All does not appear right with the biotech industry. The rhetoric is that of strong fundamentals and a robust innovation cycle. However, the reality is a lot different. Net income in the sector is driven by less than 10% of companies. The rest of the firms are loss making and most will never return a profit. Similarly, major revenues are generated by an insignificant number of firms. With regard to innovation, despite record infusions of innovation capital, the rates of approvals and filings for new molecular entities are nowhere near historic highs and stem mostly from large biotech. Everyone has heard about the exponential increase in the number of biotech initial public offerings but few are aware that there has been no commiserate upturn in the number of investigational new drug applications and in mergers and acquisitions in the emerging therapeutics space (roughly 90% of the industry). Overall, pipeline productivity has decreased while the inflation adjusted cost of drug development has increased. The exponential growth in the market capitalization of the Nasdaq Biotech Index (NBI) from 2012 to 2015 was more a function of over valuation of initial public offerings and follow-on public offerings by investment bankers and sell-side analysts than driven by any material financial performance of most of the index's constituents. Based on the posturing displayed by stakeholders, it was easy to forget that this was not wealth created by biotech, but instead money invested, that belonged not only to the estates of wealthy Americans, but also was part of pension plans of ordinary citizens. Moreover, given the high fives over peak capital inflows into the industry, it appears that generating funding not profits is the predominant objective of the stakeholders. Overall, the picture emerging is not that of a mature industry, but one that is floundering - overrun by carpetbaggers and wrecked by majority loss leader companies that are guzzling capital with little return and are busy offsetting much of the success achieved by a minority few.
Considering the data surrounding the key drivers of the industry, there appears a clear dichotomy forming between the givers (NBI top 10 + few more) and the takers (the rest of the industry). The first group are the performers and the later the laggards. Therefore, to accurately estimate the current market capitalization of the NBI, it makes sense to value the two groups separately. With regard to the valuation of the NBI top 10 holdings, based on 2017 consensus earnings estimates and forward price/earnings (P/E) ratios, I reach a market capitalization of ~$483 billion. Given, how the performance attributed to most of the group outside of the NBI top 10 has only worsened over time, it is reasonable to then assess this group on the basis of its valuation in the NBI in 2006. On those terms, I arrive at a market capitalization of ~$139 billion for the group. Consolidating the two market capitalizations, and identifying the price when the NBI was trading at roughly the same market capitalization, I estimate a value of ~$1878 for the NBI and ~$179 for the iShares Nasdaq Biotechnology ETF (NASDAQ:IBB) by proxy. These prices are based on fundamentals. Considering technical trends, the values contract significantly.
Looking ahead over the next few years, the industry is likely to mirror its own performance in the aftermath of the genomic bubble. Although venture capital funding which reached record levels in 2015 remains relatively strong this year, moving forward, I expect weakness as sponsors react to indications that there might be potentially fewer opportunities to monetize their investments in an expected challenging IPO market. The dawning reality among non-specialist investors that biotech is extremely high-risk, if not highest-risk, combined with the risk-off mood of sector specialists will reflect in only companies with innovative technology or later-stage assets with superior data being able to go public. Some might point to the low interest rate environment as a stimulus for biotech investing, but leveraging highly risky investments is a double edged sword, which sophisticated investors are probably familiar with. Overall, there is likely to occur a considerable downturn in the funding climate (particularly due to the tightening of crossover money), leading to attrition in the market capitalization of the sector as companies lose value due to clinical trials and drug failures but front-running these losses is not possible due to an erosion in the numbers and values of initial public offerings and secondaries. Until the time company valuations are properly risk-adjusted, drug development costs reined in, and drug pricing concerns dealt with, serious investors are likely to remain disinterested. With regard to the NBI, I anticipate the twin catalysts of continued selling due to risk perception and inability of stakeholders to front-run the losses through overvalued initial public offerings and secondaries to persist and further depress the index.
Therefore, over the next couple of years, shorting the IBB and investing in the ProShares UltraShort Nasdaq Biotech ETF (NASDAQ:BIS) as well as undervalued commercial companies that offer substantial potential growth appears strategic. Overall, in a sector wherein less than 10% of drugs undergoing clinical trials ever secure regulatory consent, it makes little sense to invest in individual non-commercial companies, unless you are a sector specialist who has a grasp on the science and the clinical/regulatory environment associated with drug development. Given that greater than 90% of investigated drugs fail to get approved, attempting to identify potential drug successes and companies linked to them is like trying to find a needle in a haystack. Counting on the opinions of sell-side analysts is futile, as they've historically almost always been unsuccessful in predicting drug development and regulatory failures. Therefore, a lower-risk trade in biotech is not to invest in multiple high-risk clinical-stage enterprises but instead to buy shares of newly commercial companies on their journey upwards. Recollect that Regeneron (NASDAQ:REGN) did not turn into an eleven-digit company overnight. Even after Eyelea's outstanding success, the stock traded below $100 for some time.
Ignoring the long-term time horizon associated with the investments. The price objective linked to the IBB might take multiple years to be achieved.
How Has the NBI Performed Historically?
The NBI is a Poster Child for Boom Bust Cycles. Between October 2011 and July 2015, the market value of the NBI appreciated dramatically going from a lowly ~1152 to a record breaking ~4166 representing a gain of ~261%. Comparatively, the genomic era NBI did slightly better registering an absolute return of ~313% before falling 75% to the bottom. Following that period, from July 2002 to October 2011, a period of 9 years, the value of the NBI increased by a paltry 748 points.
Since July 2015, the value of the NBI has declined. After falling ~39% to a low of ~2572 from a high of ~4166, the index has recovered somewhat and for the most part trades range-bound between ~2500 and ~3000.
When and What Popped the Biotech Bubble?
Descent Began Ahead of Hillary Clinton's Tweet. Many lay the blame for the flight of capital and downtrend in the NBI on Hillary Clinton's tweet on drug pricing. However, the contention is inaccurate. The descent in biotech started much before that. Hillary Clinton's tweet just added an additional concern, broke the camel's back, and dramatically accelerated the process.
The NBI Reached a Trillion Dollars in July Before Starting its Descent on August 6, Much Ahead of Hillary Clinton's Tweet on September 21
Source: Nasdaq Biotech Index (NBI) Database; Seamist Capital Presentation June 2016
The sell-off was driven more by a dawning among non-specialist investors on the reality of biotech investing. A reality that most of their biotech investments are likely to result in negative returns.
Hillary Clinton's Tweet on Drug Pricing Dated September 21, 2015
Source: Twitter; Seamist Capital Presentation June 2016
The response from industry stakeholders has been that the pullback in biotech is directly correlated to typical presidential election cycle politics about drug pricing. They argue that industry fundamentals are strong, the innovation cycle robust, and the correction temporary. However, analysis of key data surrounding the major drivers of the industry unfolds a different story.
How Has the Biotech Industry Performed Over the Years?
I evaluated financial data from the entire industry, the NBI top 10 holdings, the commercial leaders, the emerging therapeutics firms (~90% of the sector), and the rest of the industry (comprising companies aside from the top 10 holdings in the NBI and the commercial leaders). Overall, the investigation revealed that an extremely small minority of firms in the industry accounted for most of the revenues and net income while the rest of the industry was unprofitable.
Few Companies Drive Earnings. Based on operational results of companies that comprised the top 10 holdings of the NBI from 2006 to 2015, Amgen (NASDAQ:AMGN), Teva (NYSE:TEVA), and Gilead (NASDAQ:GILD) generated a majority of the industry's net income and offset its significant losses. Even amongst the group, AMGN, TEVA, and GILD were major contributors while the performance of the rest was marginal for the most part. Without the earnings power of AMGN, TEVA, or GILD, the sector would have been unprofitable for a significant portion of the evaluated years as presented below.
NBI Top 10 Holdings Net Income (2006-2015)
Source: Data from Thomson Analytics and IBB Prospectus; Seamist Capital Presentation June 2016
Roughly 90% of the Industry Generating Losses. From 2006 to 2015, almost all of the NBI top 10 holdings were profitable (sometimes accounting for earnings that were 2x and 3x that of the industry). During the same period, almost all of the rest of the industry were net losers, with the losses accelerating from $6.6 billion in 2009 to $16.4 billion in 2015. The earnings power of NBI top 10 holdings offset industry losses for numerous years as shown below.
Limited Number of Revenue Generating Firms. A similar story emerges with regard to revenues, where a significant fraction of sector revenues were generated by a combination of AMGN + TEVA or AMGN + GILD across the investigation period. If revenues attributed to these firms were overlooked, industry revenues would be roughly half of that reported for several of the assessed periods as illustrated below.
NBI Top 10 Holdings Net Revenues (2006-2015)
Source: Data from Thomson Analytics and IBB Prospectus; Seamist Capital Presentation June 2016
Rest of Industry Revenues as % of Overall Industry Revenues Decelerating Over Time. Considering data from 2006 to 2015, the NBI top 10 holdings and commercial leaders continued to generate a majority of the industry revenues while revenues for the rest of the industry group as % of industry revenues declined over time as shown below.
Growth Derived Predominantly from NBI Top 10/Commercial Leaders. To encapsulate, between 2006 and 2015, net earnings for the NBI top 10 holdings grew by 1053%. From 2009, net loss for almost all of the rest of the industry group grew by 148%. Revenues between 2006/2009 and 2015 expanded 156% and 22% for the former and later groups as presented below.
Growth Outcomes: NBI Top 10 Holdings vs. Almost All of the Rest of the Industry
Source: Data from Thomson Analytics & E&Y: Beyond Borders; Seamist Capital Presentation June 2016
Drug Development Success Rates Are Highly Inadequate. The disappointing financial performance of the rest of the industry group is not surprising as few drugs ever get approved. Based on a May, 2016 report by the Biotechnology Innovation Organization [BIO] and Biomedtracker, less than 10% of drugs from the Phase 1-stage secure regulatory approval. The approval rates are even more dismal for cancer drugs, of which only roughly 5 out of every 100 that undergo clinical investigation ever receive regulatory consent.
Phase Transition Success Rates and Likelihood of Approval from Phase 1 for All Diseases and Modalities
Source: Clinical Development Success Rates (2006-2015) - Biotechnology Innovation Organization + Biomedtracker Report May 2016
The probability that a Phase 1 drug will get approved is 9.6%, a Phase 2 drug 15.2%, a Phase 3 drug 49.6%, and one that has been filed for regulatory approval 85.3%.
Overall Probability of Regulatory Approval by Phase for All Diseases and Modalities
Source: Data from Clinical Development Success Rates (2006-2015) - Biotechnology Innovation Organization + Biomedtracker Report May 2016; Seamist Capital Presentation June 2016
Likelihood of Approval from Phase 1 by Disease Condition
Source: Clinical Development Success Rates (2006-2015) - Biotechnology Innovation Organization + Biomedtracker Report May 2016; Seamist Capital Presentation June 2016
Rates of NME Applications for Approval Far from Record Highs. With regard to the robust innovation cycle argument, innovation when measured in terms of the number of applications filed for new molecular entity [NME] approvals and the actual approvals falls short. Both elements are far from their historic highs. Although there appears a modest increase in the approval rate, there doesn't appear a similar upturn in the number of applications filed for regulatory consent.
New Molecular Entity NDAs/BLAs Filings for Approval and Actual Approvals (1993 to 2015)
Source: CDER New Drug Review: 2015 Update, FDA/CMS Summit, December 14, 2015
In the FDA's own words "CDER approved a higher than average number of novel drugs in 2015; however, the number of applications for these drugs that sponsors have submitted over time has remained stable." In 2015, CDER approved 45 NDAs/BLAs for NMEs, which indicates that the agency is turning constructive. However, the industry filed 41 NME applications for approval in 2015, which is considerably below the historic high of 50, and consistent with the average. Based on historic data, NME filings as % of NDA/BLA filings appears inadequate, coming in at 29.3% in 2015 against the high of 41.3% observed in 1995 as shown below. Moreover, a majority of NMEs approved were from major companies not emerging companies.
Downturn in NDA/BLA Approvals. Overall, in 2015, NDA/BLA approvals declined by 10% over the previous year with only 107 drugs out of the 140 applications filed securing regulatory consent. The endorsements represented just 76% of NDAs/BLAs filed, far from the 2014 figure of 98%, and the high of 109%, as presented below.
Unconvincing Growth in Number of IND Applications. If one considers that typically an upturn in number of drugs investigated leads to more filings for approval, then it is important to note that the rate of investigational new drug [IND] applications filed over the recent years has experienced a modest increase that is grossly inadequate with the record inflows of capital into the emerging therapeutics space and substantial acceleration in the number of enterprises in the industry. The number of public companies in the industry grew 38% over 2012 to 2015 whereas the number of IND applications filed expanded by barely 11% over the same period.
M&A Not Picking Up in Emerging Therapeutics. On mergers and acquisitions (M&A), a vital element of the biotech business model, the story does not get much better. Despite the surge in the number of public companies in the sector, the emerging therapeutics segments has not experienced a similar advance in mergers and acquisition activity as illustrated below. The 44 M&A deals inked in 2015 fall short compared to the 51 in 2008 and 49 in 2013.
Pipeline Productivity Decreased While Cost of Drug Development Increased. Moreover, pipeline productivity defined as the rate at which firms convert R&D spending into approved drugs is declining. On an inflation adjusted basis, it's significantly more expensive to generate pipeline returns in form of an approved drug today than over the past decades. It now takes $2.56 billion to develop a drug to approval. The increase in spending is attributed to resource misallocation and higher failure rates for drugs tested in humans.
Average Cost to Develop and Market a New Drug Now $2.56 Billion
Source: Tufts Center for the Study of Drug Development; Seamist Capital Presentation June 2016
All in all, although the financial performance of most of the NBI top 10 holdings/commercial leaders appears strong, the state of the industry is far from outstanding. In particular, the emerging therapeutics group (includes most of the NBI companies aside from the top 10) are not only posting increasing losses, they're also unable to convert the record inflows of capital into a commiserate surge in numbers of: IND applications, M&A deals, and approved drugs. Clearly, the weak performance of the group did not drive the 120% growth in its market capitalization in the NBI between 2011 and 2015. So, what really did?
What Really Drove the Outsized Valuations of the Emerging Therapeutics Group?
Financial Shenanigans Not Financial Performance. The over valuation of these companies was driven by a collusion between private equity/venture capital firms, the investment bankers, and sell-side analysts, not by the accomplishments of the firms. The private equity/venture capital firms in a race to realize their internal rate of return on as many investments as possible took arbitrarily researched companies to the public markets with the help of the investment bankers who attributed to them improperly risk-adjusted valuations and sell-side analysts who inflated revenue estimates to arrive at Price Targets which wildly misrepresented the true values of these organizations.
How Biotech Companies are Typically Valued. Typically, a biotechnology company's Price Target is derived from the sum of the net present values of its key drugs and the cash balance. The value is secured by projecting revenues associated with the agents, applying the appropriate probabilities of regulatory approval statistics (10% for P1, 15% for P2, 50% for P3, and 85% for NDA-stage), multiplying by a revenue multiple, and discounting the output back to the present. The cash balance of the firm is then added to net present value of the key drugs and the total divided by the number of outstanding shares to arrive at the Price Target. An alternate method would be to apply an earnings multiple to an earnings estimate that incorporates risk-adjusted revenues. Yet another method would be to find the net present value of the earnings associated with the key drugs by running a discounted cash flow model using an appropriate discount rate.
Analysts Highly Misrepresented Risk Rates Associated with Drug Development. As shown below, a majority of sell-side analysts misrepresented the probability of approval statistic in their valuations. They utilized 65%, 70%, and sometimes even 80% (instead of the actual 10% and 15%) as their probability of approval to value Phase 1 and Phase 2 drugs, thereby highly inflating revenue estimates and the Price Target. Others completely ignored risk-adjusting the projected revenue streams, and simply used the discount rate in the net present value calculations to account for drug development risk. The discount rates, most of them used were 7%, 8%, 10%, which grossly underestimate the risk associated with drug development, where less than 10 out of every 100 drugs ever get approved.
Some might contend that expertise license provided analysts the latitude to utilize inflated probabilities of approval. However, evaluating historical results, it is almost impossible to identify any drug development or regulatory failure that the sell side accurately foretold. The fact is that historically biotech analysts have been highly constructive on almost all companies (depending on the potential for investment banking fees) and scramble to readjust when clinical trials fail or drugs are rejected by regulatory agencies.
Here's an Example of a Phase 1/2 Asset Attributed a 75% Probability of Regulatory Success. The Trial Disappointed and Shares Tanked
Source: Thomson One Analytics; Seamist Capital Presentation June 2016
Here's One Which Does Not Risk-Adjust Revenues and Deploys a 10.5% Risk Rate for a Phase 1/2 Drug. Data Were Underwhelming and Shares Suffered
Source: Thomson One Analytics; Seamist Capital Presentation June 2016
This Was a Phase 3 Asset Company with a Risk Rate of 10%, Revenues Not Risk-Adjusted. Study Failed and Price/Share Declined to ~$5 from ~$35
Source: Thomson One Analytics; Seamist Capital Presentation June 2016
What Is the True Value of the NBI and the IBB?
Now that it is established that the emerging therapeutics group was significantly overvalued in the market capitalization of the NBI over the recent years, it is now time to incorporate these findings to determine the true current value of the NBI. Given the dichotomy between the high performing top 10 holdings of the NBI and the rest of the companies in the index comprised mostly of the emerging companies, it makes sense to value the two groups separately to arrive at a consolidated estimate for the NBI and by proxy the IBB.
Market Capitalization of the NBI Top 10 Holdings. Incorporating 2017 consensus earnings estimates and forward price/earnings (P/E) ratios, along with a discount rate of 15%, and outstanding shares, I arrive at a market capitalization of ~$483 billion for the NBI top 10 holdings. I have used a 15% discount rate instead of the typical 8%-10% to account for greater risks associated with drug pricing, worsening macro conditions, and inflated sell-side estimates.
Present Estimated Market Capitalization of the NBI Top 10 Holdings
Source: NBI Database; IBB Prospectuses; Inside the NBI; EPS Estimates, P/E Multiples from Yahoo Finance (provided by Thomson Reuters), July 25 2016; Seamist Capital Presentation June 2016
Market Capitalization of Rest of the NBI. Given, how the performance associated with most of the group outside of the NBI top 10 has only got worse over the years (with revenue growth as a % of industry revenues declining, net loss increasing, pipeline productivity decreasing, and the inflation adjusted cost of drug development advancing), it is reasonable to then value this group on the basis of its historical valuation in the NBI in the pre-bubble years. For my estimate, I used 2006 as the base year because the economy was in expansion mode and the number of firms in the NBI at 173 most closely mirrored the present number of holdings in the index. On that basis, I arrive at a market capitalization of $139 billion for the group by incorporating its current holding value of roughly 42% in the NBI multiplied by the index value in 2006.
NBI and IBB True Values. Consolidating the market capitalizations of both groups, I arrive at a consolidated market capitalization for the NBI of ~$622 billion. The closest match I could identify to the output was on May 10, 2013 when the NBI was trading at ~$1878 with a market capitalization of ~$628 billion. On the same day, the IBB closed at ~$179. Based on the analysis, the current Price Target for the IBB is $179/share.
NBI Traded Close to the Estimated Market Capitalization of ~$622 Billion on May 10, 2013
Source: NBI Database; Seamist Capital Presentation June 2016
The IBB Closed on May 10, 2013 at ~$179/Share Which Corresponds to its Current Fair Value
Source: Yahoo Finance; Seamist Capital Presentation June 2016
There is upside opportunity to this estimate as I have used sell-side consensus earnings projections (proven to be highly over estimated) and data provider P/E multiples to reach the market capitalization for the NBI top 10 holdings.
What Lies Ahead for the Sector?
Market to Remain Range-bound for a While. Looking ahead over the next few years, the NBI is expected to mirror its own performance in the aftermath of the genomic bubble. The NBI made a top of ~1597 on March 6, 2000 at the height of the genomic era before falling 75% to bottom at ~404 on July 10, 2002. Then onwards from September 2002 to October 2011, the index value increased by a paltry 748 points over 9 years to ~1152 before embarking on a bull market journey which led to the recently popped bubble. Based on those trends, the NBI needs to correct 62% from the top formed on July 20, 2015 to a bottom of 1565 (~150 on the IBB) and then trade range-bound between the bottom and 2420 for roughly 9 years. It took more than 2 years for the bottom to form after the genomic bubble.
NBI Has Been Range-bound for Most of its History (1993-Present)
Source: Yahoo Finance NBI Database; Seamist Capital Presentation June 2016
Venture Capital and Public Funding Will Tighten. Although current year venture funding has shrunk when compared to the record inflows last year, the amount raised is still substantial. However, over the next few years, it is possible that investors wary of an expected challenging IPO environment for biotech decide to invest in less risky assets that offer comparable yields. Similarly, public market investors, aware now more than ever of the high risks associated with biotech are likely to remain on the sidelines until valuations are more appropriately risk-adjusted.
Although both themes are probably going to hold particularly true for crossover funds that have seen their portfolios shrink following the bursting of the biotech bubble, it nevertheless will resonate with sector specialists that recognize that without a biotech bull market they're ill positioned to benefit from the ignorance and greed of non-specialist investors.
Bankruptcy Claims to Accelerate. A few years out, it is highly probable that companies filing for bankruptcy might become an industry feature. Although firms at this point appear fully funded, that might change given the high cost of drug development and the excessive out of pocket spending habits company executives inculcated during the bubble. As shown below, in the aftermath of the genomic bubble, firms appeared to be well funded. However, over time the sector experienced a significant upturn in the number of bankruptcy filings as shown below.
How to be Best Positioned to Benefit?
Limit Exposure to the Sector. Although a substantial fraction of the current downturn in the index is because of investors pulling capital as they become aware of the high risks associated with biotech, a considerable portion of the decline can be attributed to an absence of loss mitigation through overvalued IPOs and FOPOs as observed over the previous three years. Looking ahead, both factors are likely to accelerate and persist as catalysts for continued losses in the NBI as it works its way to the bottom discussed above. Therefore, it makes sense to limit exposure by investing in commercial leaders (that are undervalued and estimated to grow over the next few years) and the BIS and shorting the IBB.
Don't Invest in Developmental Stage Companies. Some investors might argue that developmental-stage companies offer opportunities for better returns. However, given that less than 10 out of every 100 drugs ever get approved, investing in a basket of clinical-stage companies is unlikely to achieve positive returns unless in an artificially boosted market as that evidenced over the previous three years. Biotech is complex and unless one has the talent to read through copious amounts of scientific information and develop a fundamental understanding of the clinical and regulatory process, it is impossible to identify companies that are likely to succeed. Even sell-side analysts (who perform research for a living) seldom accurately predict clinical trial or regulatory failures.
Participate in Upstart Companies With Drug Approval in Hand. In order to lower risk of investing in upstart companies, it makes more sense to participate in them once they have an approved drug with significant revenue potential. To illustrate, although Regeneron's Eylea got approved on November 18, 2011, the stock traded below $100 for a while. Therefore, investing in shares of quality companies on their journey upwards rather than in a basket of developmental-stage firms, the direction of whose clinical data is almost impossible to predict, presents a better risk/reward paradigm.
Regeneron Trading Patterns Prove Behemoths Don't Happen Overnight
Source: Yahoo Finance; Seamist Capital Presentation June 2016 (Updated July 18)
It was the funding coming from crossover or non-specialist investors that drove the biotech bubble this time around. They invested heavily and ran the index to stratospheric heights. However, there has been a fundamental shift in how these participants now view the risks associated with biotech investing. They're now aware more than ever that they're more likely to lose their biotech investments than achieve exponential returns. This will make it harder for stakeholders to perpetuate boom bust cycles counting on the short memory of the collective market. As a consequence, the biotech index is likely to undergo a sharp contraction and subsequently trade range-bound for years (use the period from July 2002 to October 2011 as a barometer) until the industry improves pipeline productivity and reduces costs, appropriately structures drug pricing, and accurately represents the risks associated with drug development in valuations. The biotech industry has not matured, but biotech investing certainly has. The non-specialist investors that stakeholders count on to buoy the sector have biotech to blame for the poor performance of their portfolios, and are likely alienated for a while.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in IBB over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.