Despite warnings of rich valuations from the U.S. Federal Reserve, investors in biotech stocks continued to snap up anything that moved. Elvis Picardo, vice president, research, and portfolio manager at Global Securities Corp. in Vancouver, says the dramatic share price drop of Valeant Pharmaceuticals may have been triggered by a short-selling research specialist alleging Valeant was engaging in ‘channel stuffing’, a deceptive business practice to pump up sales results by forcing more product down its sales distribution channels than the channel can ever hope to sell.
No doubt about it. When the curtain finally comes down on the current bull market, it will be one for the record books. After all, at its June peak, the bull had been the biggest creator of wealth in history, generating close to US$48 trillion worldwide.
But the biotech stocks bubble, so much a part of the bull, will also be one for the books.
Consider the performance of U.S. biotech indices during the decade that ended in September. Not only did the NASDAQ Biotechnology Index quadruple, posting annual gains of 15.4 per cent, but the NYSE Arca Biotechnology Index zoomed more than fivefold, posting annual gains of 18.4 per cent.
By contrast, the S&P 500, one of America’s market bellwethers, limped in at just 6.8 per cent a year. So, both biotech indexes outperformed the S&P 500 by a factor of two-to-2.5 times.
Of course, this doesn’t necessarily mean that biotech indexes belong in bubble territory. For a bona fide bubble, one needs an outrageously rapid ascent, stratospheric valuations, along with ridiculous initial public offerings. Still, the biotech sector met all three criteria.
For example, in July 2014, Janet Yellen, chair of the U.S. Federal Reserve Board, spoke out about the stretched valuations of biotech and social media outfits, noting their high price-to-earnings multiples.
So, how did investors react? With total disdain! Over the next 12 months, biotech indexes soared to record highs. In fact, the S&P Biotechnology Select Industry Index alone grew 90 per cent.
The speed of the run-up meant that by last summer, the valuations for many biotech stocks were abnormally high. As of Oct. 27, for example, the NASDAQ Biotech Index still traded at a P/E of 68 — more than three times that of the S&P 500. And that was after the index had made a big pullback from its peak!
As for ridiculous IPOs, look no further than Bermuda-based Axovant Sciences Ltd. (NASDAQ─AXON). In June, it sold 21 million shares at $15 each for proceeds of US$315 million, making it the biggest IPO in biotech stocks history.
In fact, when Axovant began trading June 11, its shares doubled, hitting a high of $31.17, while giving the company a market cap of over US$3 billion. Did Axovant get its rapturous reception because it boasted a portfolio of promising drugs for curing cancer or diabetes?
No, it did not. What Axovant did have was RVT-101, a single experimental drug for treating Alzheimer’s disease, that its 29-year old CEO had bought from pharmaceutical giant GlaxoSmithKline plc (NYSE─GSK) for US$5 million.
After 13 clinical trials, GlaxoSmithKline shelved the product years ago. But Axovant investors apparently decided that RVT-101 was still worth pots of money.
Of course, investors who bought the stock near its highs may be regretting their move, since it’s now 60 per cent off its peak, the victim of a deflating biotech stocks bubble.
After peaking in July 2015, the sector was hit by massive profit-taking during the exceptionally volatile month of August. And although biotech plays managed to claw back most of their losses by the third week of September, they were struck by a thunderbolt on September 21.
On that day, Martin Shkreli, CEO of New York-based Turing Pharmaceuticals, found himself in a firestorm of controversy following a story in The New York Times.
The Times reported that after buying the rights to Daraprim, a critical anti-parasitic drug, Turing then jacked up the price 55 times. In other words, the company, in raising the price to US$750 from $13.50 a pill, had done the equivalent of charging US$165, rather than $3, for a loaf of bread.
Mr. Turing’s move raised the hackles of Hillary Clinton, a leading contender for the Democratic presidential nomination. “Price gouging like this in the specialty drug market is outrageous,” she tweeted, adding that she would outline a strategy to deal with the issue head-on.
The next day, Mrs. Clinton laid out a plan that would require pharmaceutical and biotech stocks to give up billions of dollars in tax breaks. She also called for lower drug prices, as well as an increase in spending on research and development.
More importantly, Mrs. Clinton’s “tweet from hell” erased US$40 billion from the NASDAQ Biotech Index on Sept. 21, as biotech stocks tumbled across the board.
One company in particular began coming under increased scrutiny, given its policy of increasing the prices of drugs it had snapped up as part of its frenzied acquisition strategy.
That company was none other than Valeant Pharmaceuticals Intl. Inc. (TSX─VRX) which, up until recently, boasted a market capitalization bigger than that of the Royal Bank of Canada (TSX─RY).
Under Michael Pearson, who became CEO in 2008, Valeant has made more than 50 acquisitions, racking up over $30 billion in debt in the process. The acquisitions were a grab bag of businesses, from Bausch & Lomb, to Medicis Pharmaceutical and Salix Pharmaceuticals.
Bid was rebuffed
Valeant did make a blockbuster bid last year for Allergan plc (NYSE─AGN), maker of the much-ballyhooed Botox. But the bid was rebuffed.
There is, of course, method in Mr. Pearson’s madness, given his goal of making Valeant one of the top-five pharma players by 2016. And by last August, his target seemed increasingly within reach, as the company’s market cap edged close to $119 billion.
Moreover, investors who had gone along with Mr. Pearson for the ride were handsomely rewarded, as Valeant stock zoomed by more than 800 per cent.
Acquisitions are key
As might be surmised, given its spate of acquisitions, the company seeks to buy, rather than build. Not surprisingly, its spending on research and development last year was just three per cent of sales — 1,100 basis points lower than before Mr. Pearson’s arrival.
Although there’s nothing innately wrong with Mr. Pearson’s strategy, there is a risk that a serial acquirer like Valeant will either pay too much, or simply make a bad acquisition, as I noted in the Sept. 11 issue of Investor’s Digest of Canada.
But the company’s tactic of aggressive price hikes, which was already under scrutiny by regulators, became a burning issue after Mrs. Clinton let loose.
And Valeant has jacked up its prices. In April, for example, The Wall Street Journal reported that after buying the rights to two life-saving drugs — Nitropress and Isuprel — the company raised its list prices by 212 and 525 per cent, respectively. Moreover, it did so on the very day, Feb. 10, that it bought the two drugs!
In the meantime, complaints from patients, doctors and insurers about Valeant’s exorbitant prices have triggered investigations by the feds in both Massachusetts and New York.
But the biggest blow to Valeant came on Oct. 21 when a short selling research service, Citron Research, wondered if Valeant might be the next Enron. (That company, you may recall, collapsed in a ball of flame, bringing down accounting giant Arthur Andersen in the process.)
To buff its financial results, Valeant, Citron alleged, was making “phantom” sales to affiliated pharmacies, such as Pennsylvania-based Philidor Rx Services. In effect, Citron suggested, Valeant was guilty of a shady practice known as channel stuffing—pushing more product down the distribution pipeline than the channel could ever hope to sell.
Spooked by the comparison to Enron, panicky investors fled Valeant, sending its shares plunging 32 per cent on that one day.
So, what happens now for the company? Its 58 per cent freefall from its record high may have several harmful effects.
On Oct. 27, for example, Standard & Poor’s lowered its outlook on Valeant to negative from stable, noting that the company’s bad publicity had raised the likelihood of legal and regulatory risks.
Valeant may also now find it difficult to stay on the acquisitions trail, since accessing capital markets may prove impossible until the dust settles and there’s a big increase in the price of its stock and bonds.
Yet Valeant continues to enjoy the support of some of its biggest stockholders, including activist investor Bill Ackman, who now owns 19.5 million shares, having recently bought two million.
Effect is being felt
Still, Valeant’s problems have hurt those drug companies, such as Endo Intl. plc (TSX─ENL) and Mallinckrodt plc (NYSE─MNK) that have pursued similar growth strategies, given investor doubts about the viability of aggressively pursuing acquisitions. Indeed, that business model may now be permanently dented, if not completely broken.
With this in mind, we continue to like Baxalta Inc. (NYSE─BXLT), a spinoff from U.S. health-care giant, Baxter Intl. Inc. (NYSE─BAX). Not only does Baxalta boast a growing portfolio of treatments for rare diseases, its revenue from its new products is expected to jump more than tenfold by 2020 to US$2.5 billion.
Prices are steep
Some of Baxalta’s treatments for rare diseases can cost hundreds of thousands of dollars. These lucrative drugs, as well as Baxalta’s burgeoning portfolio, appeal to an outfit like Shire plc (NYSE─SPHG), which unveiled an all-stock US$30-billion bid for Baxalta on August 4.
Baxalta had rejected Shire’s initial bid, 36 per cent above the former’s share price, terming it too low. But Shire, which recently reiterated its interest in Baxalta, could possibly increase its offer in the weeks ahead.
Before the market meltdown over the summer and the biotech sector’s subsequent swoon, investors suggested that Shire would have to raise its price to US$50 a share if it wanted Baxalta.
In the meantime, the controversy around Valeant continues to swirl. Could the Quebec-based company truly be an Enron in disguise? Stay tuned.
Investor’s Digest of Canada, MPL Communications Inc.
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