If you’ve been paying any attention at all to the stock market, you know that the biotech sector has been on fire. The Amex Biotechnology Index is up 19% year-to-date (versus a 3% gain for the S&P 500).
Over the past two years, the index has more than doubled - up 106%. At the same time, the S&P 500 has climbed 29%.
The huge move in biotech has caused many skeptics to declare that the sector is in a bubble. And the recent acquisition of Synageva BioPharma Corp (NASDAQ:GEVA) by Alexion Pharmaceuticals (Nasdaq: NASDAQ:ALXN) for a 140% premium did little to persuade the bears that they are wrong.
They are wrong.
Patent Expirations
It’s no secret that the giant pharma companies are scrambling to replace drugs that are losing their patents and facing generic competition. Hundreds of billions of dollars in revenue are at stake.
For example, Astrazeneca Plc (NYSE:AZN) just reported lower first quarter profits after the patent for its acid reflux medicine Nexium expired. Sales of the drug fell 31%. The company’s cholesterol fighter Crestor will lose patent protection next year. Combined, these two drugs make up a third of AstraZeneca’s revenue.
The story is the same across nearly every large pharmaceuticals company. As a result, big pharma is constantly on the prowl for new drugs to replace lost revenue.
That means smaller companies stand to benefit as the drug giants go shopping, either for individual drugs or for entire companies. Their ultimate goal is to obtain a pipeline of multiple drug prospects - or a certain technology that is used to create drugs.
The way a partnership for an individual drug works is like this:
Biotech Company A has a drug that just finished Phase 1 trials with promising data. Big Pharma Company B pays the biotech company $20 million in cash for the rights to develop and market the drug.
The larger company now takes on the expense (and risk) of clinical trials. Along the way, the biotech company is entitled to $100 million in milestone payments. These might occur after successful Phase 2 trials... at the beginning and end of Phase 3 trials... and if/when the drug is granted final approval.
Additionally, the smaller company will get a royalty payment on sales of the drug once it’s on the market.
Obviously, the numbers vary depending on each company’s characteristics.
Insatiable Appetites
As drug companies become more desperate, they are willing to pay higher amounts for drugs.
In January, for example, Amgen (Nasdaq: NASDAQ:AMGN) said it would pay Kite Pharma (NASDAQ:KITE) $60 million for access to its cancer drug that had yet to be tested in humans. Kite is eligible for another $525 million in milestone payments as the drug progresses through development.
Of course, sometimes one drug isn’t enough to satisfy the insatiable appetites of large pharmaceutical companies. They want all the drugs. So they buy the entire company and gain access to its pipeline. This often includes, just as importantly, patented technology.
In March, Cellular Dynamics agreed to be acquired by Fujifilm Holdings for $16.50 per share. The stock closed at $7.94 in the trading session prior to the announcement. Cellular Dynamics had $16.7 million in sales in 2014. Its technology will allow Fujifilm to produce fully functioning human cells.
Also in March, Teva Pharmaceutical (Nasdaq: ARCA:TEVA) agreed to a $3.5 billion buyout of Auspex (NASDAQ:ASPX) Pharmaceuticals to obtain its drug for Huntington’s disease. Teva also gained access to its pipeline of drugs for Parkinson’s disease and idiopathic pulmonary fibrosis. The $101 per share price represents a 42% premium to where the stock closed just before the announcement.
Everybody’s Getting In on the Action
Biotech stocks have always enjoyed much larger acquisition premiums than the rest of the market. With demand so high for new drugs and technology, I expect that to continue for the foreseeable future.
It’s never a good idea to buy a stock simply because you think the company will get acquired. But as long as huge premiums are being paid for biotech stocks, big money will likely continue to pour into the sector.
Even some large investors who don’t normally invest in biotech are getting in on the action. John Paulson of Paulson & Co., who made billions betting against the U.S. subprime mortgage market in 2007, recently bought over 2% of Synergy Pharmaceuticals Inc (NASDAQ:SGYP).
Synergy is known to biotech aficionados, but is not front of mind to most big money managers.
Next week, I’ll take a look at some other fundamentals that should positively impact biotech, as well as review the sector’s technicals.