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Apr 05, 2010
 |  BioCentury  |  Finance

2Q Financial Markets Preview: Wanted Dry Powder

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Biotech run-ups have historically cooled after 25-30% gains. Thus the question going into the second quarter is whether there's momentum to keep going, or whether the sector will take a breather.

The historical numbers are pretty clear: when the NASDAQ Biotechnology Index (NBI) nears a 30% uptick, it starts to fall again, with only a couple of exceptions in the last decade.

Based on this history, the 25% NBI gain since the sector last bottomed on Oct. 28, 2009, would argue that the next few quarters will be flat or down by 20% or more as investors consolidate gains (see "Peaks & Troughs," A2).

But some buysiders and Street watchers see room for more upside, on the order of 5-10%, based on upcoming milestones, particularly among mid- and large cap stocks.

There is also plenty of anticipation that the group will see continuing M&A, more high-profile tier-jumpers and additional in-flows of money.

The latter may prove to be most important, as generalist participation in the biotech rally appears to have been mixed, at best. If fresh money comes in off the sidelines, the new buyers could keep the momentum alive.

The upswing would be hard for generalists to ignore. Last quarter, for the first time in more than two years, large and mid-caps drove the biotech upswing. Companies worth a billion or more were up 11% on the quarter.

Share prices were lifted by resolution of U.S. healthcare legislation, a perceived upswing in M&A, value among beaten down mega-caps, a handful of big regulatory wins and optimism about upcoming milestones. This optimism also has been translated into follow-on activity among mid-tier companies.

The fly in the ointment is the small cap space, which was flat on the first quarter. This lagging performance has started attracting attention from venture and specialist investors. VCs in particular see public companies to be had at a fraction of the valuation of private companies at a similar stage of development. As a result, these investors are looking to recapitalize a handful of micro-caps via large cash infusions that dilute existing investors (see "Results by Market Cap," A3).

At the back end of the pipeline, private companies aren't getting much IPO traction, with only four new issues making it out in the U.S. last quarter. And of the six total deals, only one traded up in the aftermarket.

The message from Street watchers is that the IPO queue needs higher quality, de-risked stories, but that the best names may choose to stay on the sidelines after watching the disappointing early deals.

Quick climb

In little more than a year and a half, all the biotech indices have made a round trip, exceeding pre-meltdown highs from the summer of 2008.

On the quarter, the NBI added 11%, while the BioCentury 100 index gained 12%.

The NYSE Arca Biotechnology (BTK) Index rose 30% on the quarter, driven by a positive FDA panel for InterMune Inc. and Astellas Pharma Inc.'s bid to acquire OSI Pharmaceuticals Inc. for $3.5 billion. These components account for 12.5% and 6.8% of the index, respectively. The BTK is particularly volatile because it only has 20 components; it is rebalanced on the first Friday of every quarter so that each component is equally weighted at 5% of the index.

Last quarter, the Dow Jones, S&P and NASDAQ tacked on 4%, 5% and 6%, respectively.

In fact, biotech indices outperformed every other major index through mid-March with the exception of the Philadelphia Bank Index, which rose 22%, according to Robert Rynd, director of advisory services at Thomson Reuters (see "Off to the Races, A11).

Biotech also has bounced back faster from the economic meltdown than the general markets.

The Dow remains 16% below its 2008 summer highs, while the S&P 500 is off 9%. The tech-heavy NASDAQ is within 2% of its summer 2008 highs.

In contrast, the NBI is up 25%, while the BioCentury 100 has climbed 24% from a trough on Oct. 28, 2009.

These gains are putting biotech near territory not seen since early 2001: above 1,000 for the NBI and above 2,000 for the BioCentury benchmark.

But gains of this order are historically where biotech run-ups have started to flag, and the whirlwind trip has made some investors a little nervous about what lies ahead.

According to Rynd, the median NBI run-up since late 2003 is 28%, lasting a median length of 122 days. At the end of 1Q10, the latest run had lasted 106 days.

Rynd sees "potentially another 5-10% to go to take the NBI to about 1,000." But, he noted, "we haven't been at that level since early 2001, so psychologically that will be a tough number to crack."

Still, Rynd added there are plenty of good fundamentals and a lot of high-profile news flow catalysts ahead for the sector over the next few months.

More, more M&A

As for news flow, almost every investor who talked to BioCentury anticipated continued strengthening of M&A based on 1Q deals, a series of major regulatory and clinical events throughout 2010 and revived interest for deals on the part of pharma.

Rynd argued that M&A is second only to relief over the resolution of healthcare in drawing generalists back to the space.

M&A offers picked up last quarter and included the $5.6 billion bid from Merck KGaA for Millipore Corp. and the $722 million bid for Facet Biotech Corp. by Abbott Laboratories. And the battle between OSI and Astellas is expected to conclude this quarter.

"The M&A thesis is starting to play out, which we'd hoped for last year," observed Kurt von Emster of venBio.

He expects to see more deals, led by the acquisition of private biotechs that will be "bought out at public market valuations, which is going to raise eyebrows."

Banker Joe Dougherty of Seaview Securities agreed that private companies will lead the way. "M&A buyers are really busy. You have to have something really good to show them, but there's definitely an appetite," he said. "There's active interest in some of the later stage private companies."

von Emster, like many buysiders, expects to see more acquisitions on par with the $3.5 billion offer for OSI.

He estimated there will be six similar takeouts this year, noting the mid-caps include some profitable companies with high news flow, making them perfect takeout prospects.

"There have been a series of business development reorganizations at major pharma and big biotech. Now they have five-year plans on how to replace products going off patent," von Emster added.

Banker Annette Grimaldi of BMO Capital Markets is also bullish on acquisitions of larger mid-caps. "Improvement in the equity markets is going to fuel an increase in M&A activity. Both the acquirer and the target are feeling better about their valuations and are more willing to transact," she argued.

Grimaldi added: "I think the most activity will be in the $1-$5 billion range: they've been substantially de-risked and have the broadest appeal."

One banker, who declined to be named, also noted acquirers are willing to wait until a candidate is derisked. As an example he cited the reluctance of any acquirer to touch oncology company Gloucester Pharmaceuticals Inc. prior to the approval of Istodax romidepsin to treat cutaneous T cell lymphoma (CTCL) in November.

"If you look at Gloucester, it was acquired as soon as it was approved, but you couldn't give it away before approval," he said.

Celgene Corp. offered to acquire the company for $340 million in December and completed the acquisition in January (see BioCentury, Jan. 25).

Allianz RCM portfolio manager Paul Wagner anticipates that more mid-cap M&A will pull more generalists into the space. "If we see another biotech acquisition over the next several months, I think mid-cap biotech is likely to continue its outperformance through year end as generalists further capitulate and buy 'acquirable mid-cap biotech baskets' to avoid underperforming their benchmark due to acquisitions," he said.

Sven Borho of OrbiMed Advisors told BioCentury he expects increased activity from Japanese acquirers, as well as from big pharma and generics companies like Teva Pharmaceutical Industries Ltd.

"There was a pause for six to eight months before we had OSI and Facet. I think it's going to heat up again," he said.

"I think the big cap pharma will come back; they have been busy with merging themselves," said Borho.

He argued that mid- and small cap companies almost automatically become acquisition targets when they get drugs approved. "The second you have an oncology drug on the market, you have a big acquisition target on your back," he said. "That's true for any product that can be marketed with a modest sales force - under 200 people."

At least seven drugs could be approved this quarter (see "2Q10 Milestones," A17).

"Pharma buyers are just starting to get a little more bullish; it's starting to get where the backlog is starting to turn into deals," said banker Michael Brinkman of Jefferies & Co.

"Just think how many companies have NDAs on file now versus how many there were a decade ago. It's an enormous difference," he added. "A lot of companies have died along the way, but those that remain are very late-stage."

Bill Kridel of Ferghana Partners said he expects M&A activity to stay high, particularly for molecular diagnostics and regenerative medicine companies.

von Emster noted that the de-risking theme is carrying over to partnering, where the senior player is able to squeeze the negotiations. "They can wait for Phase II or Phase III data, since there are fewer competitors out there after the consolidations," he said.

"The likelihood of them sticking their neck out on early Phase II data is even less for every Medivation that occurs," von Emster added.

Last quarter, Medivation Inc. announced negative Phase III data for Dimebon latrepirdine to treat Alzheimer's disease. In 2008, Pfizer Inc. paid $250 million up front and committed to paying 60% of development costs for U.S. rights(see BioCentury, March 8, 2010, & Sept. 8, 2008).

That does not mean buysiders couldn't make money. "Medivation was a big contributor to performance for a lot of biotech fund managers, including us, because a lot of us were short," said Andrew Bogan of Bogan Associates. "We simply didn't believe in the Russian Phase II."

Originally disclosed in 2006, the Russian study met all its primary and secondary endpoints, and FDA later said it would accept the trial as pivotal.

Across the board, buysiders and bankers expect to see more structured acquisitions, with some money up front and subsequent milestone payments.

"Mid-tier pharma and larger biotechs are making more structured acquisitions; it will be more than just large pharma," said Wedbush banker Tom Deitz. "Across the board, there is a desire to share the risk and not put everything up front."

Tier jumpers

Beyond M&A, market moves on successful clinical trials, positive FDA panels and drug approvals are continuing to grab investor attention and put pressure on generalists to take a closer look at biotech.

"Jazz went from $1 to $9; there have been a half dozen of those. It's not an aberration. You can find true value in the mid- to small cap space. That's going to bring in either new investors or...

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