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Source: U.S. Food and Drug Administration. 

Unless you're a short-seller, the correction during the past couple of weeks has probably been a bit of an unwelcome surprise. However, it's also important to understand that corrections are a natural part of the stock-market cycle, and that over the long run, stocks have a tendency to generate real wealth for investors who seek out high-quality stocks.

Unfortunately, when a correction does occur, it can expose certain sectors more than others. Among the sectors that stands to be hit the hardest, arguably, is healthcare. Why healthcare?

Unlike the vast majority of companies that can be compared based on their growth prospects and fundamentals, a large number of healthcare companies aren't profitable. In other words, trying to use traditional fundamental metrics like price-to-book and price-to-earnings on companies in the biotech sector would be somewhat pointless.

Instead, healthcare stocks, especially those still losing money and/or in the clinical-development stage of their product lines, are valued based on an investor's perception of the potential of the company's product line and eventual profitability. It means that, when a correction does come around, these perception-led stocks tend to be among the most volatile.

However, Big Pharma and blue-chip biotech stocks may have other problems on their hands beyond just investor sentiment.

Images
Source: Flickr user Nguyen Hung Vu.

A deal a day keeps the short-seller away
Whether you've been monitoring the pharmaceutical and biotech sector like a hawk or not, you're probably well aware of the multitude of mergers and acquisitions we've witnessed during the last couple of quarters. According to research firm DealLogic, through mid-August, M&A activity in the biotech sector had hit a total deal value of $270.9 billion.

For added context, $277.4 billion is the highest total deal value ever recorded for a full year, and it happened in 2014. It would appear we're well on our way to smashing this record in 2015. 

Why are Big Pharma and blue-chip biotech stocks so eager for M&A? Although the reasons can vary on a company-to-company basis, it boils down to three main factors.

First, combining two businesses results in the removal of overlapping departments, and thus cost synergies that translate into improved margins and profitability. Secondly, M&A activity allows a combined business to potentially improve its market share in select indications. In short, being No. 1 or No. 2 in cancer sales, or cardiovascular products, could dramatically improve a company's pricing power, or the way investors view a company's growth prospects.

Finally, Big Pharma has been especially guilty of paring back their research and development expenses in order to buoy their EPS during the patent cliff. The result has been a slowdown in new product development that many pharmaceutical companies are solving by purchasing complementary pipelines.

Images
Source: Flickr user Mike Poresky.

M&A could be about to backfire big time on Big Pharma and biotech
Yet this wave of increased M&A could wind up burning a lot of the acquiring Big Pharma and biotech companies. Wharton School of Business emeritus professor of management Lawrence Hrebiniak perhaps summed up the biggest concerns of the industry best in May 2014 when he had this say:

If you have an aggressive M&A strategy within the industry, then over time there is a loss in valuations. When companies overpay for their acquisitions, shareholder value falls because [the firms] are not able to reap commensurate benefits in cost savings or synergies. 

In other words, we've witnessed everything from bidding wars (see Allergan) that have pumped up proposed buyout valuations to just enormous premiums being offered, such as Merck's acquisition of clinical-stage hepatitis C drugmaker Idenix Pharmaceuticals for $3.85 billion, a nearly 240% premium to its prior-day closing value. With the understanding that Big Pharma and blue-chip biotech stocks were willing to pay quite the premium to acquire first-in-class, or complementary product portfolios and pipelines, small-, mid-, and even smaller large-cap biotech companies have maintained the upper hand. Now it appears that it could be Big Pharma and blue-chip biotech companies that reap the nasty side effects of this correction.

Although we've witnessed some clinical-stage biotech valuations deflating during the past couple of weeks, this doesn't do much good for the high-premium deals that have already occurred. It's also concerning if these deals aren't being conducted by the Big Pharma and biotech management with a long-term focus in mind.

A possible textbook example of overzealous M&A
For example, AbbVie (NYSE: ABBV) ponied up a whopping $21 billion for cancer drug company Pharmacyclics earlier this year, or $261.25 per share. Nonetheless, Pharmacyclics does have a potential blockbuster in its front pocket in Imbruvica, which is currently approved by the Food and Drug Administration to treat patients with a select type of chronic lymphocytic leukemia, mantle cell lymphoma, and Waldenstrom's macroglobulinemia. Peak annual sales estimates for the drug typically fall around $5 billion and $7 billion, depending on its label expansion.

Jnj Imbruvica
Source: Johnson & Johnson.

But Imbruvica's revenue stream isn't wholly owned by AbbVie. It shares sales and profits with Imbruvica's development partner Janssen Pharmaceuticals, a division of Johnson & Johnson. Thus, it could take another five-plus years for Imbruvica to realize its full potential.

Though the deal does help AbbVie diversify away from its heavy reliance on Humira, currently the best-selling drug in the world, the common stock issued by AbbVie to raise the $109 per share in cash offered in the cash-stock deal could counteract any near-term revenue and EPS gains. Furthermore, Andrew Baum, the covering analyst at Citigroup, has implied that AbbVie would need to find as much as $5 billion in revenue beyond just Imbruvica to make the acquisition pay off for AbbVie over the long run.

Stay vigilant
Make no mistake, AbbVie isn't alone. There are other potential zombie M&A deals out there that could weigh on the profitability of Big Pharma and blue-chip biotech stocks in the coming years, and become readily apparent if healthcare valuations continue to deflate.

What you need to do as an investor is stay vigilant. This isn't to say that AbbVie, or any other acquirer isn't worth owning, or that all deals made during the last couple of years were bad, because that's just not the case. Instead, it means taking the gloves off and digging into what an M&A deal might mean for your stock holdings.

It means understanding what sort of synergies can be expected, and whether there is a genuine bargain over the long run for the acquisition in question. If the deal doesn't look as if it makes sense, it could be time to reconsider your investment.

Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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