Back to School 2002: The sweet spot
Enough of gloom and doom. This year's Back to School issue leaves aside all thoughts of the stock market and instead focuses on what in the end is really important: strategies for building very small biotech companies into very large biotech companies.
As the rebasing of big pharma continues, it becomes more and more apparent that exceptional growth in the drug industry is less and less likely to come from the top. At the same time, the market cap space between $5 billion and $50 billion is virtually empty save for a handful of weakened pharma names, leaving a vacuum for growth investors that upwardly mobile biotech companies could fill. The latter could provide more realistic growth opportunities, with smaller products than would be required of big pharma (see "Looking for Growth," A2).
Indeed, if biotech does it right, the industry could dominate this "Sweet Spot" for healthcare growth investors for years to come.
The question is, what are the critical valuation benchmarks for these companies, and what kinds of strategic plans get companies through to each valuation threshold? This year's Back to School review provides some lessons offered by companies that are managing themselves into the Sweet Spot.
Defining the Sweet Spot
While its exact beginning and end points could be argued, the Sweet Spot embodies several characteristics. For starters, it has to include a minimum market capitalization to fit investor profiles. While this could be the $1 billion threshold required by most small cap funds, $5-$10 billion might be a more comfortable starting point for growth investors who have played in the big pharma space.
Perhaps not coincidentally, this appears to be a consensus strategic goal for companies that have successfully gotten their first major product to market.
To cross into the $5-$10 billion arena, a company has to have at least one major, marketed product, defined as a minimum of $500 million in peak sales. Better yet are two products, to demonstrate that the company is not a one-shot wonder, as many have been.
The Sweet Spot also has to include a critical mass of R&D to produce a pipeline that contains more potential products of the same size. Based on both the history of companies that spend less and discussions with senior management, the minimum R&D spend to get into the $5 billion club appears to be about $100 million a year, if it is very focused and makes clever use of outside collaborators. To get beyond that point, it looks like companies need to spend upwards of $300-$500 million to stay competitive (see BioCentury, Dec. 17, 2001).
Given those metrics, companies like Agouron Pharmaceuticals Inc. and Cor Therapeutics Inc., despite developing excellent products, concluded they lacked the critical mass to take them into the Sweet Spot. This contributed to Agouron's decision to be acquired by Warner-Lambert Co. in 1999 and Cor's decision to be acquired by Millennium Pharmaceuticals Inc. late last year.
Agouron's R&D budget at the time was running about $150 million, and then-President and CEO Peter Johnson said the company would have had to spend two to three times that amount to have a "comfortably productive pipeline" (see BioCentury, Feb. 1, 1999). Cor was spending about $47 million on an annualized basis.
The Sweet Spot model also demands that the EPS numbers should be achieved through accelerating product sales, not through transient bottom line benefits of one-time cost cutting that pharma-pharma mergers usually provide.
By this definition, Pfizer Inc. (New York, N.Y.) is no longer in the Sweet Spot, notwithstanding that its pending merger with Pharmacia Corp. (PHA, Peapack, N.J.) will result in a pro forma ranking as the third largest industrial company by market cap using this year's Fortune 500 list. While PFE is projecting 2004 EPS growth of 18% following the merger, it's clear that that number will be attained only via cost cutting, as PFE is projecting revenue growth of only 9% that year to $57.8 billion (see BioCentury, July 22).
In fact, size ultimately becomes its own insurmountable hurdle. Take, for example, a company of PFE's size that posted $32.6