From the March 2008 issue of Research Magazine • Subscribe!

Healthy Entrance

Stocks in health care, including biotech and pharmaceuticals, are poised for higher levels in 2008 - thanks to present valuations, developing pipelines and acquisition horizons, analysts say.

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Jason Kantor, Ph.D.RBC Capital Markets415-633-8565Jason.kantor@rbccm.com

Sector Outlook: Concerns over competition in monopoly franchises have led to significant P/E contractions for the big-cap biotechs in 2007 and created an attractive entry point for many stocks.

We continue to expect M&A to be an important growth strategy for large-cap biotech companies, and late stage small- to mid-cap biotech companies should remain targets for both large-cap biotechs and big pharma companies.

In the big-cap space, we recommend sticking with the high-quality stocks with solid revenue growth and the least exposure to regulatory and political headwinds, and looking forward to potential sentiment changes for more out-of-favor names. In the smaller-cap space, we recommend later-stage companies and recommend owning a basket of stocks with upcoming catalysts.

Merger and acquisition activity has been on the rise since early 2005, with many of the large pharmaceutical companies and major biotechnology companies participating in this shopping spree. The pace of M&A activity has increased significantly in the past 12 months, with six deals valued at more than $1 billion in 2007. The driving force behind the increased M&A has ranged from marketed products to late-stage product candidates to early-stage technology. Among publicly traded targets, nearly all have had late-stage or marketed products.

We believe that the best valuation metrics for biotechnology companies are P/E (price to earnings) and PEG (price/earnings to EPS growth). Currently, the top-tier biotech companies trade at a mean of 21.3 times 2007 consensus EPS estimates and at a PEG of 1 times. These metrics are roughly in line with their historical averages.

In comparison to large pharmaceutical companies, biotech has historically traded at a higher P/E multiple (consistent with higher growth rates), but the premium over pharma is at a multi-year low. Although the valuation gap between biotech and pharma is narrowing, currently the biotech sector is trading at a PEG discount to both pharma and its long-term historic average, indicating to us significant room for upside in the group through multiple expansion.

We believe that we are in a period of rapidly improving fundamentals in biotech (more products, more profitable companies, more retained product rights, etc.), so we believe that the currently depressed valuations make the sector very attractive for investors willing to ride out the current cycle. The depressed valuation is attributable to increased risk premiums and the fear of slowing growth for some of the larger companies. We are already seeing improvements in the risk premium for smaller companies, and current growth projections for many of the larger companies may underestimate the value of the current pipelines and acquisition opportunities, in our opinion.

Genentech (DNA) Outlook: We maintain our Outperform rating and believe that 2008 will be defined by four key events which should provide important visibility on incremental sales growth: (1) Avastin PDUFA (Prescription Drug User Fee Act) data for breast cancer in February, (2) Phase III Rituxan data for lupus in the first half of 2008, (3) Phase III Rituxan data for multiple sclerosis in the first half of 2008, and (4) most importantly, Phase III data for Avastin in adjuvant colorectal cancer. We believe the stock is relatively cheap at 20 times our 2008 EPS estimate of $3.40 and would be buyers of DNA particularly based on our expectation for positive adjuvant Avastin data which should re-accelerate sales growth in 2009 and beyond.

In our view, the positive thesis for Genentech remains intact given its growing robust pipeline, potential new blockbuster indications for existing products, and ongoing operational execution. We expect a number of events in 2008 to provide better visibility on outer year sales growth.

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Charles C. Duncan, Ph.D. JMP Securities 212-906-3510cduncan@jmpsecurities.com

Felicia Miller, Ph.D. JMP Securities 212-906-3505 fmiller@jmpsecurities.com

Sector Outlook: Expect challenges in 2008 to favor select small- and mid-cap names. 2007 was a relatively in-line year for biotech, with both the large-cap index (BTK) and the broader index (NBI) gaining 4-5 percent, compared with a 3.5 percent increase in the S&P. In 2008, we expect that macroeconomic, political, and sector-specific factors could present challenges to biotech stocks, in general. However, we believe select small- and mid-cap names with transformational news flow, including late-stage clinical data and potential partnering activity, and with value-added molecular diagnostics could outperform in these conditions. Stocks with lower-risk fundamentals could outperform in tough economic conditions. In 2008, we envision three types of challenges that could negatively impact the biotech sector.

Expect value-added molecular diagnostic names to win out in an election year. We, therefore, anticipate that select molecular diagnostic stocks that have products to minimize health care costs and improve patient outcomes will likely outperform in this political climate. We expect the FDA to maintain its safety-conscious stance in 2008, and we expect investors to shy away from stocks for which an FDA decision is pending in the near-term. As discussed above, we recommend stocks with late-stage clinical news flow in this risk-adverse regulatory climate.

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Adam GreeneJ.P. Morgan212-622-5235Adam.i.greene@jpmorgan.com

Edmund Kim, Ph.D.212-622-6720HYPERLINK "mailto:Edmund.c.kim@jpmorgan.com"Edmund.c.kim@jpmorgan.com

Sector Outlook: Forest Laboratories' (FRX) Azor (hypertension) and Cephalon's Amrix were the only new product launches during the quarter.

Overall, we expect most of our specialty pharmaceutical companies to at least meet our projections. In our view, the focus will remain on 2008 drivers and beyond ... and business-development updates. We expect Barr Pharmaceuticals and Watson Pharmaceuticals (WPI) to be mostly in-line with expectations, with investors focusing on the magnitude of 2008 guidance.

Forest beat estimates handily in its latest quarter, with results well above estimates. Core franchises continue to perform ahead of expectations but the focus remains on Forest's ability to replace potential lost revenue from Namenda and Lexapro patent expirations.

Watson Pharmaceuticals (WPI) Outlook: Watson expects to file three new drug applications for products in the urology market next year, Silodosin in the first quarter and both Oxybutynin topical gel (overactive bladder) and Telstar (prostrate cancer) in the second quarter. The company has about 70 abbreviated new drug applications pending at the Food & Drug Administration, including the newly filed Yaz.

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David M SteinbergDeutsche Bank415-617-3296HYPERLINK "mailto:david.m.steinberg@db.com"david.m.steinberg@db.com

Forest Laboratories (FRX) Outlook: Forest reported diluted F3Q08 EPS of $0.96, significantly exceeding our forecast of $0.73 and consensus estimate of $0.75. The earnings out-performance was largely driven by (1) higher than expected product sales of $918 million (+$34 million vs. our estimate, but includes $28 million of wholesaler re-stocking of Lexapro and Namenda) and (2) lower-than- expected operating expenditures (-$57 million vs. our estimate) largely attributable to a reduction in aggregate R&D milestone payments made to development partners.

In light of the recent mixed pipeline results, successful commercialization of recently approved Bystolic as well as positive trial results and timely regulatory approval of current late-stage product candidates, including Milnacipran ($600 million in peak sales, FDA review), Ceftaroline ($400 million, Phase 3), Aclidinium ($400 million, Phase 3) and Linaclotide ($500 million-plus, Phase 2b) are crucial to help diversify FRX's current product mix from the company's historically dominant depression franchise. To that end, on the conference call, management stated a goal to double its current late-stage pipeline through business development activities or advancing its own pipeline candidates.

Given management's $0.25 EPS guidance increase (to $3.35-$3.45), we now project EPS of $3.43 for FY08 (excluding one-time R&D charges). Rolling forward our valuation, our price target remains $42, based on 11 times (15% premium to the company's forward growth, in-line with a peer group of high-quality specialty-pharma companies) our CY09 EPS estimate of $3.77.

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