The Future of Biotech: Party Like It's 1999

by: Joseph Krueger

At the 28th annual JP Morgan Healthcare conference, which ran from January 11- January 14th 2010, there were more than 300 companies represented, making their presentations to more than 6,000 public and private equity and venture capital investors.

Leading up to the conference and early last week there was bullish movement in many companies presenting at the conference. Many of the larger companies like Amgen (NASDAQ:AMGN), Genzyme (GENZ), Biogen (NASDAQ:BIIB), Celgene (NASDAQ:CELG), Gilead Sciences (NASDAQ:GILD), TEVA Pharmaceuticals TEVA), Watson Pharmaceuticals (WPI) and OSI Pharmaceuticals (OSIP) previewed 2009 earnings during the conference.

There was considerable enthusiasm for the sector this past week; it seemed like every biotech company rallied and closed the week up. Some notable mentions are Amag Pharmaceuticals (NASDAQ:AMAG) up nearly 25%, Sunesis Pharmaceuticals (NASDAQ:SNSS) up nearly 20%; BioCryst (NASDAQ:BCRX) up 10%, Jazz Pharmacueticals (NASDAQ:JAZZ) up nearly 15% Idenix Pharmaceuticals (NASDAQ:IDIX) up nearly 20%, Inspire Pharmaceuticals (NASDAQ:ISPH) up nearly 10% , Other companies who saw significant movement at some point but didn’t hold their gains were NovaVax (NASDAQ:NVAX) up nearly 20% at one point, Micromet (NASDAQ:MITI) up 11% at one point , Cyclacel (NASDAQ:CYCC) up 15%, Cardica, (CRDC) up 50%, Rosetta Genomics Ltd. (NASDAQ:ROSG) up 50%, and MDRNA (NASDAQ:MRNA) up 70%.

But what will happen after the JP Morgan Healthcare Conference? Was the activity the last couple weeks just due to short term investor enthusiasm? There is thought to be an established cycle to biotech where the stocks tend to rally in the last 3 months of the year and ending January, which would put us at the end of this cycle. But the bullishness is probably not temporary, it seems: Reports coming out from the conference strongly suggest that 2010 will be a booming year for biotech and pharmaceutical as mergers and acquisitions run wild. In 2010, I don’t expect an ending to the rally for biotech.

As many of us have witnessed in the end of 2009, I expect many smaller-cap biotech stocks to continue coming into investors view. I believe that smaller-cap biotech stocks will be the best place to make money in 2010. In fact, I believe the case may be extreme; where there is an aversion to big pharma and a homing into biotech, causing sustained rallies not seen since 1999.

Capital funding activity does suggest a new bull market for biotechs: Rough estimates show that in 2009, biotech companies raised about $50 billion; and the capital raises are clearly continuing. Perhaps this is due to backlog of much needed funding that ground to a halt in 2008; but regardless these necessary capital infusions are allowing promising small companies to survive, and better yet thrive.

To me, this is reminiscent of 1999: After a year of unbelievable gains in large pharmaceutical companies 1998, the rally continued with vigor through 1999 in biotech companies after in the industry was already run up over 100%, and the rally in big pharma lost its strength. In 1999 and 2000 the NASDAQ Biotech Index gained a whopping 148%, with many companies like Human Genome Sciences (HGSI) gaining over 1000% in that period. (It should be noted that the same index plummeted 54% over the following two years).

During this time, in 1999 biotech firms raised $7.8 billion and went on to raise a staggering $37 billion in 2000. This was obviously reflective of the bullish sentiment of biotech, and in my opinion 2010 vs 1999 is likely to be a similar comparison.

Why do I make the 1999 comparison? Many large pharmaceutical companies are bracing for the patents for their largest revenue generating to expire over the next few years. With few in-house drugs coming through the near term pipeline, the answer is to focus on biotech acquisitions instead. 2009 was a huge year of large mergers of the giants- this was the first step: consolidation.

The next step is acquisition of technology/drugs. I expect in 2010 to hear about numerous acquisitions or partnerships with smaller biotech firms with drugs late in development (coming out of phase II or going into phase III). In the case of partnerships you can expect a large company to pay a small biotech company tens of millions of dollars up front with continued milestone payments to support the studies; with royalties upon marketing of the drug.

This is obviously a huge boon to the smaller company, but is also a worthwhile investment for the large pharmaceutical company because the downside is defined and limited to their investment in the smaller company. The upside upon approval and marketing, however, can mean hundreds of millions for the larger company and tens of millions for the biotech company.

The same factors that are triggering the current health care crisis are the very same factors favoring biotech companies right now. Biotechnology is offering some of the best solutions for disease management related to an aging population full of degenerative diseases and rising cancer rates, who are living longer than ever before. The growing need for more potential drugs to treat the large host of diseases drives the development for them.

However, the boon for biotech will likely be big pharma’s expense: Investors worry the health-care reform won’t be good for big pharmaceutical companies as potential reform will lower prices of drugs through Medicare and Medicaid. They worry that drugs protected by patent in the US will be circumvented by importing generics from outside the United States.

Beyond this, investors worry the government will de-protect patents and accelerate the approval of generic drugs. On top of all this, more drugs will become generics as their patents expire. Investors are likely to leave big pharma and trade it in for small biotech.

Such changes to health care, if they occurred, would indeed be quite detrimental to the profits of large pharmaceutical companies. The only way that big pharma can protect itself from such possible changes is through innovation. This is where biotechnology comes in: acquisitions and partnerships are the most expedited way to gain innovative technology.

This innovation is needed because our understanding of and approach to modern medicine is changing: We will soon see more personalized medicine, where drugs are matched to an individual’s genetic profile. Patients will be pre-selected for a particular drug, which requires the development of a companion diagnostic to select for the suitable patients. Both of these are potential sources of revenue for the drug companies.

This will push small biotech companies to identify innovative products to meet these needs. Biotech companies will not only be creating such drugs and companion diagnostics, they are most likely the ones who will be identifying the genetic markers which predispose a patient to a disease and also to respond to a particular drug. Their success in understanding these relationships will in turn bolster the trend of more acquisitions of smaller companies and the biotech 1999 party.

Rod Raynovich, a freelance writer for Genetic Engineering and Biotechnology News, recently reported some broad themes and market trends he gleaned from company presentations at the JP Morgan Healthcare conference in this article.

His conclusions, which in my opinion are highly relevant and quite worthy of reiteration, were as follows:

1. There is a shift from small molecule drug development to biologicals and vaccines, exemplified by Pfizer’s recent deals.

2. "Bolt-on" acquisitions of smaller companies are being done to bolster product portfolios and positions in emerging market, for example, GlaxoSmithKline has inked a number of agreements in India and China.

3. There is increasing synergy between diagnostics and pharmaceuticals, like is the case with Roche’s new drug development activities.

4. A migration of diagnostics out of the lab and into the home will occur for chronic diseases such as obesity and diabetes, as seen from Inverness’ focus.

5. Pure-play personalized medicine companies are targeting cancer treatments through genomics, for example, Genomic Health.

6. There continues to be an increasing number of partnerships between pharma and biotech.

7. Pharmacogenomics also continues to gain traction.

8. On the healthcare reform scene a luncheon presenter Thomas Scully, an ex-administrator of the Centers for Medicare and Medicaid Services, said the reform will trigger an expansion of insurance benefits that will be positive for the industry in the short term due to increased demand but will create federal budget problems in the long term from around 2013.

But remember, we are still in the middle of a great recession that shows little signs of easing soon. Banks are not lending money, venture capital funds are hesitant, and the number of initial public offerings for upstart biotech companies has dropped considerably in recent years. Don’t assume that permissive venture capitalism, capital raising, and IPO funding of 1999 will occur in 2010- credit is still quite tight.

Nor should you assume that investors and board members are willing to tolerate reckless buyouts by big pharmaceutical companies like in 1999. In this decade, pharmaceutical companies must be much more conservative about what they will pay for cash-burning, development-stage biotech companies that will not offer anything in the form of revenue in the near-term.

At the same time, pharmaceutical companies may take advantage of the reduced ability of biotech to raise cash and may be unwilling to pay the large premiums seen in past biotech deals.

So what companies are the ones most likely to find themselves tender offers or partnerships from big pharma? Consider the timeline approaching: Blockbuster drugs are going generic; a more nationalized healthcare system may not pay for expensive biologics; and big pharma needs to come up with new drugs and applications that will fit under the intentions of the pending health-care bill.

Many pharmaceutical companies are looking for new drugs that match the indication and purpose of their current revenue generating drugs that are threatened with patent expiration. These types of drugs are often called “biosimilars”, and can serve to replace versions of drugs that are now generic or will be threatened with generic competition in the future.

These drugs have reduced development risk, as their biology and mechanisms are known, and the company has experience in gaining regulatory approval for these types of drugs.

Beyond this, the company may already have an assembled and effective sales force which can immediately gain the current market share by simply “replacing” the current marketed drug with the “new version”.

So what companies are ripe for a buyout or lucrative partnership? There is obviously more value for the buyer in companies with early- to mid-stage programs, but give the length of time it may take for those development programs to generate revenue, the more risk-averse sentiment these days favors buyouts and partnerships with companies who have very late stage programs.

Be mindful that a phase III study can still take 2-3 years to complete and 1-2 years to gain approval and bring a drug to market. Companies who are just entering phase I or even phase II studies will likely be ignored as potential acquisitions despite their potential value.

Look for companies who have completed or are close to completing at least phase II trials as buyout targets. There are many companies out there with a couple drugs who are completing phase II trials or are currently running phase III trials who do not have enough cash to see the drug through approval or marketing. Many development-stage biotech companies are surviving the financial crisis by cutting costs or focusing on a single, late stage drug.

Indeed, most of the capital raised in 2009 went to such companies with a single product on the market or a single drug close to finishing development.

Companies with highly experimental drugs or devices will most likely at best be offered an alliance- a deal containing small upfront cash payments, with continued milestone payments as the program progresses with promise of partnership if the technology comes to fruition. These are indeed quite beneficial for these types of companies, but the payoff to shareholders is still quite a long way off.

These days big pharma may steer clear of buyouts and focus on partnership and alliances, which share revenue from drug sales, rather than making large upfront payments in the case of buying a company or its technology.

Although this is quite beneficial to the smaller company, the larger company has the majority of the leverage in the partnership and licensing talks, so don’t expect them to be as favorable as the types of partnership that have occurred in prior years. It is still a tough battle for smaller drug companies that will have to count on partnerships larger companies to bring their drugs to market.

One way to take advantage of all these factors is to invest in companies who are developing a “biosimilar” or a companion diagnostic for a disease. Ideally, you may expect these companies to make a partnership or his year.

To get in on the offerings and mergers and acquisition activity, you will be looking for companies who are looking to expand the uses of some existing drugs or are developing drugs to treat more than just one disease. Look for companies who are making notable scientific developments in molecular biology, immunology, and genomics: These companies will be targets for takeover and partnership if their technology will result in more targeted approaches and better diagnostics for the “personalized medicine” which big pharmaceutical companies are developing.

This approach to investing will take significant understanding by the investor in the technology they are investing in. As well, they need to have a fundamental understanding of the development process and what it takes to gain FDA approval; investors should know at what stage in development the technology is in and what it is needed to complete the process. Investors need to determine if the company has good management teams that know what has to be done to market a potential product. Investors need to understand the significance of the pre-clinical and clinical trials.

However, as the average investor does not likely have the knowledge and experience base to judge this, he/she will have to rely on the opinion of experts. Remember that a majority of a biotechnology companies market cap is not related to products already out on the market but to the in the development stage; market cap is reflecting the likelihood of success only.

Ironically, the lack of understanding by the average investor may be in fact what fuels the biotech boom of 2010: As analysts (“experts”) recommend stocks, investors will generally have to act on good faith in the analyst recommendations. This tends to create a “herd mentality”, where investors flock into stocks based on analysts recommendations alone.

Success in this way for analysts encourages bolder and bolder recommendations, which in turn drives more investor momentum. All of this feeds into a cycle that drives speculation, urgency, and volatility, creating the same type of bubble for biotech as was seen in 1999. Biotechnology sector is high on risk but also reward, and this type of momentum only adds to both sides of the story. If you pick the right company, developing the right drug, at the right time, the stock will soar and you may easily see 500-100% gains. In contrast, bad news about pivotal clinical trials can easily evaporate 50-90% of your investment overnight.

Given the level of risk, you may not choose to own individual biotech stocks. If chasing down and babysitting volatile biotechnology stocks is overwhelming to you, there is a way you can still participate in the 1999 party: Biotechnology exchange traded funds (ETFs).

There are currently seven biotech ETFs. Each differs in their stock holdings and indexes they follow. They all have different advantages and disadvantages, you cannot simply choose one and hope for the best. However, with the small number of ETFs available, it requires least effort to determine which one you feel may perform best and it is easier to diversify your portfolio by perhaps owning a collection of biotech ETFs. Most importantly, these ETFs allow you to participate in the 1999 party while keeping off the dance floor.

These funds are:

  • First Trust Amex Biotechnology Fund (NYSEARCA:FBT)
  • iShares NASDAQ Biotechnology (NASDAQ:IBB)
  • Powershares Dynamic Biotech and Genome Portfolio (NYSEARCA:PBE)
  • First Trust Amex Biotechnology Trust (FBT)
  • PowerShares Global Biotech Portfolio (PBTQ)

But whatever your approach to biotech and pharmaceutical investing you choose, keep these four major concepts in your mind:

  1. Big pharma is under a lot of stress and as investors sentiment reflects changes in the healthcare system you can expect their share price to reflect that as well.
  2. Look for small biotech companies that have technology or drugs which will help big pharmaceutical companies overcome the current stresses.
  3. Biotech is extremely bullish right now due to the flurry of partnerships and deals expected this year; speculation about such things is likely to drive stocks.
  4. Individual stocks could soar as a result of new coverage which points investors towards these concepts, keep an eye out for these events.

I hope to follow this article with specific mention of stocks which may benefit the most from the concepts I discussed here. In the meantime, happy trading, and party like it’s 1999! (hear the famous Prince song in your head)

Disclosure: I currently have no positions in any of the companies or ETFs mentioned.