Biotech Update: Revisiting our 2015 Report – A Similar but Slightly Less Compelling Conclusion

• Introduction
• Biotech: M&A and IPO Data Update
• Valuation: A Biohazard in Biotech?
• Conclusion: Finding Opportunity in Biotech
• Appendix: Does Valuation Matter Within Biotech

Introduction

Over the last few months several partners of Kailash Capital’s work have asked us to revisit our October 2015 paper “Where Are We in the Biotech Cycle?”. In that paper we led out with the conclusion:

…we see more risk than opportunity in the sector. Data indicate that we are very late in the cycle. M&A activity is running near the second-highest record level [and] even more concerning is that deals… done in 2015 have been at valuations that are 3x-4x previous peaks. This would seem to suggest significant speculation and even a potential bubble… The number of IPOs was recently at record levels, and the market cap of IPOs is at the highest level by far since the Technology Bubble. Between M&A and IPOs, capital appears to be flooding into the Biotech industry at a time when valuations for the sector are near historic peaks. Over 75% of the stocks in the Biotech sector are currently trading above 10x Price/Sales. History shows that valuations this high for Biotech stocks have usually led to meaningful underperformance for not only the expensive stocks but also the entire sector on a forward basis with nearly twice the level of market volatility. Our reading of history suggests that even after the recent 20%+ pullback, Biotech seems to offer a poor risk-reward proposition and likely unattractive risk-adjusted returns from these levels.

Said more simply: in October 2015, looking at a combination of fundamentals, deal volume and value we were unambiguous in our bearish view of the group’s future prospects. We will happily take a lap around the stock market’s “Better Lucky than Good” track and note that a combination of heady sector valuations and exuberant deal prices did indeed combine to produce some painful results for the Biotech space. Figure 1 below shows that since our first paper’s publication the Biotech Index has suffered severe underperformance when compared to the S&P500, R2500 and R2000.

With the recent uptick in price as seen in Fig. 2 below a number of partners have asked for an update of our 2015 work. As absolute prices creep higher after such dramatic underperformance we found the exercise interesting and informative.

Biotech: M&A & IPO Data Update

Figure 3 below shows the number of acquisitions within Biotech by year.¹ Figure 4 shows the dollar volume of those deals by year. Kailash Concepts released our original publication in 2015 when the number of deals was just below all-time highs and the dollar value of those deals was the second highest on record.²

To summarize what has happened since “Where Are We in the Biotech Cycle?”:

1) 2016: deal volume measured in both volume and value raced higher

2) 2017: deal volume continues to rise but deal value fell precipitously

3) 2018: so far this year, deal volume has been far more muted but deal value is rapidly approaching 2015 levels

Volume has a big part in charts. To know more volume, visit our what does volume mean in stocks white paper.

Kailash Capital updated Figs. 3 & 4 at the request of our partners. The data strikes us as less compelling than in 2015 but we feel the rising deal value worth noting.

Figure 5 below updates the data on FCF/EV ratios of acquired companies through 2018. To reiterate our original notes: when deal values last peaked in 2009 the acquired Biotech companies had positive aggregate FCF. Although only time will tell, one could suggest that the spike in acquisitions then was more understandable than what we have seen over the last few years.

Figure 6 updates the data on the Price/Sales (P/S) of acquired Biotech companies by year through 2018. While valuations today are significantly more forgiving than in 2015 they are still the third highest on record. We recognize that 26x sales is substantially “cheaper” than 43x sales but continue to believe this hardly offers potential investors a margin of safety relative to both the broad market and the sector’s own history.

Finally, Figs. 7 & 8 update the number and value of Biotech IPOs since our 2015 publication. While Biotech equity issuance as measured in dollars (Fig. 8) peaked during the Tech Bubble we can see that at the time of our original paper issuance fell short of that all-time high by a mere $13 billion. We believe with 2018 on track to potentially match the most recent high in 2015 on a dollar issued basis there may be cause for concern yet again.

2015 was a year of high M&A activity, high IPO activity and extremely high valuations as money rushed into the Biotech sector. As we emphatically noted then, we believed these conditions were conducive to potential risks for the sector as whole. With 2018 looking increasingly similar to 2015 we feel compelled to recommend caution yet again despite slightly more forgiving data.

Valuation: A Biohazard in Biotech?

Figure 9 shows the percentage of Biotech stocks that are trading above 10x P/S. Consistent with the findings from Figure 6 for acquired companies, we can see that Biotech valuations today are nearly as precarious as in 2015. While today’s valuations look slightly better relative to 2015 and the Tech Bubble the data shows that 73% of firms are still trading above 10x P/S.

The dark blue bars in Fig. 10 show the forward returns for the entire Biotech sector in periods when greater than 70% of the Biotech stocks trade above 10x P/S. The light blue bars in the Figure show how Biotech has done when more moderately valued and less than 70% of the sector is trading above 10x P/S. In periods like today Biotech historically goes on to generate losses. Lastly, the red bars in Fig. 10 show the painful performance since our 2015 paper “Where Are We in the Biotech Cycle?”.

Figure 11 below expands on the analysis in Fig. 10 but shows the 12-, 24- and 36-month performance of just the Biotech firms that are greater than 10x P/S in environments like today. As you can see looking at the dark blue bars, the poor performance is amplified when isolating on this cohort.

Conclusion

In this update we document less extreme yet still potentially hazardous valuations and dollar activity in M&A and IPOs today when compared to 2015. We further observe that while 2018 acquisition valuations have fallen considerably since 2015, this year’s prices are still the third most expensive in our history file. Exacerbating the risk, 2018’s M&A and IPO volume is on pace to reach levels seen in 2015 when looking at total dollars. Lastly, history has shown that when greater than 70% of the sector is trading at 10x P/S or higher the subsequent performance of Biotech as a whole is challenged.

While somewhat less compelling than 2015, the risks plaguing the sector appear to rapidly be re-emerging. Similar to our view in 2015, the benefits that society may receive from Biotech investments made today may not extend to investors who ignore fundamentals and valuations.

Finding Opportunity in Biotech

In doing the work for this piece, Kailash Capital found itself swept down a research path that highlights what we believe are powerful and highly diffuse conclusions within the Biotech sector.

In our forthcoming piece we lay out what we believe is a compelling bull-case for a small subset of firms while re-emphasizing the risks we believe inherent in the vast majority of Biotech constituents. Please see our upcoming Biotech Update Part II which will lay out the roadmap to potential winners and losers.

Appendix: Does Valuation Matter Within Biotech?

We are republishing what we wrote in 2015 in the following paragraphs with slightly updated numbers through September of 2018. As this is a more historical view on valuations in Biotech, the story has not changed.

Our research has shown repeatedly that valuation across the entire stock universe clearly matters in subsequent stock returns. However, does valuation matter within Biotech? There are some valid reasons why valuation may not matter nearly as much within Biotech as it does in other sectors. Biotech stocks often trade based on the future prospects of a Biotech company rather than on recent results, particularly for younger Biotech companies that have minimal revenues because their primary product(s) have not yet gone to market. Figures 10, 11 and 12 show that valuation still matters a great deal within Biotech even if less than outside of Biotech.

When we analyzed how valuation as measured by Price/Sales (P/S) correlated with future stock returns, we saw that valuation still matters in Biotech, but less than it usually matters outside of the Biotech sector. We used P/S for this analysis to have usable data for as large of a sample as possible. Figure 10 shows 1-, 2- and 3-year median forward returns for the universe of stocks excluding Financials and Biotech as compared to the Biotech stocks. These two groups (first and third rows) are comprehensive and include all valuations (cheap and expensive). We also looked at the expensive subset of each group as measured by a P/S ratio greater than 10x.

Figure 10 shows that Biotech’s median forward returns are similar to the returns for the non-Biotech universe. However, Biotech has had almost double the volatility as measured by the standard deviation of returns as compared to non-Biotech. Biotech has been much more expensive than the broader market with Biotech having an average median P/S ratio of 20.5x vs. only 1.4x for the broader market. This table also shows that the return of expensive Biotech stocks with valuations above 10x P/S was roughly half of the returns of the entire Biotech sector, but with similar or greater volatility. Because the full Biotech sector also includes the expensive subset, the performance gap between the expensive vs. cheap Biotech stocks would look even wider. Not only did expensive Biotech underperform the entire Biotech sector, but it also underperformed the broader universe of stocks outside of Biotech and Financials on a median returns basis, which means that expensive Biotech had negative excess returns while still suffering from significantly higher volatility.

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