Cash-equity equivalence for pharma.

Pfizer says they're looking for acquisitions around $4B. They've had a bit of success buying assets of that size, but that buyout space is becoming crowded - every big pharma would be happy to acquire meaningful but not humongous assets of that size to pave over their patent cliff.

But why is it that PFE or any other big pharma is willing to splash out billions for acquisitions when internal R&D budgets are under pressure? Here's why big pharmas have more incentive to buy innovation externally than fund it internally:

1. Risk/reward & timing: An investment in internal R&D might pay-off in ~5 years, whereas acquiring assets (particularly approved products) are a "sure thing." Until R&D becomes more predictable or higher reward, pharma will always be oriented to lower-risk, shorter term rewards.

2. Financial expectations: all big pharmas are sensitive to the almighty EPS (earnings per share.) An investment in internal R&D has a current cost to EPS and uncertain rewards, while an acquisition often has (understated) current costs and overstated future rewards. (Depending on synergy, more broad distribution, etc.)

3. Access to excellence: No offense to (internal) pharma researchers, but by buying assets, big pharma can buy from the top research efforts in the world. An acquisition likely has a tremendous concentration of focused expertise - be it in the target or disease of interest. Who knows more about diabetes, BMS, or Amylin, or who knows more about transgenic expression systems, Protalix or Pfizer? Internal R&D efforts can of course be high-quality, but most are very, very broad, and by definition somewhat dilute.

4. Internal inefficiencies. Pharmas have expensive structures and high legacy costs. Take another look at this chart from my February post "R&D Efficiency," indicating that pharma spends ~$5B in R&D per FDA approved drug.

In contrast, every biotech big or small is targeting a cost per drug approval in the hundred of millions, not billions, indicating their efficiency advantage. (As an example, Amylin - rumored as an acquisition target of BMS for ~$4B - probably spent between $500m and $750m in developing Bydureon, suggesting that they, if representative, are ~8X more efficient than BMS' historical internal efforts.


5. M&A accounting: this is the big one - our tax laws have a massive preference for equity-based M&A. Pfizer has ~$70B in cash on hand and generated an additional $20B in operating cash in 2011, while investing ~$10B in R&D (which includes cash payments to development partners, so this figure is not entirely internal R&D.) PFE has ~7.5B shares outstanding

Consider 2 scenarios for PFE:

-PFE increases cash R&D spending by $10B/year.

Financial result: EPS falls by about $1 per share.(-80%). (Assume $10B more in R&D is offset by $2.5B less (ballpark) in taxes.)

-PFE buys 2 companies (such as 2 x Amylin) for $5B in PFE stock. (Each.)

2 x Amylins would contribute ~$1.3B in new revenue (using 2011) figures, and while Amylin loses a small amount of money, Pfizer would likely assert that they would cut some overhead, and increase sales using PFE's sales force, eliminating the annual operating loss in the short term. Longer term, PFE grows sales (@ a profit margin in excess of 90%), and cuts Amylin overhead and R&D by $750M per year.

To fund the deal, PFE issues 442,000,000 new shares at current prices, or a roughly ~5% increase in shares outstanding, slightly diluting EPS in the near term. However, the acquired assets could  increase PFE's annual earnings by $1B roughly in the second year (assuming ~20% increase in revenues, with the costs detailed above, making the deal quickly accretive (=~12% EPS). Also: post-merger accounting may lead PFE to write-off half ($5B) of the M&A value as "goodwill." This is a hit to book (GAAP) earnings, but has, in effect, a cash benefit, as corporate taxes are reduced by the write-off of goodwill. End result: small near-term share dilution, medium term EPS increase due to the acquired assets and a lower tax bill, without spending much/any cash.

M&A is even more advantaged by the tax rules that reward share repurchases. If PFE repurchased $10B in stock (tax-free) instead of spending the same amount on R&D, EPS would be increased as the denominator shrinks.


My original goal was to calculate an equivalence between cash and equity ("$1 cash = $10 in equity spent in M&A," or something like that, but it seems that the ratio is more like $1 to infinity., advantage M&A.

With math like that, and the other advantages outlined above, it is almost surprising that Big Pharma does ANY internal R&D.

Carl Icahn: net positive or negative for the biotech industry?

I can't decide if Carl Icahn's activism in the biotech sector is a good thing or a bad thing. On one hand, his insight, activism, and capital drives stock appreciation in the biotech sector. (And even just his interest in the sector is a good thing.)

On the other hand, no one is more responsible for making mid-cap biotechs an endangered species.

I first looked at this five years ago on the Xcovery blog (Wanna scare a CEO? Just say these 7 words: "Mr. Icahn is holding on line 2.") At the time, Icahn was agitating for the sale of MedImmune, and had recently bagged ImClone. Since then, he's a had a big influence in the sale of Genzyme, and made runs at Biogen and Forest Labs. BIIB and FRX raids did not conclude with a company sale, but both companies had bumps in stock values due to Icahn, and a big profit for Icahn.

Now Carl Icahn is chasing Amylin.

On my old blog I listed 10 reasons why Icahn's interest may be a net positive, and they're worth another look:

1. Interest by corporate raiders validates the biotech industry as viable businesses, rather than a collection of high-risk experiments.

2. Raider interest will attract other sources (non-alternative investments) of capital sends the message that biotech may be volatile, but not necessarily risky. (As opposed to the current notion that biotech is risky, but not necessarily volatile.)

3. Corporate raiders will keep biotech more slim and agile versus big pharma. (Though I've heard rumblings that some hedge fund could take down a pharma one of these days, so maybe this edge won't hold for long.)

4. Raiders force target companies to focus on "what's next," rather than complacently focusing on the sales and marketing of existing products.

5. Raiding will bring about needed consolidation among mid-sized biotechs, as the raiders view the overhead for companies at this size as a bad investment.

6. Raiders will increase the amount of business discipline within the industry. (And likely instigate management turnover, which could also be management evolution.)

7. Raiders will increase attention on the biotech industry.

8. Biotech has (and probably will always be) a game of capital raising. Raiders will bring more capital to the biotech industry, though the capital will tend to be higher-velocity.

9. Attention to financial returns by biotechs will increase among industry folks, as raider interest is in part related to the very high margins earned by biotechs. The high margins decrease risk for raiders, and can generate large amounts of incremental cash to justify raider transactions, if the margins are believed to be improvable.

10. Raiders (and other private equity types) may innovate new vehicles to finance biotech. One of these 'innovations' is quite old, but new to the biotech industry: dividends. (Icahn, in particular, often presses target boards to increase their dividend to drive stock prices.)




In retrospect, I think the label "raider" is harsh and inaccurate - Icahn certainly has high short term expectations, but I think he's also well-intentioned, trying to find the best home for at-risk, underperforming assets. He's not squeezing companies to cut staff to take more cash out of a target, or leaving behind half-dead Zombie companies, but rather hastening the process of smaller company selling out to big.


However, as a result, there are less small-to-mid biotech's left, meaning there's a "lost generation" of companies that could aggressively or reasonably re-invest in early-stage biotech, thus having the knock-on effect of impeding early biotech. (Historically, mid-cap companies have been less risk-averse than big pharma when it comes to partnering with smallish/early biotech. Plus, focusing on fending off Icahn's advances takes attention and capital away from planting partnership "seeds," and may make a mid-cap less attractive to a potential partner.)


The counter-argument that Icahn might make is that capital gains from his activities generate more capital to be invested in the biopharma sector at all stages. I think, though, that the law of supply & demand trumps all: reducing the number of potential "buyers" of early stage tech (i.e. GENZ, IMCL, etc.) drives the prices down on such tech/leads.


There's one other way to look at this that is very much to Icahn's credit: economic impact. Since selling MEDI to AZN, MEDI's footprint in Maryland (MEDI's home) is much, much larger, as they've become AZN's biologics center of excellence (CoE), and it seems that GENZ is also likely to similarly expand in Boston as a CoE for Sanofi. If Icahn's activism provided purely return on capital (rather than labor or assets), you'd see talent and IP sucked up into the corporate parent, and a diminished physical presence as the acquirer cut costs. This was pretty much the case with IMCL, but that might be a factor of Lilly's management style, as much as anything else. (An entrepreneurial NYC company and a starchy midwest giant don't make for a great pairing.)


Ultimately, your opinion of Icahn's impact in the biotech world likely depends on who you are. If you're a shareholder at a target company, you like him a lot. If you're an executive at a target company, you definitely wish he'd go away.




Finally, while this post is centered on Carl Icahn, it is important to note who else has been a key player on Team Icahn, and now on his own: hedge fund manager Alex Denner, who is credited with generating $2B in profits (or is it value?) while chasing under-appreciated biotech stocks, mostly with Icahn.


related: Amylin (AMLN) management: BUSTED!

"The gravy days are over." (WSJ)

This just in: financing for biotech companies is scarce.

The WSJ article reporting this has in-depth analysis and loads of figures. Depending on your view, any and all of the following are responsible for a general decline in biotech financing:

-big pharma being more selective
-FDA intransigence
-trouble getting liquidity/the difficulty of IPOs. (Due to Sarbox.)
-better options for investors in other industries, especially the internet
-generics and the threat of biosimilars.
-economic difficulties (and US budget pressures) are increasing pressure on basic R&D budgets.

The truth is, with a few very rare exceptions (1999-2000), biotech financing has almost always been scarce, and to think otherwise, or plan otherwise is just plain stupid. There's a high technical barrier to entry for investors, long turnaround times for investments, and enormous technical risk with any drug development effort. Revenue-generating companies - which more investors understand, and therefore have an expanded pool of investment capital for them - take 7-10 years to build in this industry.

This is a sector that SHOULD have a high cost of capital, and probably an undersupply of capital.

But I'd say that this is just about the best time to have a great idea to develop, because:

• pharma's need for new products has never been higher, and the aging US & European populations are increasing demand for pharmaceuticals

• start-up and operating costs have been driven down by outsourcing & virtual operations.

• the abundance of specialized CROs & consultants lets smallish companies rapidly access expertise and capacity.

• with big pharma continually restructuring, there is an abundance of talent and facilities available.

• the current FDA & NIH administrations are trying to streamline the regulatory burden. Also: more regulatory paths are opening. I've heard of plans to gain approval first in China by some companies.

• increasing globalization makes it easier to collaborate. (Design a molecule in the UK, synthesize in the USA, screen in China, on a faster AND more efficient basis than if you had a fully integrated operation at one site.)

• increased genomic understanding and lower sequencing costs are enabling more effective R&D.

• China, China, China: increasing the supply of capital, talent, ideas, and lab assets. And not just in China: I've been told by US & EU academics that it has never been easier to find talented, financially-supported post-docs, from China for their American or EU labs.

• increased IP clarity with the America Invents act, and probably lower patent friction, given developments in gene patenting court cases.

• a growing generation of successful firms and alumni to incubate, mentor, and lead new ideas. (Guys like Patrick Soon Shiong (Abraxis founder, among other ventures) Henri Termeer (ex-Genzyme CEO), and RJ Kirk. (Not that this is exclusively a new development (think Alejandro Zaffaroni), but their numbers are growing. I can't wait to see what emerges from the Genentech alumni in years to come.)

If anything, biotech may suffer from an abundance of good - new drug targets, under-validated lead compounds, and interesting but not bulletproof diagnostic technologies are very easy to find these days. Just walk into any university's tech transfer office - they probably have some promising target IP just waiting for the right investor/believer.

The scarcity of investment capital is probably a good thing, culling the herd such that (on average) only the best ideas go forward.

This is all small consolation to the team at a small company struggling to raise their next round, but it definitely seems that better days are ahead, and it'll be a Molecular Future.

Very positive development for financing on the horizon…..

From A VC comes news that there's a bill in Congress to greatly loosen reporting and regulatory requirements for smallish and youngish publicly traded companies. Sort of a partial & temporary rollback of Sarbanes-Oxley for companies with <$1B in revenue.

I knew one publicly traded life science company with ~$200M in revenue who gauged their Sarbox compliance costs at $3M annually. Most of this money went to outside accountants and compliance experts who created more paperwork, but little extra comfort for shareholders. (And certainly less than for shareholders than if the $3M had instead been spent on R&D.)

The change under consideration would make IPOs more viable for virtually all private biotech companies (since no biotech company has ever busted $1B in revenue in their first 5 years public. Perhaps Intrexon could do it someday, if RJ Kirk decided to keep the company to himself long enough, but they'd be the exception, rather than the rule.) More financing viability = more liquidity for the life science sector. Also: more public issues = healthier financial markets.

In a perfect world we'd just rollback the entire Sarbanes-Oxley law - it doesn't solve any problems, but creates massive reporting and regulatory burdens for all public companies. It is widely acknowledged that Sarbox would not have stopped Enron or Worldcom from happening, and post-Sarbox, we've had Madoff and mortgage fraud, so I don't think it is any less risky for investors because of Sarbox.