TWST: Please tell us about your coverage within the health services sector.

Mr. Leonard: I cover the life science tools and diagnostics group. These are companies that provide tools and services to understand chemistry and biology, and apply this understanding to both drug development as well as clinical diagnostics.

TWST: What are some of the big issues for this group right now?

Mr. Leonard: In the tools group, the big themes would be that large pharma R&D budgets are under pressure, and the large pharma R&D pie actually shrank in 2009. But in 2010 this pie probably won't grow, but I don't think it's getting any worse. The funding environment for small biotech companies, those companies that burn cash, is actually getting a little bit better following a very poor 2009 and late 2008. Also academic and government-sponsored research support could be improving worldwide. You not only have the NIH stimulus in the U.S., but you have some science stimulus programs happening around the world in places like France and Germany. And it looks like the Japanese science spending is actually improving a bit and showing the first signs of life in a long time.

TWST: How significant is the regulatory environment in these two subsectors? Are they heavily impacted?

Mr. Leonard: It is very significant on the diagnostic sector. The tools sector is not regulated, but in the diagnostics space, that's very heavily regulated.

TWST: Will health care reform impact them?

Mr. Leonard: Perhaps, but it's still a little unclear. There could be two impacts. One, there could be a negative impact if the diagnostics companies are expected to pay a medical device tax, and that looked like it would be a big deal for a while. The initial proposal I think was a $4 billion annual tax on the medical device companies. Since then, at least in the most recent version of health care reform that passed the Senate on Christmas Eve, that's been paired down quite significantly. The most recent fee was $2 billion, and there are exceptions that would apply to the diagnostics companies. So for instance, Class I medical devices and Class II medical devices, which sell for less than $100, wouldn't be part of the tax. It looks at the end of the day like the negative side is pretty benign. On the positive side, if you have increased health care coverage, you could potentially have more people going to the doctor and having more testing ordered. That could be a positive for them.

TWST: What other opportunities are out there?

Mr. Leonard: Growth in the diagnostics industry is driven by a lot of new product cycles, and that is driven by technology. So one of the hotter spaces in diagnostics right now is molecular diagnostics, and that's just the name given for diagnostics tests where your target is nucleic acid. That's still a relatively new technology, and that's been able to create markets that didn't exist before - one of which, for example, would be HPV testing, human papillomavirus testing. And persistent HPV infection is a cause of cervical cancer. Digene started marketing an HPV test several years ago, and they were later acquired by Qiagen (QGEN). And that market is still very underpenetrated, and it's a very fast grower for Qiagen. And that's why you have other companies, like Hologic (HOLX), which recently entered that market through its acquisition of Third Wave. Gen-Probe (GPRO) is entering that market; Roche (RHHBY) is entering that market in the U.S. in the next couple of years. So it's a good growth area.

You also are seeing some growth in companion diagnostics, or diagnostic tests used in conjunction with a pharmaceutical. So the result of the diagnostic informs upon your treatment decision of what pharmaceutical to use. So for example, KRAS mutation testing - mutation of the KRAS gene - is a predictive biomarker for response to EGFR inhibitors, such as Erbitux and Vectibix. A paper published on this in The New England Journal of Medicine implicated the gene mutation with response of these drugs. The FDA then changed the label for both Erbitux and Vectibix to include this information. There are organizations such as The National Comprehensive Cancer Network, which updated their guidelines to recommend their oncologists to determine a patient's KRAS status as part of their pre-treatment workup for patients diagnosed with colon cancer. So that market is a growing market, and there are all sorts of others. Qiagen is a company that talks about having 15 partnerships with pharmaceutical companies to develop these companion drugs. So that could be a real market, each of those markets individually. The KRAS testing market, maybe that's only a $50 million market for the diagnostics manufacturers. But if you start stacking a bunch of $50 million markets on top of each other, you can get something that's meaningful.

TWST: What makes a company a good pick in the life sciences group?

Mr. Leonard: Right now I am more predisposed to recommending stocks that have a good amount of exposure to academic and government-sponsored research in the tool space because I think that's a good growth trend worldwide currently. I'm also recommending names that have good product breadth because there is a lot of competition for some of the companies that have a very niche and specific focus on one or two product areas. There can be pretty heavy competition.

One of the big trends in life science tools, which I didn't mention, the big product cycle is next-generation sequencing. The cost of sequencing a person's genome has fallen dramatically in the past several years, and Illumina (ILMN) just came out and said they introduced an instrument which can sequence a genome for less than $10,000 in consumable cost. There is another private company called Complete Genomics, which is currently selling human genomes for $20,000, and they expect to be selling them for probably around $10,000 at some point in 2010, and that's their all-in cost to the customer. So whereas with the Illumina tool, if you say it's a $10,000 genome, that's really only your cost of consumables, and your actual cost of delivering a genome is probably three times that. But for Complete Genomics, they sell it for $10,000 - that's your all-in cost. So that's an incredibly competitive area right now, and there are well north of a dozen companies that are trying to develop the next sequencing technology. Those areas for investment can be a little bit dangerous, but the stocks, if you pick them right, can work out phenomenally.

TWST: What do you look for in diagnostic companies?

Mr. Leonard: The trends are a little bit different in diagnostics. They are not as exposed to the academic and government funding trends. What I generally look for is valuation, growth potential, how penetrated are their target markets for their key products, how many risks are on the horizon versus their peers, and then evaluate all that in conjunction and make our recommendations.

TWST: What do these companies spend on R&D?

Mr. Leonard: The companies tend to spend about 10% to 20% of their revenue on R&D; 10% is for the tools companies, and some of the faster-growing tools companies like an Illumina might spend closer to 20%. The diagnostics companies, some of them spend 20%, 20%-plus, like a Gen-Probe. So that's generally a big cost.

TWST: You said you didn't think 2010 would be as bad as 2009. How will these two subsectors evolve over the next couple of years?

Mr. Leonard: I think consolidation is a pretty prominent trend in both subsectors, and that tends to be driven by a company's desire to fill gaps in their product offering as well as leverage their existing channel. So I think that will continue. Over the next several years, you will have more and more acquisitions, more companies will get larger.

TWST: What are going to be the big issues for them in the next couple of years?

Mr. Leonard: I think you are going to have many more new product cycles. Also the FDA is becoming stricter on what they will allow, so more and more diagnostics products will have to go through the FDA process before they can be sold. You will have more FDA-approved products out there.

TWST: Tell us about your background. How did you become a medical analyst?

Mr. Leonard: Out of college, I went to work for a consulting company called Simon-Kucher & Partners, doing pharmaceutical pricing research. So that got me into health care. Playing with my personal brokerage account got me interested in investing. I then transitioned to First Analysis to get into the investment business, and started covering tools and diagnostics because it seems like there are plenty of growth trends, and we try to cover growth companies.

TWST: Tell us about First Analysis.

Mr. Leonard: We are a Chicago-based firm, have been around since the early 1980s. We have roughly 50 employees. One of our main businesses is providing equity research to institutional investors, and our focus there is on growth stocks. We look to leverage our knowledge in as many ways as possible. So we also have an asset management investment advisory business in private equity with a family of growth private equity funds in the areas we follow on the public side so that we can leverage the knowledge base. Our investment banking team provides transactional services to private and public companies in our areas.

TWST: Thank you. (LMR)

Note: Opinions and recommendations are as of 01/16/10.

DAN LEONARD

Vice President
First Analysis Corporation

1 S. Wacker Dr.

Suite 3900

Chicago, IL 60606

(312) 258-1400

www.firstanalysis.com