12:00 AM
Sep 03, 2002
 |  BioCentury  |  Strategy

Back to School: 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 billion in annual sales and earned $8.6 billion last year. In order to provide 20% bottom line growth to $10.3 billion, it would have to add $6.5 billion in product sales this year. Even if it were able to achieve 75% of that growth, or $4.9 billion, from accelerating sales of existing products, it still would need $1.6 billion from new products (see "Paper, Not Product," A3).

Based on the 34X P/E multiple for projected 2002 earnings for biotech companies, a company only would have to generate an annual earnings stream of about $148 million to get to $5 billion.

By comparison, a pharma company gets only about $3 billion in market value for the same earnings stream, using the current Rx multiple of 21.

More importantly, from the sales side, a biotech company only needs about $481 million in annual revenue to get to the $5 billion mark. That's because Wall Street is now paying 10.4 times each biotech sales dollar.

In any case, while the Sweet Spot endpoint can't be defined perfectly, the threshold clearly is reached when a company can't maintain the 15-20% annual EPS growth demanded by growth investors. Indeed, Amgen Inc. (AMGN), whose market cap is at $58 billion, already has to grow revenues by about $1-$1.5 billion a year to maintain 20% net income growth through 2006, illustrating just how hard it gets after that point (see "Tough Nut to Crack").

Thus, for the sake of argument, we are defining the Sweet Spot as starting at a market cap of $5 billion and going through to about $50 billion.

Having defined some rough parameters for the Sweet Spot, the issue for management is how to get there, and what to do once a company starts to grow too large to stay in the space.

The latter issue raises the question of whether there is a different model - other than the big pharma model - for biotech companies to consider.

Getting to $1 billion

Companies can't position themselves to hit the Sweet Spot until they have gotten over the first hurdle: getting a first product near the market and hitting $1 billion in market cap.

A look at some of the more successful biotech companies shows just how much work it takes to get to this first key inflection point. For a selected group of nine companies, it took nine years from inception to get the first product on the market; it also took 10 years to become profitable; and it took six years after the IPO to reach profitability (see "It Takes a Decade," A4).

MEDI reached $1 billion on the back of its first big-time product, Synagis palivizumab for respiratory syncytial virus. But Synagis, which posted $516 million in 2001 sales and was approved in the U.S. in 1998, wasn't MEDI's first product. CytoGam cytomegalovirus immune globulin for cytomegalovirus (CMV) was launched in 1991, and RespiGam RSV immune globulin was launched in 1996.

Thus Vice Chairman and CEO David Mott divides MEDI's drive to its first billion in market cap into two stages.

"The CytoGam and RespiGam stage - from inception in 1988 - was about survival," he said. "It was about putting one foot in front of the other, not running out of money, not going out of business. That whole phase of development was planning for the next financing, the next milestone, getting partners to validate our products, getting tranches of capital. It was also about taking risks in terms of product supply, commercial infrastructure, management depth, that we wouldn't take now."

To make his point, Mott contrasted the kinds of data the company obtained from its Phase III trials of RespiGam and Synagis. The Synagis trials were powered at 90% and the p value was 0.00004, while the p value for the RespiGam trials was 0.047. "Having lived...

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