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Increasing M&A activity in the pharmaceutical and biotech sectors has placed many large drug companies on high-alert mode. For them, it signals the fact that they had better hop on the bandwagon and buy something quickly before all the top choices are acquired. The major pharmaceutical and biotech companies are also looking to replace lost revenue from many of their drugs that are losing patent protection in the near future. For the takeover candidate, it means that they had better look as appealing as possible if they want to attract a suitors, and enhance shareholder value. For those merger targets with intransigent management teams and a “go-it-alone” ideology, they are quickly firming up their poison pill status, and working on their more influential shareholders.

Generally speaking, takeover targets have the following characteristics. They have small- to mid-size capitalization, and plenty of cash that can be used to help pay down the debt an acquirer might accumulate to help fund the acquisition. Too, their ownership tends to be concentrated among a few large shareholders, so that it is easier to get the voting majority needed to approve a merger. Sometimes, they have disgruntled investors who are unhappy with the current, poorly performing management team. In addition, acquirers look for a company with a stock price close to tangible asset value. For drug and biotech acquirers, these factors are less important than the over-riding goal of finding a company that has a product in its pipeline that will fulfill an unmet need. This will increase the chances of the treatment getting FDA approval. This is critical in an environment of enhanced safety and efficacy scrutiny. In particular, acquirers are seeking drugs that will cure lesser-known cancers, nervous system disorders, and immune system conditions.

We all know about the big proposed transactions such as Pfizer’s (PFE - Free Pfizer Stock Report) bid for King Pharma (KG), and Sanofi’s (SNY) unsolicited offer for Genzyme (GENZ), but fervor is increasing for lesser-known entities. For example, Merck (MRK - Free Merck Stock Report) is planning to buy closely held SmartCells; Johnson & Johnson (JNJ - Free Johnson & Johnson Stock Report) is moving ahead with its acquisition of Crucell (CRXL), and Eurand (EURX) has agreed to be bought by privately held Axcan Holdings. Some targets that have been under much discussion are Genzyme, Gilead (GILD), Biogen Idec (BIIB), and Cubist (CBST). Other, lesser-known, but equally available companies are Endo Pharma (ENDO), ISTA Pharma (ISTA),The Medicines Co. (MDCO), Inhibitex (INHX), Dendreon (DNDN),  Shire plc, Pharmassett  (VRUS), Genentech (DNA), and Angeion Corp. (ANGN). Our favorite selections in the group are Inhibitex and Dendreon.

Inhibitex

This is a small-cap ($180 million) biotech gem poised to take advantage of the huge hepatitis C market. (It is thought that there are 170 million people worldwide who have the ailment, around half of whom are unaware they have the disease due to the very long gestation period -- sometimes up to 30 years.) Inhibitex has a very promising hepatitis C treatment called INX-189, which is in Phase I clinical development trials. Although a few years behind the hepatitis products made by market leaders Merck and Vertex (VTX), INX-189 is deemed to be more efficacious. Moreover, INHX has learned a great deal about avoiding the potential pitfalls a hepatitis therapy can encounter, as it moves through the drug development pipeline. This knowledge should enable INX-189 to come to market more quickly.

INHX also has a game-changer in Phase II clinical trials for the cure of shingles and herpes zoster. This drug is called FV-100. If all goes well, we could be looking at a new drug application (NDA) for FV-100 by 2013. Management has stated that it has been in discussion with a variety of potential marketing partners for both these potential blockbusters. With insider and institutional ownership concentrated in just a few hands, getting the voting majorities needed to approve a takeover transaction becomes easier than if ownership is dispersed in many hands. Furthermore, the stock price is still relatively cheap when compared to what it could be just a year from now. Inhibitex also has $25 million in cash on the balance sheet, which could help defray the costs associated with a merger.  We calculate INX-189 and FV-100 have total peak sales potential of about $700 million and $500 million, respectively. This company is certainly an extremely attractive proposition for many larger biotech entities looking to gain stakes in the hepatitis C and shingles markets.

Dendreon Corp.

This company has a novel prostate cancer treatment named Provenge.  After 15 years of clinical development, and around $1 billion in expenses, Provenge was approved by the FDA in April. It is poised for European (EMEA) approval in early 2012. The reason this drug is different from the traditional chemotherapy-based therapies is because it is a first-in-class immune-cellular therapy. Provenge has been proved to increase survival compared to other prostate cancer drugs. And the side effects are minimal in comparison to chemo-based treatments. Should Provenge prove to be as successful as many in the biotech industry think it will be, peak sales of $2.5 billion is possible. This is partly because competition is likely to be minimal since barriers to entry are very high due to the long and arduous developmental cycle a similar product must endure to reach the market.  A formal Medicare/Medicaid coverage decision is expected by March 2011.

It should be noted that an investment in this biotech stock is more risky than most since almost all the company’s sales stem from Provenge. However, the upside potential is enormous. First and foremost, though, we are recommending this issue as a buyout candidate.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.