3Q14 Financial Markets Preview: Discerning optimism

Biotech investors: bottom hit but will be selective on IPOs, small caps in 3Q14

Investors and bankers are cautiously optimistic that the correction that began in late 1Q14 will provide a floor for a biotech recovery that should continue through the third quarter, with investors being more selective on IPOs and small cap stocks.

With the most anticipated binary event of the year already in the rearview mirror - positive data from a pair of Phase III trials for Vertex Pharmaceuticals Inc.'s combination therapy of Kalydeco ivacaftor plus lumacaftor (VX-809) in cystic fibrosis (CF), buysiders see few major pitfalls or catalysts over the next three months. This will give investors an opportunity to take a breath and position their portfolios for milestones coming later in the year (see "Summer Lull," page 9).

Investors expect the large caps to meet 2Q14 earnings expectations and continue to drive the indices back toward their February highs. While the correction saw the NASDAQ Biotechnology Index (NBI) fall 21% and the BioCentury 100 drop 22% between Feb. 27 and April 14, the NBI clawed back more than 19% to end the quarter up 9%, and the BC100 got back 13% to end the quarter up 2%.

The correction burst what buysiders viewed as a small cap bubble, and they see those names as more reasonably priced. With the worst now deemed to be over, investors expect the segment to be largely flat for the next three months, with performance driven by news flow.

IPOs that got out prior to the correction have struggled to regain their highs. The group was down a median of 20% from Feb. 27 to the end of the quarter after a median 20% gain through Feb. 27. But IPOs following the correction are up a median of 14% even if they had to take a haircut to get done.

The correction also pushed momentum investors to the sidelines, leaving more selective investors playing in IPOs. Thus stronger companies have been able to price above the range and trade up, while others have struggled to get deals done at all.

The result is a biotech market that investors view as healthy heading into 3Q14 and expect to remain so through the summer. Some investors also hope M&A news will remain brisk, given reasonable small cap valuations, while tax inversion-related deals could ramp up for larger players regardless of valuation.

Like last quarter, the long-term overhang for biotech remains concern about the sustainability of drug pricing. Indeed, the steepest part of the sector decline was sparked by a March 20 letter to Gilead Sciences Inc. from lawmakers requesting information on the pricing methodology for HCV drug Sovaldi sofosbuvir - an issue that investors don't see going away any time soon.

Healthy sentiment

The predominant optimism among bankers and buysiders is in part due to a string of clinical successes in addition to Vertex's CF trials. These ranged from positive Phase II data in January for Intercept Pharmaceuticals Inc.'s obeticholic acid to treat non-alcoholic steatohepatitis (NASH) and positive Phase III data for InterMune Inc.'s Esbriet pirfenidone to treat idiopathic pulmonary fibrosis (IPF), to a major clinical win for Actelion Ltd. In June, the European bellwether announced selexipag showed a morbidity/mortality benefit in the Phase III GRIPHON trial in PAH.

It is the second time in two years that Actelion has had a

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