Drug & Biotech Companies with Undervalued Pipelines: Updated View

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Richard Evans / Scott Hinds / Ryan Baum

203.901.1631 /.1632 / .1627

revans@ / shinds@ / rbaum@ssrllc.com


June 12, 2017

Drug & Biotech Companies with Undervalued Pipelines: Updated View

  • Phase II and earlier pipelines account for about one-third of larger biopharma companies’ market values; however, because the market knows much less about these ‘hidden’ pipelines than about companies’ ‘non-hidden’ operations (e.g. existing, filed, or phase III projects), we believe hidden pipelines drive substantially more than a third of relative share price performance – perhaps even the majority
  • Using patent data, we can better determine what’s actually in companies’ hidden pipelines, and by extension whether share prices fairly account for hidden pipelines’ contents. Since inception (4Q12), stocks identified as undervalued using this method have outperformed the peer group by 71 percent (2.0x)
  • We also use a systematic analysis of clinicaltrials.gov data to identify products that are moving along in clinical development, but not yet captured by consensus or reflected in share prices. Stocks selected using our clinicaltrials.gov-based method outperformed peers by 84 percent (2.8x) since 2Q13 (backtested until July 2015, prospectively since), as compared to the 46 percent (2.0x) prospective outperformance achieved with the patent-based method over the same period
  • The patent-based and clinicaltrials.gov-based methods tend to choose different stocks; in effect, each method tends to choose stocks the other method would likely miss. Using a blended strategy yields outperformance of 86 percent (3.5x) – better than the clinicaltrial.gov approach alone, and with thirty percent less volatility
  • BMY, VRTX, Roche, SNY and ABBV screen as undervalued using the patent-based method. As of this quarter AZN and GSK no longer screen as undervalued using the patent-based method; and, based on our well-documented belief that consensus overestimates prospects for Humira (ABBV),[1] we exclude ABBV from the long portfolio, even though it screens as undervalued under the patent method. GILD, LLY, and ALXN screen as undervalued using the clinicaltrials.gov-based method; as of this quarter CELG and REGN no longer screen as undervalued under this method

Premise and rationale

Share prices of drug and biotech stocks can be broken down into two major components: the capital markets’ estimates of the value of assets that are well characterized (i.e. on-market, filed, and late-stage developmental projects), plus the markets’ estimates of the value of assets about which relatively little is known (i.e. pre-phase III projects). For simplicity, we refer to early, pre-phase III developmental projects collectively as the ‘hidden pipeline’

To estimate the market capitalizations of hidden pipelines, we subtract from each company’s enterprise value (EV) an estimate of the present value of everything else – marketed products, products filed for regulatory approval, products in phase III development, and all non-pharma lines of business. On average, hidden pipelines account for about 33 percent of companies’ EVs, and the percentage of EV explained by hidden pipelines ranges from a low of 9, to a high of 72 percent (Exhibit 1)

Even though hidden pipelines are just one-third of companies’ market values, we believe they account for most of the mid- to longer-term change in these companies’ relative share prices. Because the markets have substantially more information regarding non-hidden operations than they have regarding hidden pipelines, the valuations of hidden pipelines are much rougher guesses. By extension, this implies that hidden pipeline valuations are far more volatile than the valuations of non-hidden operations, and by further extension that hidden pipelines explain substantially more than one-third of relative performance among these stocks. It follows that anchoring biopharma stock selection to sound estimates of ‘true’ hidden pipeline values is likely to generate outperformance

How we establish relative values of hidden pipelines

Having solved for the market capitalization of a company’s hidden pipeline, the question becomes whether the assigned market value closely reflects the value of what’s actually in the hidden pipeline

Since 4Q12, we’ve utilized patent data to estimate hidden pipelines’ relative values. This method has worked extremely well; in ten out of twelve updates since inception, stocks identified as undervalued have outperformed stocks with fairly (or over-) valued pipelines. And since 2Q13, cumulative outperformance of the undervalued pipeline has been 46 percent (2.0x) (Exhibit 2, top rows)[2]

Patents offer a very thorough inventory of companies’ research activities, but offer virtually no insight into stages of development. Companies must disclose all clinical trials (on clinicaltrials.gov) for all products for which they intend to seek US regulatory approval, and sell-side analysts tend to publish forecasts for meaningful projects in late-stage clinical development. However, consensus estimates capture less than one in ten phase I/II projects (Exhibit 3a), and fail to capture very large portions (nearly 80%) of the total clinical development activity that companies disclose (Exhibit 3b). In fact, even controlling for phase of development, only 11 percent of phase I/II, and 63 percent of phase III assets disclosed by the peer group at clinicaltrials.gov have consensus sales estimates (with coverage by at least 2 individual analysts)

By taking into consideration the clinical development activity that consensus ignores, we can identify undervalued biopharma companies – even if we ignore patent-based estimates of pipeline value (Exhibit 2, middle rows). In fact, stocks selected using clinicaltrials.gov data appear to perform even better (cumulative relative outperformance of 85 percent) than stocks selected using only the patent data (46 percent), though this outperformance has waned of late, and has been accompanied by a substantially higher standard deviation of returns[3]

Exhibit 2 (bottom rows) also shows that a combined portfolio, holding long all stocks identified by either method, yields better performance (cumulative relative outperformance of 86 percent) with a lower s.d. of returns (0.06 combined v. 0.09 for clinicaltrials.gov alone). This risk/return tradeoff between the patent portfolio; the clinicaltrials.gov portfolio, and the blended portfolio is shown in the efficient frontier in Exhibit 4[4]

Hidden Pipeline valuation using quality-adjusted patents

We assign all active[5] patents to their corresponding parent companies, then take three key additional steps: 1) each patent is quality weighted[6]; 2) patents are segregated into those that correspond to either known (e.g. marketed, filed, or late stage projects) or hidden (pre-phase III) products / projects; and 3) each ‘hidden’ patent is assigned to disease, mechanism, and/or physical (chemical / biochemical characterization) categories[7]. The result is a company-by-company database that characterizes the sizes (numbers of quality-adjusted patents) and relative values (quality-adjusted patents, weighted further by the relative economic values of the disease areas in which the company conducts research) of the analyzed companies’ hidden pipelines

To determine which companies’ pipelines appear relatively over- or undervalued, we simply compare the enterprise value (price) of each company’s hidden pipeline to the apparent (relative) economic value of that company’s hidden pipeline

Exhibits 5 and 6 summarize the results. In Exhibit 5, column (b) provides our estimate of the market capitalization of each company’s hidden pipeline[8], and for reference column (c) shows hidden pipeline capitalization as a percent of total enterprise value. Column (d) gives each company’s hidden pipeline value as a percent of the total hidden pipeline value for all companies. Using BMY as an example, BMY’s $23B hidden pipeline capitalization is about 3 percent of the $901B combined capitalization for all 22 companies’ hidden pipelines. In column (e) we express the quality- and sales-weighted amount of innovation in each company’s hidden pipeline, as a percent of the total quality- and sales-weighted innovation in all 22 companies’ hidden pipelines (BMY has 10.6 percent of total innovation across the 22 companies, but just 3 percent of the market value). Column (g) is the ratio of columns (e) and (d); i.e. column (g) is the share of peer group innovation in a given company’s hidden pipeline, divided by that company’s share of total peer group hidden pipeline market value. Companies with larger shares of innovation than of market value (e.g. BMY) have hidden pipelines that are apparently undervalued, and vice versa[9]. Column (f) sales weights the shares of hidden pipelines depicted in column (e); and column (h) calculates the ratio of columns (f) and (d); i.e. the share of peer group sales weighted innovation in a given company’s hidden pipeline, divided by that company’s share of total peer group hidden pipeline market value. Exhibit 6 depicts the data in Exhibit 5 graphically, comparing each company’s share of the peer group’s quality-adjusted hidden pipeline (y-axis), to its share of the total peer group’s hidden pipeline capitalization (x-axis). Companies that depart significantly from the 45 degree ‘normal’ have hidden pipelines that are apparently under- (above the normal line) or overvalued (below the normal line)

BMY, ROCHE, SNY, and VRTX have hidden pipelines that appear undervalued[10]; ALXN, MKGAY, NVO, and SHPG have hidden pipelines that appear overvalued[11]

Implied performance, and actual performance to date

Implied performance is simply the percentage change in relative share price that would bring a given company’s hidden pipeline valuation to par. Fundamentally, the idea is that a given hidden pipeline, adjusted for the sales potential reflected in its therapeutic area mix and the quality-adjusted volume of total innovation, should have the same or nearly the same economic value[12] as an ‘average’ pipeline with the same therapeutic area mix, and quality-adjusted volume of innovation

Results are provided in Exhibit 7, both with and without sales weighting of hidden pipeline values. Using SNY as an example, based only on the amount and quality of innovation in SNY’s hidden pipeline and assuming only that this amount and quality of innovation ultimately is valued at par with other hidden pipelines of comparable amounts and quality of innovation, we would expect SNY to outperform its peers by roughly 24 percent. If in addition, we adjust our estimate of the value of SNY’s hidden pipeline to account for the mix of therapeutic areas SNY is pursuing, we would expect SNY to outperform its peers by roughly 29 percent. We make no assertion that our valuation method identifies single-digit percentage misvaluations. Instead, we simply argue that companies with apparently undervalued pipelines are more likely to outperform peers

Exhibit 8 provides the actual relative share price performance of a drug / biotech portfolio whose stock selection is based entirely on hidden pipeline valuation (all names with ≥ 20 percent implied share price gain are held long). Performance figures are provided for the entire period since we first published the method (Nov 2012) and for each interval between updates. Since inception, returns to stocks chosen based on hidden pipeline valuations are roughly twice the peer group[13] returns (on both an equal- and cap-weighted basis)

Our long-signal portfolio rules based on implied returns for the current update includes VRTX, BMY, SNY, and ROCHE[14]

Changes in pipeline values since our last update (August 2016)

Exhibit 9 tracks the changes in each company’s hidden pipeline since March 2017; and breaks those changes down into their component parts. CELG, REGN and PFE had the largest increases in hidden pipeline; conversely VRTX, SHPG, and BIIB had the largest declines

We break the total hidden pipeline change into three critical drivers—positively, (1) quality improvements in the existing hidden pipeline; and (2) new additions to the hidden pipeline, whether through patent grants, purchases, new assignments or a first citation on an existing patent; and, negatively, (3) patent expirations, sales, reassignments, advancement to the tangible portfolio, etc.[15]

The 20+ percent decrease in BIIB’s total Hidden Pipeline is a function of its reassignment of a large number of patents as a result of its February spinout of Bioverativ. In contrast, CELG had the most new grants / assignment – driven by the closing of its acquisition of Acetylon Pharmaceuticals. CELG, NVO, and REGN led the peer group in quality improvement over the past three months.

Hidden Pipeline valuation using clinicaltrials.gov

Companies developing prescription drugs for US approval must disclose their clinical trials on clinicaltrials.gov. We downloaded all active trials for the 22 companies analyzed, and compared active trials as disclosed on clinicaltrials.gov with pipeline products having consensus forecasts – and found that almost 80% of the active projects disclosed on clinicaltrials.gov are not captured by reliable[16] consensus (Exhibit 3b, again)

We recognize that consensus rarely forecasts very early stage products, especially for the larger companies analyzed here, and that this normal pattern contributes to the high percentage of clinicaltrials.gov products that fail to find their way into consensus forecasts – even liberally defining consensus as comprised of at least 2 separate sell-side forecasts (Exhibit 3a, again)– in fact, we find less than 1 percent of phase I projects with forecasts; 15 percent of phase II projects with forecasts; but still just 63 percent of phase III projects with forecasts

We also recognize that the moment a significant project moves into consensus is a point at which mid- to longer-term estimates are likely to rise. As such, systematically identifying active projects before they find their way into consensus (or into share prices) is potentially worthwhile

As a first step, we back implied growth out of current share prices using a dividend-discount model (DDM) based approach; however, because dividend policies vary across the companies of interest (and in the case of faster growing and/or biotech companies, dividends may not exist) we use free cash flows as a substitute for dividends

As a second step, we estimate the revenue growth of companies by supplementing consensus (in-line) forecasts with clinicaltrials.gov data. Where reliable consensus estimates exist for pipeline products we use these; however, where clinicaltrials.gov data identify pipeline products that are not in consensus forecasts, we add these products to the underlying consensus forecasts

More specifically, we use standard estimates of time by phase of development and cumulative attrition across phases of development to project the probable number and timing of product launches, by company. We make the simplifying assumption that all launches have peak sales and lifetime sales trajectories identical to the average historic peak sales and average sales trajectories for products launched over the last twenty years. We assume large and small molecule products achieve average peak sales and average trajectories for large and small molecules respectively, but we make no further forecast refinements to reflect product characteristics such as therapeutic area, presence or absence of competition, and so forth

As a third step, we compare growth implied by share prices with the growth we estimate using a combination of consensus estimates and clinicaltrials.gov data. Over the past two years, quarterly observations of fundamentally-derived and share price-implied growth have aligned very well (R-squared >0.60)

Where fundamentally-derived growth is substantially higher than share price-implied growth, it is an indication of undervalued mid- to long-term product flow. Since 2Q13, the 3 companies whose product flow appeared the most undervalued on this basis have outperformed their peers (the remaining 19 companies) by a cumulative 85 percent (Exhibit 2, again)

Despite this long-term outperformance, we must acknowledge that since October 2015, the algorithm has underperformed. This has been driven almost entirely by GILD, which has traded down by more than 40 percent during the period

Through this fundamental-derived v. share price-implied growth lens, ALXN, LLY, and still GILD appear to have near- to mid-term product flow that is most undervalued (Exhibit 10)


  1. See most recently “ABBV’s US Humira trend: Why genuine slowdown in end-user demand, and corresponding growth in channel inventories is a likely scenario”, May 18, 2017, SSR Health, LLC; and “ABBV: Humira Pricing … Let’s Play a Game”, December 19, 2016, SSR Health, LLC
  2. Exhibit shows only performance since 2Q13 when we expanded the peer group beyond major pharma and only equal-weighted portfolios. The relative cumulative performance of a cap-weighted portfolio made up of the same stocks has been nearly identical
  3. The performance comparison is not apples-to-apples – patent-selected stocks’ performance was achieved prospectively by an algorithm we set in motion in 2Q13; in contrast the clinicaltrials.gov selected stocks’ performance is a back-test of an algorithm we’ve developed over the last several months. Thus despite the performance differences shown in Exhibit 2, it’s important to realize that in a very real sense the performance record of the patent-selected stocks is more firmly established
  4. The two strategies generally choose different stocks. Over the last 9 quarters, less than 10% of the stocks chosen by the patent-based strategy were also chosen by the clinicaltrials.gov strategy. Arguably this is a good thing – because either strategy alone only identifies only about one-fifth of the stocks that outperform in any given quarter, combining the relatively non-overlapping strategies results in a combined strategy that identifies a substantially larger percentage of outperformers
  5. We work with US patents only. At least since the Patent Cooperation Treaty (PERCENT), patent filings for larger, multi-national research-based organizations have become global – thus we believe adding ex-US patents to our datasets would add little or no useful signal
  6. Our method of quality weighting relies on several variables, including in particular citation patterns (e.g. number of citations and rate of citation accumulation) and patent ‘vintage’. Raw (unweighted) patent counts have very limited relevance
  7. Specifically, we categorize patents according to the World Health Organization’s ATC (Anatomic, Therapeutic, Chemical) classification scheme
  8. Essentially enterprise value less the present value of all products / projects / lines of business other than projects in phase II and earlier development
  9. We recognize there are two limits of our method which emerge when analyzing smaller companies. First, the most fundamental premise of the ‘hidden pipeline’ is that it is in fact hidden. In the case of very large companies, the assumption that pre-phase III pipelines are in fact hidden is robust; however the quality of this assumption deteriorates as companies become smaller. Smaller companies will have fewer pre-phase III projects, making it more practically feasible for investors to identify and assess these – making them more comparable to the assets we define as ‘tangible’. Second, our method relies on an assumption of central tendency – i.e. that a large portfolio of projects in a given set of therapeutic areas and with a given overall quality-adjusted patent count will have a similar economic value to a comparable large portfolio of the same therapeutic area mix and overall quality-adjusted count. This assumption is robust with large portfolios – especially since the larger companies have such tremendous overlap in terms of diseases (and disease mechanisms) pursued. However the assumption is weaker with small portfolios. Smaller companies A and B may be in similar therapeutic areas with similar quality-adjusted patent counts, but could be working on highly distinct approaches
  10. Based on arbitrarily defining overvalued as having a ratio of innovation : value ≥2
  11. Based on arbitrarily defining undervalued as having a ratio of innovation: value ≤ 0.5
  12. In reality we’re very aware that ‘hidden pipelines’ with similar therapeutic area mix and quality-adjusted ‘weight’ of total innovation will have different economic values. However, we argue that when these pipelines are ‘hidden’ that the market has no factual basis (other than quality-adjusted patents and therapeutic area sales weighting – which we don’t believe the market uses) on which to assign the pipelines different values – and that the market’s assignment of different economic values reflects nothing other than the market’s inability to efficiently value intangibles. Thus over time, the most reasonable guess as to the relative values of two pipelines of identical therapeutic area mix and quality-adjusted volume of innovation is that the two pipelines have identical values
  13. We define the peer group as all the companies in the screen that are not held long
  14. We exclude ABBV from the portfolio because of our bearish view on Humira. See most recently “ABBV’s US Humira trend: Why genuine slowdown in end-user demand, and corresponding growth in channel inventories is a likely scenario”, May 18, 2017, SSR Health, LLC; and “ABBV: Humira Pricing … Let’s Play a Game”, December 19, 2016, SSR Health, LLC
  15. The fourth, “other” category captures any uncategorized mathematical remainder due largely to algorithmic calculations.
  16. Separate forecasts from 3 or more analysts for a given product in any year through 2024

©2017, SSR, LLC, 225 High Ridge Rd, 2nd Floor, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein. The views and other information provided are subject to change without notice. This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. In the past 12 months, through a wholly-owned subsidiary SSR Health LLC has provided paid advisory services to Pfizer Inc (PFE), BioPharmX (BPMX), Gilead Sciences (GILD), Bristol-Myers Squibb (BMY) and Sanofi (SNY) on both securities-related and non-securities-related topics. One or more of SSR Health’s analysts owns long positions in the following stocks: Amgen (AMGN); Bristol-Myers Squibb (BMY); Roche (RHHBY); Nanostring Technologies (NSTG)

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