With GlaxoSmithKline finally landing Human Genome Sciences, and Bristol-Myers Squibb and AstraZeneca respectively snapping up Amylin and Ardea, the recent pace of acquisitions has propelled the Nasdaq Biotech Index (NBI) up over 26% in the first six months of 2012 to 1,369 points. The last time the index was at this level was in the heady days of the 2000 tech boom.
Healthy demand by pharmaceutical companies for biotech assets has not only propelled the index to historical highs, but has also brought the sector to the attention of investors who had either forgotten about it or had previously favoured less-risky assets or equity sectors. This renewed interest could, however, come to an abrupt halt if the NBI is unable to continue as the source of big pharma's acquisitions.
And if the pace of acquisitions from the NBI falters - as it usually does over the summer period - then generalist and retail investors who have recently been attracted to biotech will have invested at the top of the market, just as they did in 2000.
Keeping the deals flowing
In addition to the summer doldrums, the pace of acquisitions from the NBI is likely to slow because for some time the index has not been refreshed by new companies floating, leaving increasingly limited waters for pharma to fish in.
An open IPO window needs two dynamics: an increase in public market valuations, which thanks to historic acquisitions has happened; and the acceptance of lower IPO exit valuations by venture capitalists. In the last three or four years, the reduced appetite for IPOs and the poor aftermarket performance for those that have exited onto the public markets has rebased the NBI among an ever smaller pool of stationary, or stagnant constituents.
In addition, the moving of product sales from the biotech to the pharmaceutical sector as the result of the acquisition of the more successful companies in the index tends to put a cap on the profitability of the sector, as big chunks of biotech sales, from the likes of Genentech and Genzyme, are now attributable to Roche and Sanofi. This has reduced the earnings denominator in the price earnings ratio of the NBI, making it look overvalued.
Better by comparison
One of the other unintended consequences of the resurgence in M&A on the NBI and the resulting numerical elevation of the index is that it makes the index look more attractive when compared with other indices like the S&P 500. However, underlying this is the implication that recent exit acquisition multiples are also applicable to all the remaining companies (Pharma reacquaints itself with risk in first half, July 26, 2012).
This is because, when acquired companies leave, the NBI is rebased at the same value among the remaining constituents rather than removing the sales, profits and market capitalisation of companies at the time they leave.
But for investors the alternative is less palatable since then the NBI would go down when a company is bought out. The 'relative' strength of the NBI, therefore, attracts investors to the remaining components of the index despite the fact that the investment proposition of those remaining companies likely differs significantly from those that have recently been acquired.
Indeed, looking at companies developing hepatitis C virus drugs as an example, those in the space since Inhibitex and Pharmasset were acquired are at an earlier stage, more risky and therefore undeserving of the exit multiples applied to the two recent buy-outs. Those remaining companies developing HCV drugs nevertheless become slightly bigger parts of a re-based NBI that has risen as a result of the acquisition premiums.
Another important point is that Gilead and BMS likely also took a close look at Achillion Pharmaceuticals and Idenix Pharmaceuticals before saying "pass" and seeking better assets.
Putting the brakes on
There are a number of reasons why the pace of acquisitions that brought the NBI to historical highs could slow. The prevalence of structured transactions and contingent value rights are just two indications of how pharmaceutical acquirers are now more price-sensitive than they were five or six years ago when companies like GlycoFi and KuDOS were acquired outright for cash.
Furthermore, pharma is much more clinically risk-averse than it used to be, requiring more and later-stage data before entering into a dialogue with potential targets (Takeovers tick up in 2012 but feeding frenzy still some way off, July 25, 2012).
Despite their resulting weighting in the NBI, companies like Dendreon, Savient Pharmaceuticals and AMAG Pharmaceuticals are more likely to be founder members of the NBI stagnant pool than big pharma's next targets.
To contact the author of this story email Andy Smith in London at email@example.com