High as a Kite

Why biotech indexes could take a breather in 4Q17

The acquisition of Kite Pharma Inc. by Gilead Sciences Inc. turned what would have been a flattish quarter into another period of outperformance, and relieved the cash constraints that could have prevented specialists from continuing to carry the sector through 4Q17.

The consensus view from 21 bankers and buysiders polled by BioCentury is that the public markets are now fairly valuing biotech stocks.

Buysiders therefore do not expect widespread buying, and wouldn’t be surprised to see growth in the biotech indexes slow down in 4Q17. The result is a true “stock picker’s market,” where placing bets on the right companies could lead to outperformance (see “Coasting on Catalysts”).

A significant rotation into biotech by generalists could alter this thesis, but that doesn’t look likely in the near term. While generalists have begun to nibble at biotech, bankers and specialists said a broad-based rotation would require a series of wins in the clinic and a spate of deals -- which nobody expects to materialize in 4Q17.

“Most of the winning back in biotech has been much more reasonable, with companies showing people that they’ve actually been successful.”

Marshall Gordon, ClearBridge

 

At least for now, the specialists aren’t particularly eager for the generalists to return. To the contrary, some said significant inflows from generalists could stretch prices beyond fundamental levels, leading to distorted valuations and increased volatility.

Moreover, generalist cash isn’t a requirement just now. While a lack of dry powder was a concern heading into the third quarter, specialists have more capital to work with heading into 4Q17 than they did three months ago. Some trimmed winning positions to free up cash, but the Kite takeout was much more impactful.

Following the announcement on Aug. 28, multiple Kite investors who spoke to BioCentury quickly offloaded their shares to arbitrageurs. The investors who cashed out prior to the Oct. 3 deal close have already started putting their newfound gains to work, or plan to do so by year end.

With specialists armed with cash, and a confidentially filed IPO queue that’s as deep as any in the last few years, bankers expect the momentum from the last days of September to continue in 4Q17.

In addition, follow-ons are expected to continue their exceptionally strong pace. A slight pickup in more opportunistic financings as 3Q17 came to a close is viewed as a sign of strong investor demand leading into the next quarter.

Fair value

Biotech indexes outperformed the broader stock market for the third consecutive quarter, driven in large part by Gilead’s acquisition of Kite.

In 3Q17, the NYSE Arca Biotechnology Index (BTK) added 8.9%, the BioCentury 100 gained 7.9% and the NASDAQ Biotechnology Index (NBI) tacked on 7.6% (see “Bargain Shopping”).

The BTK had posted a modest 0.6% gain through Aug. 25 -- despite a $6.9 billion gain in market cap for Vertex Pharmaceuticals Inc. on July 19, after it announced data for its triple combination regimens to treat cystic fibrosis.

After the Aug. 28 deal announcement, the index saw a five-day winning streak that brought it to a 9.7% gain as of Sept. 1.

Gilead’s and Kite’s gains both played a part in lifting the index, which contains 30 equally weighted component companies. Gilead, the second largest component, saw its shares increase 10.5% between Aug. 25 and Sept. 29, translating into $9.4 billion in market cap gain.

Kite’s 29.3% gain postannouncement translated to a $2.3 billion increase in market cap.

According to an analysis by BioCentury, the pair accounted for roughly a quarter of about $52 billion in market cap created by the BTK component companies between Aug. 25 and Sept. 29. During that period, 23 of the component companies gained in value while seven declined.

The NBI followed a similar pattern. The index was flattish with a 0.3% gain as of Aug. 25, then climbed to an 8.3% quarter-to-date increase by Sept. 1.

Akin to the BTK, the NBI uses modified market capitalizations to determine its index value. As of Aug. 1, Gilead was the largest of the index’s 161 companies, with an 8.46% weighting, while Kite’s was 0.91%.

“I think investors are able to differentiate between stocks and drug projects.”

Kai Brüning, apo Asset Management

 

Through the first nine months of the year, the BTK, BioCentury 100 and NBI were up an aggregate of 37%, 33% and 26%, respectively.

This performance continued to outpace broad market proxies such as the NASDAQ Composite and the Standard & Poor’s 500 index, which themselves are performing very well with YTD gains of 21% and 13%.

The BTK and the NBI are just 3% and 15% off their mid-2015 peaks, meaning stocks have almost fully recovered from 2016’s drubbing. But unlike the 2015 peak, which was driven by an extended rotation into the sector and an M&A bubble in mid-cap biotech and specialty pharma, buysiders believe current valuations are rooted in reality and have been earned through solid execution.

“In the summer of 2015 it was really getting overheated. A number of stocks went up and fundamentals appeared to be of less importance,” said HBM Partner’s Ivo Staijen.

ClearBridge’s Marshall Gordon agreed, and pointed out that the present recovery has, in contrast, been driven by measurable successes. For instance, he highlighted the strong commercial launches of Dupixent dupilumab by Regeneron Pharmaceuticals Inc. and Spinraza nusinersen by Biogen

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