New products and other factors drive growth in health care/biotech, despite a cautious regulatory environment, analysts say.

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Jason Kantor

RBC Capital Markets

415-633-8565

Jason.kantor@rbccm.com

Outlook: Fundamentally, I don’t think the biotechnology sector has ever really looked much better. We’ve got a lot of high-growth products in the market and a lot of new products coming to market. We’ve got more profitable companies than ever before. We’ve got an increase in the amount of M & A activity with big pharmaceuticals buying smaller biotech companies. All of that is very positive.

Counterbalancing that is a more cautious FDA and a very skittish market. In a skittish market, high-risk stories like biotech tend to under perform.

My outlook is positive. I think the industry is going to adapt to the new regulatory environment; and certainly right now we are at a low point in valuations, so there’s a lot of room for the sector to do well from here. When it will turn around is a more difficult question for which I don’t have an easy answer.

My outlook is positive based on the commercial successes of a lot of different drugs and different companies and historically low valuations.

Outperforms: Adolor Corporation (ADLR), Alexza Pharmaceuticals (ALXA), Cubist Pharmaceuticals (CBST), Genentech (DNA); Genetope Corp (GTOP), Gilead Sciences (GILD) and Panacos Pharmaceuticals (PANC)

Top Pick: Gilead Sciences

Why Gilead Sciences (GILD): Gilead has the dominant market position in HIV with the first and only one pill once a day for HIV therapy. The company also has some of the best margins in biotech, an exciting pipeline, a great track record and good management.

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Patrick Flanigan

WR Hambrecht

617-892-6168

pflanigan@wrhambrecht.com

Outlook: Fundamentally biotechnology is probably the strongest it’s ever been. We have an increased number of products being approved and an increased number of companies that are becoming profitable.

In terms of innovation, we’ve just had a pretty decent run over the last three years due to the emergence of what we call targeted cancer therapies. These are therapies that are going after specific signals responsible for the proliferation of cancer cells.

This represents everything biotech has to offer in the sense that it is extremely innovative and it takes a dramatically different approach from that which pharmaceutical companies have taken for the last 100 years in treating cancer. It really represents a perfect marriage between basic biology and pharmacology.

Biotech’s next big innovation will be in the field of hepatitis where certain companies are taking a radically different approach to treating that disease. Now biotech is really going after the ability of the virus to replicate. This new approach represents everything biotech has to offer. It will, if successful, change the treatment paradigm for Hepatitis C.

In the long term, I would expect biotech to continue to innovate and be associated with stellar top-line growth prospects in health care. That said, this year the biotech group is down primarily due to disappointments from the FDA. It doesn’t necessarily have to do so much with the FDA not approving drugs as it does with the FDA clamming up in this post-Vioxx environment and issuing what we call approvable letters. It almost seems as if the FDA will only approve a cancer drug on its first cycle approval and for indications that are less severe.

Buys: Adolor (ADLR); Array BioPharma (ARRY); Avalon Pharmaceuticals (AVRX); and Exelixis Inc. (EXEL)

Top Pick: Adolor Corporation

Why Adolor: Adolor is a late-stage biotechnology company that has a string of very significant catalysts in front of it for the second half of the year. Its lead product is Entereg. Entereg negates the gastro-intestinal side effects associated with opiates. Entereg, in the chronic setting, goes after chronic opioid-induced bowel dysfunction (OPD). About four million to five million Americans who have this condition are not responsive to standard remedies.

Phase Two studies had very impressive results, increasing the quality of the life of these patients. Phase Three data, due toward the end of September, are expected to be positive and to serve as a significant catalyst for the company. The next catalyst is the FDA decision on the lead indication for Entereg. The lead indication is a condition called post-operative ileus (POI), and this is the acute setting for the drug. The particular application is for patients undergoing bowel surgeries. The data show an improvement in gastro-intestinal function and shorter hospital stays.

Overall, totality of the data set was very impressive. An FDA decision is expected in early November, and the drug is expected to be approved.

Finally, the last key catalyst for Adolor should occur before the year’s end. It’s basically visibility on the combo program. Adolor is evaluating the potential of combining the active ingredients in Entereg with Vicodin.

This has a billion-dollar potential because the company owns 100 percent of the rights to the combo program. (For the Entereg product, Axolor has a relationship with GlaxoSmithKline in which Axolor gets slightly less than 50 percent of U.S. profits plus mid-double-digit royalties for sales outside the U.S.)

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William Tanner

Leerink Swann

212-446-6766

billt@leerink.com

Outlook: Across the board, the market is tough right now. There are a lot of geopolitical concerns. Inflation has been a problem. These and other factors make people flee to stocks that are more stable than biotech.

That said, I have been covering this sector for 10 years, and you definitely see the industry maturing. There are more companies that are profitable, and more companies that have drugs on the market. There are also more companies that are closer to getting drugs on the market. So biotech is definitely maturing.

The real question comes down to separating the winners from the losers — figuring out which companies are going to be successful and which ones are going to blow up. This year, we have already had several blowups. So that’s going to kind of shake people’s confidence from time to time. People talk a lot about mergers and acquisitions and all the M&A activity in the group. It’s been fairly well known that pipelines of big cap pharma companies are probably not adequate for them to maintain decent earnings growth going forward. They will have to go out and license drug candidates’ products and/or acquire biotech companies.

From a regulatory perspective, the FDA has become much more risk adverse and much more concerned about safety. That’s probably a net negative for everybody that’s developing drugs since agencies can require companies to do a lot more clinical testing which takes time and costs money.

Finally, a lot of biotech companies are developing drugs for the treatment of cancer. You have to worry whether the ability of the system to actually pay for these extremely costly therapies will, at some point, break the system or will there be downward price pressure on the products.

Outperforms: Amgen (AMGN); Biogen Idec (BIIB); Genentech (DNA); and Genzyme Corp. (GENZ)

Top Pick: Genentech

Why Genentech: The company has demonstrated the greatest R&D capabilities, and it is the most innovative. As for financial performance, it expects to grow earnings from 2006 to 2010 at a compounded annual growth rate of at least 25 percent. Most of the companies in the sector with decelerating growth can probably expect long-term growth rates closer to the mid-teens.