Biotech's Next Major Pullback

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There’s no denying that biotechnology is the ultimate industry of momentum, where companies often trade with multi-year rallies, reaching valuations that can not possibly be explained. In the last six months we have witnessed the fall of Alexion Pharmaceuticals (NASDAQ: ALXN) from its multi-year rally, and in this article I am looking at which companies might be next.  

Back in October Alexion Pharmaceuticals reached an all-time high of $119.54. In the five years prior, the stock had rallied nearly 1500%, from being a $1.5 billion company to a $23 billion company. The company achieved this feat with explosive top-line growth and a promising pipeline filled with Orphan drugs. However, despite this promise its valuation remained excessive, and has since pulled back 20%

Within the sector there are several other biotech stocks that have traded with a similar trend and therefore have a similar valuation as Alexion, compared to fundamentals. Once again, these are great companies, but might be overpriced stocks. Therefore, in order to protect yourself from the 15%-30% pullback it might be wise to take profits, or at least perform the necessary due diligence to determine the level of upside that might exist.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>Alexion Pharmaceuticals</strong></p> </td> <td> <p><strong>Regeneron Pharmaceuticals</strong></p> </td> <td> <p><strong>Pharmacyclics</strong></p> </td> <td> <p><strong>BioMarin Pharmaceuticals</strong></p> </td> </tr> <tr> <td> <p>Ticker</p> </td> <td> <p><strong> </strong></p> </td> <td> <p><strong><span class="ticker" data-id="205202">(NASDAQ: <a href="">REGN</a>)</span></strong></p> </td> <td> <p><strong><span class="ticker" data-id="216860">(NASDAQ: <a href="">PCYC</a>)</span></strong></p> </td> <td> <p><strong><span class="ticker" data-id="202974">(NASDAQ: <a href="">BMRN</a>)</span></strong></p> </td> </tr> <tr> <td> <p>Market Cap (billions)</p> </td> <td> <p>$18.50</p> </td> <td> <p>$17.60</p> </td> <td> <p>$4.35</p> </td> <td> <p>$6.12</p> </td> </tr> <tr> <td> <p>Trailing P/E</p> </td> <td> <p>84.17</p> </td> <td> <p>85.96</p> </td> <td> <p>45.04</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Forward P/E</p> </td> <td> <p>34.21</p> </td> <td> <p>37.81</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>Price/Sales</p> </td> <td> <p>17.29</p> </td> <td> <p>16.15</p> </td> <td> <p>22.23</p> </td> <td> <p>12.55</p> </td> </tr> <tr> <td> <p>Profit Margin</p> </td> <td> <p>21.33%</p> </td> <td> <p>20.83%</p> </td> <td> <p>55.31%</p> </td> <td> <p>(18%)</p> </td> </tr> <tr> <td> <p>Revenue Growth*</p> </td> <td> <p>44.20%</p> </td> <td> <p>315.9%</p> </td> <td> <p>N/A</p> </td> <td> <p>13%</p> </td> </tr> <tr> <td> <p>Income Growth*</p> </td> <td> <p>40.60%</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> </tr> <tr> <td> <p>One-Year Return</p> </td> <td> <p>46%</p> </td> <td> <p>246%</p> </td> <td> <p>405%</p> </td> <td> <p>47%</p> </td> </tr> <tr> <td> <p>Five-Year Return</p> </td> <td> <p>920%</p> </td> <td> <p>670%</p> </td> <td> <p>2,880%</p> </td> <td> <p>77%</p> </td> </tr> </tbody> </table>

 *year-over-year growth from last quarter

If you go through and look at each of the metrics charted above, you might think that these stocks aren’t too expensive. In regards to earnings, a forward P/E ratio under 40 is not unprecedented and all have great margins. However, the problem might be the price/sales. Companies such as the ones listed above, with blockbuster pipelines, can typically trade with this level of momentum. However, once margins begin to tighten, you typically see a decline, such as in the case of Alexion.

Once you begin to look at the large cap pharmaceutical companies such as Pfizer, none trade with price/sales ratios in double digits. However, each of these companies are trading with massive premiums as investors believe they are the next class of Pfizers or Bristol-Myers. The combination of novel therapeutics and Orphan drug classifications has guaranteed long-term exclusivity on drugs with big sales potential. However, as a company’s valuation begins to climb, and reaches the level of large cap, investors will begin to assess the fundamentals and will notice the distinction in value.

Looking at each of these companies, it appears all are too reliant on one or two products, unlike large pharma, and have a great chance at a pullback. For example, Bristol-Myers is worth three times the valuation of either Alexion or Regeneron, yet has more than 18x the annual sales! This represents a significant issue in the valuation of these companies. Bottom line: If these companies are to become the next class of great biotechnology companies, then they will have to endure several years of flat trading, or a pullback, to allow fundamentals to meet the technicals.

Gilead Sciences might be the most expensive company among large pharma, with its price/sales ratio of 6.04. For the most part, large pharma companies trade at three times sales. Companies such as Gilead, Pfizer, and Bristol-Myers are just as innovating, if not more innovating, than either Regeneron or Alexion. Therefore, I doubt seriously that either can continue to trade with such lofty valuation as their market capitalization becomes greater. Unfortunately, fundamentals must eventually meet valuation, and it happen soon for either of these companies.

In regards to both Pharmacyclics and BioMarin, both are still too cheap. Both are still speculative, relying on the blockbuster performance of upcoming products. But $4 and $6 billion valuations in biotechnology is nothing new. Both look to trade with excessive valuations, and are expensive, but in the last decade there have been several companies to trade with such valuation without an approved product. Therefore, although a popular choice because of their gains, I doubt either will see a significant pullback, pending any drastic developments.

Obviously, with PCYC and BMRN having smaller valuations their chance of continuing the trend is greater than ALXN or REGN with their $20 billion market cap. Therefore, with Regeneron and Alexion trading around the $20 billion mark, I expect flat trading or a pullback, as the valuation becomes too large to buy. But, in biotechnology it is difficult to predict future trends, because so much if dependent upon unknown data. However, one thing we know for sure, these are very expensive, fast-growing, companies that at some point will have to correct. But trying to predict when it will occur can pose a challenge. 

BrianNichols ows BMRN. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend BioMarin Pharmaceutical. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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