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Biotech goes into the breach


Put me in coach, I'm ready to play.

At noon yesterday, the NASDAQ Biotech Index (NBI) tumbled out of the range it has been stuck in for most of two weeks. Two hours later, it broke through the 650 floor I've been writing about. It bounced briefly off 646, then continued to the session low of 643 before rebounding slightly at the low to close at 645.

The damage was widespread as there were only 17 advancers, 2 unchanged, and 140 decliners in the NBI. It has been some time since this index of largely development-stage biotech companies has been so negative.

The next support level is the August 2004 low at 622. Support after that is the April 2003 low at 505.

While we must account for the possibility the August low will come into play, a piercing of the 650 support was expected. I did not believe that biotech would bounce cleanly and would, in fact, need to have a blow off through obvious support in order to begin to make some progress.

I expect that blow off to begin this morning. At the bottom in 2002 (07/10/2002), we had consecutive 3% down days followed by a 7% down day that put in the bottom. I wouldn't be too surprised to see something similar take place this week and into the early part of next week. I'm not certain any significant rally can be put in before the payroll data on Friday.

It's also fair to note the NBI in July of 2002 year put in a few -6% and -7% days to get to that low on 7/10. I'm not convinced we can have the kind of single-day volatility we saw that July in today's black box environment, but it is worth factoring those tail events into your risk assessment. Just in case.

A few days back I shared with you an IBB common/IBB put option strategy not as advice, but as an illustration to what I was thinking about the sector. If you're inclined to play for picking the bottom here, that kind of defined-risk play makes the most sense to me.

If you have a bunch of biotech, I feel your pain. It's not been fun watching the portfolio drop day in and day out while the fundamentals get better or stay level. If you're paralyzed, you have to get unparalyzed.

If you don't want to defer to the price action, you have options. You don't have to be paralyzed. Go out and get yourself some put coverage. I'm not talking about emptying your piggy bank, but get something in your biotech portfolio that increases in value when the sector is going down.

This isn't a panacea or a placebo or a substitute for real action if you're overweighted portfolio is in danger of killing your net worth. What it does is give you some breathing room. B-R-E-A-T-H-I-N-G R-O-O-M.

Use that breathing room to go back to the sheets you wrote when you entered the position. Make sure you should still be in the stock by making sure none of the reasons you wrote down for exiting have happened.

Use the breathing room and lack of paralysis to make some smart decisions about weighting in your portfolio.

Use the breathing room to avoid the panic. Stand back and watch everyone else freak out. While they are freaking, you're planning to take the other side of their trade.

Biotech outlook

$100B in repatriated cash from the top nine pharma companies.

$119B market cap (roughly) from the 159 companies in the NASDAQ Biotech Index.

More than $40B in big pharma revenue at risk in the next 3-4 years either directly from patent expirations or indirectly from generic competition.

That math makes me want to be in the biotech sector. That math makes me want to give myself some breathing room during this time of carnage so I can get a plan to take advantage of other people's panic.

Big pharma must switch their business model from large population drugs sold through general practitioners and towards drugs targeted to smaller populations and sold through specialists. The therapeutic benefit is clearer in the smaller populations. Targeted drugs have fewer side effects. Trials are cheaper to run. Sales teams focused on specialists are smaller. Lower costs, less risk, higher margins.

The problem is all of those advantages allow biotechnology executives to sell their own drugs - or at least think they can sell their own drugs. After all, with Pfizer (PFE) laying off 12,000 sales people, constructing a sales force shouldn't be too difficult.

Three years ago, biotech executives wanted to get a bunch of cash and a royalty on U.S. sales around 25% from their big pharma partners. Today, they want to run their own U.S. marketing (sometimes with help, sometimes on their own), get 25% from ex-U.S. sales, and they want a bunch of cash. This is the type of deal big pharma is facing.

The playing field has shifted for big pharma and they've sat on their hands. That wasn't very smart as biotech companies raised a ton of money last year and can wait their bigger brothers out. If it were not for the repatriated cash and ticking time bomb of patent expirations, I might be persuaded big pharma would hold off a little while longer.

But their months-old bluff isn't working. Their negotiating position is getting worse. Want to hear the latest deal twist we're hearing about? The big obstacle in many partnering negotiations is that both biotech and pharma want U.S. marketing rights. The compromise biotech execs have devised is to negotiate cash payments for what I call "reverse royalties." A reverse royalty is where the biotech company handles all the sales for North America, but pays a percentage of those sales to their big pharma partner in exchange for a substantial up-front cash payment (or equity investment priced at a premium). This is an exact flip-flop of the relationship we saw three years ago.

Mark my words: Before this time next year, we will see some eye-poppingly large deals with this feature.

Bottom line is I'm still excited about the prospects in biotech. I wish I could guarantee you a bounce around these levels, but I can't. The best I can do is tell you to get yourself some breathing room and avoid the panic that is obviously gripping the sector.

No positions in stocks mentioned.

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