Merck & Co., Inc. (MRK): Don’t Invest in Biotech IPOs Until You Read This

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A spate of 10 biotechs went public this year, raising over $725 million. As one banker put it, this is a sector “where investors take binary risks, and investor willingness to take on additional risk is picking up.” However, IPO investment is risky business, and one needs to consider who makes the most money – the company, the investor or some third party who buys up a struggling IPO.

A changing scene

A classic example is that of the 2011 acquisition of Inspire by Merck & Co., Inc. (NYSE:MRK)$430 million was considered a great offer – at $5 a share, it represented a 26% premium to Inspire’s share price at that time. However, it did not cover the amount spent by Inspire to develop its pipeline.

Merck & Co., Inc.Credit: Merck & Co., Inc. (NYSE:MRK)

In 2010 and 2011, the biotech IPO market was almost dead. Plexxikon, a drug discovery company, was forced to sell itself to Japan’s Daiichi Sankyo after the former’s IPO did not evince any investor interest, although it had an impressive candidate for treatment of melanoma and a strong management team.

But there is renewed investor interest in small biotech companies now. One reason is that last year, the FDA approved the highest number of drugs (39) in over a decade. Another possible reason could be that year to date, the NASDAQ Biotechnology index has outperformed the sluggish S&P 500.

The most recent IPO announcement comes from Agios Pharmaceuticals, going up for $86 million. Earlier there were Epizyme Inc (NASDAQ:EPZM), Tetraphase Pharmaceuticals Inc (NASDAQ:TTPH), and Enanta Pharmaceuticals Inc (NASDAQ:ENTA), which all went public and started trading earlier this year.

A risky gamble

Five of the ten IPOs this year are trading above their offer prices. In June first week, Epizyme Inc (NASDAQ:EPZM), with two candidates in clinical trials, went public at $15 a share. The stock touched $30.86 in a single day, and now trades at $23.82.

However, regardless of the decent returns from biotech IPOs in 2013, generally IPOs are not good for your portfolio — at least not for the first year of their trading. BusinessWeek studied 25 of the biggest IPOs of 2010 and 2011 with the biggest opening trading pops. It found (at that time) that 20 of them had fallen since then and were trading below their opening price – many had fallen 50%.

Biotech is no exception to the rule. Only about 50% of the biotech IPOs of 2011 are up since their debuts, which is not exactly an optimistic investing scenario.

Some lesser-known facts

Small biotech companies excel at discovering and developing new drugs, while Big Pharma tries to acquire them as those drugs progress towards FDA approvals. However, these small biotech companies spend far too much money on drugs that seldom get to the market. When a big biotech acquires such a smaller one, you need to see whether the premium price it’s offered covers the smaller company’s cost of product development.

Consider Adolor’s takeover in 2011 by Cubist Pharmaceuticals Inc (NASDAQ:CBST). At a premium of 143%, it appeared good; however, it was actually a bad deal for investors, because Adolor was getting only $221 million against the $530 million it had spent developing its product portfolio.

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