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Jul 1, 2007 (Vol. 27, No. 13)

Biotech Business Model Thrives

Countering a Recent GEN Article Author Believes the Prevailing Business Strategy Is Valid

  • Gary P. Pisano’s contribution to the Point of View column in the April 15 issue of GEN argues that “… the business models of biotech have worked poorly because they were based on the wrong inferences about the science.” I would contend the contrary, that the business models are indeed valid because they are based on the correct inferences about the science.

    For example, in the October 2006 issue of the Harvard Business Review, Pisano shows that for publicly held biotech companies, R&D spending per new drug launched (in constant dollars) decreased from $2.0 billion in 1985 to $1.2 billion in 2004. He also shows that for the top 20 pharmaceutical companies worldwide, R&D spending per new drug launched decreased from $4.3 billion in 1985 to $1.3 billion in 2004. These figures actually demonstrate an increase in R&D productivity, as indicated by a decrease in R&D spending per new drug launched. It also shows that pharma firms now use the same biotechnology techniques pioneered by the biotech industry.

    Moreover, progress can be measured by the increasing rate in the number of compounds that are approved by FDA. In 1982, the first genetically engineered pharmaceutical, human insulin, was approved by FDA. According to an overview of the biotech industry in the March 2006 issue of Nature Biotechnology, of the 127 biotech drugs approved over the 24-year period from 1982 through the end of 2005, 55, or 43%, were approved over the five years ending December 2005 (representing just 21% of the 24-year period).

  • R&D Expenses vs. Revenues Earned

    Granted, it seems to take forever for biotech companies to make a profit. Nevertheless, revenues have been growing at a much faster pace than R&D expenses. According to Biotech 96, an Ernst & Young publication prepared by Kenneth B. Lee, Jr., and G. Steven Burrill, in 1986, for all 850 U.S. biotech companies at that time, including public and private firms engaged in areas of healthcare, agriculture, chemicals, food processing, and energy, revenues and R&D expenses were $1.1 billion and $1.7 billion (155% of revenues), respectively. In 1996, for a total then of 1,308 such companies, revenues and R&D expenses were $9.3 billion and $7.7 billion (83% of revenues), respectively. Last year, Burrill estimated at his presentation at BIO 2006, total revenues and R&D expenses of 1,500 plus U.S. biotech companies at the time, public and private firms included, would reach $72 billion and $19 billion (26% of revenues), respectively.

    An indication of what may eventually happen to some newer companies in the industry can be illustrated for five of the oldest, which are also the five largest U.S. biotech companies that compete in the pharmaceutical marketplace. All five companies—Amgen, Biogen Idec, Genentech, Genzyme, and Gilead—reported in their 10-K filings to the SEC over $2 billion in revenue in 2005. Total revenues for these five companies increased from $15.0 billion in 2003 to $20.9 billion in 2004 to $26.1 billion in 2005. All five companies were profitable in 2004 and 2005, whereas just two were profitable in 2003. Total net income increased from $1.8 billion in 2003 to $3.7 billion in 2004 to $6.4 billion in 2005, even though R&D expenses remained around 20% of revenues for all three years.

    It should be noted that the five biotech companies listed above, representing just 0.3% of the 1,500+ U.S. biotech companies, account for around 36% of total industry revenues. The fact that only a few companies dominate an industry, though, does not invalidate the industry’s business model. It simply means that there are winners, challengers, and losers at any point in time. Who is ahead at that point in time by no means guarantees who will be ahead five years later. Entrepreneurship results in what Austrian economist Joseph Schumpeter called “creative destruction.”

  • Comparison to Other Successful Industry Business Models

    To illustrate, let’s take a look at the semiconductor (SC) industry, certainly one with a viable business model. In 1997, I published an article in Technology Management, entitled “Radical Innovation and Industrial Transformation in Biotechnology: Comparison with the Early Semiconductor Industry.” In constant dollars, biotech product sales were compared to SC sales at similar stages of development (at comparable time intervals following the seminal events for those industries—the discovery of recombinant DNA in 1972 and the invention of the transistor in 1947). Twelve years after their respective seminal events, SC sales were 25% greater than biotech product sales, after which biotech product sales grew faster than SC sales. At 17, 18, 19, 20, 21, and 22 years, biotech product sales were 3%, 19%, 29%, 51%, 59%, and 63% greater, respectively, than SC sales.

    In 1982, 35 years after the SC industry’s seminal event, five U.S. SC companies accounted for 24.5% of the U.S. market. Yet these five companies represented only 0.65% of all the U.S. SC firms at that time. In fact, the top five SC companies worldwide, which represented an even smaller percentage of all SC firms worldwide, accounted for about 29% of the world market. These percentages are comparable to the percentages previously mentioned for the biotech industry after the same time period.

    Also, when one looks at the leaders in the SC industry over time, one sees dramatic turnover. None of the top five companies throughout the 1960s were among the top five companies by the early 1980s, and the largest SC company today, Intel, was only seventh in market share in 1982.

    The same type of creative destruction has resulted in the dotcom era. Many people at the time thought the dotcom bust in 2000 reflected a nonviable business model. With the right amount of investment capital, however, Amazon, eBay, and Google emerged in addition to a lot of other viable but smaller dotcom companies. Bear in mind, that in any industry, roughly 80% of all startups fail within five years.

  • The Biotech Investment

    Thus, the emergence of a small number of market leaders does not invalidate the business model of the biotech industry—in fact, it validates it. In biotech, the top five companies in 2005 were also among the oldest such companies, three of which were at least 25 years old at the time. They all required lots of investment capital and a good many years to produce FDA-regulated therapeutics. Several of them had made acquisitions along the way. Biogen Idec, for example, was among the top five because of the merger between Biogen and Idec. In other words, many biotech companies that have a good chance of being successful just haven’t been around long enough to have developed marketable products.

    The investment community has obviously concluded that biotech’s business models are indeed valid. Data collected by Burrill & Company show almost $35 billion raised by the U.S. biotech industry in 2005, versus $5 billion 10 years earlier. Even Pisano acknowledged in the aforementioned Harvard Business Review article that “an investor who bought all 340 biotech IPOs from 1979 through 2000 and held on to those shares until January 2001 (or until a company was acquired) would have realized an average annual return of 15%.”

    Note that the comparative figures for the S&P 500 Index, the Dow Jones Industrial Average, and the NASDAQ Composite are 12.6%, 12.5%, and 14.8%, respectively.

    Indeed, if one looks at the NASDAQ Biotechnology Index and the AMEX Biotechnology Index for the first full 11 years of data (1995 through 2005), the average annual returns were 19.3% and 21.2%, respectively, versus 9.5%, 9.8%, and 10.3% during the same time period for the aforementioned S&P, Dow Jones and NASDAQ indexes, respectively.

    I’ll close with one more set of statistics. Over the years, Nature Biotechnology reported that worldwide there were only 29 profitable public biotech companies in 1996, but 45 in 2005 (an annualized increase of 4.5%), and 64 in 2006 (a 42% increase in just one year).

    In summary, the data show actualization of biotech’s promise. The glass is half full and filling increasingly faster.

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