The biotech sector offers a great buying opportunity for investors right now as they are cheap and f...
The biotech sector offers a great buying opportunity for investors right now as they are cheap and fundamentals are excellent.
Furthermore, there may be a major catalyst in the form of M&A activity, with large-cap pharmaceuticals potentially buying biotech companies. Ever since the early 1980s research and development productivity in large-cap pharmas has declined.
Many of today’s blockbuster products were discovered about this time and have fixed patent lines that are due to expire in the coming years. When this happens, generic companies can launch their copies of the product once approved. The generic industry has become competitive, and this has been intensified through the involvement of Indian companies with a huge cost advantage.
In fact, a pharmaceutical company can lose up to 80% of its revenue within a couple of months once a large branded product goes generic. This is an extreme environment if you consider that a $5bn product, once its patent expires, could potentially lose $4bn in sales within two months. With many large pharmaceutical products set to lose patent protection over the next few years, the harsh competitive environment in the generic industry and weak pharmaceutical pipelines, there is a logic to the argument that we might see the purchase of biotech companies by large pharmaceutical companies.
Another factor leading us to this conclusion is a particular tax break that is available to US companies in 2005. Many global US companies traditionally base their international operations out of other countries because of the tax benefits. There is then a tax rate of 35% to repatriate their cash to the US.
However, the US congress has put in place a tax break of 5.5% for 2005 and this means large-cap pharmaceutical companies could repatriate $73bn in cash, which could be used to buy biotech companies.
We have already seen high levels of activity on the M&A front, with the recent purchase by Pfizer of the US biotech Vicuron. This acquisition highlights both the potential for M&A and the current discount at which biotech stocks trade relative to the fair value of their assets. Pfizer paid an 84% premium to the closing price of the previous day for Vicuron’s stock.
In terms of growth prospects, large-cap US biotech stocks offer a five-year EPS compound annual growth rate (CAGR) of 19%, compared with US pharmaceutical stocks that offer a 4% EPS CAGR over the same time period.
We think the valuation argument is compelling considering the relative growth rates of these stocks. For the small and mid- cap companies, these stocks are trading at implied discount rates that are typical when these stocks are cheap and oversold.
Large-cap pharmas have lots of money to spend on acquisitions.
Biotech stocks are fundamentally cheap.
Drugs coming off patent have negative impact on earnings of pharmas.
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