Bernie, Here's what H&Q had to say about target-driven drug design (which is one of the reasons why van den Broek loves LGND):
The H&Q Road Map
for Investing in the Drug
Business
Healthcare
January 5,
1998
(90 pp.)
Richard A. van den Broek
(212) 207-1412
rbroek@hamquist.com
A. Rachel Leheny, Ph.D.
(212) 207-1489
rleheny@hamquist.com
Meg Malloy, CFA
(212) 207-1439
mmalloy@hamquist.com
Ken L. Miller
(415) 439-3734
kmiller@hamquist.com
Robert J. Olan
(212) 207-1472
rolan@hamquist.com
Alex Zisson
(212) 207-1443
azisson@hamquist.com
Michael Wood
(212) 207-1481
mwood@hamquist.com
Weidong Huang, Ph.D.
(212) 207-1602
whuang@hamquist.com
Dow 30:
7978.99
S&P 500:
977.07
Investing in the drug business used to be simple. There were only a dozen or so drug
companies in the old days, and they were either multi-billion-dollar global stalwarts, like
Merck, or domestic mainstays, like Searle, Rorer, and Marion. Investors did not have
many choices.
Then came biotechnology. Its emergence in the 1980s transformed the landscape of the
drug business and ushered in a host of new players. Today, while many investors are still
trying to fathom biotechnology, more and more companies are being created based on
technologies such as target-driven drug design, genomics, and combinatorial chemistry,
etc. At last count, there are more than 300 publicly-traded companies involved in the drug
business in the United States and perhaps 1,000 more privately held.
How Do We Invest in This Complex Landscape? Or Should We Invest at All?
The answer to the latter question is an unequivocal yes. With the recent Food and Drug
Administration (FDA) reform and a free-market approach to healthcare reimbursement,
the political climate has become favorable for drug makers. We believe drug spending will
increase as a percentage of total healthcare expenditures as the cost-saving value of drug
treatment is recognized by managed care. The breakdown of vertical integration in the
business model presents unprecedented opportunities to invest in the growth drivers of the
drug business.
This report is a road map that identifies the ongoing trends in healthcare and addresses
their implications for the drug business. Investment opportunities are highlighted, with
companies organized into discrete groups to delineate their divergent roles in discovering,
developing, and selling drugs. Each group of companies is described in detail, including the
picks of our favorite names. Investors who want a more thorough analysis, can refer to the
section "Reference," which lists related Hambrecht & Quist research.
The Changing Healthcare Landscape -- A Need for Novel Drugs
Human healthcare is a significant growth industry in the United States. In 1960, healthcare
expenditures accounted for 5.3% of the gross domestic product (GDP). Today, the nation
spends 14% of its GDP, or about $1 trillion annually, on healthcare. Several factors have
contributed to this extraordinary growth. One is the aging of the population: as people live
longer they require more care for age-related diseases. Another factor lies within the
healthcare financial system. The shift of responsibility for healthcare costs from individuals
to third-party payers, such as businesses and government (which began during World War
II), entices individuals to demand expensive care regardless of cost, and the
fee-for-service reimbursement system encourages healthcare providers to oblige. Over
time, the uncontrolled expenditures became a severe financial burden on third-party
payers. Employee health benefit expenses in the private sector grew from 17% of pretax
profits in 1974 to 58% in 1992. Combined Medicare and Medicaid spending grew almost
$200 billion in the same period.
Managed care emerged in the 1980s as a means to rein in healthcare costs. Based on
capitation, rather than fee-for-service reimbursement, managed care organizations (HMO,
PPO, and POS) have forced fundamental changes in the way that healthcare is delivered in
the United States. As managed care penetration increased from 13% of the insured
population in 1985 to over 60% today, its annual premium growth fell from the 10%-20%
range to below zero. Recognizing the cost-effectiveness of managed care, many federal
legislators are now pressing the Health Care Financing Administration (HCFA) to place
the financially-strained Medicare program under some form of managed care.
Managed care achieves cost-containment primarily by transferring financial risk from health
insurers to healthcare providers, thus giving providers the incentive to stem abuses in
healthcare. Such structural improvement has its limits, however. As managed care
organizations squeeze out the last bit of excess in the healthcare system, their earnings
growth is diminished and their margins compressed by price competition. In the past five
years, HMOs have seen net margins drop from 4%-6% to below 2%.
In our opinion, further healthcare savings will come from novel drugs. Currently, drugs
account for about 8% of total healthcare costs in the United States. Notwithstanding this
small share, we believe that drugs provide the highest value in healthcare: they lower the
overall costs by shortening hospital stays; reducing the need for doctor visits, surgery, or
out-patient care; and restoring otherwise lost productivity. By the latest estimate, the nine
major intractable diseases cost $450 billion annually in the United States. It is foreseeable
that a novel drug that could delay or stop the onset of Alzheimer's disease, for example,
would save tens of billions of dollars in nursing home costs.
In general, the forces in the healthcare marketplace motivate drug companies to develop
novel drugs. Wielding its collective bargaining power, managed care refuses to pay high
prices for late entries into a new class of drugs, and pushes generic substitution of
off-patent drugs and frequent substitution of cheapest in a class of on-patent drugs. This
has cut into drug companies' revenue growth and profit margins. Developing "me too"
drugs is much less profitable, especially as new therapeutic classes become quickly
crowded. The only avenue through which drug companies can maintain their growth and
margins is to develop patented, first-in-class or best-in-class drugs for inadequately treated
diseases.
The Drug Business Today -- a Trend Towards Specialization and Outsourcing
Making new drugs is a long, complex, and expensive undertaking. Starting from research
conception, a typical drug takes about 15 years to reach the market. The process consists
of three stages: discovery research, clinical development, and sales and marketing. At
different stages, armies of scientists from multiple disciplines, legal and business staff,
clinicians, engineers, regulatory agents, and sales people are involved. Because of the
requirement of such tremendous manpower and the high failure rate of clinical
development, drug companies spend an average of $350 million for each new drug
approval.
Historically, companies involved in the drug business performed this entire process alone,
assuming all associated risks and costs. Complete with R&D infrastructure, manufacturing
facilities, and sales and marketing forces, such companies are referred to as fully integrated
pharmaceutical companies. Growing at an annual rate of 10% to 15%, these companies
have, to date, been responsible for bringing most new prescription drugs to the market.
Recent growth, however, has been driven mainly by increases in units of sales rather than
price, due to the growing influence of managed care and the fear of government regulation.
Over the last decade, or so, a new paradigm of drug discovery has evolved in
pharmaceutical research. Popularized as "drugs from genes," or target-driven drug
design, this new paradigm builds upon advances in our understanding of the molecular
basis of diseases, and promises to yield novel drugs with higher efficacy and fewer side
effects. The basic science behind these advances is performed mostly by academic
institutions and biotechnology companies. Although they have new technologies and leads
to novel drugs, biotechnology companies generally lack the financial resources or
infrastructure to bring products to market. Through strategic partnerships, however, most
of them have given pharmaceutical companies the dicey task of clinical development as
well as their marketing rights in exchange for financial backing and future royalties.
Cash-rich yet always hungry for drug leads, pharmaceutical companies find such
partnerships useful both in filling their development pipeline and in gaining access to new
technologies.
Technological innovations have led to a new, modular approach to drug discovery, which
allows for the more rapid, thorough, and efficient identification of drug leads. The new
approach centers around three key technology modules:
Genomics, which identifies new drug targets;
Assays, which incorporate the targets for screening;
Combinatorial chemistry, which provides a large number of diverse compounds as
potential drug leads.
Underlying all three modules and linking them together is the application of automation and
information technology (informatics). Companies that specialize in each of the three
modules have emerged in the biotechnology arena and been successful in selling their
technologies to pharmaceutical companies on a non-exclusive basis. Together with the
instrumentation and informatics companies, they can be best described as "drug
discovery service companies." These biotechnology companies implement a business
model distinctly different from that of the product-oriented biotechnology companies.
Downstream from discovery research, the prolonged and complicated clinical
development process creates an opportunity for a group of service companies called
contract research organizations (CROs). In their drive to bring drugs to the market
faster, pharmaceutical companies often overwhelm their in-house development capacity
and find the need to outsource. Among biotechnology companies conducting clinical trials,
few have, or can afford, an in-house development infrastructure. Filling this gap, CROs
perform preclinical testing and manage clinical trials for pharmaceutical and biotechnology
companies on a contractual basis.
Outsourcing has become an integral component in many companies' business strategy.
Keeping overhead low is key to sustaining earnings growth. With pipeline uncertainty being
a fact of life, it is untenable to create and maintain large, fixed-cost departments in-house.
Outsourcing provides a solution by turning fixed costs into more manageable variable
costs. Also through outsourcing, companies can access a broad spectrum of expertise and
technologies that they often lack. Following this strategy, companies are outsourcing not
only clinical development, but also drug manufacturing and sales and marketing.
Correspondingly, two additional groups of service companies, contract manufacturing
organizations (CMOs) and contract sales organizations (CSOs), have emerged to
meet these needs.
Further downstream, the trend towards specialization has also given rise to two groups of
companies which profit from drugs that are already approved and on the market. Drug
delivery companies develop novel formulations or devices to deliver drugs. For these
products, premium pricing is justifiable because these companies improve the existing
drugs' bioavailability, pharmacokinetics, and patient compliance. Another group, emerging
pharmaceutical companies, acquires underpromoted or unpromoted drugs from major
pharmaceutical companies. As the major pharmaceutical companies increasingly focus on
the blockbuster drugs, smaller (under $100 million) drugs lose their strategic importance.
Yet the medical need for these drugs still exists. When small companies bring these
high-margin drugs into their sales infrastructures, the impact can be very accretive.
Investing in the Drug Business
The trend is unmistakable. Vertical integration of the drug business has broken down,
giving way to a variety of specialty companies, each of which excels in one or a few
aspects of the business. By far, most of these specialty companies are involved in
discovery research. While some of them discover drugs and even take on the risk of
clinical development, others adopt a service-based business model and focus on selling the
"picks and shovels" of the drug business. This product-versus-service bifurcation can be
extended downstream. CROs, CMOs, and CSOs are essentially service companies for
drug development, manufacturing, and sales, respectively, whereas drug delivery and
emerging pharmaceutical companies are product-oriented.
We anticipate that, in the near future, major pharmaceutical companies will continue to
bring a majority of the new drugs to the market. The technologies that enable their
discovery, as well as a substantial number of the drug candidates will come from the small,
specialty companies. We are optimistic about the outlook for the big pharmaceutical
companies, and are even more bullish on the specialty companies because they own the
technologies that power the R&D engine. Specialty research companies, which opt for the
service business model, offer the prospects of near-term profitability, and shield
themselves from the risks of clinical trials. However, we caution investors not to overlook
values in product-oriented companies. Although clinical failures continue to highlight the
risks of product development, the upside of an approved drug is simply too great to resist.
Those product companies which have built strong pipelines and deep cash reserves will be
able to weather the ups and downs inherent both in clinical trials and in the financial
market. Their success in product development will continue to lead rallies in the
biotechnology sector. |
