If the market is not as strong as I think it will be for the next several months, the more stable stocks like foods, beverages and healthcare should do better than the more cyclical stocks like computers and electronics. That’s typical. But if the market keeps going up, as I expect, then the cyclical stocks should outperform. That’s also typical. But an interesting point is that in the past, biotech stocks often did OK in mild down markets, where they were treated as healthcare stocks, and in up markets, where they were treated as emerging growth stocks.

That may be changing, so I wanted to update you on the Biotech MegaShift and how our strategy is changing to take advantage of what’s coming.

Biotech MegaShift

The major concern right now is the FDA and the fact that the agency has not approved many new drugs recently. Some tie this to the lack of a confirmed FDA Commissioner for much of the time that President Bush has been in office. Others think it is an overreaction to the Vioxx mess, painting the FDA as even more of a stick-in-the-mud when it comes to approving new chemical and biological entities.

I disagree. Dr. Andrew von Eschenbach may not have been confirmed until December 2006, but he was clearly running the agency well before that. And while it is true that the FDA has responded in many ways to their Vioxx failure, including requiring cardiac safety testing of virtually all new drugs, at the same time they are getting more aggressive and more open to new drugs that can either cure the diseases of aging or at least cut the costs of treatment.

I think the main problem is the paucity of interesting drugs coming through Big Pharma’s pipeline. I’ve been pointing out for at least 10 years that Big Pharma drug research has become amazingly unproductive, with billions of dollars spent on me-too drugs, tiny incremental improvements and failed programs. The FDA may not have approved many drugs last year, but they didn’t turn down many, either. They just don’t have a lot to do if the companies don’t serve up drug applications.

Having said that, there are some forces at work to make the biotech situation worse. If you immediately suspected Congress must be in session, you are correct. Representative Henry Waxman, a California Democrat, and Senator Charles Schumer, a New York Democrat, introduced biologics bills in their respective houses of Congress and seem determined to attach the legislation to a bill renewing industry fees paid for FDA drug reviews. The bills give the FDA a legal path to approve generic biotech drugs after patents expire without requiring the generic makers to repeat the clinical trials already done by the patent holders. The FDA would have the authority to decide on a case-by-case basis how much testing to require for each generic biologic.

The biotech companies point out that biologic drugs are complex and hard to copy exactly, so without testing there is no way to tell if the inevitable slight variations make the generic less effective, or even hurt people. The biotech companies call them “follow-on” drugs to distinguish the situation from generic chemically-based drugs, which are generally easier to copy.

The Generic Pharmaceutical Association says copies of biotech drugs would cost 10% to 25% less than the branded version. I can’t imagine how they can say that with a straight face, when chemical generics cost 50% to 95% less than the patented version did before expiration.

Amgen, acting as point man for the industry, said that follow-on biologics will play a “limited role” because the science is moving so quickly that newer biologics still under patent protection have dramatic advantages over biotech drugs that have been around so long that they are losing patent protection. There is a good deal of truth in that, but it requires companies to keep their place in the product development cycle. In fact, any biological drug that is still selling in large amounts when its patent expires probably deserves to lose market share rapidly to make room for newer, better drugs.

I think this bill will pass, but it won’t have much effect on the industry for many years. However, it could have a strong effect on the stocks this year, as the debate on the bill rages. So it makes me more cautious on recommending new biotech ideas unless they have positive late-stage clinical news or outright FDA approval coming soon. Even then, they need to be doing everything else right in order to qualify for a place in our portfolios.

The other possibility is that fear of generic competition can knock a stock down all out of proportion to the likely outcome, as happened to Amgen (AMGN), which I recommended in the last issue. Amgen has already replaced all its old products with new products that have many, many years of patent protection. Like Genentech, they understand that they must continually obsolete their old products from now on, so the market for a generic biologic is essentially meaningless when the time comes.

I’ll be watching three things especially carefully for the next six months or so:

• The progress of these bills through the Senate and House
• Wall Street’s reaction or overreaction
• The FDA’s approval record, especially the May 15 announcement on Provenge by Dendreon (DNDN).

Regarding that last bullet, I had a question from Aneil: “Michael, how sure are you about Dendreon? The stock is starting to pick up steam. This usually happens with new biotech companies awaiting an FDA approval. Might be a good ride up until the time frame when the FDA announcement will be made. After then, it seems so risky that I’m not very sure if the risk/reward can be justified. Any thoughts?”

I follow a three-step process to make a judgment call on whether a drug will be approved or not. You will not be surprised to learn that I’ve been both right and wrong both ways. I’m generally more right than wrong, but that’s because most drugs that get this far get approved, which makes the outcome easier to predict. I have been able to predict some turndowns in advance, and make money selling those stocks short. I’ve also been not only wrong but stunned from time to time by an FDA turndown — that generally happens when there is no FDA Commissioner, and therefore no one to prod the bureaucrats to take a stand.

The first thing I look at is the clinical data. The ‘problem” with Dendreon’s results is that they missed their primary endpoint. But extending survival is the gold standard for a cancer drug approval, especially in the case of relapsed prostate cancer that has not responded to other therapies. That describes Provenge.

The second thing I look at is the filing process. Dendreon got FDA approval to do a “rolling” filing, with the agency reviewing data as it came in all during 2006. They also got Fast Track review. They used numerous consultants to help prepare the filing, most of whom are ex-FDA examiners. They have “role played” what the examiner might question or need, and then have been proactive in providing the answers.

The third thing I look at is the Advisory Committee process. Most of the time, the FDA will follow the recommendation of the advisory committee, and it seems likely the agency will ask an advisory committee to evaluate a drug that missed its primary endpoint of tumor shrinkage, but hit its more difficult secondary endpoint of extended survival. The advisory committee is composed of doctors and researchers who are not FDA employees.

I try to put myself in their position. Would they like to have this drug in their treatment options? Who can really be helped by this drug? Does it make economic sense compared to other treatment options? Are their meaningful risks? Are their parts of the method of action that might create unknown risks?

It comes down to a risk/reward recommendation based on individual patient situations. In the case of Provenge, it has seemed to me for two years that doctors desperately need something new for patents that otherwise have to be told they are terminal, with nothing left to do. There are a lot of men every year in this situation. (And when the drug is expanded to breast cancer, an equally large number of women.) There appear to be very low risks of side effects, and the mechanism of action is well understood.

Therefore, I think Provenge will get a recommendation for approval from the advisory committee, and the FDA will approve it.

Your second question is whether we should hold the stock after approval. That depends on when Dendreon announces their distribution partner deal. If they get approval first, we will want to own it for the lucrative deal announcement. There probably will be a sell-off after both approval and a deal are announced, but will we want to trade it? Maybe, or maybe with a portion of our holdings. But as soon as they have the cash, Dendreon will start label expansion studies for Provenge in breast cancer and head and neck cancer. These two clinical research programs were put on hold in 2005 to conserve cash, and can be taken off the shelf quickly. So Dendreon could attract a whole new set of buyers based on a profitable product and a technology that can spin off similar products against any solid tumor cancer. This is the main reason why I expect that we’ll hold the stock through approval and beyond. The stock has started to move, but DNDN remains a Top Buy all the way up to $7 for my $14 target after Provenge is approved.

eResearch (ERES) reported their December fourth quarter in line with the consensus, but below my expectations. I have been going over the numbers and conference call, and I am convinced that each quarter for the rest of this year will be sequentially stronger. At the same time, I do not understand why revenues have not started accelerating yet.

The numbers tell the story. Sales were only $19.9 million, down from $25.4 million last year, yet backlog is up sharply to a whopping $96.4 million. Net income was four cents a share on a GAAP basis, or five cents pro forma. The Street was looking for four cents pro forma on $19.4 million, so they slightly beat the Street and the stock traded up 11 cents today.

The company had guided for $18 million to $20.5 million in sales and two cents to four cents a share, so they seem to be setting the guidance bar low enough to make it easy to beat. That’s why I think they guided for $19 million to $21 million and four cents to six cents a share in the March quarter, when the consensus was $23.1 million and six cents.

For the year, they earned 24 cents a share pro forma on $86.4 million in sales. They guided for $95 million to $103 million and 25 cents to 30 cents, compared to the consensus for $97.4 million and 25 cents. The analysts’ range of revenue estimates for this year ran from $78.9 million to $104.4 million, and I expect to see the very low forecasts go away in the current round of revisions.

What drives me nuts about this company is that they are guiding for $95 million to $103 million in sales this year when they have a backlog of $96.4 million already on the books! They already have as many transactions in backlog booked for 2007 as they performed in all of 2006. And, they signed $121.1 million in new contracts during the year, including $27.5 million in the December quarter. There is no shortage of business, and they continue to book new orders at a rate far higher than their quarterly revenues. They have to grow to a $30 million per quarter revenue rate in order to complete the work they have on their books. There used to be a reliable six-month delay between contract signing and commencement of the study, which started revenue recognition. Now the delay apparently has doubled to 12 months. We know ERES has the capacity to do much higher revenue levels, so the delay has to be coming from the customers. But why? This has been the factor I missed in my original analysis, and I don’t think anyone really understands why it is happening.

Fortunately, the adjustment appears to be over. Prices for semi-automated studies rose 8% from the September to the December quarter, suggesting less pressure on booking business. It could be that the backlog will steadily build from now on, reflecting a new business model based on a 12 month delay between contract signing and clinical trial commencement. That would mean revenues will steadily grow to the $30 million per quarter level and beyond. But I still think there is a time crunch lurking out there that will cause ERES customers to try to accelerate cardiac safety trials, which would be very good news for ERES quarterly sales and earnings, jumping us to the $30 million per quarter rate in June or September, rather than December.

Even without that, though, I think the stock is past its bottom and headed up for many years to come. At today’s close it was selling for 3.5X this year’s sales and 24X earnings guidance, with sales expected to grow 19% and earnings 25%. ERES remains a Top Buy all the way up to $16, and I think my $30 target is just a matter of time.

Geron (GERN) got FDA approval to start Phase I trials of a telomerase-based cancer vaccine to treat acute myelogenous leukemia. This vaccine is based on the same technology as their successful Phase I/II trials in prostate cancer. Essentially, they expose the immune system to telomerase, which occurs in cancer cells and normally remains hidden. The immune system then send killer T-cells sensitized to telomerase out to kill the cancer cells. Rather than try to find and “turn off” the telomerase, this approach simply kills any cell with telomerase in it. I like it because it matches the real cause of cancer — an inadequate immune system — and uses natural body processes to fix the problem. Some telomerase does occur in reproductive cells, so that may be a side effect that needs to be considered on a patient by patient basis. But the prostate cancer trials showed the telomerase vaccine to have a good safety profile with few side effects. Buy GERN while it is under $9 for my $18 target.

QLT(QLTI) reported this morning before the opening of the market, and the news was mixed short term, but excellent long term. Wall Street took the stock down a trivial 15 cents today, but the company’s long-term outlook matches my original reason for buying the stock: Macular degeneration is going to be treated by combination therapy, with QLT’s Visudyne combined with every other new drug. It is just a question of getting from here to there, which means getting through the Lucentis launch in Europe and getting results of combination clinical trials. The story for 2007 will be knocking these barriers down one by one, and I think QLTI’s new management team is going to outperform Street expectations this year and again by a wide margin next year.

The U.S. and Canadian experiences are a model for what happens when a new anti-VEGF (Vascular Endothelial Growth Factor) drug like Lucentis is introduced. Visudyne sales fall as the new drug takes market share. Then practitioners start using Visudyne in combination with the anti-VEGF drug, and sales stabilize. As combination therapy spreads, Visudyne sales start to grow.

In the U.S., although Visudyne sales fell over 30% for the year, they were flat in November, December and January. Combination therapy now has 10% of the U.S. market. In a January survey, 41% of U.S. retinal specialists said they would increase their use of combination therapy this year. That is not out of line, combination therapy already accounts for 38% of the Canadian market.

QLT is sponsoring a patient registry to track those using Visudyne plus an anti-VEGF drug like Avastin or Lucentis. There are over 1,000 patients being tracked in the registry, and that should go to 1,500 to 2,000 patents by the end of2007. So far, the average vision improvement is one line on the eye chart, with 35% of the patents requiring no retreatment. For the whole population, the average number of retreatments is 1.3 and the mean time to retreatment is 90 days. This data is being presented at various scientific conferences, including the Macula Society meeting in early May.

Another study from Germany, in the February issue of Retina, showed a mean increase in visual acuity of 1.8 lines on the eye chart after nine months, using a triple therapy of Visudyne, Avastin and steroids. There are numerous other studies underway, some supported by QLT and others by their marketing partner, Novartis.

Why does this work? Because Visudyne closes leaking blood vessels in the retina, while anti-VEGF drugs prevent these blood vessels from reforming. The two treatments have different and complementary methods of action.

First, the quarterly results. QLTI beat the consensus for $37.3 million in sales and three-cents a share pro forma, reporting $38.6 million and eight cents. It was a confusing quarter with divestitures, reserves for downsizing, a major legal settlement with the accompanying costs and so on. But I think the main message was that this management is guiding conservatively and methodically executing their plan to focus on ocular and dermatology products.

For the year, the company earned 37 cents a share on $175.1 million in sales. That was down 23.8% from 2005 due to the decline in Visudyne sales in the U.S. Because Lucentis will launch in Europe this year, I expect Visudyne sales to fall again, although the company is not giving specific guidance. Overall revenues should be about $150 million to $155 million, and that will be the bottom. Visudyne sales could be growing again by the September quarter due to combination therapy sales, which will be the key to this stock going forward.

QLTI remains a buy on dips under $8 for my $16 target this year, and higher numbers in 2008.

I had a question from David on buying last week’s recommendation of Amgen LEAPs: “Michael, I would like to buy the AMGN January 2009 LEAPS you spoke of but don’t know how to purchase/sell them. My broker is Ameritrade. Can you help? Thanks.”

Sure, David. On the Ameritrade website, go to the Trade Options page and you will see a box for “Underlying Symbol.” Type in AMGN and click “get option chain.” At the top of the page, change the Chain Type to “Calls” and in the Expiration box, use the down arrow to open the menu and scroll to near the bottom where it says “Leaps.” Then click “View Chain.” You will see the Amgen January 2009 $70 LEAP calls have an Ameritrade symbol of “+VANAM.” Every broker has different ways to denote options — Ameritrade with a “+” at the beginning of the symbol, Etrade with a “.”, others with a “+” as in VAN+AM, and others with a hyphen, VAN-AM. Yahoo uses “.X” as in “VANAM.X”. They are all different, but if you start with the stock and then look for the option change, you will find out how that broker or quote service wants the symbol formatted.

Market Outlook

The “overbought market that has to correct” continues to do a good job of confounding the bears. The S&P 500 took a couple of more dips down towards the 1450 to1453 breakout area yesterday and today, and prices were once again quickly repelled back to the upside. This confirms that this latest breakout area is significant, and the SPX should soon continue its inexorable rise to the 1510 target. Notice that the NASDAQ Composite Index (COMP) had a clear daily breakout on Wednesday, and closed up today in an otherwise down market. It would be very typical for NASDAQ technology stocks to lead the market up. We are well positioned for this move. Relax and enjoy it.

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