Pharma and Biotech

Is it possible to continue growing?

Joachim M Greuel,  Founding and Managing Partner, Bioscience Valuation BSV GmbH, Germany

While the industry still performs on a high level, growth prospects are not as they had been in the past.

Novartis recently released the results for its fourth quarter of 2007. While the company's turnover increased 6% to US$ 9.9 billion, its net income decreased 42% to US$ 931 million. If the income statement is corrected for extraordinary expenses, Novartis' operating earnings for the fourth quarter of 2007 were US$ 1.3 billion, about 20% less compared to the earnings of the fourth quarter of 2006. Although the financial performance is still good, many analysts are disappointed with Novartis' actual financial results.

Novartis' performance is representative for the whole pharmaceutical industry. While the industry still performs on a high level, growth prospects are not as they have been in the past. For the year 2008, analysts expect an overall growth in global sales of about 5% to 6%, in contrast to the double digit growth at the beginning of the decade. The US market, arguably the most important one, may only grow by about 4%. The modest growth will not only affect big pharma but also large biotech firms. Genentech, for example, used to report double digit growth; however, it reported only single digit growth in the last quarter of 2007.

One reason for the declining performance of pharma and biotech is the lack of true innovation. Last year the FDA approved only 18 drugs, one of the lowest numbers since 20 years. Despite the fact that the mean pipeline size of larger companies has constantly increased during the last years, attrition rates have increased as well, leading to a shortage of promising drug candidates for approval. At the same time the costs for developing and taking a drug to the market are escalating. Experts believe that the costs to develop a molecule until launch are approaching US$ 1 billion if attrition is factored in. Furthermore, aggressive cost containment efforts in most European countries are compounding the problem of diminishing returns.

Not surprisingly, many industry observers doubt whether pharmaceutical companies can maintain growth rates as seen in the past. Indeed, for many diseases that are 'easy' targets in terms of well validated pathophysiological mechanisms, a reasonably high therapy standard has already been achieved. For example, currently available statins control low-density lipoprotein quite well and it may not be worth the effort trying to identify more efficacious drugs specifically targeting, e.g., artherosclerosis. The same may be true for antihypertensives. Calcium channel blockers and angiotensin-converting enzyme (ACE) inhibitors are effective therapies commonly prescribed in many countries, and it may not pay to develop new anti-hypertensives.

Net Present Value - How is it calculated

NPVs are calculated by discounting future expected cash flows back to the present day.

The NPV is a measure of value: if a project's NPV is positive, the project creates value, if, however, the NPV is negative, a project may not create value.

Net present value analysis
NPV
The current pharmaceutical dilemma can be well illustrated by calculating the net present value ("NPV") of an average drug in discovery or pre-clinical development. "Average" refers to a compound that can be characterised by an average, or benchmark, risk of failure and average cost of development. An ordinary compound today generates about US$ 250 million in peak sales, a low figure compared to the blockbusters that generate on an average worldwide sales that are clearly above US$ 1 billion. Still, most drugs in development do not have blockbuster potential. If the projected cash flows of those 'average' projects are adjusted for potential attrition and discounted to present day values, many will end up with negative NPVs. A negative NPV means that a project may not generate value; thus, the project may be abandoned.

Figure 1 shows the result of a NPV analysis for a typical project, using three different discount rates. The discount rate represents the annual return expectation of investors.

An 8% to 10% discount rate is often used by large pharmaceutical companies. Smaller biotech companies require higher rates as they are riskier investments; 15% to 18% is typical for small capitalised public biotech firms, and a rate in the order of 25% is usually applied by venture capitalists. Discovery projects show negative NPVs at all discount rates and may appear, therefore, not as good investment opportunities. Pre-clinical projects have a positive NPV only in the hands of big pharmaceutical companies; more aggressive discounting, i.e. applying 18% or 25% discount rates, produces negative NPVs also for pre-clinical projects. The preclinical NPVs at the 18% and 25% rates are more negative than the NPVs of the discovery projects because, for discovery, early attrition prevents higher losses. Fortunately, development projects are often regarded as real options: managers analyse the increase in a project's value that would occur when reaching the next milestone and the investment needed to reach that milestone. This kind of analysis often demonstrates that it is worth pursuing negative NPV projects. Nevertheless, based on classical finance theory, negative NPV projects are regarded by many as critical investments and building a business case for a pharmaceutical development project is not at all a 'no brainer' anymore. Most projects require, at least from a financial point of view, a second thought and more detailed analysis.

Figure 1: NPVs of typical discovery and
pre-clinical projects at different discount rates
Potential strategies
One may now ask: What can the pharmaceutical industry do in order to find positive NPV projects that, if successful, would support further growth. Financial analyses indicate three potential strategies:
1. selection of indications with a high sales potential,
2. risk reduction and
3. cost reduction.

Sales potential
NPVs
A drug's sales potential tends to be strong for high prevalence diseases with significant unmet need, such as in oncology. In line with the ageing population cancer prevalence increases steadily; still, despite intense research efforts, our ability to treat advanced malignant tumours is very limited. Projects targeting neoplasms tend to have positive NPVs when the drug considered is, or will be, developed for several distinct cancers. For example, the blockbuster sales of Taxol?
or Rituxan? are the result of broad development programs that cover various cancer indications.

One may argue that attempting to develop a new cancer therapy is quite risky and, therefore, value may be compromised by a low launch probability. Although this is true, the high sales potential usually compensates for the higher than average risk of failure. Another argument against an engagement in oncology, or any other indication with high unmet need, is the competitive nature of the market. The higher the sales potential in a certain indication, the more competitors can be expected. The resulting potentially lower market share may actually compromise a drug's sales potential. This argument is partly true: if a drug is distinguished by its clearly superior profile, it will capture the lion's share of the market, irrespective of the number of competitors. Recent licensing agreements show that many pharmaceutical companies offer premium terms for drugs that have a high potential in the oncology market. In contrast, strategies to focus on niche markets are hardly ever rewarded by the stock markets; companies engaged in niches often have poor valuations.

Risk reduction

Another potential strategy to increase value is to invest in low risk development candidates. For example, a company may focus on developing 'branded' generics. As with all generics, the original drugs' patents have expired. However, the formulation of a drug may have been suboptimal, thus allowing further improvement. For example, Abraxane? is an albumin enhanced formulation of paclitaxel. Paclitaxel is a very successful chemotherapy without patent protection for the active molecule. As paclitaxel is an approved drug to treat cancer, the reformulation will be less risky and market acceptance likely if clinical benefits can be demonstrated. As Abraxane? enjoys patent protection for its formulation, its sales potential is maintained and not subject to generic competition.

Cost reduction

Finally, a company may try to reduce a drug's development cost in order to increase value. However, NPVs are not very cost sensitive and cost reduction provides much lower NPV improvements compared to increases in sales potential or the reduction of development risk. Also, excessive attempts to reduce development costs may lead to a poor clinical study design and thus increase the risk of failure. Therefore, cost containment rarely helps to significantly increase a project's value.

High sales and low risk business strategies are not the only means to increase a company's potential for growth. Much can be done to improve the R&D operations. Companies that implement professional portfolio management systems tend to grow more than companies that lack those systems . One reason may be that for companies without good portfolio management, gaps in the development pipeline are realised too late, or the mix of projects does not balance the portfolio risk in the optimal way. Another intelligent way to support growth is to routinely check whether a project's development risk has been minimised. There are numerous ways to design pre-clinical and clinical development, and companies do not always choose a design that maximises a project's chance of success. Finally, most companies engage in market research much too late. For example, conjoint analyses are usually performed while a drug is in Phase III. However, it is very difficult, if possible at all, to change a drug's profile that late in development. It would be a much wiser strategy to perform market research early on, when a drug's target profile can still be modified.

The growth of biotech firms is tightly linked to the growth of the pharmaceutical industry. Many biotech companies depend on licensing agreements with Big Pharma. If growth of the pharmaceutical industry slows down, for example, by governmental cost containment initiatives, pharmaceutical companies will not be able to pay adequately to license promising compounds from biotech firms. As a result, pharmaceutical innovation will decrease and harm the entire industry. The US plays a central role in supporting worldwide growth. We have to acknowledge that we all benefit from a comparably free pharmaceutical market in the US, one that is less restrictive when it comes to drug pricing. When a drug is developed for the world market and the US is compared to Europe, a drug's NPV may be negative for Europe and positive for the US if development costs are allocated based on the number of diseased patients and cost containment in Europe is factored in. From an economic point of view, drugs are developed for the US (where it is profitable even if development costs are fully loaded to the US) and then sold worldwide.

Conjoint Analysis
Conjoint Analysis
Kerstin M. Bode-Greuel and Klaus J. Nickisch: Value-driven Project and Portfolio Management in the Pharmaceutical Industry: Drug discovery versus drug development: commonalities and differences in portfolio management practice, Journal of Commercial Biotechnology, in press.

A conjoint analysis is an advanced, computerised market research method that allows the analyst to compare a product's target profile against other drugs, thus enabling to optimise a drug's profile before launch or to identify a drug's optimum price.

In conclusion, further growth is possible if the rate of innovation for 'high impact' drugs increases. High impact drugs are compounds addressing significant unmet need in high prevalence markets, thus having considerable sales potential. Alternatively, low risk development strategies may be pursued, such as developing 'branded generics'. Advanced portfolio management systems and risk mitigation strategies may support biotech and pharmaceutical companies to generate maximum value with the resources available. Asian companies are well positioned to play a leading role here, and its increasingly skilled workforce will soon compete head-on with the most advanced Western pharmaceutical companies to develop innovative, high value drugs.

Author Bio

Joachim M Greuel

Joachim M Greuel is the founding and managing partner of Bioscience Valuation and of Bioscience Market Research based in USA. He holds a PhD in Physiology and an MBA with a finance focus from the Wharton School of the University of Pennsylvania, USA. Joachim supports pharmaceutical and biotech companies in project and portfolio valuation, the implementation of value-driven project and portfolio management spin-off and company management and in the evaluation of licensing opportunities.

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