#Biotechnology

Although the best biotech companies can generate enormous free cash flow—biotech giant Amgen threw off more about $1.5 billion in free cash flow in 2002—most are too speculative for all but the most aggressive in- vestors. Picking successful firms requires a bit of skill, some understanding of the science, and a lot of luck.

Biotechnology firms are often thought of as younger, hipper, more in- novative, and faster growing than their pharmaceutical counterparts. They seek to discover new drug therapies using biologic—cellular and molecu- lar—processes rather than the chemical processes used by big pharma. Biotech firms are also on the cutting edge of developing novel therapeutic products, using groundbreaking technology platforms such as proteomics and genomics.

However, biotech drug development is still all about probabilities, but with even more product risk because the therapies are often completely new forms of treatment. For example, Genentech has been developing a treat- ment that attempts to stop the body’s mechanism for growing new blood vessels (a process called angiogenesis) on the theory that a cancerous tumor will die if it no longer receives blood. Although several companies are work- ing on similar therapies, none have been successful to date. Even if they are successful, the true size of these markets is anyone’s guess. This adds another layer of uncertainty to the drug development process—as well as volatility in stock prices.

Hallmarks of Success for Biotech Companies

Think about biotech firms in three categories: established, up and coming, and speculative.

Established: These are the bigwigs of biotech and include companies such as Amgen, Genentech, and Biogen IDEC, which each have annual product rev- enues of more than $ billion and market capitalizations beginning to rival those of big drug companies. They generate positive earnings and cash flow, and their drug development pipelines are large enough to sustain decent sales and earnings growth. As these firms become larger, their future cash flows be- come less risky.

In this category, look for:

• Firms with a large number of drugs in late-stage clinical trials
• Plenty of cash on hand, plus cash flow to cover several years of research and development expenditures
• Firms that have built a salesforce of their own—so they no longer have to pay another firm to market their products and can begin to build relationships with physicians
• A stock price that provides a margin of safety of around 30-40% to its fair value

Up and Coming: Many biotech firms are on the cusp of success, either with a product on the market or within arm’s length. Some are on the verge of break- ing into the black, while others have already demonstrated small but positive earnings. In other words, they’ve got more than a cell in a petri dish, but they still have a lot to prove. All of these firms hold lots of risk and typically have a narrow economic moat or none at all, depending on competing products.

Cash is king during this stage, and these companies are often able to raise capital during the market’s periodic biotech booms. But it’s worth keeping an eye on how quickly they are spending that cash because the last phases of clinical trials are the most expensive, and preparing literally truckloads of documents for the FDA isn’t cheap. That’s why it often makes sense for up-and-comers to form partnerships with bigger pharmaceutical or biotech firms. Although a partnership agreement means giving up a chunk of the profits, getting to market faster can be worth the cost.

Speculative: Newer biotech companies, which make up the majority of all companies in this industry, are too risky for the vast majority of investors. Although firms in this category undoubtedly have interesting technology and could be extremely successful some day, real revenues from real drug products are many years away, and positive cash flow from operations is even further out. Compound that risk with the slim odds that most early-stage drugs will ever reach the market, and we’d classify them as high-risk, no- moat stocks—which means we’d need a gargantuan margin of safety before we’d be willing to own them. These stocks are more like lottery tickets than anything else.

Research on Biotech

If you’re doing research on a biotech company, the company’s 10-K is the best place to start. Here, the company typically explains in layman’s terms the technology and drugs in development and explains how the company is funding its research and partnerships. Disease Web sites cancer.gov and MedicineNet.com and science journals often have information about drug classifications, market sizes, and competing and substitute products. In addi- tion, industry resources such as the Biotech Industry Organization and Bio- Space each have drug, company, and industry information.

#Pharma

Big pharmaceutical companies typically have wide moats and some of the most attractive financial characteristics of any industry. Branded pharmaceu- tical companies (as opposed to generics, which have a lower return business model) generally boast top-notch profit margins. Most global pharmaceutical companies have returns on invested capital (ROICs) in the mid-20s.

Top- notch companies such as Pfizer are often in the 30s. Drug-company margins are also worth salivating over, with gross margins often near 80 percent and operating margins between 25 percent and 35 percent. What’s more, drug companies offer plentiful free cash flow and virtually debt-free balance sheets. But innovation isn’t cheap. It takes money to make money, and the aver- age cost of taking a drug from discovery to the pharmacy shelf is $800 million. Only a third of those drugs ever return their costs of development. Plus, drugs take years to develop. The clinical testing phase (trials in humans) alone can take a decade. All the while, the company is pumping money into the research process with no guarantee of a return.

There’s also budgetary pressure in the United States to reduce health care costs, specifically the dollars spent on prescription drugs. Since 98, pre- scription drug costs have increased faster than every other health care cost, al- most doubling as a percentage of total health care dollars, from 4.9 percent to 9.4 percent. But if political pressure leads to lower drug prices (as a Medicare prescription drug plan might), big pharma could see its margins come down.

Demystifying the Drug Development Process

Drugs are discovered in many different ways. Sometimes they’re discovered by mistake, like Viagra. (Pfizer scientists noticed the “side effect” from a blood pressure drug.) Other times, they’re discovered only after an exhaustive process of testing thousands of compounds in petri dishes and lab rats. This process of identifying possible targets and determining whether they should move down the development chain can take five years or more and cost in the hundreds of millions of dollars.

With new technology and supercomputers, scientists are finding ways to “virtually” test moleculesagainst different genes to narrow the number of compounds before they start testing in live animals. But for now, drugs still go through years of initial research before being tested in mice, let alone humans.

Preclinical Testing: This animal testing phase is called preclinical testing. The primary objective is to evaluate potential toxic effects. Before a drug gets any- where near a human, scientists must have a clear understanding of the possi- ble damage it could do. It takes two to three years on average to discover a viable drug candidate and another year to find out if it is fit for human test- ing. For the small percentage of drugs that survive, an investigational new drug (IND) application is filed with the Food and Drug Administration (FDA). Approximately 85 percent of INDs move on to Phase I.

Human Clinical Trials (Phase I): Phase I is the first of three stages of human clinical testing. In Phase I, a drug is tested in a small group (fewer than 100) of healthy volunteers with the goal of gathering initial data on safety and efficacy—whether the drug has the ability to produce the desired effect. Safety is the number-one concern here, though scientists and physicians also evaluate the body’s reaction to the drug. A drug in Phase I has only a 20 percent chance of eventual approval but can still cost a few million dollars, in- cluding the cost of development, clinical trials, and continuous communica- tion with the FDA.

Human Clinical Trials (Phase II): In Phase II, the drug is tested in a larger population (usually 300 to 500) of patients afflicted with the targeted disease to get a more comprehensive profile of how well the drug works. The managers of these trials use them to compile additional data on safety and side effects. Here, physicians and scientists test for how much of the drug to give and how often to give it. This phase often costs more than $5 million, and more than half of all drugs in Phase II fail to move to the next phase.

Human Clinical Trials (Phase III): The final testing hurdle is Phase III. These trials involve testing the drug in a much larger group of afflicted patients over longer periods. Safety is still an issue—Phase III trials are the first trials to focus on long-term patient safety—but efficacy gets more attention. Because of the number of patients (often 5,000 patients or more), administrative needs, and time and resources involved, Phase III trials are very expensive. These tri- als consume the bulk of the $800 million cost of developing the average drug, and a drug in Phase III has about a 60 percent chance of eventual approval.

Hallmarks of Success for Pharmaceutical Companies

Blockbuster drugs (typically defined as drugs with more than $1 billion in sales): Companies with blockbusters gain manufacturing efficiencies by spreading fixed costs over more products. Selling the drug at high prices, driven by strong demand, inflates a drug maker’s profitability and provides more bang for the buck. Pfizer is the perfect example: In 1997, only two Pfizer drugs had annual sales greater than $1 billion, but by 2002, eight drugs surpassed the $2 billion mark, with four drugs breaking the $2 billion mark. Thanks in part to these blockbusters, Pfizer’s operating margins improved from 20 percent in 1997 to 38 per- cent in 2002.

Patent protection: All drugs eventually lose patent protection, but thecompanies that manage those losses the best will generally provide in- vestors with a steadier stream of cash flows. Bristol-Myers Squibb showed what can happen when a drug firm loses patent protection on large products without replacement drugs waiting in the wings. Between the second quarter of 2000 and the first quarter of 2002, Bristol lost the U.S. patents on three heavy hitters, and nearly 20 percent of the firm’s total revenue evaporated in less than two years. On the other hand, when AstraZeneca’s Prilosec was about to lose its U.S. patent in 2001, the company had already begun switching patients from the first- generation drug to the patent-protected second-generation version. By the time a generic competitor entered the market, AstraZeneca’s new drug had established itself in the market and was bringing in 35 percent of the revenue of the first-generation drug.

A full pipeline of drugs in clinical trials (and the larger the population those drugs serve, such as cancer and arthritis, the better): Merck is a decent model for this strategy. It generally has had an abundance of products in devel- opment and has directed research efforts toward unmet medical needs with millions of potential patients. Merck’s five top-selling products in 2002 had a combined potential market of 138 million Americans.

Strong sales and marketing capabilities: Physicians rely on pharmaceutical salespeople to learn about new products, and a salesforce that has success- fully penetrated the physician market in the company’s core therapeutic franchises already has physicians’ ears and often their trust as well. Pfizer’s relationship with cardiologists, Wyeth’s access to gynecologists, and Eli Lilly’s close ties with psychiatrists shouldn’t be ignored. This expertise is so valuable that biotech firms often partner with large drug firms and give up a sizeable chunk of their profits just to leverage the marketing re- sources of their drug-company partners.

Big market potential: Drugs that treat conditions affecting a large percentage of the population (such as erectile dysfunction, high cholesterol, de- pression, or high blood pressure) typically have better potential than niche products. So do drugs that treat chronic conditions, because patients must continue taking the medication to stay healthy.