MANAGEMENT INSIGHT - The Biotech Bubble: What Goes Up Must Come Down

Physicists know it. Coffee drinkers live it. Roller coasters capitalize on it. Yet stock market investors – even coffee-drinking physicist-investors strapped into roller coasters – routinely deny it. What goes up, must come down! How much? How fast? How hard? When? These are the relevant questions.

In the past 12 months, the Nasdaq biotech index has skyrocketed 80%, borne aloft on a wave of new drug approvals. The overall stock market climbed just 20% in the same period. This is far from normal. Last year, we saw more biotech IPOs in a single calendar year than we saw in the previous 5 years combined.

Biotech is delivering. Landmark approvals abound. In December, California biotech Gilead saw the FDA approve Solvadi, a treatment for Hepatitis C, which could earn the company $3 billion this year if they don’t have a large backlash on the reimbursement. Biogen Idec is expected to see $1 billion in revenues for Tecfidera, a multiple sclerosis treatment approved last year.

Biotech is the spigot that feeds our pipeline. Everyone in this industry wants to hear that biotech is booming. Right now, the spigot is wide open. But will this continue? Or is it just a blast of activity that comes from taking the kinks out of the hose – kinks created during 5 years of pent up recessionary pressure.

The biggest threat to the industry going forward may be the stock market itself, which is a major source of capital. Investing in biotech is always highly speculative, and with the recent peaks and dips it may feel more like a gamble than ever. At one point, biotech was up 40 percent for the year. It’s cut those gains since then, but remains solidly up for the last twelve months. As of this writing, the IBB index has fallen 20% which is officially bear market conditions. Is further correction in sight?

There are some very real reasons behind the past year’s growth, and if those reasons remain strong and steady, we may be able to hold off a precipitous downward plunge, though it may be wise to buckle up for more loops just the same. Let’s start by looking at three of the engines behind biotech’s amazing last year.

ENGINE 1: HARVESTING THE GENOME

All those years of unraveling the human genome are finally paying off with a surge in new drugs. Vertex has a drug that treats a subset of patients with cystic fibrosis, made possible because of improved understanding of the malfunctioning gene that causes it. Bluebird Bio, a small Celgene partner, is making progress toward a treatment for sickle cell anemia that inserts a properly functioning version of the bad gene into the patient’s blood cells.

There is every reason to believe there will be more of these exciting discoveries, and yet implications of the unraveling of the human genome go beyond more and better medicine. Because we can now identify precisely which patients have the genetic markers that make them candidates for a particular treatment, clinical trials can be smaller, cheaper, and show better results. Cheaper clinical trials make it more economical to research treatments for rare diseases and for those that have proved immune to existing treatments.

The FDA gives special treatment to these drugs, allowing them a speedier path to approval. Witness NPS Pharmaceuticals (NPSP), which developed a treatment for a rare disease known as short bowel syndrome. Hyperion Therapeutics (HPTX) is developing a drug for another rare illness known as hepatic encephalopathy, a decline in brain function that results when the liver is unable to remove toxins from the blood. The stock is up 20% this year. This is a solid development that gives industry growth legs.

ENGINE 2: OPTIMISM OVER OBAMACARE

Optimism fuels markets, and at least in the biotech market, there is a lot of optimism about Obamacare. More Americans than ever will have insurance in the future, meaning more people than ever will be able to afford expensive drugs. The fact that it’s too soon for most of these people to have actually begun buying these drugs is irrelevant. The stock market acts not on what is, but on what it anticipates. For the past year, the market has beenanticipating that more people than ever will be able to afford expensive drugs in 2014. Hence the growth. Can we expect more growth based on this optimism? It may be baked in at this point.

ENGINE 3: BIOTECH AS THE ENGINE FOR PHARMA GROWTH

Biotech is benefiting from a shift in large pharma thinking. Internal R&D used to be a major part of any large pharma operation. Biotech is the engine of large pharma R&D today; big pharma cherry picks promising candidates from biotech’s field of dreams.

There are a few companies that still rely heavily on internal R&D, and they’re taking a hit for it. Merck poured a massive $8.16 billion into its R&D department last year. To put this in perspective, the XBI, the largest biotech ETF, contains 44 companies and is worth just slightly less than $8 billion, even after the massive recent run-up in stock prices.

What results did Merck see? Precious few. Perhaps Merck’s R&D department failed to produce any juicy cherries, forcing the company to throw support behind a few Craisins. The FDA gave Merck countless sleepless nights over Suvorexant, a new sleep drug, forcing it to revise its NDA to limit use to small doses. Progress with the osteoporosis drug Odanacatib has been extremely fragile, plagued by delay after delay. And the embarrassing failure of the cholesterol drug Tredaptive, the latest iteration of Niacin, once marketed in Europe, was a major cardiac event for the company. Tredaptive didn’t cut the risk of vascular events while it raised several side effects, such as diabetes, bleeding, and infections.

Sanofi, meanwhile, has staked its fortunes on biotech with a very different result. Sanofi depends increasingly on its American biotech partner Regeneron to stoke the ovens that fire the pharma giant’s growth. This year, the massive French company will pump about $1 billion into Regeneron’s research program. That’s a sizable amount, though nothing like Merck’s $8 billion. Interestingly, Sanofi isn’t trying to absorb Regeneron and make it into an internal R&D department. Rather the company prefers to keep it at arms-length, allowing Regeneron to do what it does best – breaking new ground in research, while allowing Sanofi to exercise its considerable skill and experience in bringing the new treatments to market. The trend of large pharma looking to biotech for innovation is a mature trend, but it still has room to grow.

BIOTECH MARKET FUTURES: ENGINE FAILURE?

The biggest threat I see to biotech’s upward momentum in the near-team future is the stock market itself. As the industry’s primary source of funding, the gyrations of this market could temper the near-term future of a very promising industry.

Whether or not you agree with me depends on how you answer this question: Would you put your investment dollars into a biotech ETF right now?

Your gut reaction may be, why not? Biotech is delivering profits, saving lives, and furthering science. The fundamentals are strong, and as we’ve just outlined, positive.

But the market is not a perfect reflection of fundamentals. The fortunes of a particular drug develop slowly, yet individual stocks generally languish on the ocean floor then skyrocket based on a single news story. Karyopharm Therpeutics stock doubled in January from $16 to $32, reaching a company value of $950 million when the company reported Phase I data on Selinexor as a treatment for metastatic colorectal cancer. Keryx doubled from $8 to $16 over the past half year when Zenerex, under review by the FDA, showed favorable efficacy as a treatment for chronic kidney disease associated with hyperphosphatemia. Such erratic leaps and crashes are the norm of the biotech stock market. For every one that skyrockets, 8 or 9 smolder and fail. It’s a risky business.

If you’re a savvy investor, you may believe you can better your odds by choosing only biotech ETFs with favorable P/E ratios. This is a basic tenant of investing. Except when it comes to biotech. Most people don’t realize that you can’t analyze P/E ratios in the biotech industry like you do most other industries.

P/E is the ratio of the Price of the Stock, divided by its Earnings (profits). The lower the positive number, the better. If the price of a stock is $10 and it earns $1 a year, it has a P/E of 10 and you can expect to earn profits at a rate that you could recover your initial investment in 10 years. That’s good.

The P/E of the SPDR Biotech ETF is 34. That’s high, but most of the market is a little pricey right now, so you might surmise that because biotech is actually growing at 20% a year, 34 is not bad. You’ll recover your investment sooner than 34 years.

The problem is that P/E ratios are only a good measure of an ETF when most of the companies in it are making money. When this is the case, the cumulative P/E ratio for the index will be positive. Negative P/E ratios throw the entire measure off.

Bear with me. Let’s say you have a company with a price of $10 and earnings of negative $1. The P/E is negative $10. Next door, is another company that also has a price of $10, but a negative earnings of $2. That yields a P/E of negative $5. But that makes no sense! Negative $5 is a better number negative $10. You see how negative P/Es are misleading? You also can’t just add them up like positive numbers. The result would lead you in the wrong direction.

Generally, when grouping large numbers of stocks and averaging them, sites like Morningstar and Yahoo just toss out the negative P/Es, or assign them a very high positive number, like 300. If you have only a few negatives, this doesn’t affect your ETFs total P/E much. But in biotech, three-quarters of all P/E ratios in a given ETF may be negative. The result of this strategy gives, for example, the XBI ETF a P/E of 34, when in fact the ETF is losing money hand over fist.

If you want a better way to calculate an ETF’s true P/E, try this. Add up all the prices of the component companies in the ETF. This is your price. Then total the actual losses of all the component companies. This is your earnings. If you do this with the XBI ETF, instead of a P/E of 34, you will get a far more accurate P/E of negative $21.

A P/E of negative $21 tells you nothing. It can’t possibly take negative 21 years to recoup your investment. My point is that you must base your biotech investment decisions on factors other than P/E. If you are in a privileged position to understand (without insider information) how well a particular company’s dual-specificity kinase inhibitor effecting the serine-threonine and tyrosine kinases of the MAP kinase cascade might perform, then that is something that might give you an advantage over Wall Street.

I’ve emphasized the riskiness of biotech investing, but I’d be remiss if I didn’t mention that biotech has come a long way toward learning to make a profit. They’ve been selling for high prices, and that’s good for the industry as a whole. Every time a biotech company commands a noteworthy price, a few more venture capitalists wade into the investment pool. Investment stimulates R&D spending, and that benefits everyone reading Drug Development & Delivery.

While such progress buoys my spirits as an industry player, the steep 80% upward growth of the past year makes me steel my gut for a fall.

After reading this, have you changed your answer to my question? Do you believe a biotech ETF is a good place to invest your money right now? If you say no, I suspect you’re probably in a growing majority, and that’s not a good sign for the market’s upward trajectory. Because the market provides capital fuel for the industry, we could see some downside in the near to mid-range future. But the underpinnings are strong enough that I believe we will all weather another dip.

To view this issue and all back issues online, please visit www.drug-dev.com.

Derek G. Hennecke is President and CEO of Xcelience, a CDMO in formulation development and clinical packaging located in Tampa, FL. Mr. Hennecke launched Xcelience as a management buyout in 2006, and the company has more than doubled in size. Prior to starting Xcelience, Mr. Hennecke worked for DSM as a turn-around manager in the global drug development community, managing an anti-infectives plant in Egypt, technical and commercial operations in a JV in Mexico, and a biologics facility in Montreal. He developed the formulation and business strategy of several drug compound introductions such as clavulanic acid, erythromycin derivatives and Tiamulin. A Canadian, he covets the Florida sun, but can’t be kept away from the rink for long. He is an avid fan of the Tampa Bay Lightning.