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How
to evaluate biotech companies?
The
unpredictable and complex nature of biotech firm’s business makes
its evaluation a highly precarious job say, Alok Gupta and
Mark van der Geest
One
of the most striking aspects of the biotech industry is its scarcity
of earnings. Most biotech companies carry losses for years, even
after they
have launched a new product. As a result, valuing biotechs is a
precarious undertaking at its best.
The details of a biotech firm’s business, its research methods,
its test results, even the products themselves, can be highly complex.
The success or failure of a drug
during clinical trials is difficult and often impossible to predict.
Investing in biotechnology stocks is somewhat unlike other investing
stocks because in valuing biotechnology stocks, it has always been
difficult to use traditional net present value and discounted cash
flow approaches in isolation, particularly for the clinical and
pre-clinical stage companies. Predicting the probability of a single
product’s success in the clinic depends on many variables such
as clinical trial design, difficulty of indication, and quality
of phase II data.
In addition, the company’s financial well-being and corporate
partnerships may further complicate the valuation analysis. The
large cap and profitable biotechnology companies have had the broadest
appeal to investors, but that is only a handful of companies. Investors
in biotech stocks take a long term approach to investing. There
are stocks that can significantly appreciate in value overnight
if a trial is successful.
Conversely, they can also drop by 30 per cent to 70 per cent in
value with disappointing results. Biotech companies’ stocks
tend to be heavily influenced by favourable or unfavourable news
regarding the development or testing of a product.
Key factors that one needs to look for while evaluating a biotech
company are:
Proprietary expertise
Specialist in-house knowledge and expertise is key to the belief
that a company can offer something novel and differentiate itself
from a large pharmaceutical or biotech player. This is sometimes
referred to as a platform technology.
Robust pipeline and technology
A broad pipeline of potential drugs at various stages of development
provides some comfort that a company’s fortunes are not hinged
on the success of one product. If for some reason the product proves
to lack efficacy, then the company has something to fall back on.
Another approach is to look for companies diversified around a specific
disease class or that have a niche technology that can be used as
a platform for a range of different drugs. However, historically
stock prices are largely geared around the fortunes of the most
advanced development product.
In May 1997, Celltech’s share price dropped about 60 per cent
when a partnered antibody candidate, being developed by Bayer for
septic shock, failed in phase III trials. There are only limited
checks that can be performed on products in clinical trials. Analysing
the available data is a prerequisite, but direct contact with the
lead investigators on the trials can provide additional comfort
or even concerns. An ideal due diligence process would include checks
with medical opinion leaders, clinicians, companies with competing
products, and practitioners with specialised knowledge of the therapeutic
field.
The important issues to address for a potential drug candidate would
include:
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Does the product address a medical need either unmet with existing
therapies, or with the potential to offer superior efficacy or
reduced side effects?
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Is the published pre-clinical data suitably compelling to progress
the product to the next stage of development?
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Has the clinical trial programme been designed with achievable
end-points? If the trials are pivotal for approval, do they fulfil
all the regulatory requirements?
Appropriate business model or collaborations
Most
appealing on a risk perspective is a model based on partnering drugs
at an early stage of development. Biotech companies that fail to
link up with a corporate or academia partner can have trouble surviving.
To ensure survival or lower risk, biotechnology companies can attempt
to engineer several collaborative agreements with various pharmaceutical
companies for research or marketing. Partnerships with major pharmaceutical
companies provide valuable endorsement of the product in addition
to the essential financial support for ongoing development.
However, the terms of any deal must be analysed to assess the long-term
returns for the biotech company. Deals which appear generous in
up-front and milestone payments are often to the detriment of downstream
royalties. Biotech companies that adopt a go-it-alone approach,
are, of course, inherently higher risk. Bearing the full cost of
clinical development, together with manufacturing and the investment
in sales and marketing infrastructure, is more than most companies
and investors would like to stomach. However, an appropriate strategy
could be to retain rights for certain indications or specific geographic
regions.
Strong management
To
a large extent, the biotech sector became a victim of its hype in
the latter half of the nineties, as companies failed to deliver
on promises, causing investor and market confidence to slip. Inherently,
the market should expect some setbacks in drug development, but
many of the missed milestones of this period were put down to the
inability of management to guide on timelines and events.
For early-phase companies, it is critical to have senior management
with a proven track record of taking a drug through the regulatory
hurdles and to the market place. The management teams should be
able to set out their expectations and deliver on them. Being able
to achieve stated milestones is key to market performance for companies
that are at the development stage.
Financial resources
The
majority of product-oriented companies in the biotech universe are
still loss-making as they fund the discovery and clinical development
of their drug candidates. The release of a commercial product is
often many years away and requires millions of dollars. Thus a company’s
burning of cash in ongoing research and development or burn rate
is a critical measure of a company’s longevity. Companies that
have a minimum of two years’ cash reserves are in a comfortable
position.
As such, biotech companies are dependent on the vagaries of the
capital markets to provide periodic cash injections, with the only
other source being partnership agreements which involve giving up
certain rights. Support from the market cannot be guaranteed, and
this has forced some companies into highly dilutive rights issues
to ensure their ongoing viability. For companies requiring further
cash before reaching profit, an opportune financing strategy is
to access the markets after reaching an important milestone.
Market
Biotechnology
companies that are developing products aimed at markets for a new
drug which is large and underserviced will be obvious winners. Another
key factor in a drug’s success is how frequently it is likely
to be prescribed. Drugs that are used to treat chronic conditions
such as the afflictions related to aging or AIDS, will generate
a lot more cash flow than infrequently used treatments like vaccines.
Life style diseases cancers, heart attacks, strokes and other illnesses
in which diet and exercise are often believed to play a part will
increase as the customs of industrialised nations spread around
the globe. Biotech companies that are targeting these therapeutic
categories will have a large demand for their products.
The authors Alok is from Rabo Bank, India; Mark is from Rabo Securities,
Amsterdam
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