Morphosys: A Biotech Rule Breaker (Part 1)

Morphosys (MPHSF.PK) is one of the most unusual biotech companies, as it breaks three basic rules that apply to drug development companies:

Rule No. 1: Development-stage companies burn cash and therefore must constantly raise capital and dilute existing shareholders.

Rule No. 2: Development-stage companies are risky and volatile because they rely on a limited number of binary events.

Rule No. 3: Investing in cutting edge, growing segments of the pharmaceutical industry is associated with a high level of risk.

Morphosys is the only company I am familiar with that systematically breaks each and every one of these rules. It does not have any drugs on the market and is not expected to have any in the foreseeable future, yet it is profitable. It is involved in drug discovery which is associated with a high attrition rate, yet statistically, there is a very high chance that it will have commercial revenues at some point in the future. It is involved in one of the fastest growing segments in the industry, but can be regarded as a conservative holding since it will never be dependent on a limited number of binary events. And finally, it has no need to raise cash in the coming decade in order to support its activities, as its costs are covered by other companies.

Morphosys has developed a unique technology for discovering and producing monoclonal antibodies. The technology, called HuCAL (Human Combinatorial Antibody Library) basically mimics the immune system, as it scans a vast repertoire of antibodies and identifies the ideal ones for a given target. This approach represents a shift from the traditional approach of developing antibodies, because it does not involve animal immunization.

The classic way of developing antibodies involves immunizing an animal (typically a mouse) with the target of choice and utilizing the animal’s capability to produce antibodies against the specific target. Morphosys’ solution bypasses the need of immunization, as the entire process of screening and selecting the antibodies takes place on the scientist’s bench. Although most of the antibodies on the market were developed through animal immunization, the “artificial” approach is well accepted and going forward, the industry will probably see plenty of drugs based on both approaches. At the end of the day, the only thing that matters is the ability to generate an antibody and get it approved, which can be achieved by both avenues, and in some cases, screening technologies have a clear advantage over the immunization. Morphosys’ technology is not the only screening technology out there, but it is certainly considered one of the best, if not the industry’s leading screening system, as underscored by this long list of collaborators.

Morphosys’ platform is the basis for three business segments, each representing a different risk profile and market potential: (i) Research and diagnostics, (ii) partnered pipeline and (iii) Proprietary Pipeline. It is the combination of these segments which makes Morphosys such a unique investment opportunity.

Research and diagnostics

The research and diagnostics division was built primarily by acquisitions and is currently serving research labs and diagnostic companies around the world. Of the three divisions, this one can be seen as the most “traditional”, as it has a relatively low growth rate and commercial potential. On the other hand, the research and diagnostics division is considered very safe, as it is independent of clinical results. In 2008, after several years of losses, the division finally became profitable, despite a sequential decrease in revenues, down 7% to $18.2M. The company expects the unit to grow 10% in 2009 and to maintain a modest level of profitability in the near future.

Morphosys is trying to reshape this division by focusing more on antibodies for diagnostics. The market of diagnostics, albeit much smaller than that of drugs, is expected to experience strong growth in the coming decades as part of the trend towards personalized medicine. Antibodies have an important role in the field and are well entrenched in the market, due to their high specificity and ease of use. Morphosys is addressing the market for antibodies for diagnostics, estimated at several billions of dollars annually, by licensing its platform to diagnostic companies. It is currently involved in over 20 projects, some of which are expected to mature into commercial products. Last year, Morphosys announced that Sweden based Phadia would use an antibody developed by Morphosys in one of its tests for auto-immune diseases. The financial potential of such projects is relatively small, but unlike therapeutics, diagnostic products represent a fast route to market and limited regulatory risk. Without a doubt, the big potential for Morphosys lies in its partnered therapeutic pipeline.

Partnered Pipeline

The partnered pipeline segment is Morphosys’ cash cow, responsible for the vast majority of revenue and profit. The capability to discover and screen antibodies is now very common in the industry and in research labs, but only a small number of companies mastered this technique and created an efficient platform that can feed a vast number of projects. Morphosys is considered one of the four horsemen of antibody discovery, along with Medarex (MEDX), Cambridge Antibody Technology, now part of AstraZeneca (AZN), and Abgenix, which is now part of Amgen (AMGN). Medarex and Abgenix have developed immunization-based platforms whereas CAT and Morphosys have developed screening platforms that do not require animal immunization.

The universal and highly adaptable nature of the HuCAL platform enables Morphosys to be actively involved in tens of projects every year. Typically, Morphosys licenses its technology to pharmaceutical companies and develops anywhere between several to tens of development programs, each program revolves around a single target. The typical deal structure entails an initial licensing fee, full cost reimbursement by the partner, milestone payments of $12-16 million per program and mid single digit royalties on sales. Each program by itself may be modest in size, but considering the fact that Morphosys currently has 55 partnered programs, three of which already in clinical testing, the overall value is obvious.

Morphosys has agreements with a large number of partners, including some of the largest pharma companies, but in 2007, the company decided to focus most of its research activity on one collaboration by inking a transformative deal with Novartis (NVS). The deal, one of largest ever deals in the pharmaceutical industry was a ten year collaboration which includes more than a hundred new programs. In return to full, but not exclusive access to Morphosys’ technology, Novartis committed to pay $600 million over the course of ten years on top of the standard milestone and royalties on future sales. Although Morphosys is not limited with respect to partnering with other companies, Morphosys does not intend to sign additional broad discovery deals. Therefore, going forward, the Novartis collaboration will account for the vast majority of Morphosys’ activity, and will unofficially turn it into Novartis’ antibody division.

In 2009, the company expects 20 new programs to commence, primarily with Novartis, as well as the advancement of 4 antibodies to clinical testing by its partners. Looking ahead to the coming decade, Morphosys believes it will be involved in a “triple digit number” of programs. Based on present collaborations, Morphosys could cumulatively be involved in as much as 180 programs, an exceptional number by any standard. Most of the programs will not be financed by Morphosys, which will carry the cost only for programs it pursues independently or co-develops with partners.

Suffice it to say, the vast majority of these programs will fail to reach the market. In drug development only a minority of drugs prove both effective and safe, with approval rates traditionally in the single digit range, depending on the indication. Luckily for Morphosys, antibodies are thought to have better success rates due to their excellent safety profile and the ability to identify patients who would derive benefit from the treatment. According to several retrospective analyses, antibodies have a ~3 fold higher approval rates in indications such as oncology and autoimmune diseases, making Morphosys’ prospects even better.

The company tried to illustrate this in one of its presentations last year (see figure), by applying its internal statistics and historical approval rates for antibodies in order to predict the number of programs that will get approved. According to its analysis, which should be regarded as an extreme form of forward looking statement, the company will eventually see more than 17 (!) drug approvals. Investors would gladly settle for half of that number. Assuming average peak sales of $500 million per antibody per year, ten years of peak sales and a royalty rate of 5%, the cumulative value of Morphosys partnered pipeline could reach $4.25B, spread over fifteen years. This figure excludes any revenues from Morphosys’ wholly owned pipeline.

Three partnered antibodies that were developed by Morphosys are currently in clinical trials, in the hands of Roche (RHHBY.PK), Novartis and Centocor. To date, none of them generated proof of concept data, however, that might change during 2009.

Gantenerumab (Roche)

Roche is developing gantenerumab, an antibody for the treatment Alzheimer’s disease. The antibody is similar, in concept, to Elan’s (ELN) and Wyeth’s (WYE) bapineuzumab (bapi) as both antibodies target Amyloid beta, a protein which is one of the hallmarks of the disease. Roche advanced gantenerumab to phase I in 2006 and since then completed the accrual of 30 patients. This trial is somewhat atypical for a phase I study because it is a randomized, double blind comparative trial, so there could be signs of efficacy in the data. The market potential for Alzheimer disease is estimated at over $10 billion, however, to date, no drug proved successful in changing the course of the disease. Until recently, antibodies against Amyloid beta were considered a very promising target, however, following disappointing data for bapi, investors’ excitement towards this approach waned. Roche is expected to publish data from the phase I trial during the course of 2009.

BHQ880 (Novartis)

Novartis is developing BHQ880, an antibody against DKK-1, a protein that inhibits bone growth and has been shown to be involved in bone related conditions. By neutralizing DKK-1 with an antibody, it may be possible to stimulate bone formation. The potential market for BHQ880, providing it proves effective, is very large, spanning from osteoporosis to multiple types of cancer.

The concept of preventing breakdown of bones with an antibody has already been validated by Amgen’s denosumab (Dmab), currently evaluated in a battery of phase III studies. Last year, Amgen published very positive results from a study in post-menopausal women with osteoporosis, in which the antibody led to a meaningful improvement in fracture incidence and bone density. Additional trials showed that Dmab decreases bone loss in breast and prostate cancer patients who received hormonal therapy. A third potential use might be prevention or shrinkage of bone metastases in cancer patients, with data expected in the 2009-2010 timeframe. Dmab is expected to hit the market next year, and instantly become a blockbuster, due to the large addressable market (~5 million people in the US are receiving treatment for osteoporosis) and the substantial cost to society as a result of osteoporosis complications, such as fractures.

Novartis will probably pursue BHQ880 in the same indications Amgen’s Dmab is being evaluated, but the two antibodies should not necessarily be considered as competitors. Not only does each of the two antibodies binds a different target, they are involved in distinct biological signals. Dmab is thought to inhibit bone destruction whereas BHQ880 is expected to stimulate bone formation, so the two may even be synergistic. But first, Novartis will have to show BHQ880 is effective on its own and bring it to market. In order to do so, it picked a relatively small indication – multiple myeloma.

In February of 2009, Novartis started a phase I/II study in multiple myeloma, a blood cancer in which tumors colonize in the bone and degrade it. The vast majority of patients will develop bone lesions at some stage of their disease, resulting in bone loss, pain and increased likelihood of fractures. By stimulating bone formation, BHQ880 may decrease or even prevent bone loss that seems essential for the creation of bone lesions. This, in turn, may lead to not only better quality of life but also reduced tumor burden.

The concept of targeting DKK-1 is based on a growing body of evidence which shows that DKK-1 has an important role in multiple myeloma. For example, a study published in 2003 showed that multiple myeloma cells can create bone lesions by secreting proteins which lead to bone loss, and that one of the proteins they secrete is DKK-1. In addition, the investigators examined cancer cells from patients and found that cancer cells in bone lesions secrete high levels of DKK-1 whereas cancer cells from the blood of patients without bone lesions do not produce the protein.

The decision to start from a small indication like multiple myeloma as opposed to larger indications such as osteoporosis or even prostate cancer has its merits. Despite the significant progress with drugs such as Celgene’s (CELG) Revlimid and Takeda’s Velcade, no drug has been able to cure multiple myeloma, so new treatments are in high demand. In addition, multiple myeloma is not nearly as prevalent as osteoporosis, making it an ideal fast track indication, with a short time to market and a relatively low cost. A typical registration study in multiple myeloma requires less than a thousand patients, while in order to file for approval in osteoporosis, Amgen had to accrue 7800 patients.

Novartis is evaluating BHQ880 in a fairly large study (267 patients) with a placebo arm, which could make potential positive results more credible and serve as a proof of concept for the drug’s activity. This demonstrates again the advantage of having a large partner behind the wheel, as a company like Morphosys would never start such a large and costly trial at such an early stage. Novartis will probably initiate clinical trials with BHQ880 in additional indications in the near future.

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