The Top 3 Biotech Stocks for 2015

With 2014 coming to a close, the biotech sector has, once again, defied virtually all conventional stock market wisdom.

On Friday, December 6, biotech stocks spiked to all-time highs despite widespread warnings of lofty valuations and a pending burst.

The Market Vectors Biotech ETF (NYSE: BBH), First Trust NYSEARCA Biotechnology Index ETF (NYSE: FBT), iShares Nasdaq Biotechnology Index ETF (NASDAQ: IBB), and SPDR S&P Biotech Index ETF (NYSE: XBI) all reached record valuations this year, outperforming all other established sectors on the market.

If you’d ignored every other industry and focused only on the leading biotech ETFs in 2014, your portfolio would be up anywhere between 38% and 52% since January.

For perspective, the Dow Jones is closing the year out at a gain of 12%, and the S&P 500 is closing out at a gain of 15%.

2014 was undoubtedly a stellar year for stocks in general, but the gains seen in the biotech sector have made the record-breaking levels of the broader market look like peanuts by comparison.

The question now, of course, is how much longer can this bull market go on? Will 2015 be another logic-defying year for biotech firms, or is this sector a house of cards waiting to come crashing down?

House of Cards

One of the first things pundits will point to when talking about the “biotech bubble” is price to earnings (P/E). 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 is quite a lot. For every dollar earned in biotech, investors are spending, on average, $67 — and that’s only 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 51 are turning a profit. Despite record industry highs in 2014, 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 find that from the start of 2014, 60% of biotech stocks are currently trading 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 in a year when ETFs are trading up as much as 52%.

Playing Biotech in 2015

With biotech performance hitting record levels, it’s certainly a safe play to take any gains off the table. The market has to correct at some point, and 2015 could very well be the year for this to happen. 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 of 2015 will have two things in common: value and diversification.

As fear builds, investors are going to fall back on companies actually generating money. When the bubble pops (and it will), stocks with the highest multiples (or no earnings at all) will come crashing down the hardest. For this reason, the best biotech plays in 2015 will 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)

Gilead is perhaps the cheapest large-cap growth stock currently on the market. The company became a force to be reckoned with in 2014 when it launched its hepatitis C therapeutic Sovaldi in February and received approval for its hepatitis C combo drug Harvoni in October.

These two drugs alone are expected to bring in ~$3.5 billion in the fourth quarter and will go on record as the most successful drug launch in history based on first-year sales.

Gilead’s Sovaldi/Harvoni treatments are just starting to launch in Europe and Japan, and sales are not expected to peak until 2017 at the earliest.

In addition, Gilead’s market-leading HIV franchise is still showing solid growth at about 10%. Further, the company continues to develop a deep pipeline with promising drugs in late-stage trials.

Gilead’s earnings for 2014 are projected to hit $8 a share — four times its earnings in 2013. Earnings growth in 2015 won’t be 400%, but earnings are expected to reach $10 a share.

In spite of this growth, the company still trades at a trailing P/E of 18.51 and a forward P/E of 10.5. Gilead is a clear discount compared to the rest of the industry.

PDL BioPharma (NASDAQ: PDLI)

PDL is a $1.3 billion company that’s patented a process to create humanized antibodies, which are used to treat cancer as well as infectious and autoimmune diseases. The company licenses its technologies to pharmaceutical and biotech companies in exchange for royalty payments.

PDL’s technology is especially valuable because its antibodies target diseased cells while leaving other cells unaffected. This method is in contrast to radiotherapies and chemotherapies that can damage healthy cells.

In addition, a patient’s immune system will not recognize PDL’s humanized antibodies as a foreign substance, as is the case with non-humanized antibodies.

PDL offers seven main products and has seen increased royalty revenue since 2000.

At face value, PDL is a major bargain. On top of consistent annual revenue growth, the company sports an abnormally low P/E of 4.2, a forward P/E of 3.68, and a five-year PEG of 0.3.

Furthermore, the company boasts a profit margin of 57%, is sitting on sales growth of 64% quarter over quarter, and pays out a generous 7% dividend.

Patent Cliff

The one caveat with PDL is that its set of patents is set to expire by December 2015 with no chance of renewal. Royalty obligations to PDL extend through 2016, though, so you can expect investors to hold on throughout the year for one last dividend payout.

The company has also recently invested $780 million into new revenue-generating assets according to analyst David Zanoni. Specifically, PDL is now offering financing to late-stage health care companies, essentially transforming itself into a biotech-focused lender.

PDL is providing debt financing for Durata Therapeutics (NASDAQ: DRTX), Direct Flow Medical, LENSAR, and Paradigm Spine in exchange for interest over time. And in addition to interest payments, PDL also remains focused on its royalty-based revenue model.

In exchange for providing growth capital, PDL is acquiring portions of royalty payments from some of its partners. This includes a recent $240 million investment for the rights to 75% of royalty and milestone payments for Depomed’s (NASDAQ: DEPO) type 2 diabetes products.

Because PDL is still in the process of acquiring income-producing assets, it’s impossible to project revenue past 2016, but the company has at least four more quarters of runway before we see any significant drop-off.

PDLI may not turn out to be a long-term hold, but 2015 could be its strongest year yet.

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 multi-drug resistant pathogens.

Development and Future Revenue

Enanta has been quietly developing a new class of antibiotics — the first in nearly 30 years — called “bicyclolides.”

As of 2014, the FDA began offering expedited programs for therapies targeting urgent infectious diseases to address the issue of antibiotic resistance. Drugs that meet the proper conditions are now classified as qualified infectious disease products (QIPDs).

Essentially, these are pipeline candidates put on the fast track.

In addition to an expedited approval process, QIPDs are granted an additional five-year exclusivity period. This environment, along with the growing threat of resistant strains, bodes incredibly well for companies such as Enanta.

As CEO Jay Luly, Ph.D., points out:

“[Enanta’s] new class of antibiotics shows promising in vitro activity against isolates resistant to vancomycin, linezolid and daptomycin, the three leading therapies often used against drug-resistant bacteria.”

As the first new class of antibiotics in decades, bicyclolides hold a major competitive advantage: Because resistant strains have yet to be exposed to this new group of drugs, they’ve not had the opportunity to develop any protective mutations.

While many current antibiotics are already becoming obsolete, it will take decades before bicyclolides lose their edge.

Current Revenue Stream

When it comes to a strategic business model, Enanta runs an incredibly tight ship. The company has been profitable for the last four years, earning a total of $62 million between 2010 and 2013.

Additionally, Enanta reported $100 million in cash and marketable securities as of March 31, 2014, with an estimated $155 million in milestone payments expected by next spring.

In terms of liability, the company has less than $3 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.

In April 2014, AbbVie submitted a New Drug Application seeking approval for a regimen of hepatitis C treatments that includes Enanta’s ABT-450 protease inhibitor. The regimen was designated as a “breakthrough therapy” by the FDA last year and is expected to be approved by the FDA on December 19th.

Further, the regimen is awaiting approval by the European Medicine Agency (EMA) and has already been granted “accelerated assessment.” Both applications generated a total of $40 million in milestone payments to Enanta, which is just a fraction of what will be seen in the future.

Upon commercial approval, Enanta is entitled to receive up to an additional $155 million in milestone payments, as well as royalty payments up to 20% on net sales. For reference, a recently launched rival hep. C product (Sovaldi) by Gilead Sciences brought in $2.27 billion in sales in Q1 of 2014 alone.

At the same time, Enanta is in a very similar partnership with Novartis regarding Enanta’s EDP-239 candidate, another hepatitis C therapeutic a bit earlier in the company’s pipeline.

In exchange for commercial rights to EDP-239, Novartis is obligated to reimburse Enanta for the manufacturing and quality assurance of up to $34 million. Enanta would also receive over $400 million in milestone payments through clinical trials and drug approval, as well as royalties in the mid-teens when EDP-239 reaches the market.

Value

As for value, Enanta remains one of the cheapest companies in the industry.

The stock trades at a trailing P/E of 27.09 and a forward P/E of 11.67. With zero debt, hundreds of millions in milestone payments on the way, and plenty of cash on hand, this is a relatively low-risk biotechnology stock.

Enanta hit a one-year high earlier this month and should bounce on approval of AbbVie’s hepatitis C regimen late next week.

Until next time,

Jason Stutman

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