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Jun 4, 2009

Biotech Companies Face the Key Question—Deal or No Deal?

Advice: Set aside dreams of becoming the next Amgen or Genentech; instead know when to partner, take the money, and run.

  • The publically traded biotechnology industry is entering a period of significant change in our view. Companies in the industry are always in need of cash, and with big pharmaceutical firms cash-rich and in desperate need of pipeline drugs, M&A and licensing activity has been taking place at a torrid pace over the past few months. That being said, biotech firms are being divided up into two categories, the haves and the have-nots.

    The haves are getting stronger. These are firms with access to cash either through their own product revenues or through big pharma licensing deals. They are being acquired and are doing the acquiring. The have-nots are cash-strapped and struggling to survive.

    Of the 225 publically traded biotechnology firms in our database, only 10 trade with a market capitalization over $2 billion, according to the Zacks database. Only 18 trade with a market capitalization over $1 billion. There are only five large-cap firms, or those that have a market capitalization over $10 billion: Amgen, Genzyme, Gilead Sciences, Biogen Idec, and Celgene.

    Survival of the Fittest

    The truth is, it’s hard to find a successful large-cap biotechnology company because most get acquired before they reach large-cap status. Names including Immunex, Myogen, ICOS, ImClone, MedImmune, Millennium, and Serono all had the potential to become large-cap biotechnology firms but were acquired instead.

    The days of the independent large-cap biotechnology company are coming to an end. Two of the largest biotech companies in the world, Genentech and Centocor, are owned by pharmaceutical companies Roche and Johnson and Johnson, respectively. Of the independent big-cap names, we would not be surprised to see Gilead, Biogen, and Celgene all gone within the next few years.

    We are witnessing a period where the strong get stronger, while the weak are left fighting to survive. An astonishing 148 companies of the 225 in our database (66%) are considered microcap, i.e., they trade with a market capitalization below $100 million. Only 57 stocks (25%) trade above $5 per share. Nearly half the industry at 109 firms (48%) trades below $1 per share.

    There’s a reason for that: Cash is drying up, and big pharmaceutical companies are cherry-picking the winners. And among those companies left independent, a large percent trade at sub-$1 levels, because biotech drug development is both extremely expensive and very high-risk. As a result, most biotechnology companies either fail in the clinical program or run out of money while trying.

    Big Pharma Should Use Their War Chest More
    Having said that, M&A activity could increase further. There seems to be a significant psychological impediment to pharma-biotech M&A activity. Large pharmaceutical companies have been far too slow to spend money on biotechnology M&A or licensing. Most pharmaceutical names are sitting on billions of dollars in cash, while their late-stage research pipelines are drying up. Pharmaceutical companies made so much money in the 1990’s and early 2000’s that there is almost a lasting hubris that has yet to allow reality to sink in for some of the upper level managements.

    Big pharmaceutical executives can be kids in a candy store with respect to the number of deals available right now. Roughly 40% of the industry has less than 12 months of cash on hand, according to Biotechnology Industry Organization (BIO). Asset prices are cheap for early-stage molecules. There are some great deals available right now for big pharma to take advantage of. Instead of actually going into the store and buying the candy, however, pharma managements are waiting outside the store, confused and overwhelmed.

    Biotech Firms Need to Cash Out Earlier
    On the flip-side, most management at biotech firms are overconfident, underexperienced, and fail to truly understand the competitive landscape for their drug. This results in biotech companies reluctant to partner with pharmaceutical companies too early in the development process, because they think they can either do it alone or they will command a far greater price the further along they develop the asset.

    In theory, this is true. The difficulties of commercializing a successful biotech drug, however, only increase as development pushes further along. And successfully completing a Phase III trial is not the finish line, it is just the start of a whole new marathon that now includes preparing an NDA/BLA, getting that application passed by the FDA, manufacturing the drug, and then, managing a sales force, as well as Wall Street expectations. As a result, an asset that was partnerable after encouraging Phase II data becomes unpartnerable after the Phase III trial fails or the FDA requests additional data prior to approval.

    Like watching NBC’s “Deal or No Deal,” knowing when to take the money and run is a difficult task. And like most participants on the TV show, most biotech companies take things one step too far. Most biotechnology companies are started by a brilliant scientist with an idea. These companies dream of becoming the next Genentech, Amgen, or Genzyme. But building a successful biotechnology company takes a lot more than just a brilliant scientist with a great idea. Management must have expertise in designing a clinical trial to prove the drug does what they theorized. They need expertise in filing an NDA/BLA, dealing with the FDA, and manufacturing the drug. And once the company commercializes the product, a whole new slew of challenges relating to selling and managing the brand ensue. Very few biotechnology companies do this well.

    A brilliant scientist is not always a brilliant businessman. Enbrel was a product that was significantly hammered by manufacturing issues early on in the launch. As a result, Immunex stock struggled. Amgen management, though, saw an opportunity to take the expertise they obtained with Epogen and Neupogen and turn Enbrel into the mega-blockbuster it is today.

    Similarly, sales of Cialis were never the reason why ICOS stock suffered. It was the massive operating expenses necessary to drive those sales and the mounting losses associated with the company’s joint venture with Eli Lilly. Companies like MedImmune and CV Therapeutics were sold at significant premiums not because things were going so well, but because the managements at those firms had taken the products as far as they could, and larger organizations such as AstraZeneca and Gilead Sciences, with expertise on the commercial end of the busines, saw an opportunity.

    The majority of brilliant scientists who start biotechnology companies seem hesitant to monetize their assets, because they are waiting around for the big payoff. They fail to take the deal in hopes that going one more round will bring an even bigger payout. Half the industry is trading below $1, though. A good chunk of those names had an opportunity to partner, license, or sell prior to the stock falling to that level.

    It is likely that several micro-cap biotechnology companies would have never declined to micro-cap status had they partnered the drug with a more seasoned pharmaceutical company with expertise in how to design a clinical program or how to successfully file an application with the FDA. These are no easy tasks. Such significant hurdles that exist beyond the science of drug discovery are what caused a large portion of the above 148 firms to fail.

    Industry Requires More M&A
    Too many biotechnology companies are in desperate need of cash. And too many pharmaceutical companies, ripe with cash, are in desperate need of drugs. It’s natural order that these firms should be getting together. Yes, we have seen a torrid pace of biotech-pharma M&A activity so far this year. That pace is still, nonetheless, far below what it should be. This has created a rather difficult market for their respective stock prices.

    Perhaps, if the psychological barriers to partnering are lifted. more deals would get done. Biotechnology companies should focus on discovering new drug candidates up to the proof-of-concept stage. And once proof of concept is achieved, larger pharmaceutical organizations should pay up for the technology.

    If this starts to happen at an accelerated pace, both pharmaceutical and biotech stock prices should rise in concert. Perhaps, scientists that start biotechnology companies should set aside their goals of becoming the next Genentech, Amgen, or Genzyme. Instead, they should be focusing on becoming the next ICOS, CV Therapeutics, or Immunex. Know when to take the deal.

     


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