GSK - XBI: Uncorrelated Growth Capitalizing On The M&A Tidal Wave In Pharma

2023-04-21 11:13:41 ET

Summary

• We believe the M&A wave in the biotech sector presents a prime opportunity for investors to profit from the rising valuations of small and mid-cap firms in SPDR® S&P Biotech ETF.
• Big pharma companies, facing patent cliffs and pricing pressures, drive M&A activity, with substantial acquisitions expected from major industry players.
• M&A deals benefit target companies and reinvigorate biotech investors' portfolios, enabling reallocation to other high-potential biotechs.
• Investors must remain alert to regulatory hurdles and drug pricing scrutiny, but a 2023 M&A surge is projected to reinvigorate the industry and bolster biotech equities.

Thesis: Time to buy small- and mid-cap biotechs

As the M&A wave gains momentum in the biotech arena, we believe it is an opportune time for investors to capitalize on the rising valuations of small- and mid-cap biotech firms. The recent transactions in the pharmaceutical sector are promising indications of a potential industry recovery and bolster a scanty roster that features noteworthy ventures like Pfizer Inc.'s (PFE) $43 billion purchase of Seagen and Amgen Inc.'s (AMGN) $27.8 billion acquisition of Horizon Therapeutics.

The recent spate of M&A transactions, including Merck & Co., Inc.'s (MRK) $10.8 billion purchase of Prometheus Biosciences and GSK plc's (GSK) $2 billion bid for Bellus Health, exemplifies the growing hunger of big pharma companies to rejuvenate their pipelines in the face of impending patent cliffs and sustained pricing pressures.

Factors that are driving this recent M&A momentum in 1H 2023

Major industry players such as Bristol-Myers Squibb Company (BMY), Royalty Pharma plc (RPRX), AbbVie Inc. (ABBV), Biogen Inc. (BIIB), Gilead Sciences, Inc. (GILD), Pfizer, and Viatris Inc. (VTRS) are also anticipated to pursue substantial acquisitions in the near term, as per Moody's Investor Services . We believe this development could lead to deals worth 10% or more of the acquirer's market cap, potentially materializing as single or multiple transactions in a condensed timeframe.

Another key positive driver for the M&A momentum would be slowing down interest rate hikes from the federal reserve and slowing down the inflation rate. As the Federal Reserve moderates its pace of interest rate hikes and adopts measures to curb inflation, the cost of borrowing remains relatively low for corporations, including big pharma. This favorable financing environment facilitates the funding of M&A deals, as companies can access capital at attractive rates to pursue strategic acquisitions. Moreover, with the slowing inflation rate, the purchasing power of cash reserves on hand is preserved, incentivizing big pharma to deploy this capital in value-creating M&A transactions. Consequently, this macroeconomic backdrop supports an acceleration in M&A activity within the pharmaceutical sector as industry giants seek to enhance their pipelines and maintain a competitive edge amid changing market dynamics.

SMID cap M&A is the inflection point for XBI

These M&A activities not only benefit the target companies but also reinvigorate biotech investors' portfolios, enabling them to reallocate their assets to other high-potential biotechs. The notable premiums commanded in recent buyouts, such as GSK's 100% premium for Bellus Health, further underscore the profit potential of these deals for biotech investors. Recent occurrences, like Pfizer's $43 billion purchase of Seagen , have reinforced expectations for a revival in industry consolidation and backing for biotech firms. As big pharma corporations like Pfizer, Merck, Novartis, GSK, and AbbVie confront patent cliffs and revenue reductions, the $1.4 trillion in dry powder on biopharma balance sheets at 2021's end presents an unparalleled opportunity for M&A activity to thrive.

Furthermore, the present financial difficulties experienced by small and mid-sized biotechs render them ideal acquisition candidates. The SPDR® S&P Biotech ETF ( XBI ) has plunged +50% since the 2021 high, and both IPOs and SPAC funding for biotech firms have waned, constraining their access to capital. Given that these enterprises generally necessitate significant capital infusions to maintain their extensive product development cycles, a resurgence in M&A activity would offer a crucial lifeline.

XBI: excellent ETF to get exposure to SMID cap biotech

The SPDR® S&P Biotech ETF offers generalist investors a more advantageous route to gain exposure to small and mid-cap biotech stocks compared to individual stock picking, particularly due to the following reasons:

1. Diversification: Investing in the XBI ETF allows investors to spread their risk across a broad range of biotech companies, reducing the impact of any single stock's underperformance on their overall portfolio. This is particularly crucial in the biotech sector, where the success of a single drug or therapy can significantly impact a company's valuation.

2. Expertise: The biotech industry is highly specialized, and accurately assessing a company's potential often requires a deep understanding of the underlying science, clinical trial data, and regulatory landscape. The XBI ETF is managed by professionals with domain-specific knowledge, providing investors with an expertly curated basket of stocks, which mitigates the risk associated with individual stock picking.

3. Cost Efficiency: The XBI ETF typically boasts lower fees compared to actively managed funds, which can erode returns over time. Additionally, investing in an ETF eliminates the need for investors to perform extensive research and due diligence on individual companies, saving them time and resources.

4. Liquidity and Flexibility: ETFs, including the XBI, are traded on exchanges like individual stocks, offering investors the benefit of liquidity and flexibility. This enables them to enter or exit positions conveniently, based on market conditions and their investment objectives.

Risks

1. High volatility: Small and mid-cap biotech stocks typically exhibit greater price fluctuations, exposing investors to higher levels of market risk and potentially impacting short-term returns.

2. Longer time to profitability: Biotech firms often require extended periods for R&D and regulatory approvals, resulting in delayed revenue generation and potential financial strain on investors.

3. Regulatory hurdles: The complex and stringent regulatory environment in the biotech sector poses risks to product approvals, potentially affecting the future success and valuation of small and mid-cap companies.

4. Competitive landscape: Rapid advancements in the biotech field and competition from larger, well-funded pharmaceutical companies may challenge the growth prospects of smaller firms, impacting investment returns.

Summary

We maintain a buy rating for XBI ETF. The accelerating M&A fervor in the biotech sector presents a prime opportunity for investors to profit from the increasing valuations of small and mid-cap biotechs. We believe by investing now; investors can leverage the capital and innovation influx stimulated by big pharma buyouts, ultimately reaping substantial rewards as their portfolio positions are procured at enticing premiums. However, investors must remain alert to potential regulatory hurdles posed by anti-trust authorities and the broader examination of drug pricing. Nevertheless, a surge in M&A undertakings in 2023 is projected to reinvigorate the industry, hasten innovation, and bolster the performance of biotech equities. For most investors, we believe XBI would be the safest way to get exposure in small- and mid-cap biotech with optimal diversification.

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