Genomics Shares Slide as Lehman Calls Sector Overvalued

Lehman Brothers shouldn't expect any Valentine's Day cards from genomics investors.

In a distinctly bearish note, the brokerage said Wednesday that the genomics sector could be 30% to 50% overvalued and that these companies have a long way to go to show that their technologies can bring new drugs to market.

While the findings may come as little surprise to long-term investors in biotech and pharmaceuticals, it's likely to jar some companies that have built up huge valuations on the promise that genetic research holds for new drugs. Indeed, leading genomics outfits saw their shares slide Wednesday: Millennium(MLNM Quote - Cramer on MLNM - Stock Picks) dropped $2.75, or 5.2%, to $50.12, Incyte (INCY Quote - Cramer on INCY - Stock Picks) slipped 44 cents to $27.88 and Celera (CRA Quote - Cramer on CRA - Stock Picks) dropped $2.75, or 5.3%, to $49.01.

Companies like those, while well off last year's highs following the much-ballyhooed mapping of the human genome, still sport multibillion-dollar valuations. That's way too optimistic, Lehman said in a report that was co-authored by McKinsey, the consultant. Genomics companies and their big drug company partners won't be reaping "fruit" in the form of new drugs or late-stage prospects before 2005, they said.

Ah, the Space

"Despite the recent pullback in the shares of genomics technology companies, we believe the space may still be overcapitalized by 30%-50%," said Lehman analysts Rachel Leheny and Joe Dougherty. "We also worry that there is an underappreciation of the challenges these companies will face, notably rapid technology change and short product lifecycles."

The brokerage took pains to point out that it wasn't downgrading the whole genomics sector to a sell, and that it still has some favorities. Companies like Human Genome Sciences(HGSI Quote - Cramer on HGSI - Stock Picks), Genentech(DNA Quote - Cramer on DNA - Stock Picks), Curagen(CRGN Quote - Cramer on CRGN - Stock Picks), Immunex(IMNX Quote - Cramer on IMNX - Stock Picks), Tularik (TLRK Quote - Cramer on TLRK - Stock Picks) and Corixa (CRXA Quote - Cramer on CRXA - Stock Picks) have built up substantial capability in genetics that will likely form the basis for profitable new drugs in the future, the brokers said.

The Lehman-McKinsey report drew skepticism from some investors who have watched genomics stock values evaporate in the last year. "This would have been a great call a year ago," says Carl Gordon, portfolio manager for OrbiMed Partners, which holds a selection of genomics and biotech stocks. "These stocks have been trashed since then."

But Tony Butler, who heads the Lehman healthcare team, said the study was conceived last summer when valuations were still healthy. And while many cooler heads have warned that genomics companies would have to jump through many hoops to show they can demonstrate their promise, the Lehman is among the first to issue a comprehensive analyses based on scores of interviews with industry players.

Wait and See

The Lehman-McKinsey report said investors should expect few results in the form of new drugs before 2005 for genome companies, most of which still sell their databases to big pharmaceutical companies in return for royalties on sales and other revenue.

And it said drug companies are going to have to spend a lot more money in genomics to bring forth new drugs, particularly since much of the technology offered by genomic companies is still unproven. At minimum, companies will have to plow $100 million or more into their genomic drug discovery technologies, a cost that could be prohibitive to any but the largest drug companies.

Still, the brokerage says that even with additional research and development spending, U.S. pharmaceutical companies on average are likely to meet their goal of 15% annual earnings growth in the next four years on traditional drug discovery technologies alone. After that, the brokerage forecasts 16% average annual earnings growth for big pharma companies as the benefits of genetic research begin to bear new drugs.

Butler said there was no particular failure of genomic-based drugs that prompted the brokerage's bearish near-term outlook on the industry. But he said that SmithKline Beecham(GSK Quote - Cramer on GSK - Stock Picks), which pioneered big drug company investment in genomics through an alliance with Human Genome Sciences nearly five years ago, has little to show for its efforts. It has since merged with Glaxo.

"SmithKline was a leader, but you don't see a late-stage pipeline [of genomic drugs], so where's the disconnect?" asks Butler. The company, which was among the first to hype the promise of the human genome as a rich source of new drugs, claimed previously to have 300 promising drug targets from the human genome.

Still, some investors said they knew all along that it would take a while for genetic research to bear fruit. The industry aims to first find the promising genes that control the production of proteins that control life processes then manipulate them for a desired therapeutic goal. So far, however, the industry has borne only ancillary benefits in the form of diagnostic tools that may show propensity to certain diseases or in drugs that work only in patients with certain genetic makeups, such as Genentech's breast cancer drug Herceptin.

"There are a lot of misconceptions when it comes to genomic investing," says Meb Faber, chief technology officer for GenomicsFund, a $30 million Maryland fund that buys only companies like Affymetrix(AFFX Quote - Cramer on AFFX - Stock Picks), Human Genome Sciences and Myriad Genetics(MYGN Quote - Cramer on MYGN - Stock Picks). "Many investors expect it to be a short-term process, but it still takes 10 years and a half-billion dollars to bring a drug to market. Genomics increases the targets, but you still have to develop the drug from there."