On the face of it, a rebound in life sciences stocks — which include big pharmaceutical firms that develop medications through chemistry, biotech companies that develop drugs based on molecular manipulation and outfits that make medical devices — seems overdue.

From Dec. 31, 2005, to Dec. 7, 2007, the Standard & Poor’s biotech subindex returned only 4.1%, vs a 25% rise in the S&P 500 composite index and a 24.6% jump in the Nasdaq composite index over the same period.

In Canada, life sciences stocks have lagged even further. During the same period, the Toronto Stock Exchange’s health sciences subindex dropped 19.9%, while the S&P/TSX composite index moved up 28.8%.

Unfortunately, analysts believe this general pattern of mediocre returns will persist in 2008. The bigger firms are struggling to develop new blockbuster drugs to replace drugs that are losing their patent protection to generic drugmakers. In addition, the sector is facing an unusually high number of risks of a competitive, regulatory and technical nature.

This is why smart investors limit their exposure to life sciences and diversify the bets they do make in the sector. With this in mind, Investment Executive examined five groups of firms: global pharmaceuticals, biotech firms and generic drugmakers, as well as Canada’s biggest drug firms and most promising new companies. (See table.) The conclusion of analysts is that there are some promising contenders.

The top pick among the global pharmaceutical firms — Johnson & Johnson of New Brunswick, N.J. — is also the largest, with a market value of US$193.7 billion as of Dec. 7. J&J is a hugely diversified firm with significant units in medical devices, pharmaceuticals and consumer products such as beauty and nutritional products.

Three of every four analysts who cover J&J rate it a “buy.” So, it is considered a relatively safe bet — one that offers steady but slow growth.

Stephen O’Neil, an analyst with Hilliard Lyons — the Louisville, Ky.-based unit of PNC Financial Services Group Inc. — raised his price target for J&J’s stock to US$72 a share from US$70 after J&J produced better-than-expected results for the third quarter ended Sept. 30. A major factor was the weak U.S. dollar. For instance, J&J sells roughly half of its medical devices overseas, along with 36% of its pharmaceuticals, such as Risperdal, which is used to treat schizophrenia, and Topamax, which treats migraines. When these sales are translated back into U.S. currency, the result is higher revenue reported.

In the third quarter, sales of J&J pharmaceuticals in the U.S. fell 2% to US$3.8 billion while foreign sales jumped 8% to US$2.3 billion. Fully three-quarters of the gain in J&J’s foreign revenue was driven by currency — a factor not expected to play quite as large a part in 2008. O’Neil cites the company’s drive to squeeze at least US$1.3 billion in cost savings from a recent acquisition involving the consumer health-care unit of New York-based Pfizer Inc. as a major factor in keeping J&J’s earnings growth steady in 2008. His estimate is for net income per share of US$4.40 in 2008, vs a projection of US$4.10 in 2007.

This is right in line with Reuters Ltd. ’s consensus estimates, which call for a 6.8% jump in earnings to US$4.40 a share in 2008, vs US$4.12 a share projected for 2007. Revenue is expected to rise by an even more tepid 4% over the same period, to US$62.9 billion in 2008 from US$60.5 billion in 2007.

For clients who prefer more excitement, Gilead Sciences Inc. of Foster City, Calif., has been on a tear of late. Its share price jumped 45% to US$47.07 on Dec. 7, from US$32.47, adjusted for a stock split, at the 2006 yearend; 81% of analysts recommend it as a “buy.” With a consensus 12-month target of just US$50.50 a share, the potential for capital gains appears limited. That is why some analysts with a “buy” rating, such as Stephen Byers of Jefferies & Co. Inc. in New York, are recommending acquiring shares on the dips.

In other words, although Gilead looks close to being fully valued at its Dec. 7 price, analysts are nevertheless impressed with the firm. It makes Atripla and Truvada, the two most prescribed drugs for treating HIV/AIDS. Sales of Atripla and Truvada are growing at a very rapid pace, even in mature markets such as the U.S. because doctors are using them to replace older therapies.

@page_break@Gilead has also developed a promising medicine for treating chronic hepatitis B and receives royalties from Roche AG of Switzerland for the sale of Tamiflu medicine, which treats the flu.

Gilead will notch revenue of US$4.9 billion in 2008, predicts Byers in an Oct. 19 report, up 16.7% from his estimate of US$4.2 billion in 2007. He projects a further 20.4% rise in 2009 to US$5.9 billion, paced in part by the expected launch in 2008 of a chronic hepatitis medicine. Byers projects earnings of US$1.82 a share in 2008, up 9% from 2007. Earnings in 2009 will jump a further 15.4% to $2.10 a share.

The most promising pick among the generic drug manufacturers is Teva Pharmaceutical Industries Ltd. — the Israel-based firm that has grown into a US$9.2-billion giant (2007 estimated revenue) following the acquisition of more than 30 competitors since the late 1970s.

“Teva continues to boast the most impressive generic product pipeline in the global pharmaceutical industry,” writes David Steinberg, a Deutsche Bank Securities Inc. analyst in San Francisco, in his Oct. 31 report following the release of Teva’s third-quarter earnings.

Steinberg expects Teva’s sales to rise 13% in 2008 to US$10.4 billion from the US$9.2 billion expected in 2007. Earnings, he adds, should increase more quickly, by 15.5% to US$2.68 a share in 2008 vs US$2.32 in 2007. He believes that’s enough to justify a 12-month target of US$48 a share — with upside potential, given Teva management’s well-established ability to create new generic drug markets and to squeeze costs from the company’s commanding global supply chain.

Among Canadian life science firms, analysts’ top two picks are waiting for the results of advanced clinical trials. Positive outcomes could substantially increase the market value of biotech firms Æterna Zentaris Inc. of Quebec City and Cardiome Pharma Corp. of Vancouver.

Æterna has more than a dozen drugs under development aimed at treating cancer, infections and endocrine abnormalities. Two compounds are already generating sales, the most impressive of which is Cetrorelix, which increases the likelihood that in vitro fertilization will work. Cetrorelix also has a promising future in the treatment of benign prostatic hyperplasia (enlarged prostate) and endometriosis.

Æterna launched the first of three Phase III trials early in 2007 to evaluate Centrorelix for BPH. If things go as expected, Æterna plans to file a new drug application in the second half of 2010. Although that sounds like a long way off, the value of the company’s stock moves up according to how well the various trials are progressing — and the potential payoff is huge.

Peak annual sales for Cetrorelix could top US$450 million, writes Ren Benjamin, an analyst with Rodman & Renshaw LLC in New York, in a Nov. 8 report. In the meantime, Æterna’s sales will be small and sluggish. Benjamin estimates revenue in 2008 will be US$41.2 million, down 9.5% from 2007, when it reached US$45.5 million.

Æterna’s net loss in 2008 is projected to be US$37.9 million, vs a loss of US$33.1 million in 2007, according to Benjamin. However, with US$48 million in the bank and solid research and development partners (Merck & Co. among them), Æterna is expected to have no trouble surviving the next key rounds of clinical trials. Benjamin has a 12-month price target of US$6 a share, which would represent more than a tripling of its Dec. 7 share price. (The stock was trading at $1.80 a share on the Toronto Stock Exchange and at US$1.80 on Nasdaq.)

Cardiome investors should learn the fate of Vernakalant, the company’s most important drug compound much sooner. The intravenous version of Vernakalant, which has completed Phase III trials, is used to restore the heart to its normal rhythm. Cardiome expects to learn the decision of a U.S. Federal Drug Administration panel as to whether it can proceed with a new drug application on Jan. 19. Sometime in the first quarter of 2008, Cardiome also anticipates receiving interim data related to Phase IIb trials on the pill version of Vernakalant.

Douglas Loe, an analyst with Versant Partners Inc. in Toronto, predicts in his Dec. 7 report that if the results of the trials and new drug application are successful, Cardiome’s sales will soar to $67.2 million in 2010 vs $6.7 million in 2008. Over the same period, the net loss would shrink to $1.4 million from $61.8 million.

Loe has a one-year price target of $18 a share, representing a doubling from Cardiome’s Dec. 7 close of $8.91 a share. IE