Best of Times, Worst of Times

Looking back on 2003, biotech industry insiders and the analysts who cover them would agree that the opening line from Charles Dickens' A Tale of Two Cities aptly describes the current biotech market: "It was the best of times, it was the worst of times."

Institutional investors' and analysts' views of the market reflect their different investment styles and time horizons for holding individual portfolio positions. A hedge fund manager-for whom a week is long term-views the market differently than an investor looking for relative value within a sector or a peer group of companies whose investment time horizons are between two and five years. Those differences further exacerbate the volatility of the biotech market, in which some companies succeed and others fail for reasons that have little to do with quality research and development.

Based on the results of an informal survey of financial community representatives, this article highlights the key challenges and opportunities in biotech today. For some, the news is encouraging: the world of biotech investing has never been more exciting and positive. Survey respondents said:

• There are more attractive companies than ever-innovative, cash rich, and virtually unknown to most investors.

• Valuations are at their most reasonable in a long time.

• Pharmaceutical companies faced by pipelines problems have no choice but to search for biotech companies and products that complement their own efforts.

• Revolutionary technologies and products are on the verge of reaching the patients who need them.

• FDA finally has someone at the helm, indicating a new era for biotech companies and their products.

Yet, at the same time, biotech companies without a positive cash flow or products in Phase III have never faced such intense scrutiny by institutional investors:

• After 20 years, the investment community is savvier about biotech's clinical development process. As a result, companies must work harder for a piece of the funding pie.

• Many companies that skated through the 1990s with a compelling story are on thin ice as institutional investors, analysts, and FDA now demand high-quality product development packages and publication of peer-reviewed data for validation.

• The fundraising door is all but shut.

The Challenges

The survey's institutional investors reported the following issues as the most challenging to the industry right now:

Limited funding options. A glut of companies have depleted their IPO proceeds and still need to raise money before they can take their products through FDA approval. Many of those companies have not yet reached, and in some cases are not even close to beginning, their Phase III trials, decreasing the likelihood that they will be able to access additional funds in the current negative economic environment. At the same time, Big Pharma, which in the past provided biotech companies with an exit strategy and funds to fuel product development, is also under pressure to produce consistent earnings growth.

As a result, that group has grown more selective about taking stakes in companies in which the synergies are not obvious. Without those two traditional sources of funding, it seems likely that intra-biotech mergers and acquisitions will continue. Several institutional investors also mentioned that venture capital firms (VCs) are likely to take a few of the more stable biotech companies with limited cash private again.

Unforgiving climate. Most respondents felt that the current market dynamics made anything less than perfect performance and meeting every expectation unacceptable. Consequently, investors overreact to negative news and often ignore positive or expected news.

Economic cycle new to most CEOs. Many of the executives running biotech companies seeking to raise capital have never had to look for cash during a negative economic cycle. That inexperience is challenging when they must deal with sophisticated biotech investors who have experience in both bull and bear markets.

Zero tolerance for fuzzy communications. Against the backdrop of increased investor scrutiny and dwindling goodwill, companies must communicate their news clearly and accurately because the perception of any risk will send investors running to the exits. Although negative news will cause a sell-off, the decline will be exacerbated if the investment community perceives that management is glossing over or distorting the facts.

Phase III premium. Dedicated biotech investors increase their stakes and access to capital increases measurably when a company gets a product into Phase III. Moreover, the broad base of general healthcare funds open up to those companies as additional sources of funds and potential shareholders.

This trend is fueled by two factors: Until they cross the Phase III hurdle, biotech companies don't offer investors much trading liquidity. And compared to two years ago, later-stage companies are trading at much more attractive price/earnings ratios.

Macro economic environment. The build up to the war in Iraq and the war itself posed both economic and operational challenges as the market reacted to news in the Middle East. For biotech companies, the best way to navigate such macro-economic issues is to provide news about how their business remains on course.

The Opportunities

The current biotech market presents opportunities for both astute investors and nimble biotech companies. Respondents named the following trends as positive:

Undervalued equities with strong pipelines: The converse of the Phase III premium mentioned earlier is that investors see significant potential in undervalued companies with strong pipelines in growing therapeutic areas such as cardiovascular and oncology. Those companies will deliver value to shareholders based on their solid scientific foundation, respected management, and quality clinical plans. For investors with longer time horizons, the market has rarely been so attractive.

Significant discounts for biotech investors. Many of the big biotech companies (like Genentech and Amgen) are currently trading at a significant discount to their true market value. That poses high-reward investment opportunities for investors who are not dedicated to the biotech and healthcare sectors and are looking to get into a sector with upside potential.

New FDA leadership. With the new commissioner, biotech investors hope to see more decisive action in the form of approvals, streamlined procedures, and updated protocol parameters in promising areas such as oncology and biologics. Although most investors hope for a swifter approval process, they are realistic and respect FDA's authority and fiduciary duty to safeguard US citizens. In survey conversations, most investors were cautiously optimistic about the perceived positive changes taking place in the agency.

Consolidation and partnership deals. In recent months, the market has seen a spate of mergers and acquisitions mainly by pharma companies but also by intrepid biotech players. Survey respondents anticipate that, because of increased pressure on earnings, the deal-making bonanza will flourish, fueling pharma companies' ability to take strategic stakes in biotech firms rather than acquiring them outright. Also, to reduce the expense and time of raising capital, several biotech companies chose to merge this year. The pace of such deals is likely to accelerate, especially if the financing window remains jammed and companies need cash to move products through the pipeline.

The Winners

Overall, recent market action has led to a scenario in which the "dream factor" is no longer a component of biotech valuation models. The "story stocks" of the late 1990s and early 2000 have been cast aside in favor of companies with solid science, honest management, and transparent communication programs. For companies that fit that profile, this can be the best of times.