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The tortuous path of a blockbusting drug can make or break a biotech, spot a winner early on though and the rewards can be exceptional. Susanna Twidale gets to the heart

of the biotech bonanza and reveals how to play this dangerous game

The old adage ‘knowledge is power’ is true for most things but never more so than in the biotech sector. The companies involved have had their fair share of bad press recently, to say the least. Last year was an ‘annus horribilis’ according to one analyst, while credit crunch woes have led to fears that 2008 will be little better, with some companies tipped to run out of cash altogether. But among these depressed shares prices and low valuations are there any companies in the sector which could be worth a speculative punt given their blue sky potential? Well, yes there are, but knowing what you are doing is crucial, and there in lies the rub.

The exciting thing about the sector is that there is a real, and increasing demand for more drugs. People are living increasingly longer lives, especially in the developed world, and they demand ever higher standards in the quality of that extended life. Such demands are placing increasing pressure on the biotechnology and pharmaceutical industry to come up with treatments and cures for an array of diseases and illnesses. At the same time, major drug companies are, on a commercial level, equally desperate to uncover the blockbusters of tomorrow in order to replace the sales of existing big sellers as patent protection runs out and generic competition moves in on the action.

The amount of money spent on research and development (R&D) by the UK’s larger pharmaceutical companies (including UK units of overseas firms) has been rising steadily, faster in fact than sales over the past ten years. According to a report by the Department of Innovation, Universities & Skills, in 2006 pharmaceutical industry R&D outpaced sales by 26%, rising 10.5% compared with an 8.3% rise in sales, while the disparity was even greater in the years between 2002-2006, with R&D (up 15.2%) outstripping the growth of industry sales (up 12.2%) by 24.5%. Yet at the same time, the number of new molecular-based drugs approved by government agencies has declined. For this reason, when biotech companies come across a winner, the rewards can be huge, both for the company and its investors.

Licence to save

Often major pharma companies, such as GlaxoSmithKine (GSK), AstraZeneca (AZN) and Shire (SHP) will license out a product which means they will help to pay towards its development in the early stages in return for exclusive rights when it hits the market.

A basic distinction between biotech and pharma companies is that traditionally biotech companies have been responsible for drug discovery and pharma companies for drug manufacture but these days with pharma companies spending more and more on R&D and some biotechs striving to take products to market themselves the distinction is somewhat blurred. These days the main difference is the scale of the companies involved, which is why tie ups between the two are so advantageous to both parties. The pharma companies get to spread their investments around through licensing deals while the risks are reduced if it fails. On the other hand the smaller biotechs gets the cash it needs to carry out the necessary trials to get product to market.

These deals are often the lifeblood of typically loss-making biotechs, and they can exert a huge influence over a biotech firm’s share price. For example, last year Renovo (RNVO) bagged a deal with Shire for the non-EU rights to its Phase II Juvista, anti-scaring product, an agreement that could net the company as much as $825 million if it hit certain milestones. News of this sent the company’s share price soaring 21% within a couple of days to a year high of 227p, valuing the company at over £400 million. Since then, things have turned rather more sour for Renovo thanks to Juvista failing to meet one of its Phase II objectives – effectively removing skin blemishing moles. This disappointment has sparked a slump in investor enthusiasm, sending the shares tumbling to 141p, a move that has wiped roughly £150 million of the company’s market value to just £254 million, far less than the potential value of the Shire deal alone. Renovo’s management continues to look on the bright side, claiming that its Phase II set back should not ultimately prevent Juvista moving on to key Phase III trials later this year on the basis of the treatment’s other applications such as scar revision and breast augmentation.

However, investors clearly still need convincing, judging by the stock’s doggedly lacklustre performance, and should this remain the case even on the successful navigation of Phase III testing, it could lead to a takeover since it would make more commercial sense for Shire to buy the company out rather than make the next milestone and royalty payments.

Clearly there are a lot of hurdles to pass first, and Renovo’s shares may soar sufficiently that this is not an option but when pharma companies do decide they want to get their hands on a product, and carry out a full takeover, they don’t usually mess about. ‘These deals are usually all in cash and tend to come in at a 50% to 100% premium, which is almost unheard of in cash deals, but major pharma companies will make sure nothing gets in their way,’ says Sam Fazeli, a senior research analyst boutique research house Piper Jaffray.

‘It could be that the pharma is better off buying them out rather than paying the milestones or royalties in the future.’

One clear example of this was AstraZeneca’s purchase of Cambridge Antibody Technology (CAT) for £702 million in 2006. Astra already owned 20% of the company and had an agreement to invest around £100 million across a portfolio of about 25 new drug projects, yet CAT’s poor share price performance presented an opportunistic chance to for the Anglo-Swedish rug firm to take complete control of CAT’s product pipeline, plus asthma treatment Humira, which was already available to the public.

At the time of the offer, CAT’s shares were trading at just shy of 800p, so when Astra came along with a £13.20 a share offer – representing an impressive 66% premium – shareholders bit its hand off.

Knowledge is power

Checking to see what existing partnerships a biotech company already has in place is a crucial part of an investor’s background research. While they offer no guarantees of success, that a major pharma company is willing to put its money behind it is a good start, and brings with it the required cash, and also the prospect of further milestones and even potentially a takeover with a whopping premium further down the line.

But for all the success stories there are many more failures, so how can a mere mortal investor sort the wheat from the chaff in the biotech sector? One of the clearest indicators is cash.

Money in the bank and cash burn (the rate at which a company is spending its liquid resources) remain among the biggest challenges that face any biotech company, so establishing both is vital for an investment point of view.

Sometimes it is hard to work out forward cash burn exactly as different stages of trials are more expensive than others. This means that a low burn rate one year does not guarantee an equally slow use of cash the next and, as a rule of thumb, alarm bells should start ringing if a company’s cash pile does not look significant compared with its latest years operating costs.

But there are other issues surrounding cash too. The current credit crunch has led to a great deal of belt-tightening among investors and enthusiasm for blue-sky businesses that require huge investment up front has fallen sharply, perhaps unfairly so. Still, this means that any companies that need to raise new funds in the short term may well have to accept far more unfavourable lending terms to get it, while others may struggle to find it at all.

This leaves well-funded biotech companies – with perhaps 12 to 18 months worth of cash in the bank – in the happy position of being able to continue their research work relatively untroubled by wider economic worries, and much better bets for investors too. Companies which already have licensing deals will usually receive a tasty upfront payment to bolster their cash balances which is another reason why those with existing deals are more tempting, especially for a novice biotech investor.

Number crunching

With most of the companies involved loss making, and with a commercial product many years down the road, investors new to the sector could easily be forgiven for pondering just how analysts come to reach their supposed valuations. Putting a value on something that has several years of trials to come and may never reach the market is understandably a tricky business, but analysts, many of whom are often Doctors or PhDs with in-the-field experience, are paid to do just that. Every analyst has a slightly different way of working out what their valuations for a company will be, but as a general guide they will initially work out a theoretical value of each drug, based on its eventual market size and the assumption that it will pass through all the necessary trials and approvals.

The market size is worked out roughly by the potential, or forecast number of patients that will be use the drug each week, multiplied by its weekly cost. Drugs targeting areas where there are huge number of potential patients or those treating people which chronic diseases which can command more value will therefore have a larger estimated market.

As the majority of drugs fall at the first few hurdles analysts also have to factor in a risk adjustment which depends on the stage of development it is in. The earlier down the clinical path the drug is, the higher the risk that it will not make it to market, and the lower the theoretical value. So the value of the drug will be its theoretical value times the risk adjustment.

For example a drug entering Phase I with a theoretical value of £1 billion would be given a value to the company of £100 million.

Another way of de-risking the sector is to only look at companies which have more than a single drug in development at any given time. Therefore, a rough guide to overall valuation will be a series of these drug valuations added together, plus any other assets, including cash, that the company may have.

This is why some analysts have vastly higher target prices for many biotech companies than their current share price, as they can be based on what is essentially a theoretical valuation of the company based on its eventual markets and the probability of success. It is then especially important to know what the time frame of an analysts company share price target as it could be a target for many years into the future.

With prices for many companies near all time lows most analysts concur that, at the moment, the entire biotech sector is vastly undervalued. It is fair to say that, with credit for risky ventures now hard to come by, there are bound to be some disappointments, yet investors willing to do their research and look for cash rich companies who already have their foot in the big pharma door, there are de-risked buying opportunities out there.

Concept to chemist - 5 steps to drug development

Going through a Phase

Analysts estimate that it costs and average of $1 billion to fund the development of a blockbuster drug through all the necessary regulatory stages. The reason companies, and investors are prepared to pay this is that when a blockbuster does come good it can generate multi-billion revenues, usually on huge margins around 80%. It also typically takes around 11 years for all the necessary trials to be completed so knowing what stage a biotech companies products are at is vital. The closer a drug is to approval, the more valuable and less risky it is but earlier an investor commits to a story, the more money the stand to make if it all goes according to plan.

1 – Pre-clinical studies

Once scientists have discovered something they think is promising its toxicity will be tested on animals to make sure it is safe before entering human trials. There have been several advancements made over the last few years in virtual testing models but it is still the case that a company must seek approval from regulatory bodies before it can start testing on the human guinea pigs. On average only one in 1,000 compounds that go through clinical studies will actually make it to Phase I so there is usually no real uplift in a biotech’s share price if it is announcing the start of these kind of studies.

2 – Phase I trials

The first phase of human testing seeks to establish that the drugs are actually safe. Usually these trials will be quite small, with around 100 patients who are usually healthy, although sometimes terminal patients will take part for certain drugs. Trials will test how the drug is absorbed and used in the body and what its effects are over time and usually cost up to $15 million. They can take anything up to three years depending on the product but advancement to this stage can provide a boost to share prices for smaller biotech companies.

3 – Phase II trials

These trials continue to monitor safety but are mainly to establish the efficacy of a drug and to work out doses to be used in Phase III. Here patients who suffer from the disease are used and the numbers are normally larger, around 100 to 500 patients. They typically last two to three years and can cost around $25 to $40 million. Success at this stage generally means the product is safe and has a positive effect so it can lead to a significant rise in share prices. Many biotechs choose to license out products when they have received positive Phase II data because the risks are reduced enough for them to command lucrative milestone payments and royalties but often need to find a partner to help fund the more costly Phase III trials.

4 – Phase III trials

These trials are much larger, with at least 1,000 patients tested if looking for FDA approval in the US. This phase usually lasts between two and four years and costs an average of $80 million-$120 million. If these are successful an application will be made to apply for regulatory approval, and at this stage the chances of the product reaching the market are dramatically increased to around 70%, so positive Phase III data can lead to a huge uplift in share price. The US and Europe are two of the largest markets so applying for approval here will be more significant than in a smaller geographical region.

5 – Final approval

Passing through all of the clinical trials with flying colours isn’t necessarily the end of the story. Once the data is in it has to be submitted to the relevant regulatory authorities, the Food Drug Administration (FDA) in the US and the Medicines and Healthcare Products Regulatory Agency (MHRA) in the UK. The companies will have been in contact with the regulators throughout the various phases of the process to ensure they have been testing for the right kind of data that will be needed for approval. This means the majority of drugs which complete successful Phase III trials are ultimately approved but there are no guarantees as more data may be required if the regulators are not happy. The review process can take anything from a matter of months to even a few years depending on the type of drug. If the drug is treating chronic life-threatening diseases it may be reviewed quicker than one dealing with a more minor complaint. Once the approval is gained however the drugs can be marketed and start generating cash.

Biotech essentials

*More than one promising product – reliance on one lead drug is hugely risky

*Strong management team with deal making credentials

*Established partnerships with major pharma companies

*Solid cash balance – visibility of funding for the next 12-18 months at least

*Catalysts for more cash – licensing deals, milestone payments, stage completion and product approval in the pipeline

Biotech Blockbuster

Antisoma (ASM) 23.25p BUY

Market value: £103.8 million

Key Drugs: ASA404 (prostate, lung, ovarian cancer) AS1411 (kidney cancer, acute myeloid leukaemia), AS1409 (kidney cancer), AS1402 (breast cancer)

Partner: Novartis (Swiss)

Cash in the bank: £61.4 million (July 2007)

The drug developer already has a licensing deal with Swiss-based pharma giant Novartis for its cancer drug AS404 which could be worth up to $890 million (£458 million) if certain milestones and sales targets are met. Novartis is set to take the drug into Phase III trials this year which director of communications Daniel Elger says will take around 18 months with follow up trials taking around two and a half years. It is also developing several other cancer drugs itself, the most advanced of which is AS1411 which will be reporting Phase II data in the first half of the year. Elger also admits that with the company’s share price languishing where it is that it is a takeover target. ‘Further down the line is anyone’s guess,’ he says. ‘It is possible that when Phase III data comes out they (Novartis) will do the maths and that’s when companies get taken over.’

Biotech Blockbuster

Protherics (PTI) 51.25p BUY

Market value: 171.6 million

Key Drugs: CytoFab (anti-sepsis), DigiBind (pre-eclampsia), Voraxaze (cancer side effects), CroFab (anti-snake venom), Digifab digoxin (poison antidote)

Partner: AstraZeneca (UK)

Cash in the bank: £46.9m (October 2007)

Unlike many of its peers Protherics already generates solid revenues coming from its snake anti-venoms, which came in at £14.8 million at its most recent interims. It already has a licensing deal with AstraZeneca for its anti-sepsis treatment CytoFab which could be worth up to £195 million plus royalties if it meets all of its milestones. An expanded Phase II trial of the project is expected to start this year while it is also due to receive Phase II data for its pre-celampsia product in 2008. Based on its potential newsflow Seymour Pierce has a six month price target of 76p, a 48% premium on its current share price.

Biotech Blockbuster

Oxford Biomedica (OXB) 18.5p BUY

Market value: £99.4 million

Key Drugs: Trovax (kidney, colorectal, prostate cancer), ProSavin (Parkinson’s disease), LentiVector (gene delivery and transfer technology), MetXia (booster to existing cancer treatment)

Partner: Sanofi-Aventis (France)

Cash: £42.5m (July 2007)

Oxford’s deal for cancer treatment TroVax with Sanofi-Aventis (SNY:NYSE) could be worth as much as €518 million if all of the targets are met. It is due to report Phase III trials in 2009 and with its £99.4 million (€133 million) market cap currently less than the potential value of the deal it also looks to be a potential takeover target. It has other irons in the fire and among other things has started a Phase I/II trial for its gene-based Parkinson’s disease product ProSavin that should report data this year, which could provide a further boost to the shares. Its solid cash balance should also provide good support.