Theravance (THRX) keeps ticking higher and now carries a market cap of $4.1 billion, as investors anticipate a new-look split company. While the excitement surrounding Theravance's two drugs have created large gains in 2013, investors might not like what follows in the years ahead.
While in clinical development, and in the early stages of drug marketing, speculation and the promise of future earnings drives the performance of biotech stocks. A classic example of "fundamentals matter" playing out is with Ariad Pharmaceuticals (ARIA). A couple of years ago, the company reached a market cap of more than $4.5 billion in anticipation of the product launch for its leukemia drug Iclusig. In the three years prior to the launch, Ariad saw stock gains of more than 1,200%, but in 2013, shares have fallen nearly 80%.
In regards to Iclusig, we knew the product was effective, but we also knew that it had harsh cardiovascular side effects, and that it must be further developed to ever reach its blockbuster potential. To make a long story short, side effects proved to be too harsh in ongoing studies, uncertainty remains if Iclusig will ever complete another study, and blockbuster sales are unlikely to ever be reached.
History repeating itself?
Now, with Ariad in mind, let's take a look at another biotech that could experience a similar fate in Theravance. Granted, the two are completely different companies; Theravance has an FDA approved drug called Breo that treats chronic obstructive pulmonary disease, also known as COPD. However, the concern of expectations and market capitalization still applies.
For one, Theravance has soared 70% in 2013, and analysts believe that Breo could eventually reach sales of more than $3 billion. While there are several FDA-approved products to treat COPD, Breo stands out because it uses Theravance's inhaler called Ellipta, and is taken twice daily with maximum efficiency. Also, it has a long half-life, and Theravance's partner GlaxoSmithKline (GSK) has a large ecosystem in place thanks to its success with Advair, another COPD drug.
Not to mention, Theravance has another COPD product called ANORO, but the difference is that it's used just once a day; analysts believe it could top $1.5 billion annually in peak sales. With an estimated 250 million people worldwide suffering from COPD, the market opportunity is enormous.
Therefore, investors automatically see a big sales opportunity, which validates Theravance's market capitalization. But much like Ariad, the market is not considering the downside risk that comes with this valuation or the nature of Theravance's partnership with Glaxo.
Partnership becomes a valuation risk
For an example of a strong partnership, Pharmacyclics (PCYC) has a great deal with Johnson & Johnson to develop its blood cancer drug ibrutinib. This is a drug that some analysts believe could reach peak global sales of $9 billion, and Pharmacyclics gets 50% of the revenue and is only responsible for 40% of the costs. Hence, Pharmacyclics will have far better margins than J&J, as its costs are lower and its revenue will be higher.
While Pharmacyclics still has valuation-related problems, having a market cap of $9 billion, such a deal is far superior to what Theravance got with Glaxo. With Pharmacyclics, ibrutinib has great efficacy and an industry-best safety profile, but still, one of its late-stage trials could still go bad or it could have unexpected problems once the product is marketed. Therefore, trading at two times its peak sales share makes Pharmacyclics a risky investment, but nonetheless, its deal remains strong.
In the case of Theravance, to be sure it has blockbuster products, but the company receives a royalty of just 15% on total product sales up to $3 billion. Then, once cumulative sales surpass $3 billion, Theravance's royalty drops to 5%. This fact minimizes the company's pipeline, as Theravance has two other early stage COPD programs that are partnered with Glaxo. But, by the time either are FDA approved, total sales of both BREO and ANORO would've likely surpassed $3 billion.
If we assume that BREO and ANORO eventually reach combined sales of $4.5 billion, which would likely be in 2020 and is questionable due to widespread product development in the COPD space, Theravance's revenue would be just $225 million. So, take a second to digest this number, and then realize that Theravance trades at a whopping 18 times its peak sales share on both of its two blockbuster drugs.
Even if the company's two early stage drugs combine to create another $4.5 billion then Theravance would trade at a still high nine times peak sales share. Currently, the biotechnology industry trades at 8.6 times sales , and the drug industry trades at an even lower 3.4 times sales . Therefore, Theravance is excessively overvalued, much more than Pharmacyclics, and if the company doesn't click on every single cylinder then investors face the risk of significant stock losses. In the end, this reality is the risk you take to invest in momentum biotechnology stocks, a space that many believe to be safe, but is actually risky once the hype dies down.