DO THE MATH: Biotechnology valuations are finally starting to make sense
The big news in biotech is that the sector is moving en masse, up or down, less frequently than ever.
By Peter Keating
herring.com
March 6, 2002
January wasn't a banner month for biotechnology. ImClone Systems triggered a congressional investigation, the New York Times wrote about "a cloud over the industry," and the Nasdaq Biotechnology Index dropped 11 percent during the first three weeks of the month. Could this most speculative of sectors be headed for another bust?
It's unlikely. Despite that 11 percent drop, the big news in biotech is that the sector is moving en masse, up or down, less frequently than ever. This winter's falloff has been centered on a few severe but discrete disappointments, like Dendreon, Imclone, and Inspire Pharmaceuticals (Nasdaq: DNDN, IMCL, ISPH). "People are starting to focus on particular companies and not the sector as a whole," says Thomas Dietz, an analyst with the investment bank Pacific Growth Equities. "It's not a situation where one company brings down the entire industry."
It's about time analysts and investors started treating biotech companies on an individual basis. That counts doubly for valuations, which often have been driven more by hype and hope than by hard numbers. Today, biotech is a $32 billion business in the United States, with well over 100 drugs on the market. And companies have pushed a sufficient number of products through the approval process (the U.S. Food and Drug Administration green-lighted a record 21 in 2000) for the industry to develop parameters necessary for valuation. "The key factors are time and cost, and standards have been established now for almost every illness," says Peter Allison, the CEO and founder of BioGenetic Ventures, a Spokane venture capital firm.
It's not that analysts and investors haven't made valiant attempts at systematic valuation. But historically, many have settled for hazy relative-valuation approaches, even when the wide varieties of compounds in development and pathways to production made it difficult to compare companies. A more precise and straightforward method, developed by Mr. Allison, applies industry-standard data for costs and risks to a discounted cash flow model. The key steps? Accounting for a company's manufacturing and marketing deals, its odds of success, and its costs of development, then discounting the results to a present value in today's dollars.
Suppose Selgar Biologics, a hypothetical company, has developed a molecule called Eggmed that seems to halt the growth of ovarian cancer. Tests show it's not toxic to animals. Eggmed is now ready for clinical development. As Selgar prepares to run the gauntlet, possibly exchanging future revenue for capital along the way, how valuable is Eggmed?
To get an idea of its potential customer base, Selgar can look to the U.S. government, pharmaceutical companies, or groups like the American Cancer Society. And it can estimate Eggmed's sales price by examining available therapies with similar functions and delivery systems. Let's assume a total market of $2.4 billion annually for the treatment and a market share of 10 percent for Eggmed. And say Selgar believes clinical development and approval by the U.S. Food and Drug Administration will take eight years, at which point Selgar, if successful, will have the exclusive right to sell Eggmed for ten years.
Since Eggmed could generate 10 percent of $2.4 billion annually for ten years, is it worth $2.4 billion? Unfortunately, not even close. First, most biotech companies still need larger drug companies to make and sell their products. For example, MedImmune has agreed to sell its flu vaccine FluMist to American Home Products at a 65 to 70 percent discount; AHP will market the drug and pay 15 to 20 percent of its sales back to MedImmune. Such deals use varying forms of currency, including royalty payments, split profits, or volume discounts. But the bottom line is that, on average, biotech companies surrender about 60 percent of potential revenue to their manufacturing and marketing partners. This reduces Selgar's potential income stream to $960 million.
Then there's the matter of whether Eggmed will ever arrive on pharmacy shelves. Drug development is a notoriously inefficient business: just 1 out of every 1,000 compounds considered as drug candidates makes it into human clinical trials, and only 1 in 5 of the drugs that enter such tests eventually becomes an FDA-approved medication. When a drug is ready to be tried on humans, it must pass through three stages of clinical development. As it completes each phase, the likelihood of a drug's ultimate success rises. Because it is just entering Phase I, Eggmed has a mere 20 percent chance of earning that $960 million. The risk-adjusted value of the revenue is 0.2 times $960 million, or $192 million.
Something else about those three phases: they cost money. While Phase I typically involves toxicology tests on a few dozen healthy volunteers, Phase III tests often monitor thousands of patients for years at a time. Given average costs, Selgar would spend about $24.3 million to bring Eggmed to market. But that figure must also be adjusted. Think of it as the upside of failure: while Selgar will certainly pay the expenses associated with Phase I, its chances of failure reduce the probability that it will endure all of the projected costs. Reducing the costs of each phase by the odds of even making it that far, Eggmed's total risk-adjusted cost comes to $9 million.
Finally, keep in mind that the earliest the drug could first hit the market is eight years from now. Therefore, Selgar's revenue and costs must be discounted to today's dollars; analysts suggest a discount rate of 20 percent annually, which represents the average internal rate of return achieved by large drug companies and biotech venture capital firms in recent years. After discounting, Eggmed's value is just $17.7 million, a far cry from the initial $2.4 billion.
The above calculations make it clear why milestone or royalty payments to early-stage biotech companies from "big pharma" often go no higher than eight figures, even when potentially revolutionary therapies are at hand--risk and time simply devour the potential value of drugs. For instance, oral insulin could transform the treatment of diabetes, as 4 million victims currently inject the drug, and 4 million more fail to get any treatment on a regular basis. Emisphere Technologies has a product in the works, but it won't receive FDA approval until 2009, if ever. Though the market for oral insulin is $4.5 billion a year, by the above method, Emisphere's product has a present value of just $216 million.
Notice, too, that companies experience dramatic valuation adjustments as they get closer to the finish line: as a drug moves through successive trial phases, its odds of meeting FDA approval increase, while its time to market shrinks. Eggmed, for example, jumps to $36 million upon successful completion of Phase I, and $187 million after Phase II. Likewise, companies with drugs in late trials typically take huge hits if they reveal clinical setbacks. January's Phase III disappointments included a disaster for Inspire, whose share price plunged 73 percent to $4.15 when its medication for dry eyes failed to outperform a placebo, and half a disaster for Dendreon, whose shares dropped 38 percent to $5 after tests of Provenge, its treatment for prostate cancer, were inconclusive.
Real life is messier than a spreadsheet, though, and investors also put premiums on various factors that don't necessarily show up in the numbers. The market often rewards cancer drugs, for example, with especially dramatic increases in valuation at Phase II, not Phase III. It also tends to prefer a pipeline of drugs treating a broad range of diseases, rather than one filled with variations on a theme. And if a company can convince a big drug firm of its value, investors will find it easier to agree.
Of course, as ImClone's apparent shenanigans have demonstrated, there's still a lot of good old-fashioned lunacy left in biotech. "It can be very emotional, very chaotic," says Mr. Allison. "When a drug moves from Phase II to Phase III, suddenly analysts jump all over it, and so does the public." And as Mr. Dietz says, "Portfolio managers only have so much bandwidth. It takes a lot of time to really do your homework with these companies, and they usually represent only a 50th or a 100th of your holdings." The result is that valuations will still lurch--a lot.
Sooner or later, though, they will converge on discounted cash flows. Mr. Allison sketches what's ahead: "Look at the oil business, which is also based on exploration, discovery, development, and production. If you find three or four oil wells on your property and get a petroleum engineer to do a reserve report, banks will bid to within 1 percent of each other to loan you money to develop your field." In the not-too-distant future, investors will come to determine equally similar values when prospecting in the field of life science.
Peter Keating is a freelance writer living in Brooklyn, New York. Write to letters@redherring.com. |
