As they celebrated Groundhog Day 2005, the staff at the Alameda, CA, offices of the four-year-old biotech firm Peninsula Pharmaceuticals had no reason to suspect that the company had barely months...
Who Needs an IPO?
As they celebrated Groundhog Day 2005, the staff at the Alameda, CA, offices of the four-year-old biotech firm Peninsula Pharmaceuticals had no reason to suspect that the company had barely months to live. Peninsula had recently filed for an initial public offering (IPO) on the strength of a pair of innovative antibiotics, and expected to raise up to $80 million and value the company at somewhere between $290 and $340 million.
Instead, on February 10, Peninsula executives announced that they would be delaying the pricing of their planned IPO pursuant to a possible acquisition by a larger company. On April 18, the company was purchased by Johnson & Johnson subsidiary Ortho-McNeil for an estimated $245 million. This was no isolated event; six other small biotech firms were sold to larger companies in the first quarter of 2005. These sales, along with the sale of Peninsula, involved more than $2 billion worth of value—or nearly twice the total value involved in such deals in all of 2004.
This frenzy of acquisition is indicative of a fundamental series of challenges, ranging from a tighter venture capital market to more stringent regulatory restrictions, facing the biotechnology industry today. Pharmaceutical companies that have been relying on biotech to freshen their pipelines are left to cast about in search of innovative products—or to simply acquire biotech firms of their own, leading in some cases to a new set of problems. Meanwhile, physicians and the patients they treat struggle to determine whether these hurdles will be overcome and whether biotechnology can continue to produce the groundbreaking products and therapies promised by its most enthusiastic boosters.
But First, A Little Exposition
The medical biotech industry is a $30 billion/year endeavor and has produced some 160 drugs and vaccines already in use; in excess of 370 more are currently undergoing clinical testing. The 1,400+ biotechnology companies in the United States spent about $18 billion on R&D in 2003. The industry was ostensibly healthy as 2004 drew to a close; the AMEX Biotech Index, which includes only large-cap stocks, closed the year up 11%, while the Nasdaq Biotech Index—comprising mid-cap and small-cap stocks as well as those considered by AMEX—finished up a less robust but still healthy 5.8%. A total of 30 biotech firms made IPO in 2004, raising more than $1.8 billion, and the industry took in about $20.8 billion in new cash in total last year. All in all, says Business Week, “private biotechnology firms and their investors opened 2005 like kids on Christ-mas morning."
However, while large biotech firms posted positive returns last year, says Banc of America Securities, smaller firms were less successful. Moreover, of the 30 stocks debuting in 2004, only one —Eyetech Pharmaceuticals—placed among the best-performing stocks of the year, while three appeared among the worst. Although biotech continued to raise money at a healthy rate early in 2005, the industry brought in only about $4.9 billion for the first quarter, down nearly 25% from last year’s opening quarter. The biggest drop was in venture financing, down 37% from the same period in 2004. These developments have some analysts fearing a “dry spell that could last for years.”
A Tale of Two Industries
Ultimately, many of the problems described above are rooted in the essential nature of the biotech and pharmaceutical industries, and in their relative strengths and weaknesses. Big Pharma has been struggling with a series of interrelated problems for some time now; analysts expect the industry as a whole to grow by a single-digit percentage in 2005, the lowest since 1994. According to Patrick Rajan, Team Leader, Pharma-ceuticals and Bio-technology, Frost & Sullivan, “as more blockbusters go off patent and the FDA places more emphasis on safety data, pharmaceutical companies must strive for pipeline excellence to maintain high levels of profitability.” Throw in a few late-stage disappointments for drugs already in the pipeline, and you have a number of large pharma companies looking anxiously for high-quality, innovative drugs to market.
Of course, pharmaceutical companies also conduct their own re-search and development, to the tune of $38.8 billion in 2004. Unfortunately, the number of NDAs submitted to the FDA per year has decreased by 50% since the mid-1990s. What’s more, in a recent study, the Tufts Center for the Study of Drug Development found that industry-sponsored drug trials stopped increasing in 2000 and became less and less frequent after 2002.
The reason the pipelines are drying out is that aggressive R&D is no longer lucrative for its sponsors. The largest pharmaceutical companies may be able to afford to pour vast resources into a single innovative, potential blockbuster drug, but mid-sized companies simply can’t afford the risk. Instead, they focus on refinements of existing, proven products or other low-risk projects, while smaller, more science-driven companies (such as biotechnology firms) take on the development of truly exciting products. Smart pharmaceutical companies develop partnerships with biotech companies and use their products to fill the pipeline. An August 2004 McKinsey Quarterly article stated that “licensed compounds cost an average of $5 million to $9 million less to acquire at the preclinical stage than internal candidates cost to develop... and achieve similar commercial results.”
Most small biotech firms, no matter how loaded with potential their product line might be, have difficulty maintaining the financial wherewithal to continue activities. Small companies that rely heavily on a single key product can encounter considerable difficulty if that product fails in some way (note how ImClone’s stock plunged in re-sponse to the FDA’s refusal to file the company’s NDA for Erbitux). What’s more, if the patent on a biotech company’s one key product expires, that company could be left in the same position as if the product had failed.
With IPOs not generating the sort of revenue they did just a few short years ago, some biotechs simply cannot survive on their own. At that point, the final step in the dance occurs: the merger and acquisition phase. Johnson & Johnson’s purchase of Peninsula Pharmaceuticals is a good example. In the IPO boom of the late 1990’s, or even as recently as early last year, an IPO might have netted Peninsula investors a tenfold return on investment (ROI); by that standard, the $245 million sale to J&J, representing only a threefold ROI, might appear foolish. But in the current market, being acquired is a safer path, in some cases, than an IPO; nowadays, some biotechnology firms are founded with plans to be acquired built directly into their business plans.
Meet the New Boss, or Biotech and the FDA
Pressure from another quarter comes in the form of increased FDA scrutiny. The FDA has experienced a number of embarrassments in the last year or so, most famously clearing Vioxx for use and later being forced to issue alerts and warnings regarding the drug’s cardiotoxic properties. In an effort to ensure that drugs allowed into the market are safe, an increasingly conservative FDA has begun demanding more complete safety data prior to approval, sometimes even requiring additional study in this area. In early January, Senator Chris Dodd (D-Connecticut) introduced a proposal that would give the FDA the authority to require continuing active study of drug safety even after a new medication is launched. Under Dodd’s proposal, a new “Office of Patent Protection” would be created under the aegis of the FDA and given the power to yank drugs from the market, impose limits on use, and even nix advertising campaigns deemed misleading. These new requirements and restrictions pose problems for everyone in the industry but may prove to be especially burdensome to small biotech companies.
However, in the end, this may prove to be the most soluble of the problems facing the biotech industry. As The Fool.com’s Karl Thiel notes in “Will the FDA Kill Bio-tech?,” most biotech companies are primarily focused on developing therapies for cancer and other life-threatening diseases. Such drugs are not usually held to quite the same standards as, for example, erectile dysfunction remedies. Says Thiel, “Most biotech drugs are used by very sick patients, and many, while having side effects, are actually safer than the chemotherapeutics they hope to replace.” As a result, the FDA is often willing to make special allowances that enable biotechs to get their products to the consumers who need them as quickly as possible.
A Reason to Believe
Whatever problems the industry might face, from a scientific standpoint it is stronger than ever. As researchers learn more about the nature of human genetics, it be-comes possible to do things that would have been unthinkable—inconceivable—even five years ago. This is not the dotcom collapse of the late 1990’s. Science as strong —and as capable of saving and im-proving lives—as biotechnology is not going to go away. To underscore this point, the Tufts Center for Drug Development expects some 50 new biotech drugs to reach the market in the next year.
What’s more, there is evidence that the problems outlined in the early part of this article may be due not so much to a fundamental flaw with this industry, but to the cyclical nature of the industry in general. According to economist Joseph DiMasi, “In the short run, you can see a productivity decline in the form of [fewer] drug approvals and fewer new-drug applications. What’s not clear is if this problem will persist. Innovation generally comes in waves.” DiMasi cites a Senate report from the 1950s noting a similar productivity decline in terms of new drug development. “I had a chuckle at that,” he says. “We’re seeing the same thing 45 years later. Obviously the pharmaceutical industry came back from the productivity problems it had back then.”
Even if potential investors are generally frightened by the lack of profits turned in by the biotech industry, they are still willing to pony up for the right stock, as the IPO boom of 2004 made clear. “The buyers are out there and want to see the stories—they’re just selective,” says Thomas Dietz, co-CEO of investment banking firm Pacific Growth Equity. In the long run, this selectivity is probably the best thing for the industry, suggests Business Week analyst Sarah Lacey. “Traditionally, big bubble years occur where investors get carried away, followed by three years of nothing,” she observes. “Two years of tempered success could signal that the industry is maturing, and that public investors are getting more biotech-savvy.” Franklin Berger, former head of biotech research for JP Morgan, agrees, opining that “this is clearly a sign of sophistication; in up markets and down markets, investors have learned to adjust to the volatility and inherent dangers of the industry.” This can only bode well for biotech firms and the physicians and patients who depend on them, because a stable if modest stream of investment capital surely trumps periodic frantic bursts of investment followed by fallow periods.