In business, success breeds challenges, and the biotech industry's ability to build on its accomplishments over the next ten years is far from assured. As it matures, the industry will have to deal with a host of new issues reserved for larger, more mature and profitable industries. The rules of the game are likely to change for investors, as well, in a number of significant ways.
In the past, investors awarded nearly every profitable biotech company with a premium multiple on earnings. Companies that achieved profitability were in great demand and conventional wisdom was that each deserved to trade at a premium reflective of its superior long-term growth characteristics and renewable pipeline.
Certain business models, such as the in-licensing–based approach that is so popular today, might be associated with lower long-term rewards to investors. In addition, investors have learned that one success in drug development rarely ensures similar success in the future. In many respects, Amgen and Genentech are anomalies. We believe investors will begin to look at earnings and a variety of other financial metrics (cash flow, growth potential, return on invested capital, asset value, R&D investment) when assigning a valuation to an individual 'biotech' company.
This changing mind-set in the analyst community means that biotechs in the future can expect to be judged much more critically than they have been in the past.
The waning mystique of collaborations
One sure way for a smaller biotech company to gain investor attention has been to partner a drug candidate with a larger pharmaceutical or biotech company. Such partnerships were seen as providing validation for the drug candidate's quality, market potential and chances of success.
I believe the days of biotech requiring large-company validation are over. Investors now realize that drug development is a game of chance. Given the harsh reality that 90% of clinical-stage drug candidates ultimately fail to make it to the market (including 90% of those candidates developed by the larger companies themselves), it is silly to suggest that collaborative deals provide much validation.
In most cases, deals appear to be driven as much as anything by the economics of risk and reward. Many large biopharmaceutical companies are happy to make an option payment in the form of an upfront milestone to see how a drug candidate performs in subsequent trials. In the future, investors are likely to reward only companies who choose to out-license their compounds if the economics of a deal are attractive.
Historically, it was a safe assumption that any biotech product was covered by solid intellectual property lasting well into the next decade. Each year, investors have become accustomed to pharmaceutical companies losing billions of dollars of sales to generics whereas biotech drugs have been sheltered from any such risk.
Over the next ten years, several small-molecule drugs marketed by the biotech industry will see their patents expire. In addition, it is highly likely that most major markets will create a route for the approval of follow-on biologics. Although protein-based drugs are unlikely to experience the same dramatic loss in value that savaged the commercial value of small molecules, the markets that innovative biotech products serve will gradually become more competitive.
Whereas biotech products are still likely to hold an advantage over traditional pharmaceuticals, in the future they will be forced to compete against ever-more innovative biotech products and convergent technologies like medical device–drug combinations, in some cases.
During an average year, the biotech industry features between two and four significant (>$500 million) acquisitions of smaller companies by larger ones. The perception has been that the combination of a small biotech company's innovative and emerging products with large company manufacturing and commercial capabilities creates a synergy that can be leveraged by all.
With the growing number of successful smaller companies and the need for larger companies to augment their growth, there is the perception that mergers might become more commonplace. We believe smaller companies with late-stage products will hold more leverage over potential acquirers. As a result, we think larger companies will be required to pay a higher price for such acquisitions.
To us, the innovative step in the biopharmaceutical business is drug discovery and development. Manufacturing, sales and marketing have become commodities that anyone with capital can access. In this environment, large companies can only offer small companies one thing: an attractive acquisition price. With the price to acquire a company likely going up, it will become more difficult for larger companies to rationalize an acquisition based on cost synergies alone as has been done so often in the past. In the future, investors will pay a premium for companies that appear to be capable of growing organically as opposed to through acquisition.
Biotech investors have grown accustomed to initial public offering (IPO) 'windows,' which present themselves every two to three years. There is still a widely held perception that during such windows, the buyers of potential IPOs are quite indiscriminate and will purchase stock at reasonably high prices in almost any biotech company. To the extent that history supports this perception we will not likely see much irrational exuberance over biotech in the next ten years.
Investment banks typically advise private companies to pay close attention to when such IPO windows occur and run their IPO plans accordingly. As the biotech industry matures, the boom-and-bust cycles that the industry was known for in the past appear to be subsiding.
Although all sectors of the stock market experience the ebb and flow of investor interest, US biotech investors are more sophisticated now and judge companies more on individual merit rather than on sector trends. In the future, I believe that private companies will only contemplate an IPO when it is apparent that a company is mature enough to capture and maintain public interest.
Biotech products cost hundreds of millions to develop. Perhaps not surprisingly, they are becoming the most expensive medicines on the market. For much of its history, the biotech industry has successfully argued that biotech companies deserve a good return on this investment so that they can continue to reinvest in innovative new medicines that fetch a premium retail price. Likewise, legislators, patient groups and payors have generally rewarded biotech companies with carte blanche when it comes to reimbursement and pricing.
The industry has grown to the point where its products have become a significant burden on the healthcare system. In the future, it appears that products will require some form of cost-benefit justification. Only truly innovative products will avoid pricing pressures. Thus, the industry will need to focus more on innovative products that can recapture their investment. Investor experience with me-too pharmaceutical products highlights the pitfalls of backing such compounds.
Biotech managers are often considered critical to the success of their companies. Many investors believe a good CEO can create significant shareholder value and that particularly capable executives are even able to reverse the prospects of a troubled company. Historically, the biotech industry has considered good CEOs to be in short supply and has handsomely rewarded executives with a successful track record.
Favorable compensation trends for biotech managers have been facilitated by a lack of stock option expensing and trends toward higher executive pay in other industries. In reality, it is very difficult for a biotech CEO to create value. Although the converse is not true (it is easy to destroy shareholder value through fraud, dishonesty or poor business dealings), perhaps the best a CEO can do is to create an environment that fosters success on the part of others.
Biotech is still an R&D-driven enterprise and CEOs rarely determine whether or not a drug candidate succeeds. Those CEOs who are provided with enough successful drug candidates will look like geniuses at business, but might not deserve to be rewarded as such. Investors will likely pay more attention to management compensation in the future.
Biotech's striking success over the past decade has placed the industry on solid footing. Whereas biotech should continue to grow and prosper, matching the success of the past ten years will be a challenge and require successful execution on multiple fronts—and awareness that the financial community will increasingly be judging it with a different measuring stick."