Biotech Stocks to Watch During This Correction

The Life Sciences Report |

While waiting for biotech stocks to correct, investors should be focused on performing due diligence, says Hartaj Singh of investment firm BTIG LLC. Growth in company valuations has outpaced sales for several years, but the coming weeks will see rapid fluctuations as the two begin to realign. In this interview, Singh shares his predictions for the rest of 2015 with The Life Sciences Report, and identifies several companies to hold for potentially big returns.

The Life Sciences Report: The IPO window has been open for a couple of years now. Venture capital is flowing, and stocks have hit record highs. The NASDAQ Biotech Index (NBI) had a return of more than 500% over 6.5 years, versus the S&P 500's return of about 180%. With all that good news, why do you think the first half of 2015 was rocky for biotech stocks?

Hartaj Singh: Let's put those gains in context. Since 2009, market valuations for the approximately 140 companies on the NBI are up more than 500%. Sales by those companies, however, are only up about 300%.

I say that biotech has had a rough first half of the year because, for the first time in almost three years, large bellwether companies are starting to miss their sales and earnings forecasts. Expectations have become too high.

For example, in the first quarter of 2015, of the four large caps, Biogen Inc. (BIIB) and Celgene Corp. (CELG) missed their projected bottom lines. In the second quarter, Biogen again missed and lowered its guidance for the year. Celgene barely beat expectations. Some could argue that even though Gilead Sciences Inc. (GILD) exceeded expectations for the second quarter of 2015 by about $600 million ($600M), that growth wasn't based on its fundamentals. Instead, expectations for its hepatitis C product, Sovaldi (sofosbuvir), were low. Sovaldi, essentially, will be a niche product. The combination drug, Harvoni (ledipasvir/sofosbuvir) is the growth product.

Looking at the market since 2001—the last time biotech stocks had a massive downward move—the rate of growth in market capitalization of the aggregate NBI underperformed sales growth until about 2006–2007. Sales continued increasing, and companies like Amgen Inc. (AMGN), Genentech (now a unit of Roche Holding AG (RHHBY)) and Gilead Sciences were maturing.

In 2006–2007, however, the market cap began growing faster than sales. The figures crossed in about 2009 and normalized. Then, by 2012, valuations caught up with the very large increase in sales. Since 2013, the increase in valuation for biotech companies has actually surpassed the increase in sales and earnings.

This explains why the biotech sector has been growing so strongly. Its growth isn't just because pipelines have improved and the FDA has become more flexible—it is approving 10–15% more products per year. There also has been a fundamental change in the sales and earnings power of the entire industry.

The pharmaceutical and software industries went through this in the 1980s, and then the growth rates declined. This happened with the Internet industry in the mid-1990s, too. At BTIG, we believe the biotech industry is going through a once-in-a-generation change in its sales and earnings power, which explains this massive move in valuations.

The NBI was up 55–60% in 2013, more than 40% in 2014, and 20–23% year-to-date. With such consistent growth, we see momentum plays. The sector won't turn on a dime. Instead, small changes to sentiment will slowly erode the momentum.

In April 2015, when Q1/15 results were reported, the large cap companies underperformed the small caps. Performance was down that quarter by 6–7% because the large-cap companies didn't meet expectations. Then the sector rebounded.

Q2/15 results also were down because stocks underperformed. People began to realize that the heyday of massive sales growth that resulted in 300% increases between 2009 and 2015 were slowing.

The industry is breaking even now. Once that happens, operating expenses will stabilize, and earnings will go through the same hockey stick increase that sales have experienced. That probably will happen in the next three years.

Still, while the biotech sector has had a rough ride relative to the performance in 2013 and 2014, it is up 20–25%.

TLSR: What do you predict for the remainder of the year, and why?

HS: We saw an inflection point in large-cap biotech sales and earnings in the first half of 2015. In 2014, sales and earnings of the seven large-cap biotech companies in the S&P 500 increased at four times the average from 2010–2013. Growth is hard to maintain when measured against such high baselines. Therefore, sales growth is flattening.

That said, expectations have come down 10–20% from the beginning of 2015. We think the third and fourth quarters of 2015 will be much more amenable, enabling biotech companies to beat guidance.

TLSR: What other factors are affecting the biotech sector?

HS: Industry-wide movements also change expectations for individual companies because so many more investors are now generalists. In fact, in the last three years, about 50% of the money that's come into the sector has come from the generalist community as opposed to the specialist community. Generalists are driving a lot of changes now in how stocks move.

TLSR: How do you think the potential Chinese recession will affect U.S. biotech stocks?

HS: The U.S. dollar is facing some currency headwinds that may affect the industry, but I don't believe the Chinese devaluation of the yuan will impact the U.S. biotech sector unless the situation escalates and the entire U.S. economy is affected.

Any impacts will most likely be marginal, triggered by investors with exposure to China who may pull some money from their biotech portfolios—if those stocks performed well for them during the last two years.

TLSR: How do biotech stocks relate to the national economy?

HS: Biotech stocks have a low correlation to the overall economy, and have high volatility. Biotech stocks, like Internet stocks, tend to underperform all other sectors when the economy is very volatile, like it has been recently. To put this in perspective, if the S&P is down 3–4% on a given day, biotech will be down 10–12% that same day.

TLSR: Would you say we're in a biotech bubble?

HS: I think we're in a short-term bubble, but not a biotech bubble.

During the past two to three years, valuations have outstripped fundamentals. We're due for a short-term correction. That correction will flush out some of the investors who think the biotech sector just keeps gaining value. Once valuations decrease 10% to perhaps 25%, the sector will be more in line with sales and earnings expectations. At that point, 20–40% growth will be doable for two to three years.

TLSR: Are any particular therapeutic areas or technologies most likely to spark excitement among biotech investors in the remainder of 2015?

HS: There's been a lot of talk about chimeric antigen receptor (CAR) T cells, various gene therapy approaches, and immuno-oncology. These approaches, however, are at the "science experiment" phase. Companies are conducting Phase 1 and Phase 2 clinical trials. This stage has the highest risks and rewards, because the science is very new, and because early-stage trials tend to fail more often.

Today's investors, more often, are looking for companies with new therapeutics in well-validated areas that might be better than the standard of care, and are in Phase 2 or Phase 3 development.

In terms of therapeutic areas, infectious diseases are interesting. They're not very sexy, but there's been a lot of development in that area because the U.S. government has been granting patent extensions to various therapeutic entities, as well as "orphan" or fast track" designations that benefit companies economically.

I think there will be a lot of merger and acquisition (M&A) activity during the next three years in the infectious disease space. Larger companies are watching small- to mid-cap companies that have differentiated products in Phase 2 and Phase 3 development. I believe they will snap them up very quickly. Merck & Co. Inc.'s (MRK) acquisition of Cubist Pharmaceuticals Inc. was the first move we saw. Other companies are working to target hospital-associated infectious diseases.

Another interesting area in the clinical space is hepatitis B treatment. We're going to see products commercialized that have real clinical ability and reduced risk. Although hepatitis B therapeutics are in early-stage clinical trials and less investable short term, there are a lot of interesting, longer-term, niche approaches. Many of the larger-cap companies still have interesting technologies. Within the next two years we will see a lot of M&A activity as late-stage data is released.

Companies developing treatments for nonalcoholic steatohepatitis (NASH)—a major disease that makes the liver fatty—will be very controversial. The causes of NASH aren't well understood. The field is huge, and companies will be interested. It has great potential, but it will be hard to pick winners because it will be difficult to get robust mid- to late-stage clinical trial data for the next one to three years.

Intercept Pharmaceuticals Inc. (ICPT) has a big play on NASH. Its stock price jumped from $50/share to $300/share in January 2014, bounced around a bit and now is at $189/share.

TLSR: What other companies should investors watch through the end of the year?

HS: Large caps and small caps are two different beasts. Because of the amount of generalist money that has come into the sector in the past two-and-a-half to three years, bigger companies like Amgen, Gilead and Biogen have a lot of upside already impounded in their share prices. I'm not saying those companies will see declines, but on a relative basis, they might underperform the peer group.

Celgene, in contrast, is still a very well-run company that has great growth ahead of it. Among these four large-cap companies, I think Celgene currently has the most upside potential because it seems likely to win its Revlimid (lenalidomide) patent litigation. I expect the stock to do phenomenally well next year relative to its peer group. Among the large caps, I think Celgene is the most interesting.

Among the smaller-cap companies, Celsion Corp. (CLSN) is a very interesting company. It has a market cap of only about $46M, but its range of clinical trials exceeds that of companies with comparable capitalization.

It's rare you meet a value play in biotech that has a good management team that says what it will do and then does it, putting forward science that is exceptionally well validated in peer-reviewed literature. The Celsion team does that.

Celsion probably will publish results in a leading peer-reviewed journal analyzing the result of new, follow-up trials of one of its drugs that failed in Phase 3, ThermoDox (liposome-encapsulated doxorubicin). If any of those trials succeeds, Celsion could easily gain a market cap of $1 billion ($1B). That's probably two-and-a-half years in the future, and there's still a long way to go. Based on the range and breadth of its programs, Celsion currently should have a market cap in the hundreds of millions of dollars.

TLSR: Are there other small-cap companies investors should watch?

HS: There are several. Paratek Pharmaceuticals Inc. (PRTK) is an antibiotic company with one compound, omadacycline, in two large Phase 3 trials for skin infections and pneumonia. Readouts of those trials are expected by the end of 2016.

Preliminary data for this compound in both therapeutic areas may be slightly better than the standard of care, Zyvox (linezolid; Pfizer Inc. [PFE]). If the Phase 3 trials work as well as Phase 2 trials, I believe this company's market cap of about $453M could increase.

Cidara Therapeutics Inc. (CDTX), another infectious disease company, is at a much earlier stage. Its management is, literally, the dream team of antifungal development. From the CEO all the way down to the product development people, this team has developed all the major drugs in the antifungal space over the last five to 10 years, notably caspofungin and anidulafungin. They invented and developed those compounds at Merck and other companies, and now are all working at Cidara.

Biafungin (a novel echinocandin) is the company's lead compound. That best-in class therapy alone is worth the current stock price of about $14/share.

But Cidara also has a blue-sky technology platform called Cloudbreak. Essentially, Cloudbreak uses the theory behind antibody drug conjugates (attaching a targeting molecule to a payload molecule) to target invasive fungal infections that are so intractable they can't even be removed surgically. Mortality rates for these infections are very high, so if Cloudbreak works, it will be phenomenal.

Finally, EPIRUS Biopharmaceuticals Inc. (EPRS), which is focused on biosimilars, should be on investors' radar screens for long-term investment. Its CEO headed some of Amgen's early biosimilar work.

Today's biosimilar environment is like the generics environment in the 1980s, when nobody believed the generics companies in the U.S., Israel and India would be able to compete with the branded companies. I believe the coming biosimilar wave will have the same magnitude as the generics wave of the '80s. Estimates of the likely biosimilars market range from $30–80B, depending on whom you ask and how it's computed.

Investors need exposure to pure-play biosimilar companies like EPIRUS. EPIRUS has a market cap of $138M. If it achieves a revenue run rate of even $500M, the company will do very, very well. This is peanuts compared to what Amgen, Pfizer, Samsung Bioepis Co. Ltd. or even Biogen need to make their biosimilar franchises profitable.

Investors willing to hold EPIRUS for five years could see five- to tenfold returns. This won't happen in the next year or two. Biosimilars have a five-year horizon. EPIRUS is definitely a long-term play, but it has the management team and development in place to generate a significant return.

TLSR: How does EPIRUS' recent acquisition of Bioceros Holding BV (private) strengthen the company?

HS: The acquisition adds three new products to the EPIRUS pipeline. Bioceros' portfolio of biosimilar products is focused on immunology, so it doesn't need a diverse sales force or medical science liaisons. It has a biosimilar for Remicade (infliximab), Humira (adalimumab)‎‎ and Actemra (tocilizumab), treating severe arthritis and related diseases.

Its only biosimilar outside immunology is for Soliris (eculizumab; Alexion Pharmaceuticals Inc. [ALXN]), which treats paroxysmal nocturnal hemoglobinuria.

The EPIRUS CEO has said the company will explore biosimilars in rare diseases, but will maintain a tight focus to avoid spreading its resources too thinly.

In acquiring Bioceros, EPIRUS also acquired the ability to conduct preclinical and early-stage pharmacokinetic/pharmacodynamics studies in-house. These studies show whether a biosimilar is equivalent to its reference product. Equivalence is, essentially, what the FDA and European Medicines Agency (EMA) expect to see with biosimilars.

TLSR: Is there another company you find interesting?

HS: Sunesis Pharmaceuticals Inc. (SNSS) is in the acute myelogenous leukemia (AML) space. We're the only shop on Wall Street with a Buy on it. The company had very good data in its pivotal Phase 3 trial, the largest trial ever run in AML, but the compound, vosaroxin, missed its primary endpoint by a hair's breadth.

Unstratified analysis showed no significant difference in overall survival, but stratified analysis showed significant prolonged survival among patients over age 60 who were treated with vosaroxin. There are few primary therapeutic options for AML patients age 60 and above, and approximately 80% don't quality for second-line therapies like stem cell transplants because they aren't healthy enough.

Using stratified analysis for the endpoint probably would have propelled the company to a $1B market cap right now. As it was, the FDA gave it negative guidance based on unstratified analysis. The share price fell from about $3.50 to $1.

We think there's a 60% chance the EMA will approve vosaroxin, however. Historically, the EMA has been much more flexible than the FDA in terms missed endpoints for drugs addressing high unmet need. I think Sunesis is getting ready to file a new drug application (NDA) with the EMA. At that point, historical data suggests an 85% probability of success for oncology programs.

Therefore, at about $1.11/share, Sunesis is significantly undervalued. Given the visibility into the EMA drug approval process (which gives feedback at 90, 120, 150 and 180 days, and a determination at 210 days), the share price should be at least $3–4. That's based on our assumption of $200–250M in peak, non-U.S. sales five years after approval.

TLSR: If you had one message for biotech investors this year, what would that be?

HS: Hold your powder for the next four to eight weeks, and use the time to perform due diligence. The stock market will still be volatile, so stock picking will be much more important in the next 12 to 24 months. We can no longer assume the entire sector will continue increasing 30–40% every year.

TLSR: Thank you very much.

Hartaj Singh is the director/biotechnology analyst, for the investment firm BTIG LLC. He focuses on the U.S. biotech sector, including companies that formerly were American. Before joining BTIG, he was a portfolio manager for Tecumseh Partners. As a senior project analyst at Visium Asset Management, he took advantage of fundamental discontinuities in Wall Street's perception of healthcare companies to return value to investors. Earlier, at Lehman Brothers, he was instrumental in the relaunch of the company's mid- and large-cap coverage. His tenure at Navigant Consulting enabled him to conduct hundreds of interviews with company executives and physicians, enhancing his understanding of their specific challenges. Early in his career, he was a strategic analyst for Johnson & Johnson, focusing on its global central nervous system/psychiatry franchise. While at ClinTrials Research, he coordinated clinical management for an anti-epileptic new drug application (NDA), and was the youngest clinical project manager to lead an NDA filing.

Source: Gail Dutton of The Life Sciences Report

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1) Gail Dutton conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report and The Life Sciences Report, and provides services to Streetwise Reports as an independent contractor. She owns, or her family owns, shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of Streetwise Reports: Sunesis Pharmaceuticals Inc. The companies mentioned in this interview were not involved in any aspect of the interview preparation or post-interview editing so the expert could speak independently about the sector. Streetwise Reports does not accept stock in exchange for its services.
3) Hartaj Singh: I own, or my family owns, shares of the following companies mentioned in this interview: None. I personally am, or my family is, paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: Paratek Pharmaceuticals Inc., Cidara Therapeutics, EPIRUS Biopharmaceuticals Inc. Further disclosures from BTIG can be read here. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I determined and had final say over which companies would be included in the interview based on my research, understanding of the sector and interview theme. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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Symbol Name Price Change % Volume
ALXN Alexion Pharmaceuticals Inc. 120.26 -2.21 -1.80 1,111,304
AMGN Amgen Inc. 158.51 -2.99 -1.85 3,540,978
BIIB Biogen Inc. 290.65 -9.01 -3.01 1,567,526
CDTX Cidara Therapeutics Inc. 10.08 0.15 1.51 150,585
CELG Celgene Corporation 98.91 -1.11 -1.11 4,660,808
CLSN Celsion Corporation 1.16 0.01 0.87 32,743
EPRS EPIRUS Biopharmaceuticals Inc. n/a n/a n/a 0
ICPT Intercept Pharmaceuticals Inc. 137.41 -0.44 -0.32 303,867
MRK Merck & Company Inc. (new) 61.20 -0.72 -1.16 7,406,681
PFE Pfizer Inc. 32.18 -0.36 -1.11 18,834,961
PRTK Paratek Pharmaceuticals Inc. 12.05 -0.25 -2.03 96,322
SNSS Sunesis Pharmaceuticals Inc. 4.04 -0.07 -1.70 12,533


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