As a continuation of my earlier valuation article focusing on IP, clinical trials, management, and technology, this second part will focus on market size and risk-adjusted net present value (rNPV). While not to diminish the other important aspects of an objective valuation of a development stage biotech, market size / indication is arguably the most important of all. A decade could easily be spent obtaining approval, all while accumulating a deficit of hundreds of millions of dollars (check the SEC form 10ks of biotech companies in Phase 3 trials!), only to see a drug sell a poorly. In fact, according to Karl Keegan in Biotechnology Valuation: An introductory guide, many drugs fail to sell more than $100 MM annually, falling short of estimates. This is all while fighting the clock, as patents/market exclusivity may run out before a drug manufacturer can recoup its costs.
It is also very challenging to assess the market. Broadly speaking, a company will only put information on their website that is favorable for them. For example, they might post the size of the market and why their treatment might be an upgrade over the current standard of care, or addresses an unmet need. While a good starting point, one should actively pursue a broad knowledge of the indication and become familiar with the competitive landscape. Associations, organizations, and foundations dedicated to helping people with these diseases are usually helpful. This due diligence should also extend to competitors in clinical trials as well. More globally, one should understand if the competitive landscape is filled with “me too” drugs, biologics, etc. and adjust accordingly. For example, Vivus (NASDAQ:VVUS) is seeking approval of its proprietary candidate avanafil for the treatment of erectile dysfunction (ED). While the data appears strong and would seem to favor approval (Vivus just submitted a NDA to the FDA a few weeks ago), concerns remain about the market size. As my co-author Mr. Trevor Sherwood eloquently stated in a previous piece:
“If approved, avanafil will face the harsh reality that the ED space is already crowded with Pfizer’s (NYSE:PFE) Viagra (sildenafil), Lilly’s (NYSE:LLY) Cialis (tadalafil), and GSK’s (NYSE:GSK) Levitra (vardenafil) having been marketed for several years. Further complicating an already competitive therapeutic space is the fact that Pfizer is currently in litigation with Teva (NYSE:TEVA) and several other generic companies over the sale of generic sildenafil, which could begin when Pfizer’s composition of matter patent expires in 2012. Avanafil will likely be approved by the FDA, but it is clear that Vivus will face large challenges with respect to market penetration and margins.”
How to value something like this? One possibility is to sum up the sales of the competitors products to get an overall market size, and then multiply by some factor, say 0.1 to represent 10 percent market penetration to give a peak sales number (typically a few years out from approval). While just a starting point, it is sensible to perform a sensitivity analysis whereby one modifies this market size/market penetration number to get a range of values, followed by discounting the expected cash flows back to the present. This net present value can be compared to the current market cap to give a rough idea of how reasonable the market is valuing a company.
To illustrate this approach, one procedure (described in Karl Keegan’s Biotechnology Valuation) involves estimating the market size (technically, market size 5 years past launch) as described, and adding the probability of achieving this and lastly a final profitability percentage. This value is then discounted back (lot of debate to what this number should be, but we’ll save that for another day) and this yields a NPV for the project. Summed over all the projects and divided by the number of shares outstanding and multiplied by a P/E multiple yields a quick and dirty comparison of what the company is worth relative to the current share price.
I will use Prolor Biotech (NYSEMKT:PBTH) as an example (analysis of technology and recent data from Phase 2 efficacy trials here, and here). Starting first with the hGH-CTP program (the program has released positive interim Phase 2 data), I believe the program is 4 years away from a launch (6 more months to finalize data from Phase 2, then over 36 months for Phase 3 followed by 18 months for regulatory matters (NDA preparing and FDA review). Karl Keegan suggests that sales peak in the 5th year, and I estimate 50% penetration of the current market (given the 7% growth rate of the current $3 BB market, this would represent 33% of the future market) given Prolor’s weekly injection vs. daily injection competitive advantage. Due to the validated nature of the endpoints (IGF-1 as a marker for hGH) and the de-risked nature of the platform, I believe a 50% success rate is overly conservative. As a result of licensing fees owed to the owner of the patents (Washington Univeristy in St. Lious) and to account for other potential royalties, I’ve used 90% royalty rate with a 20% net profit margin.
This yields a NPV of nearly $7.5 per share (based on 60 MM shares outstanding and a conservative P/E of 17 along with a discount rate of 20%. I believe for a newly profitable biotechnology that offers a clinically validated biobetter (not simply a biosimilar) platform, this is extremely conservative. The currently preclinical Factor IX – CTP program will be entering Phase 2 trials relatively soon, and performing a similar analysis gives $0.14/share of value (since BIOD has a long-lasting protein in development ahead of PBTH with orphan drug designation, I have decided to use a conservative market penetration number of 10%), and I have not assigned any value to the obesity program (tough indication, preclinical program, even though I think this obesity candidate has a chance).
Performing the above mentioned sensitivity analyses on the inputs, including discount rate, market penetration, and probability of success yields a wide range of potential share prices. In yellow are values below the current market price (~$5 / share as of computation in early July) and represent scenarios in which the company may appear overvalued. However, when extremely high discount rates are used (>20%, considering that the projects are already multiplied by a success factor) and a low P/E is used are the only scenarios in which the company appears to be a “sell.” Importantly, given the crowded market space of the human growth hormone market (7 current sellers of daily injectable hGH) and a slew of competitors developing longer-lasting hGH variants, a sensitivity analysis of market penetration is in order. As one can see, Prolor is still potentially attractive with less than a billion in sales, provided a reasonable P/E multiple is used.
Further developing this NPV spreadsheet into a more rigorous analysis, we can estimate cash flows (both inflows and outflows) for the future, again using Prolor Biotech as an example, and construct a risk-adjusted net present value spreadsheet for the lead candidate (hGH-CTP). This valuation model uses the rNPV method developed by Jeffrey J. Stewart (J. Stewart. Biotechnology Valuations for the 21st Century. Milken Institute Policy Brief 2002, and J. Stewart et al. Putting a Price on Biotechnology and Nature Biotechnology 2001. 19, 813.
Similar to the NPV analysis used before, conservatively estimating a 60% overall chance of reaching market for the hGH-CTP clinical candidate and budgeting 4.5 years till launch with a total product life of 10 years (15 total) and peak market penetration of 30% with a $3 BB market growing 5% annually (managements guidance: $3 BB market growing at 7% annually). Given the regulatory uncertainty around biosimilars and biobetters, I think this is conservative but prudent. Furthermore, even though this is a risk-adjusted, I have opted to use a high discount rate of 20%, which to some extent is double counting risk. Increasing expenses in Phase 3 and beyond reflects overhead ramping up. Also, a 60% marketing and manufacturing offset is reasonable given that Prolor will most likely be able to use less biologic (successful 45% cumulative dosing reported in the Phase 2) but still extract premium pricing relative to competition, thereby improving gross margin. This yields the following cash flow spreadsheet, shown below.
The rNPV value that is calculated is 566,068,000 or $566 MM (cell D19). Based on 60 MM shares outstanding, this is 9-10$ a share. This is in line with the Summer Street Research Partners analysis, who calculated $8/share value based on the hGH project. If one graphs the rNPV values given in the above table vs. time, the following graph is obtained.
As shown, the value of the project increases in the early years as hurdles are obtained, peaking with the sales of the hGH product, before dropping off as the patent life / market exclusivity is approached.
In addition, one can use a “comparables” approach to value biotech companies, although this can sometimes be more of a qualitative exercise given that no two companies are identical. In general I prefer to use the comparables approach as a starting point.
Globally, using discounted cash flow valuation techniques one can assign concrete values to development stage biotech companies that are not pulled “out of thin air” but are based on objective, rational analysis of the facts. Furthermore, I have shown that PBTH most likely remains significantly undervalued, given the conservative input numbers and no accounting for the potential of a platform technology and the fact the CTP program is already approved in Europe (Merck’s Elonva). Possibly this is why Dr. Philip Frost (>20% owner) and director has been purchasing shares on the open market, and recent analyst reports give price targets of 8$/share and $16/share.
Disclosure: I am long PBTH.