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Evan McCulloch of Franklin Biotechnology Discovery

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Quick Take: The $475.9-million Franklin Biotechnology Discovery Fund (FBDIX) plummeted 42.5% in calendar 2002, along with the biotech sector as a whole. But for the five-year period ended December 2002, the fund posted an average annualized return of 8.0%, versus 4.3% for the handful of biotech funds in our universe with five years of operating history. The biotech mandate, however, makes this portfolio very risky. The fund’s standard deviation, a measure of volatility, is much higher than that of funds invested broadly in health care.

Managed by Evan McCulloch since its September 1997 inception, this is one of the longest-running ‘pure’ biotech portfolios around. Since it gives investors a strong dose of a notoriously volatile sector, the fund’s yearly returns have varied wildly. After skyrocketing 97.9% in 1999, it rose another 46.6% the following year, before dropping 20.5% in 2001. Such variance is to be expected from an industry that is still enduring growing pains. Most biotechs are not yet profitable, and bringing a drug to market is a long, arduous, risky and expensive process. However promising biotech’s future, such a portfolio is not for the faint of heart.

The Full Interview:

S&P: The NASDAQ Biotech Index plunged 45.3% in 2002. Why did biotechs perform so poorly?

McCULLOCH: There were several factors that contributed to the sector’s weak performance. The bulk of these events occurred in the first and second quarters of the year. We witnessed many company-specific disappointments — so many, in fact, that this became a `sector trend’ unto itself.

S&P: What kinds of disappointments precisely?

McCULLOCH: There were a number of negative FDA-driven events, i.e., delays or outright rejections of new products. There were also numerous drugs that failed in clinical trials. Some companies faced manufacturing problems. The sector suffered as a whole due to the scandals at Elan Corp. plc (ELN) and ImClone Systems (IMCL).

S&P: What are your largest individual holdings?

McCULLOCH: Out of 49 positions as of Dec. 31, 2002, our top ten holdings were Amgen Inc. (AMGN), 12.6%; MedImmune Inc. (MEDI), 7.7%; IDEC Pharmaceuticals Corp. (IDPH), 5.6%; Gilead Sciences Inc. (GILD), 5.0%; Genzyme Corp-General Division (GENZ), 4.3%; Biogen Inc. (BGEN), 3.3%; Serono SA, 3.1%; Millennium Pharmaceuticals Inc. (MLNM), 2.7%; NPS Pharmaceuticals Inc. (NPSP), 2.6%; and Neurocrine Biosciences (NBIX), 2.6%.

S&P: Given that Bristol-Myers Squibb Co. (BMY) was badly hurt by the Erbitux/ImClone fiasco, did it dissuade big drug companies from entering into partnership arrangements with biotech firms?

McCULLOCH: I think initially big pharma did indeed step back from entering into deals with biotechs, but this hesitation was short-lived. In fact, just recently, we saw Pfizer Inc. (PFE) signing a couple of huge deals, including a $400-million agreement with Neurocrine Biosciences (NBIX) to develop Indiplon, Neurocrine’s insomnia drug.

We expect to see many more similar arrangements between big pharma and biotechs. Recognizing that product pipelines at pharmaceutical companies are still fairly weak, we think the terms of these partnership agreements will become increasingly lucrative for biotech firms.

S&P: Biotech stocks typically have strong fourth quarters, as they did in 2002. Why is this?

McCULLOCH: In the fourth quarter we have a plethora of major medical conferences and investor forums. The biotech sector is very ‘catalyst-driven.’

S&P: A new FDA Commissioner was appointed in October. Will this lead to an acceleration of drug approvals in 2003?

McCULLOCH: I think we will see an increase in drug applications and approvals this year, but this is partially because several prominent new drugs were delayed in 2002. [According to the Biotechnology Industry Organization, 20 new biotech and biotech-related drugs were approved by the FDA, which also cleared 15 new indications for previously approved products in 2002].

S&P: What are some of the prominent new drugs you expect to come to market in 2003 as related to your holdings?

McCULLOCH: MedImmune has a nasally-administered flu vaccine, FluMist, which they acquired when they merged with Aviron in early 2002. This drug has been delayed since the summer of 2001, when the FDA expressed concerns about its efficacy and safety. That hurt Aviron’s stock price, allowing MedImmune to buy it rather cheaply.

FluMist was again delayed in 2002, due to some more efficacy concerns. Finally, in December 2002, an FDA Advisory Committee recommended approval for FluMist. We have, however, been positive on FluMist all along, and we believe it will come to market in a few months. I don’t think this will be a blockbuster drug, but I expect it to generate annual sales in the neighborhood of $400-$500 million. It will be an important growth driver for MedImmune for the next several years. [MedImmune is now partnered with drug giant Wyeth (WYE) in marketing FluMist]. MedImmune’s lead compound is Synagis, which is used to treat respiratory syncytial virus in infants. This is a $700-million drug.

We have a small position in ICOS Corp. (ICOS), which has an interesting impotence drug called Cialis that was recently approved in Europe, and may be approved in the U.S. later this year. This is a situation we will be watching very closely. Cialis has some advantages over Pfizer’s Viagra, and will be co-marketed by Eli Lilly & Co. (LLY). Keep in mind that Viagra is currently doing about $1.5 billion of business annually.

One of the most intriguing drugs on the horizon is Fuzeon, an HIV drug belonging to Trimeris Inc. (TRMS) and its European partner, Roche. Fuzeon has had some very good Phase III clinical data and HIV doctors are excited about it. It will likely be launched in March, and Trimeris should start seeing profits on it by 2005. Fuzeon should see annual sales in the $500-$600-million range. However, Trimeris is going to have some problems in manufacturing the drug large scale, so they may face some capacity constraints for a few years.

S&P: Amgen is the fund’s largest position. What’s the outlook for Amgen’s rheumatoid arthritis drug, Enbrel?

McCULLOCH: We are extremely bullish on Enbrel, which we believe could generate annual revenues of several billion dollars over the long term. Not only do we think that Enbrel has a great deal of growth left in the rheumatoid arthritis field, we also think it is the long-term winner amongst biologics for psoriasis. This would make Amgen’s $16-billion price tag for Immunex seem like a bargain.

S&P: IDEC Pharmaceuticals, a top-ten position in your fund, markets the cancer drug Rituxan. What is the outlook for this drug?

McCULLOCH: Rituxan is a genuine blockbuster, it just exceeded $1 billion in annual sales. We think it will continue to grow. What’s interesting is that while IDEC has a large position in our fund, the drug’s co-marketer, Genentech Inc. (DNA), has a very small weighting. Genentech trades at a P/E that is nearly four multiples points higher than that of IDEC. This baffles us, and, as we are very value-conscious, we have a much larger weighting in IDEC.

S&P: What kind of annual earnings growth are you forecasting for the profitable biotech stocks this year?

McCULLOCH: We are projecting 21% earnings growth for the biotech sector, compared to a figure of about 12% for big pharma. On a P/E basis, biotechs trade at a 50% premium to big pharma, but much of that is due to incorporating the higher earnings growth rates for biotech. On a P/E-to-growth basis, biotechs actually trade at a significant discount to the big drugmakers.

A biotech stock typically becomes profitable two to three years after it launches its flagship drug. We expect that a host of companies, including Trimeris (TRMS), CV Therapeutics (CVTX), United Therapeutics Corp. (UTHR), InterMune Inc. (ITMN), and Cubist Pharmaceuticals Inc. (CBST), will reach profitability, by 2005.

S&P: Do you expect to see much M&A activity in biotech in 2003?

McCULLOCH: After the big three biotech mergers were announced at the end of 2001, the most notable being Amgen and Immunex, we thought 2002 would witness a huge wave of M&A activity. But it didn’t happen and that surprised us, since we need to see more consolidation in the industry.

In biotech you basically have two types of companies: companies with no products but lots of cash; and companies with no cash but with a product. Thus, it makes sense for these two types of companies to merge. I expect to see some mergers this year, particularly from the big biotechs which have large reserves of cash.


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