Is There a Biotech Bubble?

The iShares Nasdaq Biotechnology ETF (IBB) has gained 46% this year, and that includes the 6% drubbing it’s taken this week. But biotechs are rallying today–the ETF is up 2.2% at 10:28 a.m., so investors need to decide whether they should be using the dip to buy or the bounce to sell.

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With that in mind, consider the latest report from Citigroup’s Yaron Werber and Jonathan Eckard, “Are We in a Biotech Bubble?,” which hit my in-box late last night. They never really answer the question–do analysts ever?–but they offer some advice to investors wondering what to do now:

Valuations for the biotech sector have appreciated considerably driven by generalist interest in the sector and growing optimism for pipeline success, drug innovation, and M&A deals. The growth profile of the sector is particularly attractive in an otherwise uninspiring macro growth environment. However, a pullback seemed inevitable as generalists evaluate what they actually own and begin to better factor in the risks involved in the small-/mid-cap sector on the heels of several disappointments. On several parameters, the sector has appeared stretched for several months. Given the recent selloff, we continue to like some of the stocks that are developing innovative products, and offer strong revenue/EPS growth. However, we caution that drug development is challenging and that there should be a better balance between returns and appetite for risks in stocks.

Werber and Eckard remain bullish on large-cap biotechs. They write:

While we concede that the valuations for the large-cap group are not cheap, they seem reasonable given the strong fundamentals and robust growth profiles. Given the scarcity of growth stocks in the overall market, we expect these stocks to bounce back once the concerns over the cliff are resolved. But the story looks different for small-/mid-cap stocks where valuations are broadly stretched and the Street is overly optimistic of the chances for pipeline success.

Recent IPO, however, not so much:

The biotech IPO market has been busy with >30 offerings YTD. These offerings have had a strong run this year with an average return of +93% from launch to peak share price. The average return from IPO debut to present is +36%. But this week, this group is down on average by -11% as investors begin to discount the risks involved as some clinical stage drugs have recently yielded disappointing results. In our view, investors need to be cognizant of the risks involved in the biotech sector and balance them with the potential rewards especially as expectations for future sales are becoming untenably high for some drugs.

Werber and Eckhard’s favorites include Gilead (GILD) and Celgene (CELG), and they find the “risk/reward…compelling” in Medivation (MDVN) and Tesaro (TSRO).

Celgene has gained 2.8% to $150.98 today, while Gilead has gained 4.6% after its leukemia drug worked so well that the biotech giant halted the trial.

Ariad Pharmaceuticals (ARIA) had its own trial halted yesterday, but it was by the FDA and it was because one of its drugs was deemed too dangerous–and caused the stock to lose two-thirds of its value. Investors are running scared, but there are optimists at Leerink Swann Research. Analysts Howard Liang and Gena Wang write:

We believe there remains a place for Iclusig in patients in the salvage setting despite continued cardiovascular (CV) toxicity findings. We believe that the growth of the chronic myeloid leukemia (CML) market, with the prevalence expected to double in the next 20 years according to a published report, and relatively high failure rate of 10-40% a year on prior line of treatment, creates a growing salvage opportunity that is more than sufficient to support ARIA’s valuation. There is no longer expectation of front-line use, therefore generic Gleevec is no longer a risk. The upside would be if CV toxicity can be successfully managed by patient selection and/or dose reduction to allow earlier use. The downside scenario of Iclusig being removed from the market seems unlikely to us given the lack of effective options for patients with T315I mutation and after a second-generation agent.

Shares of Ariad have fallen 1% to $5.77 today.