The biotech sector is currently in the most successful period in its history based on valuation metrics, amount of money raised and number of IPOs. The perception around the current situation ranges from very bearish (it’s a bubble) to very bullish (there’s enough innovation to fuel future growth).
Before providing my take (which is very subjective and is as good as anybody else’s for that matter), there are two things most investors agree on:
1 – The biopharma industry enjoyed a massive wave of innovation in the form of revolutionary drugs that truly make a difference for patients. These include PD-1 antibodies, curative HCV drugs and PCSK9 antibodies just to name a few. Fundamentally, our understanding around diseases and our abilities to modulate them has never been better, which should dramatically increase success rates in the long run.
2 – The biotech sector has had a huge run in the past ~3 years. Since the beginning of 2012, the primary biotech indices on NASDAQ and NYSE are up 250%-260%. This means that in 3.5 years, the biotech industry (which was already quite established at the time) saw its valuation more than triple.
While I don’t think we are in a bubble, it is becoming increasingly hard to justify current valuations that appear to factor in a lot of upside but very limited risk. Here are several risks that may be overlooked by investors:
Acquisition premiums – Multi-billion acquisitions are always a source of controversy, especially when valuations are so rich to begin with. While acquisitions are proven growth drivers and can be transformative, recent takeout prices are becoming exceedingly inflated. The acquisition of Synageva (GEVA) by Alexion (ALXN) for $8.4B is a good example.
Synageva’s lead program (Kanuma) is an important and effective drug for a highly unmet need. Kanuma is a great fit to Alexion, which is the ideal company to commercialize it globally. Still, I am struggling to justify the price paid by Alexion for a drug with a limited commercial potential and significant commercial risks going forward.
Kanuma is being reviewed by the FDA for the treatment of LAL-D (lysosomal acid lipase deficiency), a disease characterized by buildup of fat in the liver and other tissues. LAL-D’s prevalence is unclear, as the disease is believed to be extremely under-diagnosed. Although Synageva believes there are at least 3000 thousand cases in reimbursable markets, the company identified only several hundreds to date. Assuming 3000 patients receive Kanuma and an average price of $400k per patient, the global potential of the drug is $1.2B. Experience with other enzyme replacement therapies shows that ramp up is gradual and it typically takes years to reach >$0.5B, not to mention complete market penetration.
Synageva has ~$700M in cash and an early stage pipeline. Assuming the pipeline is worth $500M and deducting the cash position, the transaction values Kanuma at $7.2B. This is ~7 times expected peak sales (assuming 80% penetration, which is very high), which is 8-10 years away.
Some compare the transaction to Gilead’s (GILD) acquisition of Pharmasset in 2011. At the time, Gilead’s move was perceived as exaggerated and the company received a lot of criticism but the deal turned out to be highly accretive for Gilead. Pharmasset’s HCV drug (Sovaldi) was initially approved in late 2013 and was subsequently co-formulated with another Gilead drug to create Harvoni. Although Sovaldi is one component of Harvoni, its contribution to Gilead’s early mover advantage and dominant market position makes it the valuable component in Harvoni.
In retrospect, a quick look at the numbers shows Gilead did a phenomenal deal. Sovaldi was approved in December 2013, 2 years after the transaction. Sovaldi/Harvoni generated 12.4B in sales in 2014, which is already 1.4B more than what Gilead had paid for Pharmasset. In 2015, Gilead is expected to generate 16.5B in HCV sales. In other words, Gilead paid $11B for an asset that is expected to generate $29B in its initial two years on the market.
There is a debate on long term opportunity in HCV as patients are cured and competitors Abbvie (ABBV) and Merck (MRK) are entering the market but Gilead will probably be able to generate at least $30-40B in additional revenues by 2020. This puts the overall cumulative sales generated from the Pharmasset deal at $60-70B (within 9 years), 6 times the price Gilead paid for Pharmasset. In order to replicate this, Alexion needs to sell $42B worth of Kanuma in cumulative revenues, inconceivable with a product that will take years to reach peak sales of ~$1B.
Arguably, the Gilead/Pharmasset deal poses a high bar as it turned out to be one of the most profitable deals ever. Still, paying 7 times the expected peak sales today in an indication where the vast majority of patients are still not identified is hard to justify.
Pricing power – Long term sequential growth has been a key tenet of the bull case for biotech. Innovation on the one hand, and increased demand for drugs by the growing population on the other, are seen as the fuel for the industry’s revenue growth. An integral part of this investment thesis is a hidden assumption that biopharma companies have an almost invincible pricing power. In the past, this has been the case, especially in the US but judging by the current atmosphere the tide is turning as a result of pressure from payors and legislators.
A significant aspect in the industry’s growth story, which is still somewhat unnoticed, is the constant price hikes for established drugs. The case of Amgen’s Enbrel, recently discussed by Adam Feuerstein is just one of many examples. Earlier this year, a report titled “Biotechnology drugs price increase tracker” issued by Terence Flynn and colleagues at Goldman Sacks clearly illustrate that this is a widespread phenomenon.
It turns out that a significant portion of biopharma growth is achieved by annual price hikes in the 5-10% range. Obviously, such increases cannot be justified by inflation, especially not in recent years. In some cases, they can be justified by new findings that reveal previously unrecognized benefit exerted by the drugs, however, these are the exception rather than the rule.
In some cases price hikes led to a doubling or tripling of cost in less than a decade. Surprisingly, this was observed in highly competitive markets such as chronic inflammatory diseases. Biogen (BIIB) increased the monthly cost of its MS drug, Avonex, from $1,767 in 2007 to $5,034 in 2015. Tysabri, another Biogen drug for MS, saw its monthly price go from $2,185 in 2006 to $4,960 in 2015. A similar dynamic is observed in the highly competitive RA market.
Source : Goldman Sachs , Apr 2015
Prices for new drugs are starting to become heavily scrutinized, as can be seen with HCV drugs Harvoni. Pricing for PCSK9 antibodies, which are expected to become a $10B franchise has been discussed between payors and biopharma companies long before their expected approval this year.
Biosimilars may emerge as reimbersers’ secret weapon in the long run. Despite the significant regulatory hurdles, there are multiple biosimilar programs in late- stage development, as patent for some of the top selling biologics are set to expire in the coming two years. These include US or ex-US patents for the three leading anti-TNFs (Humira, Remicade, Enbrel) as well as Roche’s oncology blockbusters Rituxan and Herceptin. These agents are expected to generate over $40B in sales this year. Although market penetration of biosimilars is hard to predict, they are likely to grab market share via aggressive discounts, especially in more cost-oriented markets such as the EU and Asia.
Current innovation wave is priced to perfection – Innovation remains the most important value driver for the biopharma industry. Drugs that recently entered the market or are about to be launched in the coming years were the single most important contributor to the appreciation of biopharma stocks. Drugs like PD-1 antibodies, HCV drugs, new CF drugs, PCSK9 antibodies and new oral MS drugs are responsible for the creation of hundreds of billions in market cap.
Hopefully, companies will continue to generate new breakthrough drugs and treatments. Nevertheless, it appears that the market is very generous with some early investigational agents while ignoring risk. This is particularly true for disease modifying antibodies for Alzheimer’s disease, where the market relies on preliminary data from a small trial with Biogen’s BIIB037 while ignoring the phase III failure for Roche’s gantenerumab, which has a very similar mode of action.
Immuno-oncology beyond PD-1 is also priced very generously despite the near complete lack of validation for tens of investigational agents. This is particularly true for early stage agents. AstraZeneca’s (AZN) recent deal with Innate Pharma for IPH2201 included a $250M upfront payment, which is quite high for an antibody that has phase I data in healthy volunteers. Earlier this year, BMS (BMY) paid $800M for Flexus and its preclinical IDO inhibitor. IDO is one of the hottest targets in immune-oncology but Flexus’ IDO program is years behind Incyte’s (INCY) IDO inhibitor and at least one year behind Newlink’s (NLNK) IDO program (partnered with Roche). Aduro (ADRO) landed another massive preclinical deal for its STING agonists with Novartis (NVS) which agreed to pay $200M upfront (plus $50M in equity investment). The rationale and value for all of these programs is clear but it is hard to justify hundreds of millions of dollars upfront for programs without proof of concept, let alone clinical data.
While we intend to maintain a high exposure to selective biotech stocks, we feel it is time to hedge the risk by allocating a portion of the portfolio to a leveraged short ETF on the biotech sector (BIS). We also decided to sell Avalanche (AAVL) after last week’s meltdown as well as Aerie (AERI) after last week’s jump.