Time to Let the Air Out
If you think biotech stocks are headed for a breakout anytime soon, allow us to burst your bubble.
By Scott Herhold, July 2002 Issue
business2.com
This time, it was supposed to be different for biotech. For investors who buy the pig-moving-through-the-python theory of baby-boomer economics, the promise of a new wave of drugs and testing devices seems like a no-lose proposition. The most affluent cohort in American history -- 60 million strong -- is on the cusp of old age, the twilight of a famously self-indulgent generation. What do they need to stave off mortality? Prescription drugs, naturally. "Do I believe that drug sales will rise in the next 20 years?" asks John McCamant, the editor of the Medical Technology Stock Letter. "I can't look at one baby boomer and not see that happen."
That's only one of several reasons that optimism abounds among biotech investors, even though many of their stocks have been hit hard this year. Scientists keep fueling hopes of new ways to fight cancer, arthritis, heart disease, even the common cold. Almost every headline from the expanding fields of genomics and proteomics -- the study of human genes and proteins -- suggests that biotech's Holy Grail, the personalized cure, will soon be within grasp. Big pharmaceutical firms keep pumping money into their farm teams, the more than 400 public biotech companies, in hopes of getting new drugs into the pipeline. Venture capitalists, having abandoned so many infotech ideas, have also kept faith; they pumped $2.25 billion into biotech startups in 2001, an amount topped only in 2000.
Are biotech stocks a bargain or a bubble waiting to burst? Tell us.
And yet some of the canniest observers of the industry are posing an ugly question: Haven't we seen this before? Didn't Internet investors also continue to believe long after the game was over? "Compared to a lot of sectors," says Jonathan Aschoff, an analyst with Friedman Billings Ramsey Group, "biotech valuations are still high." And while the Nasdaq biotech index has fallen by about a third this year, it's up roughly 80 percent for the past four years -- impressive when compared with the 9 percent decline for the Nasdaq as a whole. If the skeptics are right, there's plenty of helium still to rush from this balloon.
What's scarier is that the bearish case doesn't rest only, or even mainly, on valuation. It includes a fundamental truth about biotech: The scientists don't know as much as investors think they know. And even when the science is solid, the commercial applications won't come as fast as investors seem to hope.
Take Xoma, a biotech company based in Berkeley, Calif., that was once considered one of the most promising of its class. Xoma, which has been losing money for years, is focused on the stubborn problem of severe, chronic psoriasis -- a disease that turns the skin raw and itchy. Xoma's flagship drug, Xanelim, seeks to correct psoriasis through the use of a monoclonal antibody, a protein that seeks out and destroys disease-causing bacteria and infectious agents. And given its alliance with industry giant Genentech (DNA), Xoma seemed sprinkled with the biotech equivalent of holy water. But in early April, the company announced that Xanelim would be delayed. The Food and Drug Administration said it couldn't be certain that the version of the drug manufactured by Genentech would match the version used by Xoma in clinical trials. Xoma stock promptly fell 42 percent on the news. It now trades for about $4.
Or consider the woes of Corixa, a Seattle company that bet its future on a drug called Bexxar, an experimental radioactive treatment for one type of cancer. In December 2000, Corixa spent $917 million to acquire Coulter Pharmaceutical, the maker of Bexxar. At academic conferences during the last two years, the buzz was that Corixa had a huge potential winner. But in March the FDA asked for new studies, saying the research thus far doesn't prove that Bexxar is safe. Analysts figured that the drug could be delayed as long as two years. Corixa's stock tumbled 36 percent and now trades for about $6.
Neither of these falls from grace surprised A. Joon Yun and Patrick Lee. They are analysts for Palo Alto Investors, a 13-year-old money management firm that has returned an average of around 25 percent a year for its investors. They are also doctors: Yun works at Stanford Medical Center; Lee begins practicing there this summer. As scientists, they say they know the limits of their field. Yun estimates that as many as 90 percent of biotech companies will fail or be swallowed up by big drug companies. And that is why Yun and Lee are betting on biotech's continued fall by shorting some 20 stocks (they won't discuss specific stocks, saying they need to maintain access to the companies).
The analysts don't take any glee from their position ("We don't want to see companies and compounds fail," Yun says), but they believe that too few investors realize how speculative this sector truly is. Understanding their reasons could save you an expensive bet.
Science quickly becomes outdated. A recent Tufts University study found that it takes an average of $802 million and 10 to 15 years to bring a drug to market. Given the long lead time, new research can change what scientists believe about a disease. But the companies often have built up such inertia that they can't adapt. "Near the end of the cycle," Lee says, "the discrepancy in the science -- between what the company is founded on and what you know -- is sometimes vast." Yun and Lee argue that the recent research in psoriasis, cardiovascular disease, and cancer has already uncovered flaws in many drugs now in clinical trials.
Diseases are often more complicated than we acknowledge. Academics make their reputations, and companies win funding, by focusing on narrow solutions -- say, blocking a pathway for cancer. But the body has evolved multiple routes to keep its systems from shutting down. So trying to fight a disease by blocking a single pathway is like trying to stop cross-country travel by closing Interstate 10. Yun and Lee say recent failures in clinical trials for cancer remedies underscore these doubts.
Companies' finances are too entangled. Because most young biotech companies lose money, they're extraordinarily difficult to value in any traditional way. Also, as was the case with many now-dead dotcoms, what revenue they have is frequently tied to partnership deals with larger companies -- in this instance, pharmaceuticals. And the food chain has its own special curses. Big pharmaceutical stocks have been getting hit as their patents on profitable drugs approach expiration. As the large fall, so eventually do the small.
The opportunity is more modest than you think. With a flock of biotech companies pursuing the same markets, the size of the pie will be smaller than the bulls assume. Severe psoriasis (roughly 1 percent of the 6 million psoriasis cases) is a good example. Medical experts predict that it could be a $600 million annual market. But roughly 10 companies -- including established players like Amgen and Biogen -- are developing remedies. They can't all get rich.
In addition to everything else, there is regulatory risk, which hangs over each potential drug like an anvil on a fraying thread. A discouraging word from the FDA, even a request for more information, can crush a stock. That's particularly true for the stock of a young company that has bet heavily on one product. Take Dendreon, a Seattle company that tied its future to its Provenge vaccine for prostate cancer. In January, when the company announced inconclusive results in its clinical trials, Dendreon's stock fell by nearly 40 percent, and it now hovers at about $4.
So who's still at risk? As the examples of Dendreon and Corixa show, companies with cancer remedies face steep hurdles in getting products approved by the FDA. (This could also be a problem for firms like Isis Pharmaceuticals, which is developing a treatment for lung cancer, and Progenics Pharmaceuticals, which is pushing a cancer vaccine and an HIV treatment.) A wise investor might resist the urge to think of any of these as bargains. Remember, the Internet bubble didn't pop all at once either. |
