Henrik Ekman BioTech Equity Analyst

Outlook for Biotech and Life Science investing: Darkest before the dawn?
We have just passed the 3-year anniversary of the emergence of covid-19. It is worth celebrating that the pandemic is contained and under control, but from an investment perspective it has been a very challenging period for Biotech and Life Science investors. It started out fantastic, though. A gold rush of new covid-19 vaccine candidates projects emerged globally, and together with high risk-appetite in financial markets due to historical low interest rates, Biotech and Life Science stocks outperformed the broader market with an astonishing 80 percent in the first year of the pandemic. But as interest rates started climbing back up, and the few winners – and many losers – in the covid-19 vaccine developing race became clear, a dramatic period of underperformance started, resulting in an almost 55 percent underperformance for Biotech and Life Science stocks when measured over the last three years. So, as we look back there is nothing to celebrate from an investment perspective. And if it takes an uncontrollable global pandemic or unsustainable low interest rates for Biotech and Life Science stocks to start outperforming, that is probably not desirable either.

Dark clouds continue to haunt the sector
The negative sentiment is not just an annoyance for investors that could have earned better returns elsewhere. For the Biotech and Life Science companies it has real financial and operational implications as negative sentiment affects the ability to raise capital. It is an integral and vital part of running a Biotech and Life Science company to be able to fund development of the company’s pipeline. When capital is harder to attract and becomes more expensive, it affects operations negatively with lay-offs, and postponement and cancellations of projects etc.

Normally, when risk appetite is accommodative in financial markets, Biotech and Life Science companies can raise capital on an ongoing basis without obstacles. Typically, every 12-18 months. Normally, this means companies are free to focus on finding the right balance between the long term need for capital, and the risk of selling new shares to cheap on a short-term basis. A balancing act based on the assumption that projects continuously become more valuable as they move closer to completion, and therefore capital should be raised in smaller sizes accordingly, typically when milestones are met and add to the value of the company.

Unfortunately, there is no normal or accommodative risk appetite in the markets currently. But Biotech and Life Science companies are still burning cash and need to refinance themselves. When the share price has fallen and they need the same absolute amount of capital, they have to issue new shares at a greater discount than otherwise planned to attract investors, which means higher dilution of existing shareholders. To illustrate, a compilation of rights issues currently taking place in the Nordic countries shows the average discount to the share price is more than 50 percent, which is almost twice as much as the last time some of these companies raised capital 12-18 months ago.

Bigger discounts and potential higher dilution are not the only problems whit a low share price. As Biotech and Life Science share prices have moved lower the last couple of years, a new problem is starting to emerge. Biotech and Life Science companies need to be listed on stock exchanges to potentially be able to raise capital, and to do this at a better price than if they were unlisted companies seeking private funding. But to be listed in the biggest market for Biotech and Life Science companies at the Nasdaq exchange in US, the exchange requires that the share price for any given company stay above one dollar. Otherwise, the company’s stock risks being delisted from the exchange. According to the US based research company Fierce Biotech, Nasdaq reports that the number of Biotech and Life Science companies trading below USD 1 facing potential delisting grew dramatically to 64 in the fourth quarter last year, which was almost the same as the three previous quarters combined. The companies do get a period to fix the problem, and there are of course ways to deal with this, some of them being a reverse stock-split, or a merger with a company with a higher share price. But the first solution costs money in transaction fees and requires shareholder approval which is time-consuming, and a forced merger out of necessity is probably not desirable either, so both solutions merely just add to the challenges these companies face.

Adding to these well-known problems, the sector is being hit by turmoil in the banking sector. Half the Biotech and Life Science companies in US were clients in the now closed Silicon Valley Bank. It is unclear how a potential banking crisis will unfold, and what the general market og specific sector implications will be. As mentioned, the Biotech and Life Science sector is heavily dependent on a more accommodative risk appetite to re-emerge in financial markets, so anything that creates increased uncertainty risk lowering risk-appetite from an already low level. Financial authorities – backed by assessments from experts and analysts – are doing their best trying to calm markets and provide liquidity to the banks that needs it. Unfortunately, irrespective of the intentions of financial authorities, general uncertainty will probably remain in financial markets in the short term.

As described above there are many deteriorating risk-appetite related issues to be concerned about. But before we conclude lower risk-appetite is bad per se, we should also recognize that lower risk-appetite could provide a well-deserved inducement of more discipline into the Biotech and Life Science sector. Some argue that high risk-appetite and abundant liquidity flowing in the financial system has led to too many companies to raise too much capital for too early development projects that should perhaps have progressed further before they were used as levers to raise capital.

Biotech and Life Science is still relevant and green shoots emerging
Once again, we managed to comment on a lot of the negative sentiment issues without discussing what is ultimately the driver of Biotech and Life Science share prices longer term – the ability to develop, approve and launch new lifesaving treatments and products. That ability is by no means being diminished. In the last edition of the BioSnack we highlighted the long list of major new product launches taking place this year, that are all expected to grow to blockbuster status of more than USD 1 billion in annual sales within the coming years. Those are just examples, but they illustrate that many Biotech and Life Science companies are still very much alive and continues to develop and launch new value-added treatments and products on a large scale.

Big Pharma are also aware of this. In the beginning of the year a number ofacquisitions by Big Pharma was announced, and last week Pfizer announced one of the largest Biotech acquisitions in history when Pfizer acquired ADC-based cancer treatment developer Seagen for USD 43 billion. Of course, Pfizer had a lot of extraordinary profits from Covid-19 vaccines to spend, but other Big Pharma also have plenty of cash, relative thin pipelines, and upcoming patent expiries for some of their major products at a time when BioTech and Life-Science valuations are very low. That could be a good recipe for increased acquisition activity starting to emerge.

In the last couple of weeks, venture capital funds focusing on private financing of Biotech and Life Science start-ups are also becoming more active as they announced a number of deals that typically is being done before IPO-listings. This could be a sign that a group of important long-term and ‘insider’-type kind of investors into Biotech and Life Science are becoming more positive. The venture capital funds are not the only one becoming more active, as the so-called Advanced Research Projects Agency for Health (ARPA-H) financed by the US Government is about to invest up to USD 2,5 billion in its first tranche into projects focusing on cancer treatment in private and listed companies. The ARPA-format is not new as it follows similar ARPA-D (for Defence) and ARPA-E (for Energy) schemes launched by previous US governments, and it could prove significant going forward as a combined USD 11 billion in a number of tranches has been invested in different projects under the ARPA-E scheme so far. Combined, the increased activity from these insider-type and science-based investors could be a sign that sentiment towards Biotech and Life Science investing is starting to turn slightly more positive.

The underlying reason we see these green shoots of activity is also the current low valuation of many Biotech and Life Science stocks. Low valuation in itself is not enough to turn the sentiment around. Liquidity needs to start flowing better in financial markets, incentivizing not only the above-mentioned insider-type and science-based investors but hopefully also the generalist type of investors to start buying Biotech and Life Science stocks again. And if this leads to higher share prices, the negative spiral of lower share price leading to increased fundingdifficulties, reverses. Higher prices, means less potential dilution, increasing the willingness for investors to fund the company and so on.

Admitted, regular readers of the BioSnack Newsletter have heard many of these arguments before, but that does not necessarily mean it is wrong. Timing the market and guessing when sentiment shifts in financial markets is almost impossible, but we know that it will shift at some point – especially when we are so far into negative territory as we are with Biotech and Life Science stocks. The green shoots of increased activity from Big-Pharma, venture capital and science-based public investment programs suggest we are getting closer to that point.