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Evolution, Not Revolution

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by Winton Gibbons

Although the genomics “revolution” appears to have resulted in a short-lived run-up in stock prices and a disproportionate number of IPOs, my colleagues and I still strongly believe in the intermediate- to long-term prospects of this market.

We anticipate 15 percent sector revenue growth leading to 15 to 20 percent earnings growth for profitable or near break-even firms, due to operating leverage and improving gross margins. Although revenue visibility over the short term is unclear, we believe that by late 2002 revenue visibility should increase for three reasons: continued strong growth in academic spending; resumed growth in pharma, albeit at a lower rate; and a reversal of negative foreign exchange effects.

NIH and NSF appear to be in line for increased appropriations, and while R&D spending from large pharma seems to be shifting to development, we estimate that the total spending on drug research will grow in the mid-to-high single digits, with life sciences spending growing almost 50 percent faster, approaching at least 10 percent. Lastly, we estimate that negative foreign exchange rates reduced top line revenue an average 3.5 percent and 2.0 percent in 2000 and 2001 respectively. At current exchange rates, we anticipate that on average 0.7 percent and 1.3 percent will be added to revenue in 2002 and 2003.

As of July 8, the market capitalization of the 71 public life sciences companies that we track at William Blair & Company totaled $31 billion, its lowest level since we began tracking this data in January 2001. This total is roughly equal to the market cap of a midlevel pharmaceutical firm such as Schering-Plough ($34 billion). Additionally, we estimate that there is a positive “beta” of two for the genomics/life sciences sector versus the S&P 500 — as a benchmark of broad US equity performance. Consequently, we believe that overall stock market moves, both up and down, also significantly affect the sector and should be factored into expectations.

Developmental companies are burning cash faster than we expected, as many have built infrastructure and operating expenses well ahead of revenue. With capital still difficult and expensive to raise, we expect companies to moderate this burn where possible, as seen through the raft of headcount reductions this year, and raise small amounts of dilutive equity, leading to life expectancies in the two- to four-year range.

In light of our new projection, we found current valuations and expectations for most profitable life sciences companies to be now well in line, if not modestly undervalued, relative to other firms with similar economic drivers, particularly those in the medical technology sector.

To put these valuations in context, we compare the large life sciences with medical technology firms, ranging in market capitalization from Invitrogen at $1.6 billion to Medtronic at $49 billion, with last-12-months’ revenue from Invitrogen’s $628 million to Baxter’s $7.9 billion.

The characteristic range is from an estimated growth of 10 to 20 percent, and price-to-earnings and price-to-earnings-to-growth ratios of 1.0 to 2.0 times, leading to a P/E range of 10 to 40 times. The median earnings growth rate for this entire group is 15 percent and the median 2002 PEG ratio is 1.6 times, with a median P/E ratio of 20.4 times. Based on this analysis, the forward 2002 P/E multiples and PEG ratios for Amersham (19.0 and 1.6), ABI (20.4 and 1.3), Waters (16.9 and 0.9), and Invitrogen (16.7 and 0.8), appear well in line with the group and possibly undervalued in some cases.

It’s also important to examine developmental-stage firms in light of their execution to date and cash position. Performance and net cash position vary among this group. To best analyze these companies, one should monitor and assess the five stages necessary for the transformation from a developmental firm to a sustainable business: scientific to technological or medical findings; business development; product development; commercial sales; and sustainable company.

Investing in best-of-breed companies, both profitable and developmental, over the next two to six quarters should provide positive returns to investors. Most likely, realized returns will be affected by the overall stock market performance as well. But investors should remain aware of the considerable risks associated with developmental companies, especially those facing potential cash shortages.

Winton Gibbons is analyst, principal, and group head for the health care sector at William Blair & Company. His coverage focuses on genomics and life sciences, as well as in-vitro diagnostics and orthopedics. For disclosures regarding comments made by William Blair & Company please visit http://www.williamblair.com/pages/ eqresearch_disclosures.asp

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