Biotech stocks have been beat up since February 2021, with the XBI index still down ~50% from record highs
Headwinds in 2022 stemming from higher interest rates, "risk off" investor sentiment, and regulatory changes and challenges have stymied broad recovery in the sector
A mixture of maturing pipelines, significant cash on hand for large pharma, and need for smaller biotechs to collaborate will drive dealmaking in 2023
Biotech investing sentiment will rise and XBI will close above 100 by the end of 2023
The biotech stock index (SPDR S&P Biotech ETF: XBI) has seemingly recovered from July lows, but still sits 25% lower than it did at the start of last year. We now enter 2023 at a crossroads, unsure of whether the bear market will continue into its 24th month. Venture funding is down, dealmaking is in a dry spell (besides a few recent JPM Healthcare announcements), and valuations have been crushed. Is the time right to buy into pharma dealmaking in 2023? I believe it is for the following top three reasons:
1. Exciting Science to Fill Pipelines
Pfizer, a major M&A force in 2022 (i.e. Arena and Biohaven), mentioned during the first week of 2023 that they are divesting their early stage pipeline to favor external innovation. Part of that strategy involves de-risking later stage science and focusing on larger markets outside of gene therapy and rare diseases. There will be good pickins', as the number of drugs in clinical trials exploded in 2020 and 2021 to new heights, perhaps unsustainably. Notable Phase 2 and 3 failures have sunk valuations, stemming from science developed easy money policy, often by SPACs. The "risk off" climate is now reversing fortunes-- punishing not only companies with weak science, but causing collateral damage to many others along the way. Regardless, this cash powered this industry to new heights and paves the way for greater medicines as progress through the clinic. "The ground is harder after it rains". Look for platforms around gene editing, lipid nanoparticles, CAR-Ts and ADCs, to name a few, that will enable a new generation of therapeutics.
2. Potential Acquirers Holding Lots of Cash
Billions of dollars in government funding went into technology to develop vaccines, antivirals, and other medical products, as well as supply chain improvements and human resources. That cash is migrating through the R&D machines of large pharmaceutical companies into treatments for infectious diseases and beyond. This significant funding coupled with billion of dollars in sales gives big pharma a cash and infrastructure boost that it can then deploy into M&A activity for platform technology and build franchise potential. For some of these companies, the amount of cash on their balance sheets has never been greater (Table 1).
Table 1. Select Large Pharma Balance Sheets, Cash, Cash Equivalents, and Short Term Investments 2019 vs Q3 2022 (Source SEC Edgar database)
Company | Net Change (%) | Q3 2022 Cash & Equiv (USD 000's) | 2019 Cash & Equiv (USD 000's) |
Pfizer | 26,293,000 (267%) | 36,123,000 | 9,830,000 |
Merck | 695,000 (7%) | 11,145,000 | 10,450,000 |
Johnson & Johnson | 14,792,000 (76%) | 34,079,000 | 19,287,000 |
Novartis | 7,657,000 (67%) | 19,103,000 | 11,446,000 |
Eli Lilly | 303,800 (12%) | 2,742,300 | 2,438,500 |
Many folks have been wondering why this dry powder hasn't been deployed sooner in this environment of low valuations. Ironically, it could be the fact that valuations of potential acquisition targets are so low that the targets are not ready to sell themselves at what they perceive is an unjustifiably low valuation. Companies are typically scooped up at a premium to their 52-week averages and those 2022 averages are historically low. Once there is an overall industry catalyst, such as the Fed stopping or even lowering rates, a rising tide starts to lift overall biotech sentiment, along with valuations, and targets become more expensive with their share prices. At that time, it is expected that M&A activity will increase.
3. Collaborations Necessary to Move Tech Forward
Drug development is necessarily complex for a host of reasons. It requires significant cash investment with a long, high-risk investment horizon. Cash flow is a constant challenge, as many companies are pre-revenue generating. When cash is difficult to raise, as it is today, companies are often faced with a difficult decision: either raise money on a lower valuation or reduce spend. Both actions are necessary to extend runway with a goal of having at least two years of cash in the bank to hit value-generating inflection points such as a clinical data readouts or positive regulatory developments. Reducing spend can mean cutting programs or outsourcing through external innovation. Collaborations, although depressed in 2022, will likely pick up due to the need for smaller companies to make progress on their pipelines without having to raise dilutive funding. The drawback is they may have to give up some rights to the IP or settle on back-loaded deal terms to ensure they generate catalysts for shareholders. It would certainly not be the worst outcome for these pipelines.
I was hoping the biotech bear market would end back in December 2021, having then dropped over 25% from its peak in early 2021. In retrospect, extreme pre-revenue valuations coupled with industry headwinds from higher interest rates, increased FDA scrutiny, the passage of the Inflation Reduction Act, and transition to Project Optimus, made 2022 a challenging year for the sector to recover. In January 2023 the XBI now sits at 2017 levels. Considering the exciting science, influx of capital, and potential for more biotech-pharma collaborations, it may be time to buy into the index. A rebound in M&A activity will drive biotech sentiment upward, resulting in a recovery for biotech valuations and the XBI biotech index. I'm betting on a good year for biotech.
Disclosure: I am long XBI and many biotech stocks in the index.