Stem Cells: Dreamers, Fools, And The Valley Of Death

by: EnhydrisPECorp

Whilst stem cells have captured the imagination of the general public, they have yet to impress financers as a viable business model. In my first article on the stem cell sector, I showed how the industry is vastly underfunded given its current developmental stage, i.e., several advanced clinical trials and even a handful of approved therapies. Driving this point home, I estimated the global market cap of public and private stem cell companies here, and compared it to Apple's (NASDAQ:AAPL) projected earnings for 2013, and the projected pharmaceutical sales for the United States and the Globally for 2013 (see figure below). This bar graph makes it painfully clear that the global stem cell industry is living hand to mouth so to speak. In fact, my estimate places the entire industry well under Apple's first quarter sales of the iPhone. The poorly funded nature of the industry becomes even clearer when comparing it to U.S. and Global pharmaceutical sales, with the global stem cell industry falling below 3% of the cash spent on pharmaceuticals worldwide.

Such a lack of interest in an industry that has the potential to literally change medicine as we know it is baffling. As I will show here, the reasons for this palatable disinterest in financing stem cells are varied and complex. Even so, popular media outlets have all too often falsely reduced the financing problem facing the sector to "ethical concerns" over the use of embryonic stem cells, and in doing so have frequently placed the blame, unfairly, on upstart companies like Advanced Cell Technology (ACTC.OB). In this article, I discuss more realistic causes for this lack of financing, and why investors have reasons to be optimistic that the worst is now behind the industry.

The Ethical Fallacy Debate

Pro-life organizations have long opposed human embryonic stem cell (hESCs) research under the auspices that the research involves destroying human embryos, and thus violates the sanctity of human life. Their vehement opposition to the use of human embryos in medical research eventually led to the 1996 Dickey-Wicker Amendment, which made it illegal to use federal funds to support research "in which human embryos are created, destroyed, discarded, or knowingly be subjected to risk of injury or death greater than allowed for research on fetuses in utero under 45 CFR 46.204 and 46.207, and subsection 498(b) of the Public Health Service Act". In 2009, President Obama issued an executive order lifting the ban on Federal funding for stem cell research, which subsequently led to the now infamous Sherley vs. Sebelius case. The case ultimately concluded (sort of) with the U.S. Appeals Court rendering a 2-1 decision that the Dickey-Wicker Amendment was indeed "ambiguous", and that the National Institutes of Health had "reasonably concluded" that although federal funds could not be used to directly destroy an embryo, the amendment does not prohibit funding a research project using embryonic stem cells.

Despite the legal consternation of the pro-life group, the ethical concerns over hESCs have become rather convoluted and entangled with ancillary issues. Specifically, bio-ethicists have long espoused concerns that research using hESCs would lead to human cloning and possibly "organ-harvesting" from brainless clonal bodies. The meandering trail of this futuristic concern can be traced to the 2001 announcement by former ACT CEO Michael West, saying the company had taken the first steps towards what he coined as "reproductive cloning". Meant more as a publicity stunt to garner attention for the tiny company, this announcement backfired and gave the opposition to hESC research ample ammunition in scaring away numerous investors in the sector. Since then, the term "stem cell" has unfortunately become conflated in the public mindpool with human cloning and abortion, regardless of the actual origin of the cell (e.g., adult vs. embryonic).

Although the significant political headwinds have repeatedly been blamed for the lack of broad investor interest in stem cells, it is nonetheless an intellectually lazy explanation in my opinion. Political forces have undoubtedly helped to tie up Federal Funds at the NIH for stem cell research in the past, but it has little explanatory power in regards to the historical lack of venture capitalists participating in the sector. Namely, the stem cell industry has the potential to reach an astronomical market value of $300B by 2020, according to my recent conversations with industry insiders such as Dr. Robin Smith, CEO of NeoStem (NBS). As such, one would expect greed to trump ethics every time; and thus, the significant value proposition of the industry should theoretically be attracting investors in droves. Yet, it is not. The reason for this paradox is simple: ethical concerns are in fact not the root cause for the funding problems in the sector. By contrast, one needs to think about the stem cell sector as a business, not a controversial medical innovation, in order to understand why venture capitalists have shied away from the sector.

Bugaboos with the stem cell business model

Semiconductor pioneer and noted biotech philanthropist, Andy Grove, once said of the stem cell sector, "venture capitalists aren't interested because it's a shitty business". Adam Feuerstein of called investors in embryonic stem cell stocks "dreamers and fools" when Geron (NASDAQ:GERN) pulled the plug on its hESC clinical trials after only treating four paralyzed patients. While these statements are caustic and perhaps overly draconian, they do get at the heart of the problem facing the sector. Stem cell companies have largely failed to convince venture capitalists that they have a viable economic model in place. Specifically, every stem cell company faces the following herculean obstacles prior to commercializing their product:

1. Raising hundreds of millions of dollars to conduct lengthy clinical trials.

2. Having the trial show safety and efficacy of the proposed cell therapy.

3. Educating the medical industry on how best integrate the therapy into a standard of care for a given disease.

4. Producing and processing clinical-quality cells on a commercial scale.

5. Storing, distributing, and delivering cells to far flung places in a manner that allows the cells to have optimal efficacy upon arrival.

The first two challenges are inherent in the biopharma space, and are tough enough for traditional drug makers to meet, i.e., approximately 90% of new drug candidates have historically failed to reach the commercialization phase of their lifecycle. However, stem cell companies face a substantially more difficult uphill battle in convincing doctors that their therapies have an important role to play. For example, I recently spoke to a surgical resident at Tulane University Hospital, who said in passing that stem cells are "tantamount to selling patients false hope". He admittedly hasn't spent much time researching the subject, but was clearly parroting the common refrain amongst his peers: stem cells are hype, not a treatment modality. Moreover, the image problem faced by the industry has certainly not been helped by China's recent announcement that they were placing a moratorium on new stem cell trials, and prohibiting the use of unapproved treatments in hospitals and clinics across the country due to a number of serious adverse events, even deaths.

The production, processing, and distribution of clinically viable cells has long been a bugaboo within the industry (see several of the hyperlinks above). Yet, the marked growth of cell manufacturers such as Progenitor Cell Therapy (PCT) (acquired by NeoStem in 2011: NBS) over the past decade show that this issue has been overblown by critics of the industry. Cell therapies in general have grown exponentially since the approval of Dendreon's (NASDAQ:DNDN) Provenge in 2010, and companies like PCT have expanded their operations to meet the demand. The ability of stem cell companies to produce and distribute high quality cells for clinical applications is thus more of a perceived problem, than a genuine issue.

Nevertheless, all of these issues have conspired to place the industry in a so-called "valley of death", i.e., the financial chasm between discovery and translation into a commercial operation. The result has been predictable: publicly held stem cell companies have been forced to rely on "death spiral financing" deals with predatory investment groups, as well as dilutive financing on nearly unprecedented scales within the biotech industry. The cumulative effect has been an average share price for American stem cell companies coming in at a paltry $1.62 at the time of writing this article, with 2/3's of companies falling below $1 a share. That's a sure sign of industry under duress.

Reasons to be Hopeful

Stem cell bulls have often pointed to the dramatic increase in Governmental and Philanthropic monies starting to pour into the industry of late, resulting in organizations such as the California Institute for Regenerative Medicine (CIRM). To date, CIRM alone has doled out over $600 M for researchers in the stem cell field, and the NIH has increased its budget for stem cell research to a princely $1.3 B for 2013. While these are certainly positive developments within the sector, critics point to the fact that most of these monies end up covering administrative overhead costs or building "shiny new buildings" (see Andy Grove's comments in hyperlink above). Big Pharma has also begun to spend a limited amount of money on stem cell R&D, but large pharma companies appear to be taking a waiting and see approach before plunging significant resources in the sector.

By contrast, the most promising development is the marked increase in both the number and size of investments made by institutional investors in the sector of late. Chief amongst these deals is Mesoblast Ltd.'s (MBLTY.PK) $170M private placement to help fund the company's Phase III clinical trials for degenerative disease of the lumbar vertebrae, and Phase II trials for systematic inflammatory conditions. Such a deal has been unheard of in the sector until now, and has been the biggest deal in the entire biotech sector thus far this year. Additionally, ACTC struck a $35M dollar financing deal with Lincoln Park Capital in 2012 that marked a dramatic shift away from the death spiral financing deals etched in the company's past. Athersys Inc (NASDAQ:ATHX) also procured $9.0M in a private placement deal with accredited investors in 2012 to help fund its MultiStem platform. Prior to these deals, private placements in the sector generally topped out at $5.0 M, with most being in the $500k-$2M dollar range. In sum, the increase in largish private financing deals within the sector show that financers are finally beginning to take a serious interest in the market proposition proffered by stem cells. I believe this change in institutional investor sentiment marks a sea shift taking place within the stem cell industry, giving hope that the industry has finally reached its inflection point.

Disclosure: I am long NBS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.