4:29 PM
Oct 06, 2017
 |  BioCentury  |  Finance

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 Inc. as tangible success stories that have helped lead the recovery.

Dupixent was approved on March 28 to treat moderate to severe atopic dermatitis. Regeneron and partner Sanofi co-promote the brand, which generated $29 million in 2Q17 sales, its first full quarter on the market.

Biogen’s Spinraza is an antisense oligonucleotide marketed to treat spinal muscular atrophy (SMA).

Approved in December 2016, the drug achieved $202.9 million in 2Q17 sales, up from 1Q17’s $47.4 million. Its faster than anticipated uptake led Biogen to increase its FY17 sales guidance to $11.5-$11.8 billion from $11.1-$11.7 billion in late July.

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

Investors are generally comfortable with where the markets are now and are looking for news flow from individual companies to dictate where prices go next.

“We are still 15-20% away from the top but more than 50% away from the bottom, so we’re in a pretty OK place where fundamentals still matter,” said Staijen.

Kai Brüning of apo Asset Management added, “Large cap is still cheap, which at least looks like a floor to performance.”

Indeed, the average P/E multiple for large cap biotech stocks closed 3Q17 at 21.7x forward earnings, in line with the median value of 21.3x since 2010, and far off the peak of 27.4x seen in 1Q14.

Excluding Regeneron’s 27x multiple, Genmab A/S’s 41.9x multiple, and Vertex’s 49.7x multiple from the group leaves the average P/E multiple at a historically cheap 14.1x.

Gordon agrees that large caps are inexpensive and aren’t getting much credit for their pipelines.

“When you look at some of the bigger opportunities in the R&D pipelines I think people are pricing them with a reasonable amount of skepticism, a prudent amount of skepticism,” he said.

Loncar Fund’s Brad Loncar said after the “fantastic” year the space has already had, investors should be satisfied even if the market trades sideways for the rest of 2017.

“If we just kind of hold this level for a while I’ll be pretty happy,” he said. “That’ll suggest to me that this bounce has some fundamentals behind it.”

Buysiders said it’s more a question of when, not whether, biotech indexes will pass through their previous highs.

Deerfield’s Alex Karnal is among the most optimistic and would be surprised if the indexes didn’t surpass their former highs over the next few years. “Business execution will reveal to folks the true earnings power of these businesses,” he said.

Venrock’s Nimish Shah agrees that pushing to new all-time highs is doable, as long as it’s driven by execution.

“If the index’s performance is driven by positive data or new drug approvals, those are fundamentals that can justify performance,” he said.

Another sign that biotech stocks are trading in line with fundamentals is that clinical failures are not dragging the sector down.

Last quarter offered up two Phase III blowups that not long ago might have sent biotech indexes reeling.

First, on July 27, AstraZeneca plc reported that its MYSTIC study of Imfinzi durvalumab and tremelimumab failed to improve progression-free survival (PFS) vs. chemotherapy in first-line non-small cell lung cancer (NSCLC) expressing PD-L1 of 25% or more.

While the PD-1/L1 battle in NSCLC is mostly playing out among big pharmas, buysiders feared a negative MYSTIC readout could have hurt sentiment across the broader therapeutics space.

The announcement shaved $12.8 billion off AZ’s market cap on the day. But the NBI dropped only 1.9% and the BTK dipped 2.1%. Both bounced 0.7% the following trading session.

“There have been enough failures of late to put a little bit of a black eye on the space.”

Mark Chin, Arix Bioscience


For comparison, the NASDAQ Composite dropped 0.6% on July 27 and dipped a further 0.3% on July 28, while the Standard & Poor’s 500 index dropped 0.1% each day.

Similarly, the NBI dropped 1% and the BTK fell 1.1% on Sept. 26 after Axovant Sciences Ltd.’s intepirdine (RVT-101) missed the co-primary endpoints in its Phase III MINDSET study to treat mild to moderate Alzheimer’s disease, and each recovered 0.6% the next day.

The NASDAQ Composite ticked up 0.2% on Sept. 26 and gained 1.1% the following day. The Standard & Poor’s 500 index was flat on Sept. 26 and then up 0.4%.

Axovant killed the program and its stock plunged 74% on the day of the announcement.

Neither AZ nor Axovant are components in either index.

“In the past we’ve seen events where everything in the space was killed by one event, so I think investors are able to differentiate between stocks and drug projects,” said Brüning.

Annette Grimaldi of BMO Capital Markets agreed, and highlighted Versartis Inc. as an example.

The biotech’s shares plummeted 88% on Sept. 22 after lead asset somavaratan (VRS-317) missed the primary endpoint in the Phase III VELOCITY trial to treat pediatric growth hormone deficiency.

The NBI dropped just 0.3% on the day,...

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