Positive Outlook

While the overall industry growth is pretty solid and stable, if you look at stocks as a whole, valuations are a little bit higher than where they have been historically. I would say that these stocks are trading at 19 to 20 times earnings on average versus maybe 15 to 16 times where they have been historically. A lot of that difference can be attributed to the acquisition premium that is built into a number of the stocks.

We have seen consolidation begin to pick up over the last year. In each case after these events, you have seen the stocks run up quite a bit. So while the outlook for the industry and growth is pretty positive, we think valuations are a little rich and include some premium for takeout potential. So we are largely neutral on the stocks and are suggesting investors wait for a pullback to get involved.

For the vision sector, the underlying fundamentals are pretty positive. You have positive demographic trends. You have limited exposure to reimbursement. Most of these products are out-of-pocket pay. A lot of companies have had very company-specific issues over the last year or two, including issues with product performance and manufacturing contamination. These independent things have affected the stocks, but we feel the overall industry is pretty solid. At the moment, despite the fact that fundamentals for this industry and a lot of these different segments are attractive, we don’t have any buy ratings.

Buy: Beckman Coulter, Inc. (BEC)

Why Beckman Coulter: Beckman has been in the midst of an accounting change for the last year where they change the way they recognize revenue, basically placing their instruments on an operating lease basis rather than a cash sale or sales type lease. The result of this has been to skew year over year comparisons over the course of the last four quarters.

This fourth quarter is the first quarter where investors should get a relatively clean number and you will have year over year comparability. When they report the fourth quarter, we think the number will be strong and this will support our view. The underlying business trends have been solid despite the fact that we haven’t had a lot of transparency for the past couple of quarters.

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Graham Parry

Merrill Lynch

44-20-7996-0735

[email protected]

Area of Coverage: Pan-European Pharmaceuticals

Outlook: Looking into 2007, we see fundamentals for EU pharma as mixed. We believe the benefit of continued short-term earnings drivers such as Medicare Part D rollout and margin expansion are likely to be offset by pressure on multiples from increasing long-term growth concerns as the year progresses. However, while we are cautious on sector fundamentals, we believe market relative performance is likely to be determined by the broader equity market. From a macro point of view, we believe that the sector could underperform a strong equity market.

However, stocks are cheap on historical measures, balance sheets are strong, and earnings remain relatively immune to economic growth. We therefore believe that the sector would act as a good hedge against any cyclical or earnings growth disappointment in 2007.

Buys: Roche Holdings (RHHBF.PK), Novartis (NVS, NVSEF.PK), Novo Nordisk (NVO, NONEF.PK), and Sanofi-Aventis (SNY, SNYNF.PK)

Why Sanofi-Aventis Upgraded To Buy: We upgrade Sanofi-Aventis to a Buy (from Neutral) and set a 12-month price objective of Eur80. We believe we could see significant (10 percent to 15 percent) share price upside from current valuation levels in 2007. Most important are a potential win in the Plavix litigation, Acomplia U.S. approval in 2Q07 and any surprise from the February R&D update. While similar (10 percent to 15 percent) share price downside exists on a negative outcome from these events, we believe that the probability of this is low (less than 10 percent). Importantly, we highlight this is a higher-risk call and Sanofi is not our top pick in the sector as we remain cautious over company fundamentals (high patent exposure and limited late stage pipeline visibility).

Top Pick: Roche Holdings

Why Roche HoldingS: Roche remains our top pick due to the potential for increasing awareness of its improving pipeline beyond the oncology franchise to drive out-performance in 2007. We believe Roche’s superior growth rate justifies PE premium: Roche’s 2008-2011 earnings compound annual growth rate of 13 percent represents a greater than 4 percent premium to the European Pharmaceutical peer group (9.1 percent).

Another factor that we expect will be the key theme for Roche in 2007 is the demonstration of emerging strength in its ex-oncology pipeline. Mircera for anemia, Actemra for arthritis and its CETP inhibitor for HDL elevation are all expected to deliver news in ’07 that could see upside to our conservative forecasts. We estimate an addressable market for these three compounds of Swiss Francs 40 billion vs. our current forecasts of Swiss francs 2 billion.

We continue to see upside from multiple new indications for Avastin and longer treatment duration with Herceptin. 2007 could see interim data from ongoing Phase III studies for Avastin in adjuvant colorectal cancer and for Herceptin 2-year treatment duration in adjuvant breast cancer. And finally, several compounds could deliver proof-of-concept Phase II data within the next 12-18 months. These include R1503 (p38 MAPK, arthritis), R1626 (Hep C), R1440 (GK2, diabetes) and Rituxan in multiple sclerosis likely in April ’07.