GS on Biotech in general:
We have published on 1/18/02 a 110-page Biotech Overview on industry trends. The sector remains attractive for
growth investors based on improving fundamentals. However, we are selectively positive based on relatively high
valuation. Focusing on companies with earnings momentum & visible pipelines, we highlighted AMGN, DNA, GENZ,
GILD & MEDI. The report includes tables/figures on: key events for 2002 (release of Phase III data, FDA reviews &
potential product launches for companies in & out of our coverage), equity issuance, increasing dependence of pharma
co. on biotech, M&A, pipeline growth, failure rates of Phase III trials & FDA review. If interested, please contact GS sales representative.
SELECTIVELY POSITIVE OUTLOOK FOR 2002.
We maintain a selectively positive outlook for 2002 based on improving industry fundamentals. The risks are relatively
high valuation and sector rotation. We prefer to focus on companies with earnings momentum and strong pipelines.
Companies with broad technology platforms but a long horizon toward profitability are likely to remain volatile.
The Tier 1 companies outperformed their Tier 2/3 companies in 2000 and 2001. Therefore, there might be more
opportunities among Tier 2/3 companies for value investors in 2002.
Among large-capitalization, product-oriented growth companies, we continue to find the fundamentals of Amgen (Not Rated), Genzyme (Market Outperformer), Gilead (US Recommended List), and MedImmune (US Recommended List)
to be strong. We also view Genentech (Market Outperformer) as a core holding based on its robust pipeline. Among mid-capitalization, product-focused, growth companies, we find Qiagen attractive because of its consistent 30%-35% growth in sales and earnings.
Companies with broad technology platforms but no near-term profit prospects are particularly vulnerable to volatility.
Therefore, we believe they are more suited to investors with long-term horizons. We favor companies that are
transitioning to fully integrated biopharmaceutical companies or those with technologies that could enhance drug
development, such as Abgenix, Exelixis, Human Genome Sciences, Maxygen, Medarex, Millennium, and Vertex.
These companies have strong cash positions and growing pipelines.
2. VALUATION RELATIVELY HIGH BUT SOME COMPANIES ARE AT ATTRACTIVE LEVELS.
The summer of 1994 marked the bottom of the last biotech bear market, with an unfavorable political environment for
healthcare, a series of product failures, a dwindling balance sheet, and the skepticism that many drug companies had about the value of biotech. In 2002, industry fundamentals are unlikely to be the major negative drivers. However, sector rotation to less defensive and/or technology stocks, fear of high-multiple stocks in a volatile market, pricing pressures for pharmaceuticals leading to potentially further contraction in multiples, and relatively high valuation could weigh on the performance of biotechnology stocks.
For large-capitalization companies, the multiple of forward price/earnings (P/E) to growth (PEG) was 0.8X in 1994
versus 1.8X at the end of 2001, which is slightly below the midpoint of the historical range (0.8X-3.0X). The relative P/E was 1.1X in 1994 versus 1.7X currently. Therefore, the theoretical risk to further share depreciation is 40%-50% from current levels. However, given the fundamentally healthier state of the sector today, we believe that it is highly unlikely that the valuation would regress to 1994 levels. Rather, we believe that the worst-case scenario would lead to a PEG of 1.2X, or 20% lower than current valuations. On the other hand, a market upturn could bring the PEG closer to ’normal’ levels of 2.0X-2.5X (up 30%-40% from current levels).
For companies with a strong technology platform or early-stage product pipelines, history suggests that under 2X cash
is an attractive bottom. Depending on company fundamentals, the price-to-cash ratios of these types of companies
have ranged from less than 1.0X to over 10X. Approximately 15% of biotechnology companies are trading below 2X
cash, which is consistent with that found in 1994, even though the current Tier 2/3 companies generally have higher
cash reserves than those in 1994. For Tier 2/3 companies with strong fundamentals, we suspect the valuation would
not be sustained at a price to cash ratio below 1.5X-2.0X.
On January 23, 2002, we highlighted several Tier 2/3 companies with good entry points for long term investors based on strong fundamentals and price to-cash ratio of approximately 2X: Human Genome Sciences, Maxygen, Medarex,
and Vertex. All four companies are rated Market Outperformers.
3. KEY POSITIVE INDUSTRY TRENDS.
a. Strong earnings growth:
While the majority of biotechnology companies are unprofitable, we expect the number of profitable companies to grow to about 40 in 2002 versus 15 in 1999. The three-year average earnings growth rate of most Tier 1 companies
exceeds 20%, which we find attractive.
b. More products being developed and launched:
The industry has more than 140 products approved by the Food and Drug Administration (FDA), up from 24 in 1993.
Approximately 70% of the FDA actions on biotechnology products were positive in recent years, which is consistent
with the approval rate of pharmaceuticals. In the next two years, 10-15 companies could transition to profitability by
launching products independently or through corporate partners. Furthermore, more than 870 products are in clinical trials, more than double the number in 1995. Approximately 200 of these products are in late-stage development.
c. Increasing leverage versus pharmaceutical partners:
The pharmaceutical industry remains a major sponsor of biotechnology companies. In 2000, there were 426 alliances
between the two industries, up 11% from the year before. The competition for promising products and technology is
intense, leading to increasingly higher payments, some of which can exceed $1 billion by pharmaceutical partners, and
net royalty rates of over 25%. We anticipate the launch of 42 new pharmaceutical or biotechnology therapeutics in 2002. Twenty-two (52%) of these are derived from biotechnology companies and will be marketed directly by these companies or in collaboration with pharmaceutical partners. The level of biotechnology involvement has jumped to 52% in 2002 from 38% in 2001 and 25% in 2000. Therefore, biotechnology is playing an increasingly important role in filling the pipeline gaps in the pharmaceutical industry. Furthermore, the sales potential of the biotechnology products is on the same order of magnitude as those of pharmaceutical products.
d. Strong cash position:
Equity issuance reached a record high level of $18.4 billion in 2000, which exceeded the issuance in the prior five years combined ($16.8 billion). While the level of financing decreased drastically in 2001, we estimate that the average biotech company has cash reserves to support operations for 3.0-3.5 years, versus 1.0-1.5 years in 1997/1998.
4. EXPECT ABUNDANT PRODUCT NEWS IN 2002.
We expect Phase III results on more than 60 products in 2002 , which is consistent with the more than 200 late stage
clinical projects. More than 30 new products are under FDA review. Lists of companies with potential Phase III results,
FDA reviews and product launches in 2002 can be found in the detailed report.
5. RISKS TO FUNDAMENTALS
a. Slower FDA review:
In the past 2 years, the FDA seems to have become more stringent in accepting applications for filing, leading to more ’refusal to file’ decisions soon after submission of the applications. Such refusals may not be entirely negative because they allow companies to correct inadequacies early on instead of waiting until the end of the review period.
Furthermore, there seem to be more delays in FDA approvals recently, probably due to caution after several
high-profile recalls/withdrawals of pharmaceutical products, such as Rezulin. During 2001, investor expectations on the review times have adjusted to 18-24 instead of 12-18 months. Therefore, the risk of negative stock reaction as a result of delays should be minimized.
b. Low success rate in drug development:
The biotechnology industry is too young to offer any meaningful statistics on the success rate of drug development; however, recent data show that the success rate in Phase III studies remains below 60%, which is lower than the traditional average for pharmaceuticals (65%-75%).
c. Common pipeline gaps:
Despite an overall increase in products for the industry, many companies are faced with gaps in their pipelines after
the first one or two products are launched, leading to lower P/E multiples and stock price volatility.
d. Reliance on pharmaceutical partners:
Essentially every biotechnology company has at least one pharmaceutical partner. Sometimes, alliances with
biotechnology companies are terminated due to changes in priorities and/or delays in development by the
pharmaceutical partner, leading to a decline in the share prices of the biotechnology companies.
e. Mounting cost containment pressures:
Cost-containment pressures continue but are unlikely to preclude premium pricing on innovative biotech products.
However, we expect a renewed focus on price control at the congressional and state levels in 2002, which might lead
to negative sentiment. |
