IBB: Significantly Overbought - Sharp Declines Imminent
There has been a lot of speculation on the true value of the IBB. We’ve seen the ETF trade range bound, moving between 240 and 280 three times. The typical chatter on social and alternate media is that the correction is going to be short lived. That the downturn presents a good opportunity to double down on shares on cheaper valuations. So, I decided to do a deep dive on the industry and its current state – paying close attention to fundamentals. Based on what I found, I valued the NBI and by proxy the IBB. I also looked ahead to what to expect over the next few years and how to best be positioned to generate out sized returns. Write your post...
IBB: SIGNIFICANTLY OVERBOUGHT
–
SHARP DECLINES IMMINENT
Poonam A. Arora
parora@seamistcap.com
There has been a lot of speculation on the true value of the IBB. We’ve seen the ETF trade range
bound, moving between 240 and 280 three times. The typical chatter on social and
alternate
media is that the correction is going to be short lived. That the downturn presents a good
opportunity to double down on shares on cheaper valuations. So, I decided to do a deep dive on
the industry and its current state
–
paying close attention
to fundamentals. Based on what I
found, I valued the NBI and by proxy the IBB. I also looked ahead to what to expect over the next
few years and how to bes
t be positioned to generate out
sized returns.
About the Author:
Poonam is an investment analy
st and co
-
portfolio manager for Seamist Capital. She has more
than 10 years of experience in equity research, having followed the biotechnology,
pharmaceuticals, and medical technology sectors at the Stanford Group in Boston, and at Roth
Capital Partners,
Madison Williams, WR Hambrecht, and the Maxim Group in New York. During
her tenure on the sell
-
side, she covered small
-
cap and large
-
cap healthcare companies based
both in the United States and Europe.
Poonam has served as stock advisor to sell
-
side analy
sts associated with Canaccord Genuity,
Think Equity, Global Hunter Securities, and WBB Securities and buy
-
side analysts at hedge funds
that will remain anonymous due to confidentiality agreements. She has significant experience in
stock picking and trading
in healthcare companies both as an analyst and individual investor.
Her claim to fame is her persistently accurate analysis of Puma Biotechnology, a stock she has a
sell rating on since March 2014. She subsequently published 6 more sell rating articles o
n the
stock even when shares were trading at roughly $280, and sell
-
side analysts had Price Targets of
over $300/share. The company reached a bottom of ~$20/share and is now trading at
~$50/share. The analysis among others can be read on Seeking Alpha.
Po
onam earned a masters in finance from Hofstra University in New York and a bachelors in
business administration from Northern Arizona University in Flagstaff. In addition, she has
earned credits in biotechnology and pharmaceutical related content from seve
ral Ivy League
universities. Poonam has passed the Series 7, 63, 86, and 87 but is not currently registered. She
publishes her views on healthcare stocks on Seeking Alpha. Poonam has been ranked as 22nd of
over 4,100 financial bloggers by TipRanks for 2014
.
All content in this report is under
Copyright
of
Seamist Capital 2016
Page
1
TABLE OF CONTENTS
Investment Thesis
2
How Has the NBI Perform
ed Historically?
4
When and What
Popped the Biotech Bubble?
5
How Has the Biotech Industry Performed Over the Years?
6
What Really Drove the Outsized Valuations of the Emerging Therapeutics Group?
12
What Is the True Value of
the NBI and the IBB?
14
What Lies Ahead for the Sector?
16
How to be Best Positioned to Benefit?
17
Bottom Line
1
8
parora@seamistcap.com
Page
2
IBB: Significan
tly
Overb
ought
–
Sharp Decline
s
Imminent
Investment Thesis
All does not appear right
with the biotech industry. The rhetoric is that of strong fundamentals and a robust innovation cycle.
However,
the reality is a lot different. Net income
in the sector is driv
en by
less than 10%
of companies. The rest of the firms are
loss making
and most will never return a profit.
Similarly
, major revenues are
generated by
an insignificant number of firms.
In
regards to innovation, despite record in
fusions
of i
nnovation capit
al, the rates of
approvals and filings fo
r new molecular entities
are nowhere near historic highs and stem mostly from large biotech. Everyone has heard about the exponential increase in the
number of biotech
initial public offerings
but few are aware that
there has been no commiserate
upturn
in the number of
investigatio
nal new drug
applications
and in mergers and acquisitions
in the emerging therapeutics
space (roughly 90% of the
industry)
. Overall
,
pipeline productivity has decreased while the inflation
adjusted cost of drug development has increased. The
exponential growth in the market cap
italization of the Nasdaq Biotech I
ndex (NBI)
from 2012 to 2015
was more a fun
ction of
over valuation of initial public offerings
and fol
low
-
on public offerings
by inv
estment bankers and sell
-
side analysts than driven
by any material
financial
performance of
most of
the index’s constituents.
Based on the posturing displayed
by stakeholders, it
was easy to forget that this was not wealth created by biotech
,
but instead m
oney invested
,
that belonged not only to the estates
of wealthy Amer
icans, but also was part of pension plans
of ordinary citizens.
Moreover, given the high fives over peak capital
inflows into the industry, it appears that generating funding not profits i
s the predominant objective of the stakeholders. Overall,
t
he picture
emerging
is not that of a mature industry
,
but one that is floundering
–
overrun by carpetbaggers and wrecked by
majority loss leader companies that are guzzling capital with little retu
rn and are busy offsetting much of the succe
ss achieved
by a minority few.
Considering
the data surrounding the key drivers of the industry, there appears
a clear dichotomy
forming between the givers
(
NBI
top 10 + few more
) and
the takers
(the rest of the
industry)
.
The first group are the performers and the later the laggards.
Therefore,
to
accurately estimate
the current
market capitalization of the NBI,
it makes sense to value the two groups separately.
In regards
to the
valuation of the
NBI
top 10 holdings, based on 2017 consensus earnings estimates and forward price/earnings
(P/E) ratios, I rea
ch a
market capitalization of ~$483 b
illion
.
Given, how the performance
attributed to
most of the group outside
of the
NBI top 10 has only
worsened
o
ver
time, it is reasonable to then assess
this group on the basis of
its valuation in the NBI
in 2006. On those terms,
I arrive at a market capitalization of
~$139 b
illion
for the group. Consolidating the
two
market
cap
italizations, and identifying the pri
ce
when
the NBI was trading at roughly the same market cap
italization, I estimate a value
of ~$1878
for the NBI and
~$179 for the
i
Shares Nasdaq Biotechnology (
IBB
) ETF by proxy
.
These prices are based on
fundamentals. Considering technical trends, the
val
ues
contract significant
ly
.
Looking ahead over the next few years, the industry is likely to mirror its own performance in the aftermath of the genomic
bubble. Although venture capital funding which reached record levels in 2015 remains relatively strong
this year, moving
forward, I expect weakness as sponsors react to indications that there might be potentially fewer opportunities to monetize
their investments in a
n expected
challenging IPO market.
The dawning reality among non
-
specialist investors that b
iotech is
extremely high risk if not highest risk combined with the risk
-
off mood of sector specialists will reflect in only companies with
innovative technology or
later stage assets with superior data being able to go public. Some might point to the low
interest rate
environment as a stimulus for biotech investing, but leveraging highly risky investments is a double edged sword, which
sophisticated investors are
probably familiar with. Overall,
there is likely to occur a considerable downturn
in the
fund
ing
climate
(particularly due to the tightening of crossover money),
leading to attrition in the market capitalization of the sector as
companies lose value
due to clinical trials and drug
failures but front
-
running these losses is not possible
due to an e
rosion in
the numbers and values of
initial public offerings
and
secondaries
.
Until the time
company valuations are properly risk adjusted,
drug development costs reined in, and drug pricing concerns dealt with,
serious investors are likely to remain disin
terested.
In
regards to the NBI,
I anticipate the twin catalysts of continued selling
due to
risk perception and inability of stakeholders to front
run the losses through
overvalued
initial public offerings and secondaries to persist and further depress th
e index.
Therefore, over the next couple of years,
shorting the IBB and investing in the
ProShares UltraShort Nasdaq Biotech
(BIS) ETF as
well as
undervalued
commercial companies that offer substantial potential growth
appears strategic. Over
all, in a
sector wherein
less than 10
% of drugs undergoing clinical trials ever
secure regulatory consent
, it makes
little sense to invest
in individual non
-
commercial
companies,
unless you are a sector specialist
who has a grasp on the science and the clinical/regu
latory environment
associated with drug development. Given that greater than 90% of investigated drugs fail to get approved, a
ttempting to identify
parora@seamistcap.com
Page
3
potential drug
successes and companies linked to them
is like trying to find a needle in a haystack.
Counting on the opinions of
sell
-
side analysts is futile as they’ve historically almost always been unsuccessful in predicting drug development and regulatory
failures.
T
herefore, a lower risk trade in biotech is not to invest in multiple high risk
clinical
stage enterprises but instead to buy
shares of newly commercial
companies on their journey upwards.
Recollect that Regeneron (REGN) did not turn into an eleven
digit co
mpany overnight. Even after Eyelea’s outstanding success, the stock traded below $100 for some time.
RISKS
Ignoring the long
-
term time horizon associated with the investments. The price objective linked to the IBB might take multiple
years to be achieved.
parora@seamistcap.com
Page
4
How Has the NBI Performed Historically?
The NBI is a Poster Child for Boom Bust Cycles.
Between
Octo
ber 2011 and July 2015, the market value of the Nasdaq Biotech
Index (NBI) appreciated
dramatically going from a lowly
~1152 to a record breaking ~4166 representing a gain of ~261%.
Comparatively, the genomic era NBI did slightly better registering an abso
lute return of ~313% before falling 75% to the bottom.
Following that period, from July 2002 to October 2011, a period of 9 years, the value of the NBI increased by a paltry 748 po
ints.
Nasdaq B
i
otech
I
ndex
(NBI)
Market Value (1993
-
Present)
Source: Yaho
o F
i
nance; Seam
i
st Cap
ital Presentation June 2016
(Updated in July)
;
Since July 2015, the value of the NBI has declined. After falling ~39% to a low of ~2572 from a high of ~4166, the inde
x has
recovered somewhat and
for the most part
trades range bound be
tween ~2500 and ~3000.
parora@seamistcap.com
Page
5
When and What Popped the Biotech Bubble?
Descent
Began
Ahead of Hillary
Clinton’s
Tweet.
Many lay the blame
for the flight of capital and
downtrend
in the
NBI
on Hillary
Clinton’s tweet on drug pricing. However, the contention is inaccurate. The descent in biotech started much before that. Hill
ary
Clinton’s tweet just added an additional conc
ern, broke the camel’s back, and dramatically accelerated the process.
The NBI Reached a
Trillion Dollars in July Before Starting
Its Descent o
n August 6, Much Ahead of
Hillary Clinton’s
Tweet on September 21
Source: Nasdaq Biotech Index (NBI) Database;
Seamist Capital Presentation June 2016;
The sell
-
off was driven more by a dawning among non
-
specialist investors on the reality of biotech investing. A reality that
most of their biotech investments are likely to result in negative returns
.
Hillary
Clinton’s Tweet o
n Drug Pricing Dated Sept 21, 2015
Source: Tw
i
tter
;
Seam
i
st Cap
ital Presentation June 2016;
The response from industry stakeholders has been that the pullback in biotech is directly correlated to typical presidential
election c
ycle politics about drug pricing. They argue that industry fundamentals are strong, the innovation cycle robust, and the
correction temporary. However, analysis of key data surrounding the major drivers of the industry unfolds a different story.
parora@seamistcap.com
Page
6
How Has the Biotech Industry Performed Over the Years?
I evaluated financial data from the entire industry, the NBI top 10 holdings, the commercial leaders, the emerging therapeuti
cs
firms (~90% of the sector), and the rest of the industry (comprising companies aside from the top 10 holdings in the NBI and
the
commercial leaders). Overall, the investigation revealed that an extremely small minority of firms in the industry accounted
for
most of the revenues and net income while the rest of the industry was unprofitable.
Few Companies Drive
Earnings.
Based on operational results of companies that comprised the top 10 holdings of the NBI from
2006 to 2015, Amgen (AMGN), Teva (TEVA), and Gilead (GILD)
generated
a majority of the industry’s net income and offset its
significant losses. Even amo
ngst the group, AMGN, TEVA, and GILD were major contributors while the performance of the rest
was marginal for the most part.
Without the earnings power of AMGN, TEVA, or GILD, the sector would have been unprofitable
for a significant portion of the evalu
ated years as presented below.
NBI Top 10 Holdings Net Income (2006
-
2015)
Source: Data from Thomson Analytics and IBB Prospectus; Seamist Capital Presentation
June 2016
;
Roughly 90% of t
he I
ndustry Generating
Losses.
From 2006 to 2015, almost all of the NBI top 10 holdings were profitable
(sometimes accounting for earnings that were 2x and 3x that of the industry). During the same period, almost all of the rest
of
the industry were net losers, with the losses accelera
ting from $6.6 billion in 2009
to $16.4 billion in 2015. The earnings power
of NBI top 10 holdings offset industry losses for numerous years as shown below.
Net Income Statistics (2006
-
2015)
Source: Data from Thomson Analytics
, E&Y: Beyond Borders,
and I
BB Prospectus; Seamist Capital Presentation
June 2016
;
parora@seamistcap.com
Page
7
Limited Number of Revenue Generating Firms
.
A similar story emerges in regards to revenues, where a significant fraction of
sector revenues were generated by a combination of AMGN + TEVA or AMGN + GILD across the investigation period. If revenues
attributed to these firms were overlooked, industry
revenues would be roughly half of that reported for several of the assessed
periods as illustrated below.
NBI Top 10 Holdings
Net Revenues
(2006
-
2015)
Source: Data from Thomson Analytics and IBB Prospectus; Seamist Capital Presentation
June 2016
;
Rest of
I
ndustry Revenues as % of
Overall I
ndustry Revenues
Decelerating
Over
Time
.
Considering data from 2006 to 2015, the
NBI top 10 holdings and commercial leaders continued to generate a majority of the industry revenues while revenues
for the
rest of the industry group as % of industry revenues declined over time as shown below.
Net
Revenue
Statistics (2006
-
2015)
Source: Data from Thomson Analytics
, E&Y: Beyond Borders,
and IBB Prospectus; Seamist Capital Presentation
June 2016
;
Growth Derived Predominantly f
rom NBI Top 10/Commercial Leaders.
To encapsulate, between 2006 and 2015, net earnings
for the NBI top 10 holdings grew by 1053%.
From 2009,
net loss for almost all of the rest of the industry group grew b
y 148%.
Revenues betw
een 2006/2009
and 2015 expanded 156% and 22% for the former and later groups as presented below.
Growth Outcomes: NBI Top 10 Holdings vs. Almost All of the Rest of the Industry
Source: Data from Thomson Analytics
& E&Y: Beyond Borders
; Seamist Capital Pr
esentation
June 201
6;
parora@seamistcap.com
Page
8
Drug Development Success Rates A
re Highly Inadequate.
The disappointing financial performance of the rest of the industry
group is not surprising a
s few drugs ever get approved.
Based on a May, 2016 report by the
Biotechnology Innovation
Organization
(BIO) and Biomedtracker, less than 10% of drugs from the Phase 1 stage secure regulatory approval. The approval
rates are even
more dismal for cancer drugs, of which only roughly 5 out of every 100 that undergo clinical investigation ever
receive regulatory consent.
Phase Trans
ition Success Rates a
nd Likelihood
of Approval from Phase 1 for All Diseases and Modalities
Source: Clinical Development Success Rates (2006
-
2015)
–
Biotechnology
I
nnovation
Organiz
a
t
ion (BIO) + Bi
om
edtracker
Report
May
2016;
The probability that a Phase 1 drug will get approved is 9.6%, a Phase 2 drug 15.2%, a Phase 3 drug 49.6%
, and one that has been
filed for regulatory approval 85.3%.
Overall Probab
i
l
it
y of Regulatory Approval
b
y Phase
for All Diseases and Modalities
Source: Data from Clinical Development Success Rates (2006
-
2015)
–
Biotechnology
I
nnovation
Organ
iza
t
ion
(BIO) +
Biomedtracker Report May 2016; Seamist Capital Presentation
June
2016;
Likelihood of Approval from Phase 1 by Disease Condition
Source: Clinical Development Success Rates (2006
-
2015)
–
Biotechnology
I
nnovation
Organiz
a
t
ion (BIO) + Bi
om
edtracker
Report
May
2016;
Seamist Capital Presentation
June
2016;
parora@seamistcap.com
Page
9
Rates of NME Applications for Approval Far from Record Highs.
In regards to th
e robust innovation cycle argument, innovation
when measured in terms of the number of applications filed for new molecular entity (NME) approvals and the actual approvals
falls short. Both elements are far from their historic highs. Although there appears
a modest increase in the approval rate, there
doesn’t appear a similar upturn in the number of applications filed for regulatory consent.
New Molecular Entity
NDAs/BLAs Filings for Approval and
Actual Approvals (1993 to 2015)
Source: CDER New Drug
Review: 2015 Update, FDA/CMS Summit, December 14, 2015;
In the FDA’s own words “
CDER approved a higher than average number of novel drugs in 2015; however, the number of
applications for these drugs that sponsors have submitted over time ha
s remained stable
.” In 2015, CDER approved 45 NDAs/BLAs
for NMEs, which
indicates that the agency is
turning constructive. However, the industry filed 41 NME applications for approval
in 2015, which is considerably below the historic high of 50, and consis
tent with the average. Based on historic data, NME filings
as % of NDA/BLA filings appears inadequate, coming in at 29.3% in 2015 against the high of 41.3% observed in 1995 as shown
below. Moreover, a majority of NMEs approved were from major companies not
emerging companies.
NME Filings as % of NDA/BLA Filings (1994
-
2015)
Source: FDA Databases; Seamist Capital Presentation June 2016;
Downturn in NDA/BLA Approvals.
Overall, in 2015, NDA/BLA approvals declined by 10% over the previous year with only 107
dr
ugs out of the 140 applications filed securing regulatory consent. The endorsements represented just 76% of NDAs/BLAs filed,
far from the 2014 figure of 98%, and the high of 109%, as presented below.
parora@seamistcap.com
Page
10
NDA/BLA Approvals as % of NDA/BLA Applications for Approval
(1994
-
2015)
Source: FDA Databases; Seamist Capital Presentation June 2016;
Unconvincing
Growth
in Number of
IND
Applications
.
If one considers that typically an upturn in number of drugs investigated
leads to more filings for approval, then it is important to note that the rate of investigational new drug (IND) applications
filed
over the re
cent years has experienced a modest increase that is grossly inadequate with the record inflows of capital into the
emerging therapeutics space and substantial
acceleration
in the number of enterprises in the
industry
. The number of public
compani
es in the
industry grew 38% over 2012 to 2015 whereas the number of IND
applicati
ons filed expanded by barely 11%
over the same period.
Growth Rates of IND
Applicati
ons
a
nd Public Companies in the Industry
(2004
-
2015)
Source: FDA Databases and E&Y: Beyond Borders
;
Seamist Capital Presentation June 2016;
Emerging Therapeutics:
IPO Statistics for R&
D a
nd Market Stage Companies
(2006
-
2015)
Source: BIO
–
Emerging Therapeutic Company I
nvestment and Deal Trends; Seamist Capital Presentation June 2016;
Emerging Therap
eutics: FOPO Statistics for R&D a
nd Market Stage Companies
(2006
-
2015)
Source: BIO
–
Emerging Therapeutic Company I
nvestment and Deal Trends; Seamist Capital Presentation June 2016;
M&A
Not Picking Up in
Emerging Therapeutics.
On mergers and acquisitions (M&A), a vital element of the biotech business
model, the story does not get much better. Despite the surge in the number of public companies in the sector, the emerging
therapeutics segments has not experienced a similar advan
ce in mergers and acquisition activity as illustrated below. The 44
M&A deals inked
i
n 2015 fall short compared to the 51 in 2008 and 49 in 2013
.
parora@seamistcap.com
Page
11
Emerging
Therapeutics: Mergers and Acquisitions Activity (2006
-
2015)
Source:
Data from
BIO
–
Emerging Therapeutic Company I
nvestment and Deal Trends; Seamist Capital Presentation June 2016;
Pipeline Productivity Decreased While Cost of Drug De
velopment Increased.
Moreover, pipeline
productivity
defined as
the
rate at wh
ich firms convert R&D spending into approved drugs is declining. On an inflation adjusted basis, it’s significantly more
expensive to generate pipeline returns in form of an appr
oved drug today than over the past decades. It now takes $2.56 billion
to develop a drug to approval. The increase in spending is attributed to resource misallocation and higher failure rates for
drugs
tested in humans.
Average Cost to Develop and Market a
New Drug Now $2.56
Bill
i
on
Source: Tufts Center for the Study of Drug Development
;
Seamist Capital Presentation June 2016;
All in all, although
the financial performance of most of the NBI top 10 holdings/commercial leaders appears strong, the state of
the industry is far from outstanding. In particular, the emerging therapeutics group (includes most of the NBI companies asid
e
from the top 10) are not only posting increasing losses, they’re also unable to convert the record inflows of capital into a
comm
iserate surge in numbers of: IND applications, M&A deals, and approved drugs. Clearly, the weak performance of the group
did not drive the 120% growth in its market capitalization in the NBI between 2011 and 2015. So, what really did?
parora@seamistcap.com
Page
12
What Really Drove the Outsized Valuations of the Emerging Therapeutics Group?
Financial Shenanigans Not Financial Performance
.
The over valuation of these companies was driven by a collusion between
private equity/venture capital firms, the investment bankers, and sell
-
side analysts, not by the
accomplishments
of the firms.
The private equity/venture capital firms in a race to realize their internal rate of return on as many investments as possibl
e took
arbitrarily researched companies to the public markets with the help of the investment bankers who attributed
to them
improperly risk adjusted valuations and sell
-
side analysts who inflated revenue estimates to arrive at Price Targets which wildly
misrepresented the true values of these organizations.
How Biotech Companies a
re Typically Valued.
Typically, a biot
echnology company’s Price Target is derived from the sum of the
net present values of its key drugs and the cash balance. The value is secured by projecting revenues associated with the age
nts,
applying the appropriate probabilities of regulatory approval
statistics (10% for P1
, 15% for P2, 50% for P3, and 85
% for NDA
stage), multiplying by a revenue multiple, and discounting the output back to the present. The cash balance of the firm is th
en
added to net present value of the key drugs and the total divide
d by the number of outstanding shares to arrive at the Price
Target. An alternate method would be to apply an earnings multiple to an earnings estimate that incorporates risk adjusted
revenues. Yet another method would be to find the net present value of t
he earnings associated with the key drugs by running
a discounted cash flow model usi
ng an appropriate discount rate
.
Analysts Highly Misrep
resented Risk Rates Associated w
ith Drug Development.
As shown below, a majority of sell
-
side analysts
misrepresente
d the probability of approval statistic in their valuations. They utilized 65%, 70%, and sometimes even 80% (instead
of the actual 10% and 15%) as their probability of approval to value Phase 1 and Phase 2 drugs, thereby highly inflating reve
nue
estimates
and the Price Target. Others, completely ignored risk adjusting the projected revenue streams, and simply used the
discount rate in the net present value calculations to account for drug development risk. The discount rates, most of them us
ed
were 7%, 8%,
10%, which grossly underestimate the risk associated with drug development, where less than 10 out of every 100
drugs ever get approved.
Some might contend that expertise license provided ana
lysts the latitude to utilize
inflated probabilities of approval.
However,
evaluating historical results, it is almost impossible to identify any drug development
or regulatory
failure
that
the sell
-
side
accurately foretold. The fact is that historically biotech analysts have been highly constructive on almost all companies
(depending on the potential for investment banking fees) and scramble to readjust when clinical trials fail or drugs ar
e rejected
by regulatory agencies.
Here’s an Example of a
Phase 1/2 Asset
Attributed a
75% Probab
i
l
ity of Regulatory Success. The Trial
Disappointed a
nd Shares Tanked
Source: Thomson One Analytics;
Seamist Capital Presentation June 2016;
parora@seamistcap.com
Page
13
Check t
he 80% Approval Rate f
or AG
-
120 in Phase 1 Trials at the Time. Didn’t Work Out Well and t
he Stock Cratered
Source: Thomson One Analy
tics;
Seamist Capital Presentation June 2016;
Here’s One Which Does Not Risk Adjust Revenues and Deploys a 10.5% Risk Rate for a Phase 1/2 Drug. Data Were
Underwhelming and Shares Suffered
Source: Thomson One Analytics;
Seamist Capital Presentation June
2016;
This
Was a Phase 3 Asset Company with a
Risk Rate of 10%, Revenues Not Risk Adjusted. Study
Failed a
nd
Price/Share Declined
to ~
$5 from
~
$
35
Source: Thomson One Analytics;
Seamist Capital Presentation June 2016;
parora@seamistcap.com
Page
14
What Is the True Value of the NBI and the IBB?
Now that it is established that the emerging therapeutics group was significantly
overvalued
in the market capitalization of the
NBI over the recent years, it is now time to incorporate these findings to determine the true current value of the NBI. Given
the
dichotomy between the high performing top 10 holdings of the NBI and the rest of the comp
anies in the index comprised mostly
of the emerging companies, it makes sense to value the two groups separately to arrive at a consolidated estimate for the NBI
and by proxy the IBB.
Market Capitalization of the NBI Top 10 Holdings.
Incorporating 2017 co
nsensus earnings estimates and forward
price/earnings (P/E) ratios, along with a discount rate of 15%, and outstanding shares, I arrive at a market capitalization o
f
~$483 billion for the NBI top 10 holdings. I have used a 15% discount rate instead of the
typical 8%
-
10% to account for greater
risks associated with drug pricing, worsening macro conditions, and inflated sell
-
side estimates.
Present Estimated Market Capitalization of the NBI Top 10 Holdings
Source: NBI Database; IBB Prospectuses; Inside the NBI;
Seamist Capital Presentation June 2016
(Updated July 25)
;
Market Capitalization of Rest of the NBI.
Given, how the performance associated with most of the group outside of the NBI
top 10 has only got
worse over the years (with revenue growth as a % of industry revenues declining, net loss increasing,
pipeline productivity decreasing, and the inflation adjusted cost of drug development advancing), it is reasonable to then va
lue
this group on the basis o
f its historical valuation in the NBI in the pre
-
bubble years. For my estimate, I used 2006 as the base
year because the economy was in expansion mode and the number of firms in the NBI at 173 most closely mirrored the
present number of holdings in the ind
ex. On that basis, I arrive at a market capitalization of $139 billion for the group by
incorporating its current holding value of roughly 42% in the NBI multiplied by the index value in 2006.
Curre
nt Estimated Market Capitalization of the
Rest of the
NBI
Holdings
Source: NBI Database; IBB Prospectuses; Inside the NBI;
Seamist Capital Presentation June 2016;
NBI and IBB True Values.
Consolidating the market capitalizations
of both groups
,
I arrive at a consolidated market
capitalizati
on for the NBI of ~
$622 billon. The closest match I could identify to the output was on May 10, 2013 when the NBI
was trading at ~$1878 with a market capitalization of ~$628 billion. On the same day, the IBB closed at ~$179. Based on the
analysis, the current Price Target fo
r the IBB is $179/share.
parora@seamistcap.com
Page
15
NBI Traded
Close to the Estimated Market Capitalization of ~$622 Billion on May 10, 2013
Source:
NBI Database
; Seam
i
st Cap
ital Presentation
June 2016;
The IBB Closed on May 10, 2013 at
~$179/S
hare
Which Corresponds to Its Current Fair Value
Source: Yahoo F
i
nance; Seam
i
st Cap
ital Presentation June 2016;
There is upside opportunity to this estimate as I have used sell
-
side consensus earnings projections
(proven to be highly over
estimated)
and
data provider
P/E multiples to reach the market capitalization for the NBI top 10 holdings.
parora@seamistcap.com
Page
16
What Lies Ahead for the Sector?
Market to
Remain Range Bound
for
a
W
hile
.
Looking ahead over the next few years, the NBI is expected to mirror its own
performance in the aftermath of the genomic bubble. The NBI made a top of ~1597 on March 6, 2000 at the height of the
genomic era before falling 75% to bottom at ~404 on July 10,
2002. Then onwards from September 2002 to
Octo
ber 2011, the
index value increased by a paltry 748 points over 9 years to
~
1152 before embarking on a bull market journey which led to the
recently popped bubble. Based on those trends, the NBI needs to correct 62% from the top formed on July 20, 2015 to a bottom
of 1565
(~150 on the IBB)
and then trade range bound between the b
ottom and 2420 for roughly 9 years. It took more than 2
years for the bottom to form after the genomic bubble
.
NBI Ha
s Been Range Bound for Most of
i
ts History
(1993
-
Present)
Source: Yahoo Finance NBI Database;
Seamist Capital Presentation June 2016;
Venture Capital and Public
Funding
Will Tighten
.
Although
current year venture funding has shrunk when compared to the
record inflows last year, the amount raised is still substantial. However, over the next few years, it is possible that inves
tors
weary o
f an expected challenging IPO environment for biotech decide to invest in less risky assets that offer comparable yields.
Similarly, public market investors, aware now more than ever of the high risks associated with biotech are likely to remain o
n
the sid
elines until valuations are more appropriately risk adjusted.
Although
both themes are probably going to hold particularly true for crossover funds that have seen their portfolios shrink
following the bursting of the biotech bubble, it nev
ertheless will resonate with sector specialists that recognize that without a
biotech bull market they’re ill positioned to benefit from the ignorance and greed of non
-
specialist investors.
Biotech Industry Funding (2000
-
2015)
Source: E&Y: Beyond Borders;
Seamist Capital Presentation June 2016;
Bankruptcy Cla
i
ms to Accelerate.
A few years out, it is highly probable that companies filing for bankruptcy might become
an
industry feature. Although
firms at this point appear fully fu
nded, that might change given the high cost of drug development
and the excessive out of pocket spending habits company executives inculcated during the bubble. As shown below, in the
aftermath of the genomic bubble, firms appeared to be well funded. Howe
ver, over time the sector experienced a significant
upturn in the nu
mber of bankruptcy filings.
parora@seamistcap.com
Page
17
Biotech Industry Survival Index (2000
-
2015)
Source: E&Y: Beyond Borders;
Seamist Capital Presentation June 2016;
How to be Best Positioned to Benefit?
Limit
Exposure to the Sector
.
Although
a
substantial
fraction of the current downturn in the index is because of investors pulling
capital as they become aware of the high
risks associated with biotech,
a considerable portion of the decline can
be attributed
to an absence of loss mitigation through
overvalued
IPOs and FOPOs as observed over the previous three years. Looking ahead,
both factors are likely to accelerate and persist as catalysts for continued losses in the NBI as it works its way to the bot
tom
discussed above. Therefore, it makes sense
to limit exposure by investing in commercial leaders (that are
undervalued
and
estimated to grow over the next few years) and the BIS and shorting the IBB.
Don’t Invest
in Developmental Stage Companies.
Some investors might argue that developmental stage
companies offer
opportunities for better returns. However, given that less than 10 out of every 100 drugs ever get approved, investing in a b
asket
of
clinical
stage co
mpanies is unlikely to achieve
positive returns unless in an artificially boosted market
as that evidenced over
the previous three years. Biotech is complex and unless one has the talent to read through copious amounts of scientific
information and develop a fundamental understanding of the clinical and regulatory process, it is impossible to
identify
companies th
at are likely to succeed. Even
sell
-
side analysts (who perform research for a living) seldom accurately predict clinical
trial or regulatory failures.
Participate
in Upstart Companies With Drug Approval in Hand.
In order to lower risk of investing in upstart companies, it makes
more sense to participate in them once they have an approved drug with significant revenue potential. To illustrate, although
Regeneron’s (REGN) Eylea got approved on November 18, 2011, th
e stock traded below $100 for
a while
. Therefore, investing
in shares of quality companies on their journey upwards rather than in a basket of developmental stage firms, the direction o
f
whose clinical data is almost impossible to predict, presents a bette
r risk/reward paradigm.
Regeneron Trading
Patterns Prove
Behemoths Don’t Happen Overnight
Source: Yahoo Finance;
Seamist Capital Presentation June 2016
(Updated July 18)
;
parora@seamistcap.com
Page
18
Bottom Line
It was the funding coming from crossover or non
-
specialist investors that drove the biotech bubble this time around. They
invested heavily and ran the index to stratospheric heights. However, t
here has been a fundamental shift in how
these
participants
now
view the risks associated with biotech investing. They’re now aware
more than ever that they’
re more likely to
lose their
biotech
investment
s
than
achieve exponential returns
. This will make i
t harder for
stakeholders
to
perpetuate boom
bust cycles count
ing on the short memory of the collective market.
As a consequence, the biotech index is likely to undergo a
sharp contraction and subsequently trade range bound for years (use the period from J
uly 2002 to October 2011 as a barometer),
until the industry improves pipeline productivity and reduces costs, appropriately structures drug pricing, and accurately
represents the risks associated with drug development in valuations. The biotech industry h
as not matured but biotech investing
certainly has. The non
-
specialist investors that stakeholders count on to buoy the sector have biotech to blame for the poor
performance of their portfolios and are likely alienated for a while.
parora@seamistcap.com
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