A Time to Test Biotechs' Strength

NEW YORK ( The Deal) -- Bubbles are colorful, shimmering things. And yet they're ephemeral and can vanish in a moment, leaving behind a sticky residue. The bigger the bubble, the bigger the mess when it bursts.

That's what has some investors in biotechnology companies concerned right now. Biotechs are raking in the dough after a long period in which they were pretty much frozen out of the initial public offering market. Plus valuations are at a high, which, if they deviate too much from the underlying asset's intrinsic value, can create another kind of bubble.

Clearly, the ice that formed following the 2008 banking crisis has melted. In all of 2012, there were 12 health care IPOs, according to IPO tracker Renaissance Capital, compared with 16 in the first half of this year. An additional 15 health care firms had gone public in the early weeks of the second half.

And several of those biotech IPOs have been priced higher than expected, becoming oversubscribed, or soaring in value on the first day of trading.

"The biotechs were generally well received, with an average total return of 36%. Two biotechs, bluebird bio ( BLUE) and Epizyme ( EPZM), experienced a first-day pop of over 50% for the first time since 2004," Renaissance Capital said in a second-quarter report. Such a cycle builds upon itself, the report said. "With 16 biotech IPOs completed year-to-date, 2013 is on track to be the most active year in over a decade. We believe the intersection of several industry trends, including an increased number of FDA drug approvals, a rise in risk tolerance among IPO investors, a decline in nondilutive funding from the government, and venture firms' push to liquidate holdings, has driven this revival."

Consider the example of synthetic gene sequencer Intrexon Corp. ( XON), of Germantown, Md., which began trading on the New York Stock Exchange Aug. 9 under the ticker symbol XON. Sources said it was 15% to 20% oversubscribed and sold 11.5 million shares at $16 apiece, clearing about $160 million. In addition, it traded on its first day up more than 50%, for a new market cap of about $2 billion.

Not bad for a platform company that is not yet profitable.

But Intrexon has a lot going for it. With a well-regarded biotech veteran, Randal Kirk, as its CEO, nine collaborations under way and programs not just in health care but also in food, energy and the environment, there is a lot for investors to be interested in.

Alan Mendelson, a partner with Latham & Watkins LLP, said that the story of an individual company matters a lot to investors. "Investors do bet on management teams. That helps a great deal. The science is important. If the company has licensing agreements, then that's validation from larger companies," he said.

But not all of the recent life sciences IPOs have done great. Medical device firms haven't even entered the fray this year, even though there were a few device IPOs in 2012. And diagnostics companies account for only three of this year's filings for IPOs, and the ones that began trading already, haven't exactly blasted out of the gate like the biotechs. NanoString Technologies Inc. ( NSTG), which began trading June 26, priced below its expected range at $10 per share and hit a low of $7.01 since. LipoScience Inc. ( LPDX) in January priced its IPO at $9 per share, at the bottom of a range that it had already dropped -- it was trading at a 60-day moving average of $6.55 per share at the end of July.

Other companies, like Aratana Therapeutics Inc. ( PETX), which reformulates human drugs into animal therapies, postponed their IPOs, then priced significantly below the range they'd earlier indicated. And some very early-stage biotechs, like Heat Biologics Inc. ( HTBX), have made their money, but are trading about even with their initial stock price.

Macro events also matter, according to Renaissance Capital. "We continue to believe U.S. IPO activity remains captive to underlying macroeconomic trends, as evidenced by the deeply discounted offerings that were completed in late June following the Fed announcement referring to chairman Ben Bernanke's comments that the central bank might start pulling back on asset sales. That said, companies are offering valuation haircuts rather than scrapping their deals altogether, indicating that demand for IPOs persists, albeit only at a reasonable price," according to the IPO report.

And biotechnology companies have "massively outperformed" this year, whereas pharmaceutical firms have not, International Strategy & Investment analyst Mark Schoenebaum said in a research note. "Are we in a biotech bubble right now? The consensus view is yes, we are," Schoenebaum said, citing a recent informal survey of his clients. "But we're only in the second or third inning and have several quarters of good performance ahead of us."

The fundamentals of biotech look good. There's lots of growth and generally any licensing deal offers three to five years of future milestones. As long as productivity is up, there's no problem, Schoenebaum said.

After all, we're not talking tulips here. These firms generally have years of experience, both managerial and scientific, with solid hypotheses and some proof-of-concept data before they go public.

"There are window periods and often a period of high valuation coincides with a pretty robust stock market in general," Mendelson said.

"In life sciences M&A you usually have a couple of deep-pocketed suitors looking at a scarce asset. When that happens, yes, values can and do go up pretty high," said Dimitri Drone, of PricewaterhouseCoopers' life science practice.

Yet, in some circumstances, prices can rise too high, too fast. Onyx Pharmaceuticals Inc.'s ( ONXX) stock price skyrocketed by nearly 50%, from $89 to $136, after it rejected Amgen Inc.'s ( AMGN) $120 per share, $10 billion bid and then put itself up for sale. The higher price was enough to make Amgen and other deep-pocketed suitors rock back on their heels and ask for a closer look at what they might be buying. (A possible deal reportedly is still in the works.)

And just as negative macroevents can slow down action in a market, so can positive ones. Biotech has had several successes lately and those have raised the public's view of the industry. There are solid underlying reasons why the biotechnology industry is finally gaining interest from investors, Mendelson noted. The genomics revolution has had a major impact on how these firms analyze and develop their programs. Medicines are becoming more specific, and they're being developed based on genetic knowledge and manipulation. Those technologies have also made drug development more efficient.

If it is a bubble, then what investors most keenly want to know is, when is it likely to burst.

"I don't view it as a bubble," Drone said. "Industries go in and out of favor," he added, noting that the phenomenon of large full-service pharmaceutical companies facing holes in their drug pipelines from loss of exclusivity could give the biotechs quite a long run. "If a biotech company is attractive, then yes, there's going to be a significant positive upward push on its share price. The large pharma with an established commercial infrastructure can take that asset, even at the higher price, and commercialize it, so it's not that expensive to them.

Mendelson also said that while he doesn't "think it's unlimited," higher valuations probably won't slow down within the next three to four years.

Perhaps the high IPO rate for biotechs and heightened valuations won't end for a year, or more, but investors should definitely keep their eye on the marketplace.

As Schoenebaum said, "Think about what it means when a platform technology company is oversubscribed and trades up 50% on its first day. These are the kinds of things that happen when you look back historically and say, hey, that was a bubble. ... We are in a very, very, special time that raises some questions about when all this ends, and will it end badly or not?"

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