April 1, 2005 (Vol. 25, No. 7)

New Business Model Emerges in the Biotechnology Industry

As the pharmaceutical industry continues to experience regulatory troubles, lackluster returns, and other setbacks, some disappointed investors may be shifting their focus from pharmaceutical companies to biotechnology companies.

Investor confidence in the big pharmaceutical companies has been shaken recently by front-page headlines questioning product safety (e.g., Vioxx and Celebrex). Investors also have more deep-seated concerns about the pharmaceutical industry, especially concerning the rising cost of drugs and drug discovery and a lack of promising new drugs in the pipeline.

In comparison, investing in biotechnology companies is attractive for a number of reasons. At least at the moment, biotechnology companies do not have to stand up to the same level of regulatory scrutiny as the big pharmaceutical firms.

Partially this is due to a tacit understanding that harmful side effects, should they occur, are more acceptable if the product is attempting to treat a serious illness such as cancer (as the majority of biotechnology products do).

If (as is the case with many of the big pharmaceutical firms biggest money-makers, like Viagra) the product does not address life-threatening issues, then there is much less tolerance of harmful side effects.

In addition, pharmaceutical companies risk being hurt by a backlash against their controversial practice of marketing drugs directly to consumers (biotechnology companies, on the other hand, generally market only to practitioners). This risk is especially acute if drugs that have been aggressively marketed end up being taken off of the market for safety concerns.

Superior Returns

The most compelling reason why investors may be re-allocating assets from pharmaceutical stocks to biotechnology stocks is that the latter have recently been offering superior returns.

By comparing the performance of a leading biotechnology mutual fund (Fidelity Select Biotechnology, which invests at least 80% of its assets in biotech companies) and a leading pharmaceutical mutual fund (Fidelity Select Pharmaceuticals, which invests at least 80% of its assets in pharmaceutical companies), one can clearly see that, while the performance of the two sectors is closely related, the biotech sector has consistently outperformed the pharmaceutical sector over the past two years (Figure 1).

Burrill & Company, a life sciences merchant bank and venture capital firm, predicts that in 2005 biotechnology stocks will outperform pharmaceutical stocks, the Nasdaq, and the Dow Jones Industrial Average.

One reason why biotechnology stocks may outperform pharmaceutical stocks is that biotechnology investors tend to take a longer-term view of the market than pharmaceutical investors. The hit-or-miss nature of the biotechnology industry attracts investors who are more risk-tolerant, and more interested in future growth, as opposed to current profits.

However, especially after so many biotechnology start-ups failed in the 2000 market down-turn, biotechnology firms are conscious of the need to find ways to reduce risks in order to attract funding.

Hence, new business models are emerging in the biotechnology industry that are geared to reducing investor risk in order to attract funding from investors who are not willing to expose themselves to the level of risk normally associated with biotechnology firms.

A joint venture is often an ideal arrangement that benefits both parties. Figure 2 illustrates the relationship between a biotechnology company and a pharmaceutical company in a hypothetical joint venture.

Venture capital funding for biotechnology in the U.S. has recently undergone a significant revival (funding in 2003 was $1.3 billion, a 32% increase over 2002), but venture capital firms are being much more cautious about where they invest their moneythey are less interested in biotechnology companies that are performing ground-breaking research, and more interested in those companies that have good prospects of bringing potential blockbuster products to market.

Hence the emergence of the NRDO model. NRDO stands for No Research, Development Only, and refers to companies that attempt to reduce the high risk of failure and long periods of unprofitability typically associated with biotechnology start-ups by eschewing drug discovery. Instead they concentrate on shepherding existing but as-yet-unapproved drugs through the clinical trial pipeline and hopefully toward FDA approval.

Expanding Pipelines

The goal of the NRDO strategy is to expand pipelines, concentrating on products and profits. Chris Ehrlich, of the venture capital firm InterWest Partners, explains the appeal of the NRDO model.

The idea is to get to late-stage drugs quicker. This is a backlash against peoples disappointment with the time, cost, and lack of success that is just inherent in discovering new drugs.

The practice isnt entirely new. According to Karl A. Thiel, an industry expert, Well-established companies, often labeled specialty pharmaceutical companies, have achieved varying degrees of success and profitability largely by combing through the unwanted and underappreciated drugs in the portfolios of discovery-based pharmaceutical companies, then making savvy in-licensing deals, often augmented by new studies aimed at expanding labels or markets.

The difference is that companies following the NRDO model work with drugs that are still in the pipeline, and have not yet been approved.

Benefits for All

Theoretically, the NRDO model has the potential of being beneficial to all involved parties.

By increasing the efficiency of the market, it allows biotechnology firms that are adept at drug discovery to concentrate on what they do best, while at the same time allowing big pharmaceutical firms to profit from licensing out technology that would otherwise have sat on a shelf without producing returns, and it obviously benefits the drug development companies that are following the NRDO model.

Consumers benefit from the availability of treatments that wouldnt otherwise have reached the market, and investors benefit because they will have more varied and lower-risk investment options.

By scavenging for neglected products either too small to interest Big Pharma or with potential not fully realized, specialty pharma companies reach patients with niche needs. They make sure valuable products dont slip through the cracks, Thiel explains.

In practice, however, it is unclear whether, or to what extent, the NRDO model actually reduces riskthe drug development process still has a high failure rate, and it is not yet known whether firms following the NRDO model will be more successful at getting drugs to the market than traditional biotechnology firms.

It is also debatable to what extent the NRDO model would actually increase economic efficiency, since the investment markets are already efficient.

Some in the industry think that the model will be viable in the short term, but that consolidation pressures will inevitably cause the development firms to merge with the discovery firms.

And finally, it is not clear whether or not the current trend toward increased mergers, acquisitions, and joint ventures will make the NRDO model irrelevant by solving the same problems by different means.

It is possible to say with confidence, however, that the extent to which the NRDO model can be applied will be limited by the fact that drug discovery is and will always remain the most important step in the process.

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