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They are harnessing blue-sky technology to exploit massive markets and a select few are beginning to generate serious profits. James Crux investigates the companies embroiled in the complex world of animal genetics.

Blue sky, utopian, revolutionary, dangerous – these are just some of the usual titles applied to the select band of sophisticated stocks that are currently dabbling in the field of animal genetics. The public at large (perhaps quite rightly) are usually most concerned with the moral and social/cultural repercussions of the work undertaken by such ventures. Investors, on the other hand, are usually more relaxed in their approach. There is often just one question – will these stocks make any money?

The group that did its best to convince the City that there were stratospheric profits to aim for was PPL Therapeutics, the firm most associated with Dolly the sheep. Apart from cloning Dolly, PPL was involved in developing sheep that could produce proteins in their milk for the manufacture of a drug used to treat certain lung diseases and potentially slow down cystic fibrosis. All very complex and awe-inspiring. Unfortunately, the only thing that PPL actually managed to produce was a series of groans from its investors as loss followed loss year in, year out. Just recently the sheep protein project was suspended after it ran out of money and the shares have bombed.

But it would be foolish for investors to forgo the sector on the back of one failure, for there is much promise still around — both on and off the market. For instance, in May private equity firm Advent International bought the world's largest chicken breeder Aviagen in a £255 million buy-out deal from rival fund BC Partners. It has plans to float the company after first building its market share through acquisitions and organic growth. Based near Edinburgh and in Alabama, USA, the firm develops pedigree lines for the production of broiler chickens and turkeys, and turned over £165 million in 2002.

Elsewhere, privately held Canadian animal biotechnology venture SEQUENT is developing 'sperm-sexing' technology for the dairy, swine and beef artificial insemination (AI) industry. This technology will allow producers to predetermine the sex of the embryo before conception, and allow them to maximise productivity and profitability. SEQUENT claims the global AI industry is 'large and well documented'.

Back in the public sphere, there is a clutch of UK breeding stocks trading on reasonable ratings, whose animal breeding programmes are very well developed. Some already generate significant earnings.

Sygen calls bottom of hog cycle

'The upturn in the hog cycle has begun,' says Sygen International, which recently cheered fans with a positive trading statement ahead of its close period.

Headquartered in California, the company applies quantitative genetics and biotechnology to animal (mainly pig) breeding. It indicated the downturn in the pig cycle might have come to an end, and said profits will rise in the second half of the year.

Sygen has seen the first improvement in US pig prices for 20 months and, coupled with hog market price forecasts of pork industry analysts, suggests the market recovery is well under way. Enticingly, the group's Europe division has also shown signs of improvement despite challenging market prices.

All this means second-half operating profit should be up to ten per cent ahead of the £3.1 million scored in the first half, which was itself a respectable preformance in the face of the severe market conditions. Richard Workman, of Oriel Securities, expects pre-tax profits of £6.4 million, down from last year's £13 million, before a return to form of £13.5 million pre-tax for 2004.

This should deliver earnings of 1.45p, rising to 3.06p for 2004. On these earnings estimates, Sygen trades on 30 times 2003 expected profits falling to 15 times for 2004.

At this rating, the group might seem fully valued but Sygen has another string to its bow, namely shrimp breeding. In a bid to cut its dependence on the pig cycle, Sygen bolstered its fledgling shrimp business with the purchase of Mexican outfit 'Super Shrimp' for $4.5 million last year.

Encouragingly for investors, 'Super Shrimp' has apparently exceeded management's original expectations.

Just recently it made a foray into Thailand, which has a tasty 25-30 per cent share of the global shrimp production market. The group has signed leases for two shrimp hatcheries there and will build a genetic nucleus facility later this year. These leased hatcheries should provide the company with access to farmers and customers in Asia — the world's biggest shrimp-producing region with an 80 per cent share of the world production market.

Over the longer term, Sygen's multi-species breeding strategy could see it enter the cattle and poultry market.

Oriel Securities' Workman says buy for strong long-term growth. We agree.

Genus breeds income

International bovine genetics venture Genus is Sygen's closest comparable stock. In spite of the tough global agricultural markets, the Aim-quoted venture managed to spawn some strong results for the year to March, displaying underlying growth and margin improvement in all ongoing parts of the business. Pre-tax profits prospered by 76 per cent to £5.1 million, on sales up ten per cent at £169.7 million, and the company hiked its full year dividend by 16 per cent to 5.5p. Encouragingly, net debt was cut by £3.2 million to £12.2 million at year-end.

The group's core bovine genetics division, previously known as the breeding arm, raised market share in the USA, Brazil and Japan, and Genus has now established a 35 per cent share of the Australian market through acquisition. It now delivers almost 90 per cent of the operating profit contribution.

Having restructured other business divisions, Genus is focused on developing the core bovine arm whose world- leading bulls at stud (they include the aptly named Machoman, Lookout and Big Ben) produce sperm that is very much in demand.

The Cheshire-based venture also has an animal health business which lifted like-for-like sales by 15 per cent to £61.2 million, and a consultancy business that managed to break even in the first half — a significant improvement given the losses posted the previous year.

Analyst Stephen Thomas at Teather & Greenwood upgraded his recommendation to 'strong buy' and set a 260p target price following the figures. For the current year he envisages pre-tax profits of £11.5 million on sales of £175 million, for earnings of 21.85p. The shares are currently changing hands for 194p, against 52-week highs and lows of 205p and 150.5p, and on these estimates trade on an appetising forward rating of only 8.9 times.

TranxenoGen approaches the rubicon

One stock that is approaching make or break point is biotechnology venture TranXenoGen. US-based but Aim-quoted, the company is producing chickens that lay eggs containing specific therapeutic human proteins.

The term transgenic, from which the company takes it name, means transferring genetic material artificially from one species to another.

In this case, the human gene is injected into the cell of the embryonic chicken in the egg white at an early stage. The egg is suitable because there is pure protein in the egg white and it is also a sealed capsule.

When the chicken is born it has the human gene in some of its cells. This chicken is known as a chimeric bird. Apparently, the company is close to producing a 'founder' bird with the human gene in all of its cells, which will then create the flock.

Calendar 2002 numbers showed net losses widening from $4 million to $4.4 million, with losses per share growing from $0.13 to $0.14. But chief executive officer and president George Uveges insisted that the company had 'unrestricted' cash of $5.5 million at year-end, down from $10 million a year earlier. At that burn rate, there should enough to fund operations right through to March 2004, and cash levels on April 30 were apparently higher than forecast.

Last year, TranXenoGen achieved 'proof of principle' for two monoclonal antibodies in the eggs of chickens. A monoclonal antibody is an antibody produced by a single clone of cells grown that is capable of proliferating an unlimited quantity of identical antibodies.

The firm also speeded up its breeding programme, incorporating pre-screening and selection methods into the technology to boost the percentage of transgenic animals spawned.

When all is said and done, TranXenoGen is obviously a development play and certainly very speculative. But Uveges obviously trusts the potential. He recently snapped up 507,000 shares at 8p. This followed a change of broker from West LB Panmure to Insinger Townsley 'by mutual agreement', after Panmure wound down its life sciences arm.

Uveges recently announced an evaluation agreement with an unnamed biotech venture, under which it will provide two chicken embryonic stem cells lines for evaluation in the production of vaccine candidates. This mystery collaborator already has some therapeutic vaccines to treat infectious diseases in clinical trials, and the evaluation should be completed the fourth quarter of 2003. Fascinating stuff, although only for the brave at 11.25p a share.