Is Biotech In A Bubble Or A Golden Age? by Aaron Reames, ColumbiaManagement
- We recognize concerns over biotech valuation, are mindful of commentary from Yellen and agree that there are pockets of froth — but that is only a portion of the picture.
- Despite some signs of potential excess, overall research productivity is remarkable and we believe the group can appreciate further.
- We continue to see value in innovative franchises, particularly those with research platforms offering multiple “shots on goal” against significant revenue opportunities over time.
There is substantial debate around the overall valuation of the biotech sector given the strong performance and the eye-popping cumulative amount raised in the equity markets over the past three years. Last summer, Fed chairwoman Janet Yellen warned that, “valuation metrics in some sectors do appear substantially stretched-particularly those for smaller firms in the social media and biotechnology industries”. The NASDAQ Biotechnology Index has gained 37% since that commentary. In late March, the Wall Street Journal emphasized investor nervousness over the biotech bull run. They said that a 240% gain in the NASDAQ Biotechnology Index since the beginning of 2012 far exceeded the NASDAQ-100 Technology Sector Index’s 82% gain over the same period. This catalyzed a pullback based on fears that companies in the sector have become overvalued after an extended period of appreciation. Since the peak on March 20, the NYSE Arca Biotechnology (BTK) lost over 7.1% in 4 days. The end of 1Q15 exacerbated the sell-off, with the group down as much as 11% before stabilizing. Year-to-date, the group has still offered healthy performance, up approximately 17%. So where do we go from here? Was this modest correction healthy, or is it the beginning of a broader pullback because the group is over-valued?
There are other signs of potential optimistic excess. The sector has raised $40.5 billion in 2015 as follow-up to $56.4 billion in 2014. While some of this capital was recycled from transactions such as Allergan, Pharmacyclics, and Auspex, it has been a busy IPO calendar and M&A deals have also been fast and furious. Most recently, the Alexion bid for Synageva at a $136% premium was eye-raising, as was the total price of $8.4 billion in that deal for a company without a product on the market yet.
All of this said, we do not think the group is overvalued and can appreciate further, although it may not be a straight line. The 240% appreciation is warranted, and actually correlated to the EBIT acceleration for the biotech component of the Russell 3,000. What we saw in 2000 was probably a realization of value without regard to the duration of the drug development cycle. In contrast, over the past four years, we have seen life-altering, highly transformational innovation driving a massive increase in earnings. We have also seen the first drug to generate more than $2 billion in revenue in its first quarter on the market. However, this innovation has been there all along, funded by the genomic boom in 2000. I would argue that most investors either did not look for it or ignored it for a long time. The biotech group was in purgatory from 2002 through 2010, and I view this as a catch-up trade.
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In 2001, scientific journals published the complete human genome sequence. The resulting boom fostered some of the greatest innovations the industry has ever seen. In 1999, 55% of publicly traded biotech companies had less than two years’ worth of cash, and 35% had less than one year. By 2001, 54% of biotechs had at least three years of cash, and 42% had more than five years for funding their research activities. That round of funding is directly tied to the development of drugs like Ibrutinib, a breakthrough for certain types of leukemia. In 2006, this drug was purchased for $2 million. It recently exchanged hands again for more than $20 billion because it has had one of the fastest launches in the field of oncology, potentially becoming the highest revenue generating therapy in the field of blood cancers. The company that discovered this product could not raise funding in 2005 and 2006.
This is an example of many innovations that went unnoticed but which are now being recognized. In just the past two years, I have heard more therapies and breakthroughs described as miracles or achievements akin to landing on the moon than ever before. Hepatitis C has been cured, drugs are adding 30-40 years for people suffering from cystic fibrosis, and children with a rare form of blindness are seeing again. 80 years after Dr. William Coley first recognized that an infection resulted in an immune response that led to a patient being cured of sarcoma, scientists have figured out how to harness the immune system. Many babies with that rare disease (once a death sentence) are now living. We are using small pieces of engineered DNA and RNA to slow the progression or stop deadly diseases in their tracks.
The pace of drug development is quickening as the field has better tools, better diagnostics and better drugs. All of this leads to better responses and more meaningful outcomes, and the FDA is reacting to this. One oncology drug was approved in just two months. The FDA has openly stated that they are seeing a 300-400% higher improvement from the drugs filed for approval today than 40 years ago. All of the funding forms the past three years will drive more breakthroughs.
These advances are often long-lived assets with ~90% gross margins. Certainly, society has to pay for this innovation, but there is room. By 2020, 85% of all prescriptions will be generic, leaving 15% of prescriptions to fund all industry research and infrastructure (the ratio was 50%/50% in 2000). More room in budgets will be made by biosimilars, given the $67 billion in biologics losing patent protection. Biologics coming off patent give players the ability to make room for novel agents. This is a positive area of drug development, one that will transform how people use biosimilars versus the innovator molecule. Over the long term, the biosimilar market may turn into a generic-like market. Some believe this will happen immediately, while others believe it will take 15 years. However, all players and beneficiaries believe that it will result in savings to the healthcare system.
In short, this is truly a historic period for biotech innovation. While there may some hype on the periphery of the sector, the core breadth of research-driven productivity in the sector is real. If some investors react fearfully to the biotech “bubble” that they read about in the financial press, it only creates opportunity for those of us who recognize the magnitude of the revolution unfolding in the industry. We continue to see long-term value in the franchises that are leading the innovation charge, particularly those that have established distinctive research platforms offering the potential for multiple “shots on goal” against significant revenue opportunities over time.