Are biotech valuations sustainable?

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.

Average price increases - GS Source : Goldman Sachs , Apr 2015

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.

Avonex, Tysabri - GS

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.

Portfolio updates

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.

Biotech portfolio - 21-6-2015 - after changes

biotech etfs - 21-6-2015

71 thoughts on “Are biotech valuations sustainable?

  1. Hello Ohad………Thank you for your recent comments on XENE. I would appreciate any information you could provide on XBIT and their TRUE HUMAN ANTIBODY Platform?! It appears to have enormous potential if it can be validated.

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  2. Bouschka (XBIT) – This is a real head-scratcher to me. From what I recall they have been testing their IL-1a mAb in almost every condition known to humanity and I am not aware of anything meaningful generated to date. It is very hard to understand exactly what they are doing with the rest of their programs. Their approach of taking naturally occurring antibodies from patients is scientifically interesting and may be very relevant for anti-infective programs but so far I couldn’t identify a real fundamental advantage over other antibody discovery approaches. Bottom line, at a price of $0.5B I would pass.

    Richard (GLMD) – Sorry, cannot discuss Israeli companies.

    Ohad

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  3. Igonber – How does ADRO look cheap at what is still nearly a $2B market cap? I still don’t understand the valuation for this company.

    Ohad – On OPHT, any thoughts about their small study that showed it may actually be more beneficial to administer PDGF and VEGF inhibitor separately rather than at same time? If this pans out, it could open the door for OPHT drug to fend off co-formulated competition.

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  4. Igonber (ADRO) – Hope I am wrong but the small sample size, the fact they are developing cancer vaccines and the challenging indication make me pessimistic regarding the ongoing P2b.

    mcbio (OPHT) – Agree, if this pans out them competitors (REGN, AGN) don’t have an edge plus OPHT has a ~2-3 year lead. Personally it is hard for me to buy that hypothesis but in biology anything is possible…

    Ohad

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  5. Ohad
    any thoughts abut AQXP? They have interesting target – SHIP1 (PI3K Pathway), but failed completely in COPD trail. However they have two more trails – in Bladder Pain Syndrome/Interstitial Cystitis (BPS/IC), and one in Atopic Dermatitis (AD). Top line in BPS/IC were not stat sig (p = 0.06) but clearly positive. They should release soon the full set of data – probably on the ESSIC conference in September. The Ph2 data in AD are expected in Q1 2016.
    They have about 11M shares, so the market cap is about 20M. With 34M cash their enterprise value is negative (-14M)
    PFE and J&J have about 13% each in the company plus Baker Bros – about 10%, so good institutional support.
    Does it make sense to jump into the stock at that low level for the remaining two indications – BPS/IC and AD?

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  6. Hi Ohad,
    Any opinion on PSDV. I know you usually don’t cover medical devices. However, its’ for uveitis and thought you might be interested. Initial results in p2 was quite positive, 120M MK. Please see the following news. It would be great if you could give your opinion.

    Thanks so much!

    Jinyu

    http://www.europeanpharmaceuticalreview.com/33285/news/industry-news/psivida-announces-positive-top-line-results-from-investigator-sponsored-phase-ii-study-of-medidur-in-uveitis/

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  7. Ohad, I listened to the MEIP presentation at Cantor Fitzgerald’s Inaugural Healthcare Conference. I came away very impressed, I like the risk/reward here. The EV is much less than zero. What do you think?

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  8. Hi Ohad,

    I send this message twice, but was removed twice. What you think of PSDV? P2 results just came out for recurrent uveitis. Quite positive results: 2 legally blind patients were able to drive a car. Great platform, 120 M MC. It will be great to hear your opinions on this stock.

    Thanks,

    Jinyu

    Like

  9. Hi Ohad,
    I am also curious about what you think of ARNI. Very low market cap,$12M impressive investors like Soros and Frost. Seems like a great potential.
    Thanks as always,
    Chris

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  10. andre (AQXP) – I am not sure if the BPS/IC delta (2.4 vs. 1.3 points) should be regarded as a positive signal…

    Kelly/Chris (ARNI) – Sorry, Pontifax is an investor in ARNI so I can’t comment.

    Jinyu (PSDV) – Sorry don’t know them well, they have a murky track record with regulators from what I recall.

    Richard (MEIP) – I am still not convinced their HDAC inhibitor is differentiated and the cancer metabolism program is a riddle to me.

    Ohad

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  11. Ohad (AQXP) – the reductions is not huge, but there was positive trend in reduction of pain. Since it is not a pain medication, is it possible that it comes as a result of e.g. tissue repair? The secondary endpoints are urinary symptoms and QOL, so I may wait for the data.

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  12. Hey Ohad
    you are doing so good… it is nice to see so many new people posting here with questions and seeking your views.

    I have a question regarding CLVS – given the high valuations in biotech, with INCY hitting an all-time high just yesterday $121, and the buyout by Celgene of Receptos, I wonder if like me you are thinking that CLVS seems undervalued at this point (I think Jakafi is expected to generate $600-700M in sales this year, for a $20B+ INCY valuation). Sure the pipeline is very deep and the RA drug will be approved very soon.
    However, CLVS peek sales estimates for its lead 2 drugs, expected to be in the pharmacies early next year is about $3B? And there’s a third, promising drug in P2…

    Thanks

    Dan

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  13. andre (AQXP) – Don’t know to what we should attribute the pain signal, SHIP1 regulates a lot of processes via the PI3K pathway so anything is possible. If they see an effect on urinary symptoms (especially frequency and urgency) then this could bode well for OAB as an indication but that’s pure speculation.

    Dan – (CLVS) Thanks! Yes I completely agree with you, CLVS is an attractive acquisition target given the valuations seen with other late stage biotechs. The mainthing working against CLVS is the neck and neck race with AZD9291 and the somewhat disappointing PFS at ASCO (which can be explained by patient populations but still this is an overhang). I conservatively factor in $750M for rociletinib assuming 2nd line T790M use only and $400M for rucaparib (using conservative assumptions, excluding anything beyond ovarian cancer). Lucitanib can be bigger than both but still hypothetical.

    ESPR – Also a very good acquisition target with a $2B drug using conservative assumptions. Given CLVS’ recent fundraising looks like ESPR is the one more likely to happen in the near future but I hold both.

    Ohad

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  14. Hey Ohad
    thanks!
    Re CLVS – but seeing the growth of INCY shares (as independent company) why not let CLVS go it alone a while, if it can get to $20B valuation in 3 years time?
    better than buyout, no?

    Like

  15. Hi Ohad,

    The first half of July has been a tear for IMGN, but its market cap is still about $1.6 B. Do you think they will achieve parity with SGEN at $6B by the end of this decade now that they’ve de-risked their wholly owned pipeline with IMGN853 results? (Or maybe SGEN is overvalued for what it has?)

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  16. Ohad
    do you have an opinion about DNAI?
    The Ph 2 data, (single agent PNT2258, targeting BCL2) in DLBCL were impressive (100% response – 3 CR and 1PR out of 4 pts), also the FL were good (1 CR, 1 PR and 3 SD out of 5 pts). AE were also mild (max grade 3)
    (ProNai_ASH-2014-PNT2258-Poster-Final.pdf)

    It looks they compare well to SGEN data.

    Like

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