What Does 2016 Hold for This Closely-Watched Biotech ETF?

The iShares Nasdaq Biotechnology ETF (IBB -0.41%) is a quick and easy way to gain exposure to a wide variety of biotech and pharmaceutical equities listed on the NASDAQ. As an added bonus, this ETF is designed to limit the risk of major downward price movements by holding shares in over 140 companies, removing most, if not all, of the possibility of getting entirely wiped out by a single negative regulatory or clinical event. 

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Despite diluting its risk through diversification, the IBB has still been able to post a respectable compound annual growth rate of 9.25% since its inception in 2001. Most of that growth, however, has occurred within just the last few years, fueled by an innovation boom in biotechnology and pharmaceuticals:

This year, though, has been particularly volatile for biotech, as the market starts to weigh the growing possibility that sweeping regulatory reforms could be coming that will alter how brand name drugs -- and perhaps even biological-based therapies -- are priced. Put simply, the days of 80%-plus gross margins for biopharma products in the U.S. might be nearing an end. 

While this fear has clearly seeped into the collective mindpool of biotech investors of late, I think it's important to remember that similar concerns have crept up in the past -- and the broader industry has done nothing but continue to push higher.

With this in mind, let's consider how the IBB might fare in 2016 by digging into the ETF's top five holdings: Celgene (CELG), Regeneron Pharmaceuticals (REGN 0.13%), Amgen (AMGN 0.07%), Gilead Sciences (GILD -0.19%), and Biogen (BIIB 4.07%). 

We'll start by assessing these companies' potential for growth in the near term, as well as the health of their balance sheets, in case a so-called "black swan" decides to pay a visit to biotech next year. Here's some data provided by S&P Capital IQ:

What do these numbers tell us about the state of biopharma? The first thing that pops up is that the bottom and top lines of these companies appear to be, on average, in relatively good shape. In fact, the only company bucking this trend is Gilead, which is expected to see markedly slower growth emanating from its hep C treatment franchise in 2016.

That said, the eye-popping amount of leverage being employed -- as evidenced by the average debt-to-equity ratio of 76% -- is a cause for concern. How did we get to this point? The answer is that many big-name biopharmas have been engaging heavily in M&A activity, and inking rich external research partnerships, in hopes of juicing up their earnings and cash flows. Amgen, for example, has struck multiple high-dollar deals over the last few years with the goal of generating double-digit revenue growth in 2017 and beyond. 

The problem is that if the debate over ever-increasing drug prices results in legislative or regulatory action, or additional strong-arm tactics from pharmacy benefits managers, biopharmas could see their margins nosedive overnight. If that happens, those bloated balance sheets may require these companies to take drastic measures to meet their long-term financial obligations.  

The prognosis for the IBB in 2016
Based on the data above, the IBB looks primed to have another good year in 2016 -- that is, if the market continues its recent trend of paying a lofty premium for biopharma earnings. A more global view, though, paints a rather worrisome picture. These companies have paid staggering premiums to gain access to novel experimental products lately, causing their debt levels to soar. If things don't go exactly as planned, the biotech bull run could turn into a nightmare real quick because of these heavily leveraged balance sheets.

That's a risk I'm not personally willing to take at this juncture. My hunch -- and, mind you, it's only a hunch -- is that the biotech bubble is nearing its apex, meaning that it's probably time to start reducing your exposure to this industry in general. After all, it's quite telling that Regeneron, the only company expected to generate double-digit growth next year -- and that lacks a serious debt problem to boot -- is projected to do so based in large part on the launch of its new cholesterol-lowering drug Praluent. Revenues from new drug launches, in my experience, are extremely hard to predict, and these next-generation cholesterol drugs could certainly draw the ire of payers for a host of reasons. 

All told, the sustainability of biopharma's rapid revenue growth is now in question because of the drug pricing debate, and the ginormous amount of leverage being used across the industry is worrisome to say the least.