Tuesday, September 7, 1993
At least half the industry returns to work today from vacation. We may exaggerate somewhat, but nevertheless we hope the late summer break taken by many biotech investors and executives results in renewed energy for reviving biotech's fortunes. Because it's not overstatement to say that the shape of the industry fundamentally will be determined by management and investor actions during the next year or so.
Simply put, the next 12 to 18 months will provide telling evidence about the sector's ability to meet product milestones, and test whatever novel solutions are crafted against the realities of capital rationing.
Along those lines, this week we propose to review the common agenda for the home stretch of the year and into 1994. The emphasis is on the ultimate source of value creation in the sector - individual company performance - which is driven by a handful of key questions that every management and its board need to answer:
· Is the current business model justified?
· What are we doing to maximize the approvability of our product?
· Are we focused on product marketability?
· Are we showing investors a Clear Route to ROI?
· Are we doing what needs to be done about preserving asset values?
The business model
To start with, the realist has to acknowledge that the externals - health care reform, investor sentiment, and industry structure - are outside management's individual sphere of control. Internally, management also has no control over whether the science ultimately can be transformed into products.
The question is how managers tackle issues where they actually exercise control. An obvious list includes spending (frugal), product focus (relentless) and incentives (compensation and options based on product milestones). But in particular, we're interested in a company's choice of business model, and how management continues to justify it.
First and foremost, managers choose the corporate model for their business - Fully Integrated Biopharmaceutical Co. (FIBCo) or something else. The decision to pursue FIBCo (if early stage) or stay with FIBCo (if later stage) profoundly affects fundamental management attitudes: towards resource requirements, partnering relationships, potential sources of development capital, size of R&D portfolio, and mergers or other combinations that create organizational economies and portfolio strength.
From an investor's point of view, the question is whether management's choice of a model squares with what can be attained in terms of product development, market access and financial performance. Can management continue to justify its model for the business? As the M&A rumor-mill hots up, every company that wants to remain independent needs to answer that question.
"The corporate model is definitely something CEOs can control," says Ken Lee, national director of life sciences industry services at Ernst & Young. FIBCo has been a powerful model. "Down deep in their souls, I don't think CEOs feel any different," says Lee. "But they've sobered up enough to see that there are other things they can be in the interim - (which) could be 10 or 20 years. "
He says Biogen, Alza and Chiron are three good alternative models.
"I'm of the opinion that there's a group of 20 or 30 companies who should structure and do everything they can to become FIBCos," says Wilkerson Group Chairman John Wilkerson. "They should go after the brass ring.
"There's another 200 that should be thinking of themselves as just-in-time research companies. The large pharmaceutical companies that are under earnings per share pressure are going to be very interested in collaborating with just-in-time research companies.
"The model there is one of management coming to terms with itself, its employees and its board - that this will create similar values. The problem right now is there's no model other than Alza showing you can create that kind of value. It took Alza 20 years."
Mayfield Fund Partner Grant Heidrich says it may be better for shareholders if management settles for just being a developer of intellectual property.
"You have to work out a return to equity," says Heidrich. "If it costs $600 million to build a fully integrated biopharmaceutical company, you might be a lot better off spending $40-$50 million with a custom boutique organization or a delivery company.
"We've seen de-integration of the pharmaceutical industry. There are opportunities in those areas."
Focus on approvability
Even though management can't control whether a drug will work, companies eventually must show they can get products through the clinic and approved. The disasters of 1992-93 have to be relegated to the back of the investor's mind.
The key is sharpened thinking about the clinical process. David Crossen, president and CEO of Cortech Inc., calls it "the philosophy and execution of one's clinical trial strategy.
"That's far and away the most important issue - thinking creatively, interacting with the FDA in both a creative and facilitative manner, working very closely with the clinical investigators, and understanding the bridge between clinical intuitions and statistical fidelity to get the FDA to understand what you're doing - turning the science into a clinical result.
"The CEO mindset will be critical in how you go about doing that."
At the outset, that means establishing a list of criteria a compound must satisfy before it becomes a clinical candidate. "You have to know that up front," says Kathleen Mullinix, president and CEO of Synaptic Pharmaceutical Corp.
Once that's been done, it means designing trials in carefully chosen indications, with carefully chosen end points. It may sound obvious, but knowing that a drug works is not the same as demonstrating efficacy to the FDA - as the sepsis failures have amply shown. Over the past two years, we've heard many people say they believe the sepsis drugs work, if only trials can be designed to show that.
Wrapped up in the clinical design process are tradeoffs between indications and patient populations where clear efficacy and cost benefit can be shown - which may mean smaller subsets of sicker, high-risk patients, especially in indications where mortality is low - versus going after broader patient groups representing the widest market. In some cases, there will be a clear tradeoff between ease of approvability and getting the widest label possible.
The goal is to get something approved. "The only thing that matters is getting things on the market," says Crossen. Yet we still find companies that take the approval process for granted, are vague about their endpoint strategy, or are pursuing high-risk clinical strategies to stake out a broad market in situations that seem hard to justify.
In these cases, we do not see a focus on approvability.
Focus on marketability
Companies have to know how revenues will be made in the new cost-containment environment and direct product development activities accordingly. In the long run, management's thinking and execution in this area will be as important as its fundamental choice of corporate model.
President Clinton, who last week said he had never embraced direct price controls as a mechanism for containing health care costs, still will accelerate a budgeting process at the delivery end of the system that will have profound effects on prices across the system. In part, this is because dollars will be rationed across budget categories as providers decide how to maximize the effectiveness of their spending.
Under the circumstances, companies have to anticipate demands for value-pricing, in which price has to have some correspondence to budgeting priorities as well as clinical decision-making and patient outcomes. This will
test management's ability to correctly define and position its products, and to identify the dominant purchasing decision-maker.
In product definition and positioning, it may be obvious that most companies will shun me-too product strategies. It may be less obvious that many biotech drugs will not be breakthroughs. More likely is that many companies will compete with novel compounds in the same therapeutic areas. If "novel" does not equal "breakthrough," then companies had better be realistic about where their product stands, and prepare persuasive cases for being the drug of choice. In many cases, the equation of cost + benefit + competition should lead management to narrower markets.
"What's going to be important going forward are longitudinal studies finding the patient subgroups where your product does make a difference," says Kent Thompson, a principal at Ernst & Young specializing in pharmacoeconomic issues. "From the patient's perspective, if you have measures including the quality of life, and can show your drug improves individual outcomes, you have a better chance of getting coverage."
It's also absolutely necessary to identify the dominant purchasing decision-maker, and gear product positioning and pharmacoeconomic studies to that decision-maker's selection criteria.
"There are several channels for conflict: patient/doctor, patient/payer, doctor/payer. All may have their own values. The question is, who is dominant? Who will drive the market for this product?" says Thompson.
"For unique products which fulfill an unmet medical need, it's clearer that you look to the payer. If you look at integrated delivery systems, which cover in-patient, out-patient, home care - there the focus is on minimizing the cost of overall treatment."
To assure marketability in this environment, Thompson believes companies need to design and pursue pharmacoeconomic studies with the same scientific rigor that they conduct the bioscience. Anecdotal evidence of reduced patient stays will not meet the analytical demands of the pharmacy and therapeutics committees that must balance clinical outcomes with the resources they consume.
Smart companies also will use the clinical process to derive the pharmacoeconomic data. Prospective economic study design increases the likelihood that the results will support a product's label.
Show a Clear Route to ROI
The industry is in a capital rationing situation, compounded by the fact that biotech investments are illiquid relative to other capital market alternatives. To compete for scarce capital, companies must be able to show a "Clear Route to ROI."
This means positioning a company's stage of development with the appropriate "technology investment model" of the funding sources. Venture capital essentially vets technology and markets for early-stage companies, leaving a relatively small set of technology decisions to sources of later-stage financing.
(This VC gateway could become more pronounced as pharma companies increasingly seek "just-in-time" technology to fill dwindling product pipelines, leaving fewer corporate partnering dollars for research-stage projects.)
The growing set of cash-hungry companies with products near or in the clinic will need to answer the demands of later-stage funding sources and the public markets, which will focus on revenues and valuations rather than technology.
This is where management attention to approvability and marketability will pay off. For later-stage investors to see a Clear Route, they have to be convinced that the company has a solid package of doable milestones, smart clinical planning that maximizes approvability, and real reasons for adoption by health care providers.
They also have to see ROI, which means companies have to be realistic about valuations. The equation here is simple: valuations must be low enough to permit new money a productive multiple upon the next funding round, or as accomplishment of product milestones is reflected in a new market cap for a public company.
If the multiple is not apparent via the sniff test, calculated on the back of an envelope, or scrawled on a napkin, investors will find more interesting things to do with their money.
Maintaining asset values
Given the starvation diets facing biotech companies, and a finite number of development partners, the question is how to avoid being tossed into a Dutch auction in which liquidation values for technology assets approach zero.
The advice givers all urge moving to tie up deals before it's too late, before the burn rate arithmetic is obvious to all and the auction begins. They also all bemoan the fact that managers and their boards are loathe to admit defeat when virtually no companies have yet been banished from the scene.
"The key is to keep your company bankable - keep it differentiated enough and valuable enough so investors will fund it," says Ken Lee, who says chances for deal-making still exist when 12 to 18 months of cash remains in the till.
"Companies working in the same therapeutic categories but with different technical approaches should be bunching up," says Wilkerson.
For companies that have the luxury to look out more than two years or so, Robert Esposito, partner in charge of the health and life science practice at KPMG Peat Marwick, advocates careful selection of partners, both investors and corporate. "Choose ones with long-term objectives, who have as much interest in the product as you do," he says.
In the meantime, a "desperation scale" may emerge to track companies teetering on the brink. Investors will draw inferences from the number and quality of private placements, moves to outsource work, decisions to abandon programs, reductions in force and evacuations from the management team.
The problem is that a model for survival hasn't been created. "Two years
from now we're going to know a lot more about that," says Mayfield Fund's Heidrich.
Perhaps it's too logical, but companies in these cases still must provide increased value in exchange for investment - plain old ordinary ROI. Under this model, companies must be willing to accept suppressed valuations and staged cash infusions against investable milestones.
Managers need to review their project portfolios and identify any meaningful milestone that is within their grasp. Get it funded. Change the business plan to meet the single objective. If management doesn't do this voluntarily, the board should insist upon it.
Ultimately, of course, this strategy only will save companies that eventually offer to investors a chain of milestones that lead to the two objectives discussed above - approvability and marketability. The rest should be moving to consolidate programs and overhead with partners or acquirers.
View from the clouds
We are talking here about a sector revival based on individual company performance on a few key measures, coupled to generally low but realistic corporate valuations that will provide investors with upside commensurate with the risk and illiquidity of their investments. To reiterate:
· The successful companies will be managed against a realistic business model, which will dictate wise use of their funds, focus their R&D and point them towards productive partnerships.
· Successful managers will be obsessed with creating an approvable product, which may have less to do with science than with shrewd and disciplined clinical trial design.
· Successful managers will do all the homework necessary to make their products marketable, beginning at the earliest possible stage to identify where they can create a sustainable position within the framework of cost + benefit + competition.
· Successful companies, and their boards, will accept valuations that attract funding and then focus on accomplishing milestones that create a return on the investment. Companies facing desperate straits will strip down to accomplish meaningful milestones that can be funded and allow the company to live to fight another day.
BioCentury's view from 100,000 feet clearly misses objectives that would jump out at strong managers hovering closer to the target. But the 100,000-foot view provides some reasonable chance of relating the health of the sector to individual company performance. On the whole, improved success rates by individual companies will raise their values, and, we would expect, the net value of the sector.
However, we don't expect, and urge against expecting, that some external rising tide will drive sector value up and reward companies for hanging on without real progress on these key tests. If the water level actually rises, some companies surely will remained grounded at the bottom and eventually be submerged.
Set your alarm clock for the end of 1994.