Biotech Valuation Part 1: Science, Patents, and Management

Includes: DCTH, SVNTQ
by: Steven Breazzano

As readers of Seeking Alpha are well aware, purchasing stock or options in development stage biotechnology companies is loaded with risk. These early-stage companies (sometimes euphemistically referred to as “pre-revenue”) burn cash funding R&D and clinical trials, with no guarantee of approval or even significant revenue following successful approval! To further complicate matters, expenses increase as clinical trials increase in both duration and patient enrollment. Sometimes this development risk is mitigated by licensing deals with big pharma, in which clinical trial costs are shared and upfront/milestone payments are made in exchange for future revenues. Previously, my fellow author examined numerous factors (3 part series: Part 1, Part 2, and Part 3) that should be used to mitigate risk. The focus of this article however, is value. How does an investor properly value a biotech company?

Value is of course a hotly debated topic and libraries are filled with books on the issue, but biotech is a different animal. Many of the traditional expected growth rates and certain balance sheet/income statement ratios (price to sales, price to earnings, price to book, etc.) are not readily applicable to biotech (remember, these are usually “pre-revenue” firms). Furthermore, while the path many biotech companies take to market is very similar (Phase 1, Phase 2, Phase 3, NDA/BLA), each company has a very unique cost structure (patents, clinical trials, etc.) and these costs vary widely depending on the indications (e.g. metabolic diseases generally require large numbers of patients, etc.). Also, firms employ a wide range of technology that varies in risk. On top of all this, one must consider the target market, doctors, insurance companies, and competition in his or her valuation. Below I have detailed some of the steps I use to evaluate an early stage biotech company, beginning first with the background and science (Part 1) and culminating in a risk adjusted net present value computation and market analysis (rNPV, part 2).

As a starting point, I begin with an evaluation of the company’s science. While difficult to quantify, the science is ultimately what will drive the company’s value and cannot be overlooked. Biotech is unique in that there are two boards touted by the company: the scientific advisory board (9SAB)) and the regular board of directors. Due to the highly technical and specific nature of the industry, scientists (generally academics) and clinicians with experience in the area are usually added to the SAB to give guidance on scientific and clinical matters and to validate the technology. In short, because big important Professor X believes in this technology, so should you (or so the theory goes)! Even though these scientists are usually awarded generous stock options and thus have a financial incentive to participate, their reputations are on the line (a very big deal for academic scientists) and do not want to be associated with failed companies. Bottom line, if the individuals on the SAB have been involved in successful companies before and are highly respected and famous in their fields, it’s a good sign, but nothing more.

When analyzing the particulars of the technology itself, a company’s own website is a good place to begin. In general, biotechnology companies will address the basics of the technology (unfortunately sometimes oversimplifying) and why it’s fulfilling an unmet medical need. They should explicitly address the current market, the current standard of care, and why their treatment is the next best thing. Remember, these companies (generally under $500 MM market cap) are generally underfollowed by Wall Street analysts and actively seek investment and attention. In addition, they will often provide links (it’s a bad sign if they don’t) to their peer-reviewed publications touting the technology. Publications in prestigious journals are a good sign, but by no means predict clinical success. Furthermore, one will most likely not read anything negative about a company’s technology or risk factors on its own website, but there are other sources for this information. Getting creative with Google sometimes helps, and I’ve had luck trying simple searches such as, “problems with _____” where the blank can be filled with terms such as gene therapy. Searching around on the Internet for risks associated with a technology is a good idea, but one must remember to check the validity of sources. Wikipedia tends to do a good job with scientific information, but it’s never a bad idea to double check in a more primary source if you are completely unfamiliar with a topic. Primary literature or even textbooks (if you can get your hands on them) can be helpful in this regard.

Each time a company successfully completes a trial, the candidate becomes de-risked and hence more valuable. That is, after completing Phase 1, a compound is at least safe on a small dosage level on a short term time-scale and is less risky than a compound entering Phase 1 that has not passed this hurdle. It is also nice to see glimpses of efficacy here if possible, as this will lower the chances of failure in Phase 2. With respect to efficacy, I had written previously addressing the topic of why Phase 3 trials fail, in which many studies demonstrated that most compounds in late stage development (Phase 3) failed for efficacy, and that targeting a novel pathway for treating diseases was the best predictor of failure! In general, placebo controlled, double-blinded studies are recommended, with objective clinical outcomes, although certain circumstances may modify these parameters. Globally, it is best to look for highly statistically significant outcomes with low p-values and to be wary of post-hoc data analysis.

In addition to efficacy, safety issues must be examined closely as well (especially in Phase 1 and 2). When analyzing the company’s clinical trial results, serious adverse events (SAE’s) may foreshadow future events and one must dive deeper to see if they are drug related. For example, in patients with resistant tumors or hospital acquired infections, the patients are already very sick, and unfortunately, SAE’s are expected, but it is important to note if these events were related to the drug and elevated compared to other drugs on the market or relative to placebo. If there is any indication of cardiovascular risks or patients dropping out of trials for odd reasons, I am skeptical. I find it helpful to take the point of view of a patient. If I had condition X, would I want to be treated with this new therapeutic? Is doing nothing better than taking this drug? For example, Savient (OTC:SVNT) Pharmaceuticals received approval for its gout treatment last fall; however, the stock has suffered significantly since then. A look at the clinical trials revealed that a common side effect was injection site reaction and many patients dropped out over the course of the trial. Thus, it is not surprising that sales are poor (jury is still out though ...). With resistant tumors on the other hand, you have much more room for nasty side effects given the severity of the disease. For example, there is currently a passionate debate over the use of Avastin in the treatment of metastatic breast cancer (MCC), a condition in which post-approval trials failed to duplicate the efficacy seen previously. However, many advocacy groups still wish for Avastin to be available to patients with MCC, reflecting the lack of effective treatment options available to these patients and their willingness to accept Avastin’s significant risks.

At this point it is also wise to evaluate the company’s intellectual property. While one doesn’t in general need to dig through the claims sections of multiple patents on the U.S. Patent and Trademark office or Google patents (unless you have insomnia!), it is good to know what types of patents (method of use, composition, etc.) the company has in place and when they expire. The patent life combined with an estimated launch date should be used to model future drug revenues and should be long enough to recuperate the R&D costs and then some and should hopefully include a margin of error to account for unforeseen delays in clinical trials or FDA approval. Of course, longer remaining patent life is better and there is always the risk of a patent being invalidated and generic competition entering the market.

The management team is also a factor that cannot be overlooked as well. Dealing with the FDA is no small task, and experience here can sometimes prevent a large mistake. Just ask Delcath (NASDAQ:DCTH), whose stock price was halved after receiving a “refusal to file” for their NDA, despite what the author believes is a promising treatment. While hard to assess and difficult to quantify, an experienced management team who have successfully guided candidates through the approval process provides a small level of comfort to the investor.

In summary, a complete look at a biotech company’s technology, clinical trial results, intellectual property portfolio, and management team mainly involves searching for red flags. Looking for details on how a company has de-risked or plans to de-risk its technology to meet the next hurdle is particularly important, and close attention must be paid to both safety and efficacy. In particular, it is important to look for what is not said, i.e. a company that does not tout its strong IP might not have strong IP …

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Continue to Part 2 >>

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