A slew of milestones through year end combined with last quarter's outperformance have investors hopeful that the biotech sector can continue to fend off a dreary macroeconomic environment and weakness in the broader markets.

Buysiders don't expect to see anything catch the imagination of investors and strategic acquirers quite the way HCV has in the last year. But they think positive Alzheimer's Phase III data, as well as another obesity approval, could continue to generate excitement within the sector.

The takeout of Amylin Pharmaceuticals Inc. as 2Q drew to a close also could generate momentum from investors who have been making bets on M&A.

Late last Friday, Bristol-Myers Squibb Co. announced it will acquire the diabetes company for $31 per share in cash, or about $5.3 billion in aggregate after a two-step process involving $3.4 billion cash payment from BMS's diabetes partner AstraZeneca plc.

The real drag on the group is likely to come from forces outside biotech's control: the European crisis, the normal summer doldrums, a renewed U.S. budget debate around mandatory cuts slated for FY13, and the presidential election.

Investors also think these externalities are likely to keep a damper on what had been a strong appetite for follow-ons earlier this year.

Fortunately, many biotechs are now well set for cash, having raised money in 4Q11 and 1Q12. Non-debt financing in 2Q was at its lowest level in three years. Specialist investors remain interested in conducting financings to get promising biotechs to an important milestone. But they are more hesitant about buying shares in small caps without enough cash.

Last quarter was particularly unattractive for IPOs, with neurology play Supernus Pharmaceuticals Inc. and cancer company Tesaro Inc. the only biotechs to make it out. Wall Streeters have mixed views on whether this will change as a result of the Jumpstart Our Business Startups (JOBS) Act (see "IPO Performance").

In terms of stock performance, investors say the larger mid-cap names are likely to remain among the sector's top performers. Large caps have some major milestones in 2H12 and will have a defensive appeal if economies and markets take a turn for the worse.

Micro- and small caps suffered the most last quarter as some investors fled risk on market volatility. Investors expect this will continue to be the case.

While the group has outperformed overall, investors don't anticipate a correction anywhere near the magnitude of the one that occurred last August when Dendreon Corp. removed its annual revenue guidance for prostate cancer immunotherapy Provenge sipuleucel-T and raised fundamental questions for investors about biotech launch plays.

On the up and up

Buysiders were surprised that biotech managed to add to its first quarter gains last quarter. Indeed, the sector outperformed the broader markets and IT in 2Q.

The BioCentury 100 rose 5% on the quarter, while the NASDAQ Biotechnology Index (NBI) and NYSE Arca Biotechnology Index (BTK) each gained 4%.

By contrast, the S&P 500 and Dow Jones indices each shed 3%, while the tech-heavy NASDAQ lost 5% (see "Biotech on Top").

"On a relative basis, biotech did pretty well in the second quarter in a very weak market and a not very good economic environment. That's pretty good, all things considered," said Miller Tabak's Les Funtleyder.

This half, "it will be hard for the sector to have additional gains unless the macro environment is improving. Companies with good products will do well, but they will do better not fighting the headwinds of a weak macro environment," he added.

Overall, Funtleyder expects biotech indices will range from "treading water to up single digits. I'm not looking for double digits on the rest of the year. The best case is maybe high single digits."

Small cap specialist Selena Chaisson of Bailard was slightly more negative.

"Biotech in general has held up surprisingly well - look at the Dow compared to the BTK. It's been surprisingly strong. I was expecting a correction all quarter, given all the volatility around the world," she said.

She added, "I don't think we're out of the woods. Investors have gone to cash where they can. Maybe the third quarter will be worse than the second quarter for small cap biotechs. Sometimes there are catch-up corrections."

Still, Chaisson is among those who don't expect anything on the order of last August.

"Eventually stocks will have to consolidate, but I don't think we're in for a 30% sell-off," she said. "I think a consolidation period will happen in the markets and last three to four months, maybe a little longer. Then the markets will have a stronger rally and take out the old highs."

Medical Strategy's Stefan Kraft also thinks biotech could be in for a pullback.

"Prices have appreciated since August last year; now they are relatively flat. A little correction could come," he said. "Some companies are overvalued - that might make some room for a little correction of about 10%."

Banker Annette Grimaldi of BMO Capital Markets is similarly cautious.

"We don't see any reason for a correction, but it's reasonable to assume that if some of the macro issues remain in the forefront, there will be a correction along with the overall market," she said.

LSP-Life Sciences Partners' Joep Muijrers agreed, but noted the big milestone list could help.

"Macro issues will largely determine what the sector looks like in the back half of the year. But there are quite a few important milestones in the second half. If a few hit, it may help biotech in a broader sense," he said.

Indeed, there are at least 34 PDUFA dates through year end, along with at least 40 Phase III data readouts. The back half of last year, which resulted in strong biotech momentum, had 19 PDUFA dates and 46 sets of Phase III data (see "Miles of Milestones," A20).

Banker Peter Reikes of Stifel Nicolaus Weisel also sees regulatory milestones as encouraging. "There is more positive potential for a significant number of adcoms and PDUFA outcomes than in recent quarters, maybe even in recent years," he said.

Reikes acknowledged missed milestones could dampen interest, but noted "the market increasingly views negative events as company specific."

David Pinniger of International Biotechnology Trust was less sanguine, saying positive news will not be enough to move the group up. "I expect the sector to remain pretty static through end of year," he said.

The European crisis is weighing heavily on European stocks, which is creating tempting bargains. But investors are hesitant to actively pursue this as an investment thesis because they continue to wonder how long it will take to resolve the EU's problems.

"The valuations of some European biotechs are unreal they're so low. But it would be difficult to make money even if you get the investment thesis right," said Behzad Aghazadeh of venBio. "One could argue for a strategy that's long European biotech and short U.S. biotech, but you might have to wait a very long time for that to pan out."

Kraft predicted valuations will come up when Europe "announces that they have a plan or have built a fiscal union.

Small strategies

Specialist investors continue to favor mid-cap biotechs, which outperformed their peers last quarter, while the large caps are seen as a potential safe haven in an uncertain market.

"Growth strategies have worked better than value strategies in this market," said IBT's Pinniger. "Investors are funneling capital into names that have earnings growth. Money keeps getting pumped into companies like Regeneron, Alexion and Questcor. That makes it tough for small cap plays, since the money is sticking to mid-cap names."

Cancer, ophthalmic and inflammation company Regeneron Pharmaceuticals Inc. is up 114% on the year, while Orphan disease play Alexion Pharmaceuticals Inc. has added 39% and neurology, autoimmune and inflammatory disorder company Questcor Pharmaceuticals Inc. has gained 28%.

Pinniger noted he's been sitting on 10% cash since April, waiting to buy on a pullback. But he hasn't seen many opportunities.

"We're waiting for blow-ups, situations where something big goes wrong and investors run for the hills, where there's a chance that sentiment could return in 12-18 months. But right now we're more comfortable holding on to cash than recycling back in," he said.

Funtleyder, who focuses on biotechs worth more than $1 billion, has added to some positions on recent market weakness. But he hasn't done much on the short side. He has been hedging with options, but noted that this downside protection has gotten more expensive in recent weeks.

In the small cap space, selected names are generating interest, but recent volatility, low liquidity and performance fears are pushing away some investors who might usually be more receptive to this group. Buysiders said the ability to minimize financing risk is crucial for these companies.

Pinniger noted liquidity in some of his small cap names has dried up, with trading volumes consistently below the 100-day moving average.

"Everything is grinding to a halt. You can't tidy up or add to small cap positions," he said. "For us it's difficult to make an investment decision because of liquidity and volatility. Plus valuations aren't very cheap anywhere but big caps."

Conversely, Fidelity's Kaul is embracing small caps, participating in financings for companies he sees as fundamentally strong but currently out of favor.

"With the macro perception of risk, a lot of the smaller biotechs are getting thrown out the window. Everything that's risk-oriented and smaller cap have been suffering," he said. "I'm looking for companies with good data that need cash and that will do financings at very discounted prices."

He added: "This plays to our strengths. We have a comparative advantage being a large long-term fund, not a hedge fund that has to worry about investors pulling out on a poor quarter. The small companies that I bought on the panic in 2008 have had very good returns."

Kaul's conclusion: "Fundamental investing is not working in the short term, but it does in the long term. The macro environment is very bad, but biotech has never been better."

He singled out oncology, antibiotics, cardiovascular and diagnostics as "good areas to be in. Orphan diseases have been an ongoing theme for a while. These are areas where drugs can add important value in terms of patient value or in terms of cost-benefit ratio."

Muijrers is investing in smaller cap companies if he can participate in a financing to ensure the company is well capitalized, rather than buying shares on the open market. Last quarter, he participated in financings for two microcaps: gastrointestinal play Synergy Pharmaceuticals Inc. and neurology company AcelRx Pharmaceuticals Inc.

"There are a lot of companies that trade close to cash and have an interesting pipeline," he said.

Aghazadeh sees small caps as full of opportunities, but also worries about financing risk in this environment.

"We generally keep a long bias and look for assets that are of strategic value to pharmas. With the market volatility, that's not always easy to do, but we think that's the right thing to do," he said.

Converting to volatility

No one expects financing activity over the remainder of the year to hit the levels of the first quarter (see "Financing in the Age of Volatility").

"The first quarter was very, very active; a lot of people have filled up the gas tank," noted Matthias Spaenle of Oppenheimer.

Rahul Chaudhary of Leerink Swann agreed. "In the first quarter, companies that needed to finance or had the ability to finance did so. A lot of supply got cleared out," he said.

Follow-ons, in particular, have pulled back. Some biotechs have opted instead for convertible offerings, which allow investors to take advantage of volatility while minimizing risk. Bankers also see a lot of pent up demand for converts after a relative dearth of these offerings.

Another reason follow-ons have dried up is that investors didn't like the prices biotech are seeking.

"A number of deals that were out didn't get done because issuers didn't want to take the price. They were a little more price sensitive, and the discounts that investors expected were just too deep," Spaenle said. "I wouldn't like to invest at a 52-week high if I was an investor."

Reikes noted larger cap names are actively financing, with the real pullback being among smaller caps.

"We've seen a visible increase in financing by bigger cap, more established names, particularly those that finance in the wake of positive news like BioMarin, Alkermes and Jazz," he said. "Against that backdrop, you've seen an obvious compression with smaller cap and less well established names and unseasoned names like IPO issuers."

Orphan disease company BioMarin Pharmaceutical Inc. raised $249 million at the end of May, after 1Q earnings helped kick its share price to a 52-week high.

In March, CNS company Alkermes plc sold $398 million in a secondary offering of 24.2 million shares held by Elan Corp. plc. The offering came after FDA's approval in January of Amylin's once-weekly Bydureon exenatide to treat Type II diabetes, which uses drug delivery technology from Alkermes.

Elan gained 31.9 million shares, or a 25% stake, through the sale of its Elan Drug Technologies drug delivery business to Alkermes last September.

In June, specialty pharma company Jazz Pharmaceuticals plc garnered a $475 million loan and a $100 million revolving credit facility. The former was to complete its $680 million acquisition of EUSA Pharma Inc., while the latter was for general corporate purposes. The biotech ran up late last year and early this year on earnings expectations and better-than-expected 2012 guidance.

Reikes also expects the convert market to revive.

"Interest rates are at unprecedented lows and there's a heightened degree of volatility in the equity market," he said. "Together these conspire to make terms for convertible financings the most attractive they've been in years. Marry that with an acute supply/demand imbalance in the market with the absence of new product against a very cash-flush buyside marketplace and you've got all the ingredients for a vibrant convert market."

BMO's Grimaldi noted there haven't been a lot of convert deals, "but I think there's a receptive market and there's just been a shortage of supply."

In 1H12, biotech companies raised $2.1 billion in 29 converts compared to $1.4 billion in 20 offerings in 2H11. Almost all the convert money raised last half was by larger cap companies; there were five deals that raised $1.8 billion for biotechs with a market cap of at least $1 billion.

IPOs on JOBS

The JOBS Act has already resulted in some tangible changes in how biotech IPOs are getting done. Foremost are confidential IPO filings and the premarketing of IPOs to investors immediately before a formal road show.

Still, it remains unclear if any of the JOBS Act provisions will actually improve execution, pricing or returns on biotech IPOs. Bankers have yet to implement some aspects of the law, such as the integration of analysts and their reports into the IPO process, as they await guidance from SEC and FINRA.

In early June, SEC said there had been 30-32 confidential IPO filings. Bankers told BioCentury about one-fifth to one-third of these filings were made by biotech companies.

Bankers think the new ability to assess investor appetite during the confidential filing period could reduce the filing-to-offer discount, and potentially shield companies from the embarrassment of a withdrawn or postponed IPO.

"The JOBS Act is an incredible positive in terms of allowing a company to test the market without having the stigma of a busted IPO," said Edwin Gordon of Ladenburg Thalmann.

He noted that the reduced compliance costs resulting from JOBS have translated into interest from foreign issuers looking to list on U.S. markets.

Bozilenko thinks confidential IPO filings could enable biotech companies to time IPOs better. "If they have a prospectus on file, maybe they can hit an IPO window, because those usually last only about three months," she said.

Oppenheimer's Spaenle praised the premarketing provision in particular. "What's attractive is if you can file an IPO and go on the market before you are actually on the road. It gives investors more time to look at it, to understand and do their work," he said.

But he cautioned: "A good quality company shouldn't need to file confidentially. If a client asked me to, I would be a little worried."

Indeed, buysiders surveyed by BioCentury so far are indifferent to confidential IPOs. A couple said the practice may allow them more time to survey the deals, but they are still unlikely to participate.

Gordon expects to see more Form 10 filings this year, which allow companies to become publicly traded through a gradual process that replaces an IPO. After raising money and filing a Form 10, these companies aim to list on the OTC Bulletin Board and finally move to a major exchange.

"I think you'll see further use of Form 10 filings. In the current circumstances, where you have insider participation in IPOs that's at 50%, it just makes sense to consider it," he said.

The most recent company to take advantage of the Form 10 process is fertility company OvaScience Inc., which started the process in April. It raised $37 million in a venture round and then the following week filed a Form 10 with SEC.

M&A movers

As always, M&A activity remains a theme for specialist investors, who know high-premium biotech acquisitions get the attention of generalist investors and generate momentum for the sector.

The BMS agreement to acquire Amylin, which both boards have approved, could test that thesis. The total value of the transaction is about $7 billion, including Amylin's net debt and an obligation to its former partner Eli Lilly and Co. (see BioCentury, Nov. 14, 2011).

After the deal closes, BMS said it will expand its existing diabetes partnership with AstraZeneca to include Amylin's diabetes portfolio. AZ will pay BMS's Amylin subsidiary $3.4 billion in cash, and the companies will split profits and losses.

The deal provided a strong finish to a quarter in which M&A activity had otherwise slowed and investors were left smarting after betting on sequencing and microarray company Illumina Inc.

The tool company's shares shed 23% after management fended off a hostile takeover attempt by Roche.

Looking ahead, some buysiders and bankers expect Human Genome Sciences Inc. will be acquired this year, but others aren't so sure.

For example, a white knight hasn't emerged for HGS, which is trying to fend off a $13 hostile bid from GlaxoSmithKline plc.

"HGS had a disappointing drug launch and has failed to get investors excited since then. Their main objective now is to try and squeeze as much value as possible out of GSK. Without M&A, it's difficult to see how you make money in the stock from here," noted IBT's Ailsa Craig.

Kraft doesn't expect HGS to get taken out until next year, after Phase III data for darapladib to treat coronary heart disease from partner GSK.

He noted data for the compound have been mixed.

"We think Human Genome's strategy is to wait until Phase III data for this drug. After this data, another bid could be made by GSK. We would say that $13 is not the last word in this case," Kraft said.

BioMarin also is being tipped as a takeout candidate. It remains unprofitable despite four marketed products, as management has opted to keep investing in R&D. Investors are counting on positive Phase III data in 4Q12 for GALNS to treat mucopolysaccharidosis IVA. If the data are positive, this product is expected to push the biotech to cash flow positive (see BioCentury, June 4).

"I think BioMarin could come back into focus next year on the back of strong clinical data from their late stage pipeline, but they still have a lot of work to be compared to the likes of Alexion," said Craig.

Aghazadeh noted that stock pops on M&A rumors helped to create a floor for the sector last quarter.

"The NBI is up on M&A rumors. Amylin and Human Genome Sciences popped. These rumors have helped create a bit of a bottom for the sector," he said. "We'll continue to see that in the fall and later in the year."

"There's strong interest in the relatively small number of companies with marketed products with substantial upside. But there's really not a lot of supply," noted BMO's Grimaldi.

She said the most desirable companies for acquisitions have marketed products and are in the $1-$5 billion market cap group. But there are only about 26 biotechs with that valuation with products on the market or in registration.

COMPANIES AND INSTITUTIONS MENTIONED

AcelRx Pharmaceuticals Inc. (NASDAQ:ACRX), Redwood City, Calif.

Alexion Pharmaceuticals Inc. (NASDAQ:ALXN), Cheshire, Conn.

Alkermes plc (NASDAQ:ALKS), Dublin, Ireland

Amylin Pharmaceuticals Inc. (NASDAQ:AMLN), San Diego, Calif.

AstraZeneca plc (LSE:AZN; NYSE:AZN), London, U.K.

BioMarin Pharmaceutical Inc. (NASDAQ:BMRN), Novato, Calif.

Bristol-Myers Squibb Co. (NYSE:BMY), New York, N.Y.

Dendreon Corp. (NASDAQ:DNDN), Seattle, Wash.

Elan Corp. plc (NYSE:ELN), Dublin, Ireland

Eli Lilly and Co. (NYSE:LLY), Indianapolis, Ind.

GlaxoSmithKline plc (LSE:GSK; NYSE:GSK), London, U.K.

Human Genome Sciences Inc. (NASDAQ:HGSI), Rockville, Md.

Illumina Inc. (NASDAQ:ILMN), San Diego, Calif.

Jazz Pharmaceuticals plc (NASDAQ:JAZZ), Dublin, Ireland

OvaScience Inc., Boston, Mass.

Questcor Pharmaceuticals Inc. (NASDAQ:QCOR), Union City, Calif.

Regeneron Pharmaceuticals Inc. (NASDAQ:REGN), Tarrytown, N.Y.

Roche (SIX:ROG; OTCQX:RHHBY), Basel, Switzerland

Supernus Pharmaceuticals Inc. (NASDAQ:SUPN), Rockville, Md.

Synergy Pharmaceuticals Inc. (NASDAQ:SGYP), New York, N.Y.

Tesaro Inc. (NASDAQ:TSRO), Boston, Mass.