Biotech Focus: Chasing the Pot of Gold

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1976 was a seminal year for innovation. It was the year when Apple was founded, starting the propulsive growth of computer-driven business. After just 30 years, the results have saturated our economy and culture, changing the way we live and producing giant companies like Microsoft, Intel, Amazon, Google and Bloomberg. Microsoft alone has bred millionaires like rabbits.

That same year Genentech became the pioneer of the biotech industry, and the company (now partially owned by Roche) is still around and highly successful. Overall, however, as even Genentech CEO Arthur Levinson has bluntly said, biotechnology has been “one of the biggest money-losing industries in the history of mankind” (see sidebar, page 58). Money aside, the biotech promise has not changed the healthcare landscape the way Apple's seeds have sprouted. The cures for cancer, multiple sclerosis, and Parkinson's are still around the corner.

What went wrong? Despite the stark difference in the two industries' fates, they followed essentially the same business model—an inspired innovator, sometimes partnered with an equally venturesome entrepreneur, forms a company and attracts smart investors. It worked not only for Genentech but for Amgen, Biogen Idec, Celgene, Genzyme and Gilead Science…but they are the exceptions. Other startups, however, are either still struggling, extinct or have sold out. But the promise remains, and venture capital is still chasing the pot of gold. Whether this confidence is justified depends, as so often, on whom you talk to.            

Since BIO is the industry's trade association, it is its mission to be optimistic. Alan Eisenberg, EVP for emerging companies and business development, told MM&M in an exclusive interview that the industry “has been extraordinarily successful in terms of addressing medical needs, developing new therapies for patients that had no hope previously.” Financially, “some companies have been very successful and others less so.” He pointed out—and this was the theme of everyone we talked to—that since “the industry is fundamentally about trying to commercialize new and innovative science, it's a high-risk business.”

A look at the data

For hard numbers, we turned to Glen Giovannetti, biotechnology leader of Ernst & Young. The firm is in its 22nd year of tracking the biotech market and its reports present annual snapshots of what's happening industry-wide.

Citing the latest report, which covers the first half of 2007, Giovannetti said it reflects “a symbolic milestone”—for the first time in biotech's history, the industry is on track to achieve aggregate profitability for this fiscal year. In fact, according to Giovannetti, this milestone might have been achieved during 2006, except for charges related to the many deals completed then, which depressed the bottom lines. 

The basis for this hopeful profit picture is that revenues for US publicly traded biotech companies were up 18% as compared with the first half of 2006, a performance that outpaced the industry's historical average rate of growth. It was a record led by Amgen, Celgene, Genentech, Genzyme, and Gilead Sciences—what the report refers to as the industry's stalwarts. “This growth rate is all the more impressive,” the report adds, “because it includes the impact of the acquisition of MedImmune by AstraZeneca,” one of dozens of such acquisitions by pharma companies over the years (Alza, Chiron, etc.), which keeps their revenue statements out of the public record. Meanwhile R&D expenses kept pace with revenue growth.

Growth in revenues is nice, but the bottom line is what happens to profits. Says Giovannetti: “If you track the financial reports of all the publicly traded companies since we've been tracking it, the industry has never shown profitability, but last year we were right on the cusp of profitability. And this year (i.e., 2007) through mid-year it was clearly going to be profitable, and I have no reason to believe that the full year will not be profitable.” (The full year's data for 2007 are due out in this month.) Those are composite figures, of course, and as he points out, the profits are coming primarily from a handful of companies—the Genentechs and Amgens—while 80% to 90% of the public companies are still in the R&D stage which, “by definition means losing money.”

The private sector

Financial reports for publicly traded companies are easy to track, but when private companies lose money they do it, well, privately. Even Ernst & Young finds their financial data hard to get at. “The way you measure how private companies are doing, at least on a broad level,” Giovannetti explains, “is by how successful they are in attracting capital.” Since they have little if any revenue on the sales front, infusions of capital plus partnership agreements with pharma are what keep them afloat. And from a venture capital point of view, 2007 was also a very successful year, the second highest in the industry's history according to BIO's Eisenberg.

“There are record levels of capital pouring into biotech,” Giovanettti concurs, despite the difficulties in the stock market. It is, however, hard to generalize. “The dollars are not spread evenly, so the companies that have an interesting research platform are attractive to investors, while others are in a part of their development cycle where they are not as attractive. There are so many different stories, but if you look at how much money is flowing to private companies as a surrogate of their success, it's a pretty healthy picture.” (This conversation took place before the Bear Stearns meltdown.)

Nonetheless Eisenberg cautions that a good number of companies have less than three years of financing, and if they need to raise money this year, the financial situation might make it more difficult. Some observers we spoke to (who preferred to remain anonymous) went further, expressing concern that if the current credit crunch leads to, if not a drying up, at least to a shrinking of the capital market, that might bankrupt the more vulnerable players.             

Asked to comment on the Levinson quote, Giovannetti says, “You have to be careful about what's being measured. In terms of true operating losses as shown on companies' income statements, he's quite right. But if you look at value creation for investors, it's a different story.” His point is that hundreds of billions of dollars have been invested in start-up ventures, and while not many have become profitable, many others developed something sufficiently valuable to lead to buy-outs by pharma companies—a good deal for investors. So some people have made money but “everybody agrees that this is a high-risk area, not for the faint of heart, and companies do lose a lot of money before they ever return a dollar.” Single product companies are particularly vulnerable, especially now that an increasingly risk-averse FDA seem to be giving new product applications ever closer scrutiny.

Looking ahead, Giovannetti summed up: “Six months ago I would have said that the near future for the industry's overall picture was very positive.” Now, due to the ripple effects of the problems in the mortgage markets, “the capital market will be tighter and might even shut down for a little bit. But we've come off a couple of very good years that permitted companies to stock up their cash reserves. These cycles come and go.” An example cited by him as well as others is the genomic bubble of 1999 and 2000; the fallout when it burst was quickly overcome. By the time this appears in print we may know whether the current market bubble will prove equally benign.

Overseas trends, by the way, are similar. European companies had their best results in years in 2005, with revenue growth of 17% compared to a five percent decrease the year before. Also in that year, for the first time ever, Europeans raised more money through IPOs than their US colleagues. Meanwhile, the Asia-Pacific region, Ernst &Young reports, “recorded a scorching 46% increase in revenues” in 2006. Australia alone scored a 60% boost in biotech revenues, helping to propel Australia's biotech sector to profitability ahead of either Europe's or ours. 

Cyclical or endemic?

If, after 30 years, the biotech industry is only now on the cusp of becoming profitable, it may be, of course, that it has basic, systemic problems. That, at least, is the conclusion of Gary Pisano, a professor at Harvard Business School and author of Science Business, widely regarded as the most definitive study of the industry. Published in 2006 (and he confirmed in a personal interview that the essential facts haven't changed), the book sums up his 20 years of analyzing the industry's technology strategy and management of innovation. Having also served as an advisor to top execs of both pharmaceutical and biotech companies, Pisano asked himself: “Can science be a business?”

“The scientists and executives I met and worked with…were among the smartest, most dedicated and most imaginative people I had ever known,” he reflects. Not only that, but “everything we knew about business and industry performance suggested a very promising future for biotechnology, not just commercially but also for its ability to transform drug therapy,” and at industry conferences he kept hearing consistently “sunny prognostications.” So why, he began to wonder, “was the great promise of biotech going largely unrealized?” Conducting a productivity analysis, he concluded that despite the basic premise of biotech there was in fact no discernable difference in R&D productivity between biotech firms in the aggregate and that of large, traditional pharma companies. So he began to look for explanations.

He came to believe that the scientific and commercial promise of biotech has been hampered by the way the business is structured and operated. Specifically:

  • Effective development and application of the technology requires integration, but the founder-driven biotech business is characterized by specialization and fragmentation.
  • “The uncertainty and novelty of the science requires rapid diffusion of ‘high fidelity' information,” while each company jealously guards its trade secrets.
  • Science requires long-term, cumulative learning. Biotech firms, however, face market pressure to optimize short-term results.

These built-in inconsistencies are not amenable to easy solutions, Pisano feels. “The imperfect and often messy context in which these firms operate is taken as a given,” and therefore is not likely to change dramatically over the foreseeable future because “investors will be fickle and sometimes irrational. Academic entrepreneurs will continue to be motivated to start their own firms, whether this strategy is rational or not. Venture capitalists will still feel impelled to take companies public at the earliest opportunity.”

Since this outlook is not hopeful, Pisano concludes with a radical suggestion—abandon the current model and instead develop biotech drugs the way movies are produced. Studios, he points out, do not generally develop their own content. They get that from scriptwriters or independent producers. So let's think of scientists as the outside idea people. Once proof of the concept has been established, companies can then procure development rights. Call it “greenlighting” R&D. Finally, established pharma companies, assuming the role of the major studios, can take over, pursuing Phase III trials, securing regulatory approval, and applying their distribution and marketing skills. Thus everyone, including medical care, will benefit.

Pisano concedes that this might not be the right model for the most innovative drugs, since without strong internal scientific capabilities it would be virtually impossible to differentiate the prospective winners from the lemons. Thus “vertical integration may actually be better suited to the most novel types of innovation.” But that brings up another hitch—the way traditional companies have tried to integrate both internally developed and acquired biotech leads. “It does no good to be a vertically integrated enterprise and yet operate each major function or technical specialty as its own island of expertise,” he adds.

In other words, there is no one-size-fits-all solution. Even the fairly standard pharma/bio alliances often don't work because they are usually arms-length relationships and not true collaborations.

Low-hanging fruit

In light of all that, you wonder how it happened that some companies did score signal successes, and what strikes you as you list them is that most of them were early entrants into the biotech game. Then as you look at their early winning products, it becomes clear that they mostly started with far more attainable objectives than their successors. Genentech, for example, concentrated on its recombinant insulin program. Not only was this a specific product objective rather than trying to capitalize on basic science breakthroughs, but it provided an opportunity to partner with an established company—their R& D agreement with Eli Lilly & Co.. It provided Genentech with development funding, while Lilly acquired the marketing experience that gave it a head start among major pharma companies anxious to branch out into biotech. Incidentally, Lilly had first tried to license Harvard scientist Walter Gilbert's discovery, but Gilbert preferred to start his own company—a telling illustration of why pharma has largely been forced to rely on expensive acquisitions to enter the biotech field. But that hasn't stopped acquisitions and partnerships. As recently as 2005 to 2007, according to an MM&M analysis, there were 17 big pharma/big biotech deals, involving such major companies as Merck, Pfizer, GlaxoSmithKline, Lilly, Novartis, Roche, and AstraZeneca.

One conclusion all commentators agree on is that succeeding in or even entering the biotechnology business is fraught with hazards. First you have to get the science right, turning promising leads into experimental products. Then you face multiple R&D and regulatory hurdles, all the while keeping the money spigot open at one end as your funds pour out the other. As Pisano puts it in Science Business, “raising capital in biotech is like getting an official number for the Boston Marathon. It can be really tough to do…but it only gets you into the race. You still have to run the 26.2 miles!”

An interesting journey

But that won't keep people from trying. As Glen Giovannetti points out, the prospect of developing exciting technology that has a chance to meet unmet medical needs will continue to attract investors, and when such products are created, there will be a market for them—and they will get paid for. His Ernst & Young colleague Gautam Jaggi, managing editor of the “Beyond Borders” report, concurs.

“While the issues change, the constant is that innovation drives value in R&D, in deal structures, and in go-to-market strategies,” says Jaggi. “Yes, sometimes it feels like this industry is always at one crossroad or another. That may well be so—it may just come with the territory of being a high-risk, high-reward business. But we shouldn't complain. After all, these challenges, and the biotech industry's innovative responses to them, have always kept the journey interesting.” 

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