More Ripe for Consolidation: Regional Banks or Biotech Stocks?

By Markets Fool.com

There have been a lot of buyouts in the biotech sector recently, and it's entirely possible this trend will continue, according to one of our healthcare analysts. However, one of our banking experts thinks the regional bank space is ready for some serious consolidation, too.

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Brian Orelli: The biotech space is in a constant state of M&A for two reasons.

First, it's expensive to develop drugs. Companies raise venture capital to get their product far enough through the clinical trial process that they can go public. But even the added capital from the IPO isn't enough for most companies to get their product approved by the Food and Drug Administration and on the market. Most companies have to go through multiple secondary offerings to pay for development of their drugs.

Rather than continue to dilute their shareholders, many companies sell out along the way, sometimes before the company even goes public. Pharmaceutical companies and large biotechs have plenty of cash sitting on their books, and it's often easier to buy a product than develop one internally.

The sweet spot for a sale is generally after phase 2 proof-of-concept trials are successful, but before expensive phase 3 trials are initiated. Shire's acquisition of Meritage Pharma for its phase 3-ready compound Oral Budesonide Suspension is a good example of this.

The second reason there's so much M&A activity in the biotech sector is because, even when companies are able to make it all the way through the marathon of drug development, it's not easy to sell drugs. Larger companies have marketing down to a science, and it's usually cheaper for companies to market drugs if they already have one in the same specialty, because sales reps can visit one doctor and pitch multiple drugs. Add in the cost savings from not having to pay for duplicate roles, and pharmaceutical companies can afford to buy biotechs with drugs on the market at a premium over where investors value them as a stand-alone company.

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Rather than sell out, many smaller companies license their drugs to larger companies to sell for them, collecting royalties or sharing profits through some sort of joint venture, but that's often just putting off the inevitable. If the drug is successful, the partner will frequently acquire its partner to avoid having to share profits from the drug. And even if it doesn't, another company will often see the value and step in, as AbbViedid last month when it announced plans to acquire Pharmacyclics, which markets its blood cancer drug Imbruvica with Johnson & Johnson.

Investors shouldn't buy companies hoping they'll be acquired, because that's often out of the hands of management. But if a drug looks like it could be an attractive acquisition, it's usually a good sign that the company is worth investing in, whether an acquisition materializes or not.

Matt Frankel: In terms of size, the landscape of the U.S. banking industry is relatively lopsided. There are the Big Four banks --JPMorgan Chase,Bank of America, Citigroup,and Wells Fargo --and then there is a large gap between them and the next largest collection, regional banks.

The main reason I believe we'll see continued consolidation in the bank industry is that the Big Four have distinct competitive advantages over their smaller regional competition. Most obviously, larger companies can operate more efficiently than smaller companies and can therefore offer lower prices to consumers (the "Wal-Mart" effect).

But there is one factor that has become more of an issue for banks: regulatory expenses. After the financial crisis, the FDIC started regulating banks more heavily, and banks in different size brackets are monitored differently. For example, banks with less than $1 billion in assets are regulated differently than those in the $1-$5 billion bracket, and so on up the ladder. So, mergers help create economies of scale, while also easing the regulatory burden on smaller banks by pushing them into higher brackets.

Plus, many banks are still trading for less than book value, which translates into an opportunity to acquire rivals for less than they're worth.Regions Financial, for instance, is trading for just 80% of its book value. Now, I'm not saying Regions will be acquired anytime soon, but a potential acquirer could theoretically pay a 10% premium for the bank and still get Regions' assets for less than they're worth.

When you combine the benefits that come with being a larger bank with the exceptional values that exist in banking right now, I think we'll see a lot of consolidation over the coming years.

The article More Ripe for Consolidation: Regional Banks or Biotech Stocks? originally appeared on Fool.com.

Brian Orelli has no position in any stocks mentioned. Matthew Frankel owns shares of Bank of America and Regions Financial. The Motley Fool recommends Bank of America, Johnson & Johnson, and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup Inc, Johnson & Johnson, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.