Special Report: The Top 3 Biotech Stocks

2016 was a period of heavy consolidation for biotech stocks. The market spent much of the year finding solid ground, after an incredibly rocky showing in January and a disastrous end to 2015.

For context, in late 2015, the biotech sector took a major political hit.

In an extraordinary event, presidential candidate Hillary Clinton sent the $IBB (iShares NASDAQ Biotech Index) plummeting with a single tweet on social media site Twitter. Specifically, Hillary criticized price gouging in the pharmaceutical market and vowed to enact policies to prevent biotechs from "profiteering."

In her public display, Hillary linked to a New York Times story with the headline: “Drug Goes From $13.50 a Tablet to $750, Overnight.” Many people were quickly outraged, and investors soon panicked at the thought of external pricing pressure from the public.

The results were near disastrous for anyone who was holding biotech stocks at their peak, as the sector proceeded to collapse nearly 20% over the next few months.

But for biotech investors sitting on the sidelines, this was actually a good thing... It meant that a new buying opportunity had suddenly emerged... And as the dust settled, fears surrounding regulation largely subsided.

From February 2016 through the back end of the year, the $IBB began an upward march once again, climbing over 7% in less than a year. The question now, of course, is whether or not this momentum will be a flash in the pan, or turn into a full-on bull market in 2017...

House of Cards

One of the first things pundits will point to when talking about a “biotech bubble” is the price to earnings (P/E) ratio. That is, how much are we paying in relation to what these firms are actually pulling in on the bottom line?

If we look at the biotech sector in comparison to the remaining market, the answer might surprise you at first. For every dollar earned in biotech, investors are spending, on average, $17. Compared to broader market indices, that's actually not very expensive right now. However, this is only true if you exclude gross outliers and companies with negative margins.

The reality is, of the 325 biotechnology companies listed on the market right now (major drug manufacturers included), only about 50 are turning a profit. Despite record industry highs over the past half-decade, the vast majority of public biotech firms are actually market laggards.

The reason for this disparity in performance is that the biotech sector is being propped up by a select few heavily weighted players. Small, development-stage companies have little to no impact on major indices, so it can be difficult to tell what's going on under the surface just by looking at ETF performance.

If you peek behind the curtain, you'll find that in 2016, ~60% of biotech stocks traded at a loss. In other words, you can't simply pick a company in this sector at random and hope to come out a winner — even at a time when the broad sector is trading up 250% over the last half decade.

Top Plays in Biotech

With biotech performance coming off record levels, it's certainly a safe play to take any gains off the table if you began investing five years ago.

Then again, the same could be said for the stock market in general right now.

The truth is, biotech is only as risky as you make it. If you want to gamble, there will be a number of binary events to play this year.

If you want to speculate, there's still plenty of room for the sector to run up — especially in regards to small caps.

But if you want to invest, know that the best biotech stocks will have two things in common: value and diversification.

With a major sell off still in recent memory, investors are cutting their risk and falling back on companies actually generating money. When bubbles pop, stocks with the highest multiples (or no earnings at all) tend to come crashing down the hardest. For this reason, the best biotech plays are going to be those with strong value metrics and diversified revenue streams.

In such a bloated market, value in biotech isn't particularly easy to find, which is why we've decided to help out and share our top three picks for the year.

Gilead (NASDAQ: GILD)

It may surprise you to hear it, but Gilead Sciences (NASDAQ: GILD) is something of a turnaround play. Between 2010 and 2015, it was one of the fastest-growing biotechs in the world. Gilead's total revenue was running at a compound annual growth rate of 30.1%, according to data compiled by S&P Capital IQ.

The company became a force to be reckoned with in 2014 when it launched its hepatitis C therapeutic Sovaldi in February 2014 and received approval for its hepatitis C combo drug Harvoni in October 2014.

These two drugs were blockbusters: bringing in ~$3.5 billion per quarter in the early going. They set records as the most successful drug launch in history based on first-year sales.

solvadi

But competition in the hepatitis drug space heated up much faster than expected. After hitting $9.91 in EBITDA earnigns per share in fiscal 2014, and $15.41 in fiscal 2015, EBTDA earnings fell to $13.30 in 2016. And so after peaking in 2015 at $120 a share it fell below $100 in 2016. And the comopany hasn't turned it around yet...

At the end of 2016, analysts were still expecting Gilead to earn $10.80 a share in fiscal 2017. Those estimates have since fallen to $8.57 -- nearly half what Gilead earned just a couple years ago. And fiscal 2018 earnings are expected to fall once again to $7.94 a share.

Falling revenue, falling earnings -- what's to like about Gilead Sciences right now? 

For starters, the stock is now very cheap, even in light of fiscal 2018 earnings estimates. The trailing P/E is 7, and the forward P/E is around 9. 

Then there's Gilead's HIV treatments, which are still showing annual growth around 10%. Gilead's HIV revenues can carry the company while it seeks new opportunities. 

And speaking of new opportunities, Gilead has $32 billion in cash to fund R&D or buy a future blockbuster drug. And so you know, it is widely expected that Gilead will make an acqusiiton in 2017, which would go a long way to putting a floor under the stock price. 

Finally, there's Gilead's mamagement. They've brought blockbusters to market before, and it's a good bet they will again.  

We could also see a share buyback program, debt restructuring, or even an increase to the dividend. With the stock price as low as it is right now.

Enanta Pharmaceuticals, Inc. (NASDAQ: ENTA)

Enanta Pharmaceuticals is a development-stage biotech with a strong focus on infectious disease. The company currently generates revenue from its hepatitis C products while developing therapeutics for a liver disease known as nonalcoholic steatohepatitis (NASH).

When it comes to a strategic business model, Enanta runs an incredibly tight ship. The company has been profitable for the last five years, earning over $337 million over the last half decade.

Additionally, Enanta reported $209 million in cash and marketable securities in its most recent quarter.

In terms of liability, the company has less than $1 million in current obligations, putting it in an extremely strong capital position.

Enanta has been able to accomplish all this through licensing fees and periodic but large milestone payments. On a quarterly basis, revenue has been sporadic, but the money is definitely there and will begin to be a bit more consistent in the near future.

In the hepatitis C market, the company currently has strategic partnerships with pharmaceutical giants AbbVie and Novartis. These partnerships have offered extremely positive funding arrangements and are poised to bring in significant royalties and/or milestone payments over the next several years.

AbbVie hepatitis C treatment that includes Enanta's ABT-493 protease inhibitor brought in $58 million in royalites in 2016. And a new iteration of Abbvie's drug could result in an $80 million milestone payment in 2017, as well as royalty payments. 

Ananta is expecting Phase I results for at least two ongoing studies, which will open the door to new partnerships and royalty agreements. 

Value

As for value, Enanta remains one of the cheapest companies in the industry. Because royalty payments are sporadic, it's best to view Enanta on its book value, that is, the value of its assets. With a price-to-book of just 2, it is cheaper than Gilead (4.7 X book), Biogen (5 X book) and Amgen (4.3 X book).  

With very low debt, hundreds of millions in milestone payments on the way, and plenty of cash on hand, this is a relatively low-risk biotechnology stock.

OPKO Health (NYSE: OPK)

An investment in OPKO is an investment in its Chairman and CEO, Phillip Frost. Frost is best known for building Ivax Labs into a major generic drugmaker. Frost sold Ivax Labs to Teva Pharmaceutical in 2005 for $7.4 billion. He then served as Teva Pharmaceutical's chairman until 2, overseeing a nice run for that company. He left Teva to run Opko Health, and similar success could make OPKO a big winner.

OPKO Health is a young, mid-sized biotech firm that breaks down into two divisions: diagnostics and mid-stage therapeutics. The company's growth strategy has involved investing in companies with valuable proprietary technology and bringing those products to market.

Diagnostics (Doctor on a Chip)

Within diagnostics, OPKO offers the 4Kscore — a breakthrough prostate cancer screen — as well as a device called the Claros PSA test. The device is essentially a desktop microchemistry lab that allows doctors to receive PSA readings without having to send out the sample.

Claros_OPK_desktop_lab

The benefit of the Claros PSA is twofold: First, the test provides results in as little as 10 minutes at the location where the patient is tested. Second, doctors will be able to hold onto more profit rather than passing it off to outside labs.

We believe patients will prefer these immediate results to the stress of waiting for lab results, while doctors will prefer the long-term financial benefit of keeping diagnostics in house.

In total, nearly 25 to 30 million PSA tests are performed in the U.S. each year. At an average reimbursement of $30 per test, that's a potential $900 million annual market for OPKO.

OPKO's in-house testing should capture a significant portion of these tests, providing the company not only with direct revenue from Claros PSA, but also with a solid position to market follow-up 4Kscore testing.

The recent rollout of the Claros PSA reflects the overarching strategy of OPKO's diagnostics division: in-house or point-of-care testing — something we like to call “doctor on a chip.” The initial target market for OPKO's desktop lab is prostate cancer, but the company is developing a point-of-care system to address a wide range of applications to include:

  • Prostate-specific antigen
  • 4Kscore
  • Vitamin D
  • Testosterone
  • Alzheimer's
  • Hepatitis B
  • HIV
  • Syphilis
  • Fertility
  • Menopause
  • Cardio panel

Because of the convenience and financial benefit of point-of-care diagnostics, we expect OPKO to have strong penetration in whichever of these markets management decides to pursue.

Therapeutics

OPKO's drug pipeline runs incredibly deep. The company is developing products to treat a variety of conditions including Parkinson's, obesity, hemophilia, influenza, and kidney disease, just to name a few. We won't go into every therapeutic in this report, but we will touch on OPKO's top product candidates in terms of revenue potential.

Rayaldee

Rayaldee is a new vitamin D formulation (yes, vitamin D) drug designed as a treatment for patients with stage 3 and 4 chronic kidney disease (CKD). The drug will target approximately 9 million patients worldwide, a potential market size of around $12 billion.

Rayaldee was approved in Novmber 2016. The partnership with Vifor Fresenius could yield up to $837 million in milestoine payments plus royalties.

Existing treatments for CKD are either ineffective or have significant safety issues, and Rayaldee's clinical results compared favorably to what's currently available on the market: nutritional vitamin D and hormones.

Varubi

OPKO partnership with Tesaro in this $1 billion market could mean $95 million in milestone patytents as well as double-digit royalties. 

Rolapitant

This drug is already licensed to Tesaro and on the market. Rolapitant is a treatment for chemotherapy-induced nausea and vomiting (CINV) — an increasingly common condition in patients with cancer. CINV is estimated to afflict upward of 70% of cancer patients undergoing chemotherapy. If not prevented, CINV can result in a delay or even discontinuation of chemotherapy treatment.

OPKO originally purchased Rolapitant for $2 million and flipped it to drug company Tesaro for $6 million, a 10% equity stake in the company, and further related payments. OPKO is looking at $115 million in milestone payments from Tesaro ($30 million in regulatory and initial sales milestones and $85 million in annual net sales milestones), as well as double-digit royalties on all sales. It's estimated that peak sales for the drug may be as high as $1.5 billion.

Financials and Recommendation

As of its most recent quarter, OPKO reported cash and cash equivalents of $144 million, already providing the company with strong liquidity and the ability to continue the development of its many product candidates.

OPKO has continued to increase R&D spending related to its ongoing Phase III programs and has recently incurred costs associated with a clinical validation study for the 4Kscore.

With the 4Kscore now on the market and several Phase III candidates approaching commercialization, though, we expect these operational costs should drop substantially, pushing OPKO towards the green.

OPKO's current burn rate is approximately $40 million a quarter, giving the company several more quarters of working capital. Of course, this scenario would assume zero growth on the top line and an extension of current clinical trials — neither of which we're expecting to happen.

OPKO's 4Kscore first launched in March 2014, meaning the full effect of revenues are still just being realized.

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