Biotech Stock Outlook: Short-Term Pricing Pain to Prevail

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The revival in the ever-volatile biotech sector has not lived up to expectations so far in 2018. The performance of biotech bigwigs has been affected by the slowdown in progress of the key drugs. Competitive pressure has also adversely impacted the top line.

While issues like drug pricing and competition will remain headwinds, an ace investor will know that the biotech sector can be a lucrative market for investment. Moreover, it is widely expected that the sector will rebound in the second half of the year.

New drug approvals had boosted investor sentiment to a certain extent in the first half. Moreover, the approval of these drugs should boost their respective companies' top line as a few of them are struggling with a decline in sales of legacy drugs.

We believe new drug approvals, label expansion of existing high-profile drugs, pipeline progress, growing demand for drugs, especially for rare-to-treat diseases, an aging population and increased health care spending are some of the factors that should positively impact performance.

Owing to competitive pressure, quite a few companies have resorted to cost-cutting initiatives, which in turn should propel the bottom line somewhat.

Meanwhile, mergers and acquisitions (M&A) have picked up pace in the sector as a slowdown in mature products has forced companies to eye lucrative acquisitions to bolster their pipeline. Additionally, the increase in M&A activity is also being propelled by the implementation of the new tax law which has slashed corporate tax rate from 35% to 21%.

The new tax reform is also luring corporates to bring back huge cash held overseas at a one-time tax rate of 10%. We expect many more such deals in the latter half as well.

Industry Lags on Shareholder Returns

Even though the macroeconomic conditions look better than those in 2017, the price performance so far in 2018 has not been that impressive. As mentioned above, the decline in sales of legacy drugs and pipeline setbacks have adversely impacted the price performance of the key biotech players and in turn has pulled down the average for the industry.

The Zacks Biomedical and Genetics Industry , which is a 281-stock group within the broader Zacks Medical Sector , has underperformed the S&P 500 and the sector it belongs to on a year-to-date basis.

While the stocks in this industry have collectively declined 6.4%, the Zacks S&P 500 Composite and the Zacks Medical Sector have risen 1.7% and declined 1.1% year to date, respectively. The magnitude of decline in bigger companies has more than offset gains recorded by the small biotechnology companies.

Year-to-Date Price Performance

Biotech Stocks Trading Cheap

Given the underperformance of the industry so far this year, the valuation looks cheap now. Valuation is a tricky business for the biotech companies. It takes several years for a drug to get regulatory approval and so the regular price multiple ratios do not provide a fair picture for biotech companies. More importantly, these companies spend a lot on R&D and hence it is more complex to account for such high expenses on an uncertain future revenue stream.

While there is always uncertainty regarding trial results and FDA decisions, one might get a good sense of the industry's relative valuation by looking at its price/book ratio.

The industry currently has a Price/Book TTM ratio of 3.45, which is toward the highest level in the past year as well as the past five years. When compared with the highest level of 3.57 and median level of 2.18 over the past year, we believe investors can wait for any dip to enter the market.

The space also looks inexpensive when compared with the Medical market at large, as the current as well as median Price/Book TTM ratio for the Medical sector is 4.34 and 4.12, respectively.

Price-to-Book Trailing Twelve Months (TTM)

Compared to the Zacks S&P 500 Composite too, the space looks inexpensive. The current ratio for the S&P 500 of 3.85 and the median level of 3.74 for the same period are above the Zacks Biomedical and Genetics industry's respective ratios.

Price-to-Book Trailing Twelve Months (TTM)

Earnings Outlook Looks Negative

While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term. One reliable measure that can help investors understand the industry's prospects is the earnings outlook for its member companies. Empirical research shows that a company's earnings outlook significantly influences the performance of its stock.

One could get a good sense of a company's earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year's reported number. But an effective measure could be the magnitude and direction of the recent change in earnings estimates.

The trend in earnings estimate revisions has not been favorable either. Pipeline setbacks have led to many companies slashing their outlook.

Price and Consensus: Zacks Biomedical and Genetics industry

Looking at the aggregate earnings estimate revisions, it appears that analysts have started to lose confidence in this group's earnings potential.

The consensus EPS estimate for the current fiscal year has been revised 4.5% downward since May 31.

Current Fiscal Year EPS Estimate Revisions

Zacks Industry Rank Indicates Prospects for Improvement

The group's Zacks Industry Rank is basically the average of the Zacks Rank of all the member stocks.

The Zacks Biomedical and Genetics industry currently carries a Zacks Industry Rank #163, which places it at the bottom 39% of more than 255 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry's rank has deteriorated considerably in the past two weeks.

Small Biotechs Promise Long-Term Growth

While the near-term outlook is not encouraging, the long-term (3-5 years) EPS growth estimate for the Zacks Biotech industry appears promising. The group's mean estimate of long-term EPS growth rate reached a trough at the start of the quarter but has revived thereafter to reach the current level of 13.47%. This also compares favorably with 9.98% for the Zacks S&P 500 composite, the highest level in past one year.

Mean Estimate of Long-Term EPS Growth Rate

An important indication of solid long-term prospect of smaller biotech companies is improvement in the free cash flow yield. The image below shows a consistence performance in the group's free cash flow yield since 2017.

Free Cash Flow Yield- Zacks Biomedical and Genetics Industry

Growing demand for drugs particularly targeted for personalized therapies, increase in the incidence of chronic diseases and technological advancements, evolving treatment regimens, an aging population and increased health care spending are some of the factors that should keep the sector on track in the long term. A faster drug approval process and the proposed removal of outdated regulations that push up costs and a slowdown in innovation should also provide benefits.

Bottom Line

The Biomedical and Genetics industry is continuously evolving and largely volatile. In such a scenario, biotech companies are expected to adopt innovative business models, invest in new technologies, increase investments in personalized medicines and seek external partners and collabora¬tors for complementary strengths.

The sector is stumble upon challenges posed by the drug pricing issue, pricing/re-imbursement pressure, increasing competition, slowdown in legacy product sales, loss of patent exclusivity of some key drugs and pipeline related setbacks.

However, pipeline success in innovative and important therapeutic areas, cost cutting, share buybacks, new product launches, increased M&A activity and appropriate utilization of cash may bring the sector back on track this year.

The industry currently has quite a few stocks, which sport either a Zacks Rank #1 (Strong Buy) or 2 (Buy). Here, we list a few such stocks that have also been witnessing positive earnings estimate revisions.

Amgen, Inc. (AMGN) is one of the leading biotech companies in the world. The consensus EPS estimate for this CA-based company has moved 7.9% higher for the current year over the last 60 days. The Zacks Rank #2 stock has rallied 8.4% so far this year. You can see the complete list of today's Zacks #1 Rank stocks here .

Price and Consensus: AMGN

Illumina, Inc. (ILMN) has been seeing positive revisions in earnings estimates over the last 90 days. Analysts have revised estimates upward by 5.6% for the current year. Further, the Zacks Rank #2 stock has surged 28.5% this year.

Price and Consensus: ILMN

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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