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Biotech Roundup: Genentech Takeover, Revolving Door, Randoms


The week that was in biotech...


Another Week, Another Takeover

Genentech (DNA) announced this morning the acquisition of Tanox (TNOX) for $919 mln in cash, a nice premium to yesterday's close.

One a week is all I ask.

Takeovers as a driver of the biotech sector valuation have been a theme of mine for some time – long enough, in fact, that I sometimes feel like a stopped watch every time I write about it. I freely admit I didn't see pharma's acquisition spree in the private sector lasting as long as it did, nor did I believe that the disconnect between high private valuations and low public valuations would be so persistent. Now that the private sector is picked clean, it's the turn of the public biotechs to see their valuations catch up.

I particularly pounded the table on biotech acquisitions around this time last year. The driver was new FASB acquisition accounting rules that create much less favorable accounting policies for drug company acquisitions of biotechs. In December 2005, however, FASB postponed the implementation date of the program. I opined at the time that this would push acquisitions into late 2006 and early 2007, presuming the expected effective date of the new rules to be year end 2007.

We're there now, so let's see if this early trickle of public acquisitions turns into a flood.

Revolving Door Biotech Portfolio Managers

The portfolio manager (PM) position at some funds is something of a revolving door – particularly for sector PMs within larger macro funds. The door has been spinning particularly fast lately for biotech PMs. It has been a tough year for most biotech hedge funds as even those who are making money have been feeling a little overwhelmed by all the crosscurrents.

Short-siders are starting to get "blind-sided" by these acquisitions. Take these three recent acquisitions:

(I include the open call interest to reinforce what I've written recently concerning short interest in the biotech sector – specifically, it is very rare to find open options interest that correlates to the short interest number.)

Even if we assume all the open call interest was owned by those short the stock, which is unlikely in this sector, these deal announcements caused some migraines at a few funds. It's more likely the pain of the acquisition is magnified since biotech short sellers tend to be call sellers, too.

Any acquisition frenzy in a small sector like this feeds on itself. Speculators start moving in to see if they can pick the next takeout. Short sellers get nervous and start covering. Market caps rise, pushing prices paid higher. Rinse and repeat. It is a great deal of fun if you're long. Not so much if you're not.

When the process starts to really heat up, 100% acquisitions are replaced by big equity purchases at prices well above current market cap. For example, a company will come in and buy 19.9% of a target (keeping them off their balance sheets) for 3-5 times the current trading price of the target. Sometimes these deals come with a purchase option. Other times they don't. You'll see these deals about 3/4 of the way to the top of the cycle.

What's at the top? The tippy-top is probably the second or third company that announces it is raising umpteen billion via a public offering to roll up small biotech companies. There's a lot of money to be made when this nonsense starts happening, but your trigger finger needs to be pretty itchy.

Random Thoughts

  • It is not enough as an investor to simply acknowledge the Democrats' majority in Congress is likely to be bad for pharma companies. You have to (a) understand exactly how; and (b) figure out how to profit from it aside from the obvious shorting. The proposed rules will hit the blockbuster drugs sold through family physicians the hardest. Knowing pharma management realizes this and won't sit idly by while their sales and EPS plummet, you should start thinking about what drugs can replace the blockbusters. Drugs sold through specialists like cancer drugs and especially orphan indications are those most likely to be insulated from the worst of any regulations. Pharma has to go out and acquire these drugs. They don't own them now because the drugs don't fit their blockbuster mentality. Where do they find them? Small biotech companies.

  • The JP Morgan Healthcare Conference is Jan 8-11. Mark this down as it traditionally kicks off the biotech buying season. Remember the seasonal saw: "Buy JP Morgan (JPM), sell ASCO."

  • In case my point in the blurb about Congress, pharma and blockbuster drugs was unclear, I don't think a Democratic majority in Congress is bad for biotech. Different? Yes. Bad for some companies? Particularly those intending to create mass-market lifestyle drugs. Net positive for the sector, though? I think so, but we won't know for certain until we see what the PDUFA-4 (Prescription Drug Fee User Act) proposals look like.

  • My firm lost the net connection in our office yesterday. We had a low-bandwidth wireless connection to a couple of laptops to keep us from going mad. It was disarmingly peaceful and productive in what has otherwise been a nutso week.

  • It's been interesting reading the comments on a piece I wrote saying Dendreon's (DNDN) FDA panel early next year might be a pivot point for the sector. I opined a few weeks ago that a positive outcome to the panel might be as beneficial to the bulls as a negative panel outcome was to bears in the spring of 2004. This could be a considerable catalyst.

  • PDUFA-4? The regulatory framework of the FDA in terms of timing and user fees is memorialized in the Prescription Drug Fee User Act – PDUFA. The first of these was signed last decade and they renew every three years. The reason I can be so confident that changes to the industry are coming is that PDUFA-3 expires September 30, 2007. It has to be renewed or else the FDA loses over 50% of its current budget.
Position in DNDN

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