually pointed to the rising costs of healthcare as a grave concern during the 2004 presidential debates, nothing has been done about it. This is despite the fact that annual premium increases of 15 to 25 percent have been commonplace recently, with overall inflation only running 2-3 percent per year, and wages that have been flat for four years running.

All we can do really, aside from shopping around for better rates (which I’m doing), is try and make some of this money back via the healthcare portion of our investment portfolios. United Healthcare (UNH) will continue to grow earnings at double digit rates as long as Washington doesn’t help us citizens out with healthcare reform. And that industry growth will persist regardless of whether gasoline is $1, $2, or $3 a gallon, or if Fed Funds are priced at 3%, 4%, or 5%.