Biotech Strategy Following Brexit: Run, Don't Walk

| About: ProShares Ultra (BIB)
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The U.K.'s decision to leave the EU is going to be a lasting headwind to the biotech sector.

The effect of a much stronger dollar and weaker euro will immediately hurt the financial performance of many leading Biotech companies.

Worries over drug pricing will again come into focus Brexit's effect on the U.S. political landscape are analyzed.

Now that the UK has voted to leave the European Union, the rush is on to figure out what effect Brexit will have on various sectors and industries. Based on Friday's trading, the Financial Services (NYSEARCA:XLFS) and Financial (NYSEARCA:XLF) Sectors were the worst performers at -6.24% and -5.36%, respectively. The Utility sector (NYSEARCA:XLU) was the top performer at +0.56% and the only sector in the green.

One industry that has flown somewhat under the radar following Brexit is Biotech (NYSEARCA:XBI). On Friday, the Biotech industry only slightly underperformed at -4.02% compared with the S&P 500 (NYSEARCA:SPY) of -3.59%.

Many of the major banks have put out research notes to clients downplaying the effect of Brexit on Biotech. Piper Jaffray advised clients that the effects of Brexit on the operations of Biotech names in its coverage universe would be "minimal" on their operations. RBC Capital Markets told their clients that Biotech companies will be "somewhat insulated" from EU economic questions because they provide life-saving drugs. Excuse me while I call shenanigans.

Brexit is going to have a material effect on many Biotech companies' financial results and negatively influence investor sentiment surrounding the space going forward. I recommend investors stay far away from Biotech for the short/medium term, or short the sector directly (as I have done through ProShares Ultra Nasdaq Biotechnology ETF (NASDAQ:BIB), a 2x leveraged Biotech index ETF.)

First to address how Brexit will affect the financials of many major Biotech companies. The most obvious drag is currency. The GBP dropped to a 30 year low on Friday, and the Euro fell almost 3%. These types of moves in major currencies are all but unheard of. Most experts forecast that relative to the US Dollar, the GBP ultimately will fall 10-20% following Brexit and Euro will fall 5%-10%, according to FactSet. Seven out of the top nine trading partners with the UK are Euro currency countries, and the Euro is largely expected to follow the GBP on a slightly smaller scale.

Let's take a look at how a 5% drop in the Euro will influence revenues at some of the largest Biotech companies. Five of the seven (23.7% cumulative weight) largest holdings in the ProShares Ultra Nasdaq Biotechnology ETF are listed below. Amgen (NASDAQ:AMGN) and Regeneron (NASDAQ:REGN) don't break out European sales so they are not included.

Alexion (NASDAQ:ALXN). European revenue for Alexion in 2015 was $840 million or over 32% of total revenues in 2015. A 5% weaker Euro compared to the USD lowers Alexion revenue by over $42 million all else equal; 10% decline in the Euro vs. USD wipes out over $84 million in revenue.

Biogen (NASDAQ:BIIB). European revenue of $2.2 billion in 2015 or over 20% of total revenues. A 5% weaker Euro compared to the USD lowers Biogen revenue by over $110 million all else equal; 10% decline in the Euro vs. USD wipes out over $220 million in revenue.

Celgene (NASDAQ:CELG). European revenue of $2.6 billion in 2015 or over 28% of total revenues. A 5% weaker Euro compared to the USD lowers Celgene revenue by over $130 million all else equal; 10% decline in the Euro vs. USD wipes out over $260 million in revenue.

Gilead (NASDAQ:GILD). European revenue of $7.5 billion in 2015 or over 23% of total revenues. A 5% weaker Euro compared to the USD lowers Gilead revenue by over $375 million all else equal; 10% decline in the Euro vs. USD wipes out over $750 million in revenue.

Vertex Pharmaceuticals (NASDAQ:VRTX). European revenue of $220 million in 2015 or over 21% of total revenues. A 5% weaker Euro compared to the USD lowers Vertex revenue by over $11 million all else equal; 10% decline in the Euro vs. USD wipes out over $22 million in revenue.

(All Geographic revenue information is taken from FactSet; can be confirmed via each company's 10-K).

The average percent of European revenue for these companies is almost 25%, which is more than 3x the average company in the S&P 500 that generates 7.46% of revenue from Europe. The Biotech industry is much more heavily exposed to Euro/USD exchange rates than the rest of the market and a major reason why Biotech will underperform in the near term. In total, a 5% weakening of the Euro will eliminate $668 million annually from the revenues of just the five companies listed above.

I also want to briefly address the idea that Biotech is insulated from weakness in the broader EU economy. While this is debatable, there are certainly risks to Biotech due to a weakening economy. A weakening economy strains government budgets. Since a lot of medical expenses are reimbursed by the government in some form, deteriorating government budgets could very easily result in pressure on drug prices/reimbursement rates. This isn't a central point to my thesis and won't happen immediately, but I think it is wrong to simply view Biotech as a safehaven from the broader European economy.

The other reason I believe the Biotech space will underperform is due to investor sentiment and increased political uncertainty in the US following Brexit. This type of analysis is more subjective and difficult than evaluating the effects or currency or reimbursement rates, but that doesn't mean it is any less important. Back in September, Hilary Clinton tweeted about reining in drug costs and the Biotech sector lost over $40 billion in market cap in a matter of hours.

At first glance, the September sell-off might seem like an overreaction to one tweet. But the fact is that drug pricing is central to the market value of many Biotech companies. The most common way to value Biotech companies is to look at their pipeline of drugs and value the potential earnings each drug would generate if the drug is a success. This is done by looking at: (the number of people that would benefit from the drug * penetration rate of the drug * price charged/reimbursement rate) - expenses. Then a probability of the drug getting approval is applied for each drug in the pipeline and the sum of the probability-weighted earnings potential is roughly the market cap of the company. Drug pricing ability has everything to do with the stock prices of most Biotech companies.

So, when Donald Trump campaigns on Medicare being able to negotiate directly with drug companies on prescription prices and importing drugs from foreign countries to lower costs, and says that the practice of selling the same drug in the US for higher amounts than other countries is going to "end immiediately", it would be prudent for potential Biotech investors to take notice. Hilary Clinton has also vocally opposed the high drug prices many companies are currently charging. If he or Clinton succeeds in lowering the prices/reimbursement rates, it will absolutely lower the value of Biotech companies.

In fact, political analyst Tucker Carlson believes Trump's positions on drug pricing are further left than Hilary Clinton's. Regardless of left or right of Clinton, the prospect of a Trump presidency brings much more uncertainty to drug pricing in the US and investors hate uncertainty. Brexit, also, is seen to increase the chances of a Trump presidency.

Brexit might not ultimately mean a Trump presidency is more likely than before, but the similarities are hard to ignore: rhetoric of populism, anti-immigration, anti-elite, "silent majority" working class white support, etc. are common themes in both campaigns. Add to that the fact that the most recent Kaiser Family Foundation poll already shows 76% of Americans favor the government limiting the prices companies can charge on drugs for life-threatening illnesses, and it's easy to see how the issue of drug pricing in the US election will become a greater focus for both of the candidates.

For the above reasons, I recommend investors stay away from the Biotech space for the short/medium term and shorting Biotech through the ProShares Ultra Nasdaq Biotechnology ETF for aggressive investors. The potential risks currently far outweigh the potential upside and I believe as investors continue to evaluate the effects of Brexit on currency and the US political landscape Biotech will underperform the rest of the market.

Disclosure: I am/we are short BIB.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.