The Anatomy of Spending and Business in Biotech

Includes: ABMD, BTK, IBB
by: Franklin L Tsung

It goes without saying that the current market makes it difficult for users to find trades that work outside the realm of day trading the markets. As we venture away from day trading, we become swing traders (or more commonly known as position traders). Our objective in this case is not to day trade volatility but to understand the flows and ebbs of price and their impact on the entire trend. The opportunity for this skill is immense as it allows the trader to capitalize on the fluctuations of price; becoming bold when others are fearful and fearful when others are bold.

A key insight to spot these price trends is the understanding of businesses and their respective industries. The understanding of the relationship between the markets they serve and the underlying business entity is one of the many keys to understanding where capital, en masse, will be invested in, thus resulting in price appreciation of a given sector and the underlying company that is best of breed in the competitive market place.

So let's go ahead and analyze the biotech industry. The biotechnology market is a capital intensive industry with high returns. It's a perfect example of Pareto statistical analysis (though common culture has dubbed this as Long Tail). Well before you start fearing the need to go and take statistics classes at your nearest university, let me just explain the idea in a general way in a sentence: 10% of your customers account for 90% of your business.

The same phenomenon (often referred to as the 10-90 rule or the 20-80 rule) applies to capital intensive industries. For biotech firms, the incentive is to spend on Research and Development in order to obtain an edge and product to generate revenue. Due to the industry's intensive cost of capital, the returns generated are often relatively high and garned by the top 5% of the biotech firms. The top firms often have the economies of scale to engage the markets and increase their rate of products to market. Thus, in this effect, success begets further success.

However, given the current credit environment, the biotechnology sector has been facing a unique situation. The global economic crisis has cut funding for biotechnology companies to the lowest levels in a decade, triggering bankruptcies and threatening the development of drugs based on biomedical breakthroughs. Within the past month, at least five biotechnology firms have sought bankruptcy protection. Looking at the current environment, Biotechnology companies fell by $9.7 billion through September, or 54% compared to the same period in 2007. Currently, biotech companies are raising less cash than they have in a decade. Financing fell to $8.2 billion through September from $17.9 billion last year, and venture capital funding within this industry fell by over 16%.

The myth was that these bankruptcies were quite rare. Bankruptcies have been rare because struggling companies often dodge the bullets through mergers, licensing or development deals, or through investors willing to make PIPEs (or other forms of cash infusions). Now, given our current economic climate, Wall Street will not finance these speculative deals, and the pharmaceutical industry cannot buy them all.

It goes without saying that you will find the worst of breed firms and the mid tier firms struggling in this environment. The cost of running a business and the business model of "spend spend spend" until you get a hit product will not mesh well with the current environment. So what you have is a particular situation for medical plays in the stock trading world. Due to financial mechanics and environment that currently persists, you now have 3 categories of medical firms to invest in. This is the case because the lack of financing for many medical companies have forced a Darwinian hierarchy of investments to take hold. (Alas, this is why I mentioned the Pareto Analysis.) What you will see going forward is that 20% of the stocks under coverage in medical related plays will garner 80% of the massive returns.

  1. Large Cap Bio
  2. Hidden Undervalued Growth
  3. Assistor Companies

These are the 3 categories that will work as investments. They will also be the few companies to garner 90% of all major returns within the biotechnology industry from this point on. Unless you are a company with a strong product and FDA early approval (where the only stage is to fulfill further tests to validate already validated data), it will be uneconomical to purchase biotechnology stocks outside these 3 main categories.

For today, we will focus on the second segment (and often my favorite), the Hidden Undervalued Growth. What is so spectacular about Hidden Undervalued Growth? Well, it's pretty simple - its hidden! It's one thing to understand value, it's another to understand the aspects of why it is hidden. One of the many and wonderful aspects of understanding why a company has been hidden is its former corporate history.

This is especially the case for drug companies that were once managed beautifully, only to screw up completely and falter (resulting in a cataclysmic destruction of the stock price). The retreat of stock price and the losses for investors would have labeled these stocks as bad investments for the rest of their lives. However, a miraculous event took place during for these companies. Management was refreshed and the business model began to work for the first time in decades. However, stock prices were still quite depressed given the depressed investors, who remembered their tremendous losses from investing in these companies years ago. This negative perception, bred on nothing but pure fear, always results in opportunity for the objective and wily investor.

Such is the case for Abiomed (NASDAQ:ABMD), perhaps one of the least loved drug related companies out there. The key focal point for ABMD is clearance from the U.S. Food and Drug Administration to begin marketing its heart pump in the United States. In June, Abiomed received a 510(k), or short-term, approval from the FDA for Impella 2.5, a catheter-based heart device that is used during high-risk heart surgeries. The device is inserted through the artery near the groin up into the heart, allowing it to keep the heart pumping blood during surgery at a rate of 2.5 liters per minute. Investors should know the current standard of care, the intra-aortic balloon pump, only pumps blood at a rate of 2.0 liters per minute.

It is important for investors to realize the impact of becoming an industry standard. You obtain quick adoption initially, which is further fueled by a steady rate of growth in more institutions using the product, thus phasing out the older standard (in this case the 2.0 liters per minute pump).

The ABMD story is all about the potential for Impella, Abiomed's potentially ground-breaking device to support the heart during highrisk coronary interventions. If ABMD's PROTECT II clinical trial is successful, Impella will become the new standard of care for high-risk coronary patients. With a successful trial, we believe ABMD's out-year revenues could be 2-3 fold higher than the current consensus and drive the stock to $30 and potentially higher. The trial results should be available by late calendar 1Q09 or early 2Q.

By August, during the release of its 1Q 09 financial results, PROTECT II has so far enrolled 107 of the expected 654 patients, but there were only 34 additions in this seasonally slow quarter. We expect enrollment to be completed in the middle of calendar 2009, but this assumes that patient and center enrollment will pick up from the level in this quarter. RECOVER II has not yet enrolled patients, but 53 hospitals have started the IRB process (4 approved so far). Revenue from Impella disposables increased 323% year-over-year during the quarter and we note that the company signed up 56 commercial centers even though the product was only approved in early June.

Lastly, the impact of this new standard for the industry to possibly adopt the Impella 2.5 was substantiated by September 30 of this year, only 4 months after going "live" from the FDA approval). The company announced it recently completed shipment of its breakthrough Impella® 2.5 Cardiac Assist Device under 510(k) clearance to 100 U.S. hospitals. Abiomed is currently conducting two U.S. pivotal studies comparing the Impella 2.5 to the IABP (Protect II for high-risk percutaneous coronary intervention, or PCI; and Recover II for acute myocardial infarction, AMI or heart attack). There are an estimated 60,000 annual high-risk PCI patients and 100,000 AMI anterior infarct patients annually in the U.S. This milestone represents 6% market penetration within 4 months, which is significant.

Disclosure: Long ABMD.

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