Biotech: Making sense of the science

It was supposed to be a wonder drug. Provenge promised to turn the body's immune system into a weapon against disease, offering fresh hope to the one in seven men diagnosed with prostate cancer. Known as an "immunotherapy", it was one of the first treatments of its kind to win approval from US health regulators. When the Food and Drug Administration gave Provenge the green light in 2010, investors piled into shares of Dendreon, the company that made the treatment, sending its market capitalisation to almost $8bn.

Analysts hailed a new blockbuster, forecasting peak revenues in excess of $4bn a year. But late last year, Dendreon went bankrupt. Provenge was a flop. Annual sales of just $300m had been hamstrung by its price tag - $93,000 a treatment - and the emergence of better alternatives. The company's shares, which hit a high of $54 in 2010, ended up being worth a few cents; its assets fetched less than $500m in a fire sale in February.

The demise of Dendreon served as a reminder that many companies working on revolutionary drugs fail, but it has done little to calm market excitement surrounding the biotech industry, the subject of intense takeover activity in the past 12 months. The companies in the sector offer to harness two decades of huge advances in genetic science to create new drugs for some of the deadliest diseases. If they succeed they will save countless lives and deliver a windfall for the investors who have been piling into the sector for the past two years.

When it comes to funding, the biotech industry has never had it so good. Investors are flooding the sector with money. The New York Stock Exchange Arca biotech index has risen by over 200 per cent since the start of 2011 to 4,131 points, easily outpacing the S&P 500, which has grown 64 per cent. At this rate, it will not be long before the cumulative market capitalisation of US biotech companies tops $1tn.

Big pharma groups, facing the loss of exclusivity on many of their drugs and big gaps in their pipelines, have been busy buying biotechs at hefty premiums. Younger companies are able to raise funding with relative ease, first from venture capitalists and then from the public markets: there were 82 initial public offerings of biotech companies in 2014, according to Credit Suisse, eclipsing the record of 67 set in 2000.

Adding substance

For some, the exuberance is eerily familiar to the bull market that preceded the biotech crash of 2000. Yet many investors, analysts and executives say it is different this time. Then, investors were betting on the promise of genomic science, which, much like the dotcom boom of the same period, failed to immediately live up to the hype. Now, however, they are investing in more advanced treatments as the scientific breakthroughs of the past decade reach commercialisation.

"We are in a different era. Unlike past bubbles, where there was not a lot of substance, we have terrific science . . . leading to breakthrough therapies," says Ron Renaud, chief executive of Rana Therapeutics, a Massachusetts-based biotech group.

If the bulls are wrong, the consequences would be devastating for investors, who stand to lose hundreds of billions of dollars, but also for patients. Should markets take fright, the industry would struggle to secure the funding, hampering its attempts to discover the next breakthrough drug.

It took over a decade for the biotech sector to recover after the 2000 bubble burst. Some fear any similar fall today would leave the genetic medicine revolution moving back into the slow lane.

Investors are already jittery. Last month, Gilead, the California-based maker of a $1,000-a-day hepatitis-C pill, prompted a sharp sell-off across the sector by warning its treatments should not be used in combination with a particular type of heart drug. Mixing the two had led to abnormally slow heartbeats in nine patients, one of whom had died of cardiac arrest.

Analysts were sanguine about the impact on Gilead, let alone other biotech companies, but that did not stop the correction erasing all of the March gains on the NYSE Arca biotech index. It was the third time in six months that investors ditched biotech stocks because of problems at Gilead, the largest biotech group with a market capitalisation of $150.9bn at the end of last week.

Yet some bulls point to the very existence of large-cap biotechs as a sign that bubble fears are overdone. In 2001, the cumulative market capitalisation of the top five biotech groups was $82bn. Now Gilead, Amgen, Biogen, Celgene and Regeneron are worth over $500bn combined. Gilead is bigger than many of the best-known names in pharma, including GlaxoSmithKline, Sanofi and Bristol-Myers Squibb, while Biogen is larger than AstraZeneca and Eli Lilly.

The success of these groups, all of which were founded in the late 1970s or 1980s, shows the biotech model is scaleable and long-lasting, according to Ravi Mehrotra, biotech analyst at Credit Suisse. That is propitious for some of the groups that recently completed IPOs, such as Bluebird Bio, a specialist in rare diseases, which has seen its market capitalisation surge by almost 400 per cent to $4bn since its IPO in 2013.

"The financial markets for the first time know that successful biotechs can attain greater than a $100bn market cap . . . and thus it is logical for them to pay more for present day small and mid-cap companies that may be the bellwethers of the future," he says.

Others argue that a big leap forward in genetic science is now producing effective drugs marking a clear difference to the 2000 bubble. "Before the 1990s we only had a crude understanding of genomic science - it was a black box," recalls Kevin Starr, a partner at Third Rock Ventures, which has raised $1.3bn to invest in biotech and life sciences companies. "Circa 2000, we had the human genome and there were suddenly lots of investments in companies trying to understand genomics. But they weren't applying the science to anything investible."

Mr Starr, who worked at biotech group Millennium between 1998 and 2003, recalls how the initial euphoria surrounding genetic science was replaced by the realisation that many of their discoveries were not "druggable".

"We thought if you found the gene that caused a disease you would simply be able to 'drug it'. The technology had great promise, but then we realised it would take decades."

But, says Mr Starr, better scientific knowledge is now coinciding with a big data revolution that makes it easier to crunch laboratory data, while advances in automation and miniaturisation have made drug development cheaper.

'Not amazing enough'

Genomic science is producing revolutionary new drugs, from a cure for hepatitis-C to immunotherapy treatments. Yet some believe that the companies' prospects do not justify their stratospheric valuations.

"My gut reaction is that biotech valuations are always too high," says Amit Roy, a pharmaceuticals analyst at the independent Foveal research group. "We need to think about which patients are going to get given the drug. The same mistake is always made: the drug is amazing, but it is not amazing enough."

Mr Roy accuses some analysts of "double counting" in their sales forecasts. When a new drug is close to getting regulatory approval, some incorrectly assume the drug will be given to all the patients who would benefit. But when a rival therapy is approved, they perform the same calculation - although the two drugs are chasing the same set of patients.

Even bullish analysts admit it is a stretch to set current biotech valuations using traditional metrics. "When I look at valuations, the old way I used . . . no longer works," says Evercore ISI analyst Mark Schoenebaum. "Almost all the stocks I cover . . . trade above, in many cases double-digit percentage points, their base case DCFs," he adds, referring to a common valuation method known as discounted cash flow. "You can get to current stock prices if you assume greater R & D productivity going forward than has been the case over the very long term," says Mr Schoenebaum.

Competitive field

Ian Read, chief executive of Pfizer, admitted recently that he was concerned by "buoyant" valuations of biotech stocks. Yet Pfizer was one of the companies involved in a three-way bidding war last month for Pharmacyclics, the maker of a drug for blood cancers. It offered $19.8bn for the group, according to people who worked on its offer, but was trumped by AbbVie, which ended up sealing a deal for $21bn.

Richard Gonzalez, chief executive of AbbVie, described the takeover battle as "one of the most competitive I've ever seen". But for some, the $21bn price tag for a company that makes just one drug was proof that the sector is overheating.

Mr Gonzalez's estimates imply the drug will achieve annual peak sales of $11.5bn, compared to the typical Wall Street estimate of around $6bn. A recent straw poll of over 300 analysts found almost 90 per cent thought AbbVie had overpaid for Pharmacyclics.

"Are there valuations that are out of proportion to reality? There probably are," says Brent Saunders, the chief executive of Actavis who engineered the biggest takeover of 2014 - the $70.5bn acquisition of Botox maker Allergan. "There are certain areas where there are arms races," says Mr Saunders.

He puts hepatitis-C, where there are two companies offering an effective cure with a third soon to join the fray, in that category. Some investors fret the drugs will not be able to command high prices with so much competition.

Some lawyers and bankers say high prices could make it harder for big pharma groups to justify takeovers to shareholders. Geoffrey Levin, partner at legal firm Cadwalader, Wickersham & Taft, says high valuations and a healthy market for IPOs are prompting some big pharma groups to target smaller, often privately held, biotech groups, where the early stage science is riskier, but the potential rewards are far larger.

Yet few believe the large-cap pharma groups will stop doing big-ticket biotech deals any time soon because they desperately need new products to fill their own drug pipelines, depleted by years of under-investment and R & D failures. Barely a day goes by without a spike in the shares of a biotech group. Names that are often mentioned as takeover targets include Receptos, the Californian maker of drugs for autoimmune disorders including multiple sclerosis and BioMarin, which develops treatments for rare genetic diseases.

"Since most big pharma R & D pipelines are not producing new products with as much revenue as they need to replace drugs going off patent, these companies are willing to pay a premium for new therapies that have received, or are close to receiving, [regulatory] approval," says Frank Aquila, an attorney at Sullivan & Cromwell. "Today, more times than not, they will be biotech products."

If anything, a large correction in biotech stocks could be helpful for big pharma, allowing companies to pick up promising assets at depressed valuations. It would be a problem, though, for nascent biotech groups or for the venture capital groups they turn to for their first rounds of funding.

"I'm worried that a few high-profile failures could tar others with the same brush, which would have some blowback for the rest of the industry," warns Mr Starr. "Whenever you get success, you see a herd mentality."

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