Tuesday, April 29, 2014

"Biotech IPO Bubble"

A correspondent writes in about the "biotech IPO bubble":

"I have a different take on that phenomenon. In my view, the demand for biotech IPOs is a sign of bearishness on the part of institutional investors which are required to remain fully invested through bear markets. The reasoning is simple. Development stage biotechs with viable compounds are guaranteed to appreciate over time as the trials progress even during a bear market. They will appreciate even if the S&P falls 50% provided their drug trials are successful. Of course half of the biotech IPOs will probably fail and go to zero, but then all an institutional investor need do is purchase a diversified portfolio of 20 or so biotech IPOs and if there are two or three future winners that appreciate like ALXN, CLGN, GILD, or RGEN, their portfolios will perform very well, even in a bear market.

Next up, I should talk a bit about the failure rate for big Pharma at 90%. Not many investors have figured out that the high failure rate of development projects in the big pharma pipeline is by design, a natural consequence of the need to boost the stock price in the short term by 'selling the sizzle of a development pipeline so bright the CEO must wear shades' while promising that this time the failure rate (the rotting steak) will be much lower. Every so often the CEO will 'reorganize and restructure' the drug development group to convince the market that the failure rate will go down. And since every mature pharma company plays this game to a greater or lesser extent, there is no practical possibility of cutting development costs by limiting the size of the pipeline to the most viable candidates. The transition to drug development efficiency and a declining failure rate would be very costly to the stock price in the short term, to morale within the development group, and for management option holders in the short term. In contrast, development stage biotechs cannot afford to waste VC capital on low odds projects, thus, the failure rate of this latest generation of IPOs should be about 50 percent.

As a final side note, IBB has a large number of mature biotechs, AMGN, BIIB, CELG, GILD, ALXN, REGN, etc. Most of these are selling at or above 40 times trailing earnings, and given the typical period of patent and exclusivity period protection post trials of about 14 years, these companies will be lucky to maintain their current earnings stream 10 years from now, much less grow that earnings stream fourfold. Mature biotechs should be priced at 10 times trailing earnings, not 40 times, and all of these mature biotechs will ultimately succumb to the siren song of selling the sizzle of a big pipeline of projects even as their failure rates rise."
Biotechs versus zero coupon Treasuries are in a bear market.

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