Three biotech merger targets to buy now

Professional investor Ailsa Craig picks three biotech stocks that are ripe for takeover.

Each week, a professional investor tells MoneyWeek where she'd put her money now. This week:Ailsa Craig, investment manager, International Biotechnology Trust

Health care has led the revival in merger and acquisition (M&A) activity in recent years 2014 was a record-breaker, while 2015 has got off to an equally strong start. The total value of healthcare deals in the first six months was $344bn up 48% on the same period last year, reports Dealogic. Larger companies' hunger for new drugs is a key driver. Smaller companies are more successful at innovation, making them ideal targets. But what exactly do buyers look for in a potential biotech target?

The company should have wholly owned assets with global rights. The drug should be in late-stage development, or have already been launched, to reduce the risk for the acquirer. Buyers are also looking for drugs that address serious medical needs and offer major improvements over the current standard of care. There should be strong patent protection, and no immediate or obvious competition on the horizon. We have chosen three biotechs that match these criteria, making it likely that they could be considered targets.

Cempra (Nasdaq: CEMP) specialises in antibiotics. Antibiotic resistance is a major global threat that the US drug regulator, the Food and Drug Administration (FDA), recognises. In response, the FDA has given companies an incentive by awarding certain clinical programmes with five years' extra market exclusivity and "priority review" status under the recent GAIN Act.

Cempra has had a successful late-stage trial for its drug solithromycin, for the treatment of bacterial pneumonia, and will soon present more data from another late-stage trial. The compound is wholly owned by the company. Antibiotic resistance means the market for solithromycin could be worth $2bn-$3bn.

M&A activity in this sector has been red hot, with a number of recent deals. For example, Merck bought Cubist for $9.5bn in 2013. Cempra has anexcellent management team, led by its able chief executive, Prabhavathi Fernandes, who has shown strong technical knowledge along with sound commercial sense.

Vertex (Nasdaq: VRTX) develops drugs for "orphan" diseases conditions that affect a small number of people, but can command high prices. The company is developing a wholly owned compound to treat cystic fibrosis. It already has such a product on the market, Kalydeco, and its sales potential is $1bn a year.

However, the second-generation version, Orkambi, will target a larger group of patients. The FDA recommended Orkambi for approval in June this year, making the company much less risky for a potential buyer. Sales could hit more than $5bn, which would easily plug the hole left in a large pharma group's portfolio by a major drug patent expiring.

Actelion (Zurich: ATLN) also specialises in orphan diseases and has an established franchise, but it faces the patent expiration of its largest drug, Tracleer, for pulmonary arterial hypertension. However, it has developed and launched a next-generation compound, Opsumit, to help replace those lost sales.

Another product for the same condition, Utravi, which uses a different mechanism, is in its late-stage pipeline too. Actelion also has an earlier-stage asset in multiple sclerosis. All of its assets are wholly owned. Its Swiss location makes it an attractive target, as it has a low corporate tax rate. Biotech valuations are also lower in Europe than the US, making Actelion look better value than an American rival.

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