RB, Speaking of good things, here's what H&Q has to say about the sector:
The Case for Biotech: A Rally Approaches
The biotechnology sector has underperformed the market overall for several years. While several new sector stars
have emerged during this period, the group as a whole has lagged compared to indices representing small cap, technology,
or healthcare stocks, such as NASDAQ, SOX, or DRG. The reasons for this relative weakness include the following:
The market's surge has been dominated by large cap companies.
Technology stocks have attracted the majority of speculative, small cap investor interest.
Biotech product failures continue to routinely cut market caps in half or worse, confirming investor
fears of the risks involved in investing in the sector.
The combination of these factors would suggest continued tepid investor interest for biotech. In our view,
however, evolving factors affecting the industry bode well for strong performance of the sector for the remainder of
the year and beyond.
External Forces Aligning Favorably
Externally, we see two factors that make biotech attractive relative to other groups in the stock market.
Safe Haven from Asian Turmoil. The market's seemingly inexorable march to 9,000 and higher would indicate
that few investors are concerned that the economic turmoil in Asia will result in lower EPS growth for U.S. companies.
If it becomes apparent that this optimism is premature, there will be a premium placed on those sectors that are not
impacted by the financial health of the region. There are three reasons why biotech is well positioned to outperform
the market if investors become concerned about Asia:
Lack of exposure - Few biotech companies have matured to the point where they need to have
proprietary operations in Asia. The few biotech-developed products (e.g., alpha interferon, G-CSF,
erythropoietin) that are on the market in Asia are sold by domestic pharmaceutical companies, which
pay royalties to their biotech partners.
Products are less-discretionary expenses - A reduction in wealth and spending in Asian countries will
impact all sectors of their economies. Nonetheless, it is easier to delay the purchase of a software
upgrade or new equipment purchase than to delay the therapy for a life-threatening illness. If expenses
are trimmed, we believe medical products will be spared compared to other products.
Lower interest rates improve NPV - If the Asian crisis results in lower interest rates in the United
States, it reduces the discount rate used to calculate the NPV for companies. This is especially
important for the speculative, development-stage companies where the payoff in earnings growth is
several years away. Such companies comprise the bulk of the biotech industry.
Pharmaceutical Company Comparables. One of the biggest beneficiaries of investor interest in this market has
been the pharmaceutical sector. Attracted by sustained, above-average growth, these stocks have attracted every type
of investor over the past two years - growth, momentum, value, and defensive. The result has been a phenomenal run
for the sector, with the DRG Index up over 100% since January 1, 1996, and some companies, like Warner-Lambert
and Pfizer, up over 200% during that period.
Investors are now paying EPS multiples or about two times the earnings growth rate for most pharmaceutical
stocks. Meanwhile, profitable biotech companies with existing or potential EPS growth exceeding 30% are selling for
market multiples or below. Since the pharmaceutical companies usually have revenue streams far more diversified
than biotech companies, we believe that investors should apply some discount to biotech EPS when comparing to
pharmaceutical EPS, but the current valuation parameters appear too discordant.
One could argue that the valuation gap should be closed by a decline in pharma stock prices, but we support the
theory that drugs will play an increasing role in disease management within the healthcare industry, and that pharma
companies will be the prime beneficiaries of that trend. A more likely scenario is that investors in the pharma sector
will peel off some of the profits from the highest valuation stocks and deploy these assets in biotech. The first purchases
generally are the large cap, profitable companies, and, thereafter, the interest generally spills over to the emerging
second-tier names. As highlighted in the upcoming section, this latter group appears to be rapidly expanding.
Internally, Fundamentals are Strengthening
In support of these external influences, there are several fundamental factors that could internally drive
appreciation of the group.
Surge in New Products. The biotech industry is entering what may be the most productive period in its 20-year
history. By our count, there are over 20 new biotech-generated drugs poised to enter the market during the 18 months
from 1998 through mid-1999. While all of these drugs may not receive approval from the Food and Drug
Administration (FDA), if over half are successfully commercialized, it will significantly broaden the universe of biotech
companies with revenues and profits. Furthermore, this is not just a one-time bolus of productivity, but a reflection of
the true power of the technology on which the industry is built.
Ownership is Limited. With the relative underperformance of biotech over the last few years, institutional
ownership has dwindled. If the new products approaching the market outperform expectations, it could generate
significant buying interest as under-invested fund managers look to gain exposure.
No Oversupply - Financings are Few. As a whole, the biotech industry is still not profitable, although that should
finally change in the next 12 to 18 months. Historically, the constant need for most biotech companies to raise capital
through the capital markets has resulted in a steady stream of stock offerings. During the few periods when the sector
got hot, this stream of offerings turned into a torrent, eventually swamping demand. For more than six months, now,
the market has been selective regarding biotech financings. However, even with limited fund-raising, the financial
health of the sector has never been better, with nearly 60% of biotech companies on our "Biotech Burn Watch" (see
Appendix D) holding more than two years of cash. Moreover, a significant number of the 40% of companies below the
two-year threshold are there because they are launching products and undergoing a short-term spike in expenses
before revenues begin to flow. The bottom line is that the lack of market interest in small company offerings and the
financial well being of the larger, stronger companies have combined to create a slow financing environment.
What will happen if our prediction of a resurgence in biotech proves correct? As with any sector, as investor
interest grows, the number of deals will increase in stride, and we expect a biotech rally will stimulate financing
activity. The difference now is that the relentless need for capital has diminished for most biotech companies, which
will result in lower supply of new equity and, consequently, a more sustained rally.
Summary and Conclusion
Biotech stocks are generally underowned.
Macro events favorable; pharmaceutical comparables; no Asian exposure.
Product pipeline rich, as technology is bearing fruit.
New equity supply not a problem.
Biotech sector is positioned for upward move. |
