July 1, 2009 (Vol. 29, No. 13)
Benjamin J. Conway
Economic Realities Force Life Science Firms to Deviate from Traditional Business Models
Despite the apparent turn of market fortunes more recently, by virtually any measure it would appear that the life science industry may be poised for a period of profound structural transformation. Declines in equity values and their implications paint a sobering picture for the future.
While off their March lows, equity values have dropped precipitously—the BTK is off 29.3% and the NBI is off 26.6% from their respective August 2008 highs. And while the decline from the highs has not been as pronounced as the drop in either the DJIA or NASDAQ, given that the biotech sector highs lagged these broader indices by 10 months, might the bottom possibly lag as well?
Lost on no one is that the current market turmoil has significantly constrained the industry’s access to capital. As reported by Burrill & Co., public funding of the sector through IPO, PIPE, and follow-on equity transactions declined nearly 80% in the fourth quarter of 2008, with slightly over $200 million raised compared to the prior three months when over $1 billion was raised. Similarly, private financing witnessed a fourth quarter drop, declining $500 million from the $1.2 billion raised in the third quarter of 2008. New investment activity has been sharply curtailed, and portfolios have been trimmed as investors take more defensive investing postures.
As a result of this lack of access to capital, the industry faces severe financial constraints. Of the 400 biotech firm that are public, nearly 50% have less than 12 months’ cash, and more than 30% have less than 6 months’ worth. The situation is similarly dire among the privately held companies, with an estimated 40% of the 800 or so companies possessing less than a year’s cash. Virtually all are early development-stage companies with promising technologies yet limited near-term revenue opportunities.
The severity of this market retrenchment is even more pronounced when placed in context. For nearly six consecutive quarters, the IPO window for life science companies has been completely closed. The life science IPO drought was similar in duration during the market downturn following the dot.com bubble earlier in the decade.
A key distinction, however, was that during the previous lull the overall new-issue market remained relatively accessible—226 nonlife science companies still managed to become public. Since the beginning of 2008 only 36 companies have debuted. Effective last September, the entire new-issue market has been at a virtual standstill.
That companies in this industry find themselves financially overextended is not unusual. These companies often plan a funding effort to coincide with a valuation inflection point, such as the release of clinical trial results, despite a painfully short financial runway. The underlying premise behind this financing strategy is that at some price the financing would get done, and that the only uncertainty was the market-clearing price for the offer.
Historically, this reasoning has, by-and-large, held. Today, however, that assumption appears to be a thing of the past. For many companies, it is quite likely no market-clearing price will emerge, no matter how low, and they will find themselves without the financial wherewithal to continue operating.
Ominously, even with a rebound in the broader market, it may be the case that the life sciences will not witness a similar rebound. Investors may reflect more closely on their investment experience and recognize that of the 223 life science IPOs since the beginning of the decade, less than one-third are currently above their IPO offering price per share.
And no particular category of issue, be it biopharma, medical device, diagnostic, or discovery, has faired appreciably better than another. More striking would be the realization that an investment in one share of each of these IPOs at their IPO price would today be worth nearly 25% less than the amount originally invested.
Even before the current market collapse and the contraction in access to capital, investor enthusiasm has increasingly displayed a bias for more mature companies offering late-stage pipelines if not marketed products. This trend is exemplified by the changing profile of biopharma companies to come public. In 2000, only 38% of biopharma IPOs involved companies with drugs in clinical development. By 2007 that percentage had risen to 100%. Half of the companies had either lead compounds in Phase III trials or approved products.
Current market conditions have only exacerbated the situation. The public market bias for more mature companies is now even more pronounced. As a result, early-stage companies—the vast majority of the industry—do not have access to funding through the capital markets to advance their development. Should this situation become further protracted, there undoubtedly will be a pronounced change in how the industry conducts business.
Pharmaceutical Industry Dynamics
Changing investor sentiment and the competitive dynamics of the pharmaceutical industry are both promoting the likelihood of profound structural change in the sector.
Traditional big pharmaceutical companies thrived during the 1990s. From December 1990 through December 1998, the indexed share value of the top companies appreciated well over fivefold. The sector’s performance over the last decade, however, has been quite different.
From December 1998 through September 2008, the index dropped nearly 15%, accelerating to a decline of over 35% at the market’s March 2009 nadir. In contrast, through September 2008 the biotechnology sector, as measured by the BTK, advanced more than 300%. What might account for such a divergence in performance in sectors that seemingly share so many similar characteristics?
In 1989, more than 50% of the pharmaceutical industry’s R&D budget was spent on preclinical activities. This percentage dropped slowly through the 1990s, declining to 44% by 1999. Beginning in 2000, however, the drop became precipitous as the industry focused a much greater percentage of its R&D budget downstream on such activities as expanded clinical trials.
By 2006, this figure stood at slightly more than 25%. More striking is the revelation that when measured in terms of constant absolute dollars, spending on preclinical R&D activities actually declined 0.4% annually over the period, despite an annual increase of nearly 7% in total R&D spending.
The effect of this shift in R&D spending is perhaps best reflected in new drug approvals. Throughout the 1990s, well in excess of 50% of all new drug approvals originated with the big pharmaceutical companies. As late as 2001, big pharma accounted for over 60% of NDAs. That percentage subsequently plunged, with new drugs sourced from big pharma now only 25% to 30% of the annual total. This figure has been as low as 15%. This innovation gap has been filled primarily by biopharmaceutical companies that today regularly account for 75% or more of new therapeutics developed each year.
The divergence in stock market performance between big pharma and biotech strongly suggests that discovery and early-stage development are defining core competencies and that value creation and a sustainable competitive advantage find their origin in great part in product innovation.
Conversely, the ability to establish and maintain defensible barriers based on downstream competencies are transient at best, particularly given that information asymmetries have to a large extent been eliminated in this information age. This change in the competitive landscape has resulted in a fundamental shift in economic allocations: product innovators will increasingly capture the largest share of the economic pie.
Traditional pharmaceutical companies have been forced to adapt to these changes rapidly and compensate for a growing pipeline gap. Acquisition of bigger biopharmaceutical companies with marketed products has apparently been deemed the most expeditious means to accomplish this goal. Subsequently the sector has witnessed many prominent biotech transactions.
Yet while such deals provide a top-line benefit in the short term, significant uncertainty remains regarding the longer term value that is ultimately derived from these acquisitions. The product portfolios of the targets are often quite limited, and acquired drug candidates often still face significant regulatory hurdles and market risk.
Duplicate downstream competencies are of limited value to the acquirer, who often boasts far deeper capabilities. Cultural integration issues often also present daunting barriers, which are of particular importance given that so much of the value resides in human capital. On top of these issues, the acquisition premium that companies with approved products can command is quite high given their scarcity.
Despite the attractiveness of marketed products and late-stage candidates, the acquisition activity of big pharma more recently may be indicative of a growing recognition of the difficulty in extracting value from such acquisitions. From the beginning of 2005 through 2008, a significant majority of all big pharma acquisitions, nearly 70%, have been of companies with a clinical pipeline consisting only of early-stage candidates, if any. That traditional pharmaceutical companies are pursuing such deals may suggest that they are placing increasing importance on accessing early-stage technologies.
As a step toward reestablishing leadership in product innovation, big pharma companies may step further into the funding vacuum created by the market downturn and accelerate their acquisition activities. Moreover, given current market conditions, attractive technologies may be acquired at significant discounts, despite lofty acquisition premiums paid. And with few viable alternatives, shareholder receptiveness to acquisition overtures is high.
Recent examples of such activity include GlaxoSmithKline’s acquisition of Genelabs and Eli Lilly’s acquisition of SGX Pharma. Yet it is unlikely that the traditional pharmaceutical industry will lead a broad-based sector consolidation. The economic downturn has impacted big pharma as well, and the industry is likely to pursue such acquisitions selectively and at a measured pace.
A more permanent impact resulting from the current market dislocation could be a company development pathway that deviates significantly from historical experience. With public-market bias favoring more established companies offering a greater breadth of products, private investors will likely have neither the investment appetite nor the financial resources to bridge the ensuing and ever-widening funding gap. In consequence, there will be far fewer companies formed around a single compound or technology, a model that has been so pervasive historically.
Benjamin J. Conway ([email protected]) is founder and
managing director of Johnston Blakely & Company.