Warning: This Might Be The Most Overvalued Sector In The Market

When it comes to assessing the outlook for drugmakers, investors really only care about the pipeline of new drugs. After all, existing drugs eventually losepatent protection, and when that happens, a large hole in theincome statement can appear.

Just a few days ago, I looked at the prospects for traditional drugmakers and concluded that Bristol-Myers Squibb ( BMY ) and Eli Lilly ( LLY ) are among the handful of Big Pharma firms with appealing pipelines.

The renewed pipelines are in some instances giving thosestocks a solid boost, withshares rising at an impressive pace over the pastyear . But these stocks still can't keep up with the industry upstarts: biotechnology firms.

These companies, which have emerged over the past few decades tocapitalize on drug development through living organisms, have posted even more stunninggains over the past 12 months. Look at what these stocks have done in comparison with the 24% rise in the S&P 500.

Of course, a sharply risingstock doesn't automatically equate to anovervalued stock. How a company can sustain growth for the next five to 10 years is what can justify furtherupside . And that can only come from a broad base of clinical opportunities that canyield multiple drug platforms.

Celgene (Nasdaq: CELG) is a good example of such foundational platform building. The company has four key drugs: Revlimid, Abraxane and Pomalyst for cancer, and a newer drug, Apremilast, that is targeting autoimmune diseases in clinical trials. Thatdiversification explains why investors have pushed this stock up roughly 85% since June 2012.

Back then, investors thought that a heavy reliance on Revlimid (70% of projected 2013sales ) might lead to future vulnerability, but management has made a strong case for the other drugs, which should account for as much as half of sales by 2017.

Indeed, management's five-year plan helps explain why investors see Celgene capable of eventually generating $12 billion in annual sales by 2017. Equally important, these sales should carry solid gross margins, so management expects operatingprofit margins , which currently hover just under 50%, to hit 55% by 2017.

Yet as you start to dig into the other biotechs noted on the table above, anote of caution emerges. Concerns include:

  • Are investors andanalysts being too optimistic on the chances for FDA approval of late-stage drugs in the pipelines?

  • Will these drugs, many of which will carry very high price tags, face reimbursement pressures as health care dollars shrink?

  • Can these companies, which only a year or two ago seemed to have moribund pipelines, sustain the newfound pipeline momentum that has many investors expecting a growth trajectory well beyond 2015?

Gilead Sciences (Nasdaq: GILD) neatly encapsulates these concerns. The company's strong franchise of antiviral drugs targeting HIV and other viruses, while respected, gave the company the appearance of a one-trick pony. Yet Gilead's $11 billionacquisition of Pharmasset in January 2012 gave the company access to Sofosbuvir, a promising drug against hepatitis C.

Hepatitis C is a large globalmarket opportunity, and the two current leading drugs on the market, Vertex Pharmaceuticals' (Nasdaq: VRTX) Incivek and Merck's ( MRK ) Victrelis, have been seen as interim but not ideal long-term solutions. Those two generate roughly $1.2 billion in aggregated annualized sales.

Yet Gilead's Sofosbuvir has single-handedly changed the expectations in the hepatitis C market. Tens of billions of dollars inmarket value have been added in the past year, even though this drug hasn't been approved. (Said another way, Gilead's market value has increased at four times the rate for the $11 billion purchase of Pharmasset.)

Even assuming eventual approval, investors still need to question this drug's total opportunity, considering Gilead intends to charge roughly $90,000 for an annual dosing. Recall that this is the price that Dendreon (Nasdaq: DNDN) aimed to charge for its prostate cancer drug Provenge, which has been a disappointment (perhaps due to that large price tag).

The Laws Of Bigness

In their zeal to bid up biotech stocks, investors need to remember the key concern that has come to hamper Big Pharma stocks like Merck ( MRK ) and Pfizer ( PFE ) . Once a sales base becomes large enough, it gets harder to move the needle.

That's precisely the concern facing Amgen (Nasdaq: AMGN) . The company has five key drugs, which account for roughly $15 billion in annual sales. Still, sales grew less than 2% annually from 2007 through 2011. A few new drugs have been added to the mix recently, which should push the total sales base to around $18 billion this year, but sales are projected to grow less than 5% in 2014 and 2015 due to a fairly thin late-stage pipeline.

So why is this stock up 46% over the past year? Management has taken a cue from rivals and started to talk up the prospects of the company's longer-term pipeline, and biotech investors are eager to get their hands on anybusiness model in this industry. Amgen may look like the bargain of this group, trading for just four times projected 2015 sales, but that multiple is still higher than those sported by its Big Pharma peers.

Risks to Consider: As an upside risk, this industry is always busy withmerger and acquisition activity, and industryconsolidation could take any of these stocks higher.

Action to Take --> Biotech stocks were generallyundervalued a year or two ago in the context of those firms' clinical pipelines. Yet thatcatalyst is now gone, and these companies are expected to deliver solid sales for most of their drugs in phase II and III clinical trials. Will these companies have a high hit rate with these drugs? Time will tell.

The constrained health care spending environment, the potential cannibalization of newly approved drugs on existing drug franchises, and double-digit price-to-earnings ratios -- on 2015 projected profits -- means these stocks are now more vulnerable to a pullback than they have been in quite some time.

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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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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