Prized Bio Assets Come in Small Packages

By Josh Levine

Editor, Levine's Microcap Investor

Drug development is complex, but the math for the pharmaceutical industry's business model is very simple.

The typical drug takes eight years on average to go from lab to FDA approval. Since patent protection lasts only 17 years, a big pharma effectively gets nine years of exclusivity. Upon expiration, competitors (e.g. generic manufacturers) move in and the original patent holder's market share fall by 89% in the first six months.

From 2010 to 2013 pharmaceutical companies will lose a total of $137 billion(!) to patent expiration and generic competition, estimates researcher IMS Health. The result, according to the CEO of Medco Health Solutions, is that at least 90% of prescription pills and capsules will be generics within 10 years.

With patents on many of the world's best-selling drugs expiring, the industry is capturing less value in its traditional strongholds. Pharmas selling everything from cholesterol-lowering drugs to antidepressants, blood pressure medicines, allergy pills and stomach ulcer treatments are watching billions in sales fade away. “The mass market is really starting to disappear,” concedes Sanofi's CEO.

Innovation, which had always been the medicine that cures, is no longer the easy solution. Preliminary data indicates that R&D expenditures in the life sciences industry fell in 2011 for the third straight year, while big pharma is creating genuinely new drugs at a slower rate today compared to prior decades.

Pfizer, for example, announced plans to reduce its overall R&D budget to $8.4 billion in 2011 (down from $9.4 billion in 2010) and to $6.5 billion in 2012. This may be the strongest sign yet that the enormous R&D budgets of the pharmaceutical companies are coming to an end, according to Battelle’s 2012 Global R&D Funding Forecast.

Making matters worse, over the past ten years the average sales generated from each new drug have decreased. Rather than invest in pure research, big pharmas have channeled resources into development– finding new uses for existing drugs in an attempt to squeeze out better returns. The result is that R&D productivity has been in a long-term decline.

The opportunity for big pharma now resides in biotech and specialty drugs. Consequently, it's a good bet that acquisitions of biotech firms will increase substantially. We can also anticipate a sharp rise in licensing agreements

To fight stagnating sales, the pharmaceutical industry is focusing commercial efforts on oncology, multiple sclerosis and hepatitis C among other therapeutic areas. The narrower focus makes it easier to target only specialist doctors who deal directly with the patients. It usually means less competition for a given drug. Companies are often able to charge higher prices for more tailored treatments that are less vulnerable to pressure from governments and health insurers.

To reverse the trend in declining R&D productivity, big pharma is relying more heavily on game changers like the stem cell and DNA vaccine developers in MicroCap Investor’s portfolio.

The stakes get real interesting as small biotech firms move through Phase II clinical trials. This is most relevant to the companies recommended by MicroCap Investor. These small firms are developing drugs that could potentially be worth up to a billion dollars or more (in other words, “blockbusters”).

By the end of Phase II, biotech researchers have proven safety and demonstrated some efficacy in a limited number of patients. This is often enough to draw strong interest from industry giants, which are hungering for the next blockbuster therapeutic.

As the leading small biotechs advance through their various clinical trials and reach new milestones, the probabilities are greater that a large company will enter into a lucrative licensing agreement or some equally exciting deal.

The Burrill Report highlights the following points, which indicate small biotechs are reaping the benefits from the changes in the pharmaceuticals business:

Biotech companies with less than $50 million in revenue are reporting strong increases in sales, spurred by strategic partnerships with large pharmas and additional product and licensing revenue opportunities.

Although the industry is moving toward increased focus and careful management of cash as a strategic asset, smaller biotechs ultimately develop more products, leading to higher R&D spending on a per employee basis.

It’s clear the market trends for bio innovators are becoming increasingly favorable. Looking ahead, valuations for many of the small biotechs in the MicroCap Investor will surge, just as we've already witnessed for three of our portfolio mainstays– Antares Pharma (AIS), Curis (CRIS) and Spectrum Pharmaceuticals (SPPI).

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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