M&A: Panning for Gold

Pharma dealmaking is:

(a) going like a house afire

(b) grinding to a halt

(c) both of the above

There's a solid case to be made for choosing A. The market for deals has been robust through the first half of 2007. A Cowen research report counted 10 public deals done by July 2007, compared with 14 for all of 2006. Another data source, Irving Levin Associates, cites 455 public and private healthcare deals in the first six months of 2007, a 12 percent decrease from the same period last year—but an 18 percent rise in deal value.

On the other hand, if you chose C or even B, that's also hard to dispute. In August, as this issue went to press, the US subprime mortgage crisis was shaking confidence, torturing Wall Street, tightening credit, and sapping the steam for alliances and M&A. "On the train to New York in the morning, you can feel it," says Clarke Futch, managing director of Cowen Healthcare Royalty Partners. "It's palpable in the air."

Credit crunch or not, though, both small biotechs and big pharmas need the deal stream to keep on flowing. It's easier to imagine them developing new, creative ways to finance deals than to picture them turning away from a process that, on the one hand, gives biotechs and small pharmas the capital to innovate and, on the other hand, gives Big Pharma a way to replenish slow-moving pipelines and to fight back against the revenue losses it face because of patent expirations.

"The coming of generics, and the associated revenue losses, is a striking deal driver," says Walter Flamenbaum, MD, a partner for Paul Capital Healthcare. "Companies are making deals for both short-term revenue producers and long-term pipeline enhancers. If you look at AstraZeneca's two purchases of Cambridge Antibody Technology and MedImmune, you can get a sense of buying for long-term capabilities as well as hard revenues."

As for the credit kerfuffle, "my sense is that this will work out," says Jonathan Gertler, MD, managing director and head of biopharma investment banking at Leerink Swann. "The recent volatility will raise some of the valuations and quality bars, but there's no question the pipeline for deal flow is extraordinarily robust."

With that in mind, we asked a group of savvy investors, analysts, venture capitalists, and others to share their thoughts on the trends shaping the deal market today and to identify the companies they think are the ones to watch.

STUDY GUIDE FOR INVESTORS

First the trends:

Midsize is big Mega-mergers are the big moneymakers for top Wall Street bankers—but these days, consolidation is on hold while the industry cleans up its act.

"Everybody is trying to reengineer cost structures and prepare for the dip in the pipeline," says John Connaughton, Bain Capital's managing director. "But in a year or two from now, once that's cleared up, there should be more robust M&A activity."

Instead, the action right now is taking place among the midsize companies. The largest M&A event of 2007 (so far) is AstraZeneca's snagging MedImmune in a $15.6 billion deal. Consolidation of the generics industry continued when Mylan secured Merck KGaA's generics unit in a deal valued at $6.7 billion. More recently, Schering-Plough CEO Fred Hassan announced that the company will buy Akzo Nobel's Organon in a deal worth $14.4 billion, through which SP doubles its Phase III pipeline.

The hunted go hunting Midsize companies are hot M&A targets, but will also be the ones doing the acquiring in the future. Angela Larson, an analyst with Susquehanna Financial Group, says, "Forest has traditionally been a partner to companies, but in their last earnings call—and facing the 2012 expiry of Lexapro—they used the c-word. That is, they said they were looking to acquire companies, and they've always just acquired products." She also expects King, Sepracor, and Endo to be more active dealmakers in the coming year.

Why buy the cow? Strategic alliances between companies are the arrangement du jour, allowing pharma to practice some measure of risk control. Les Fundtleyder, an analyst with Miller Tabak, says, "There's a lot of personal career risk in acquiring a big public company—and most people don't want to take it," he says. "Instead, we'll probably see 10 to 20 times more strategic alignment of companies than M&A."

A classic example of today's new alignment strategies can be seen with Targacept, which recently inked a broad CNS deal with GlaxoSmithKline worth up to $1.5 billion to find drugs that help patients quit smoking and to treat pain, obesity, addiction, and Parkinson's disease. "GSK has a whole series of relationships with Targacept," says Steven Burrill, CEO of Burrill & Company. "Targacept is also a freestanding company that is doing very well and that has a relationship with AstraZeneca. Could GSK have bought Targacept? Theoretically, it could, although that would have been expensive. GSK is much better off letting Targacept remain independent and getting access to certain areas than acquiring the company."

Rent to own Says Leerink Swann's Gertler, "Licensing and acquisitions remain a continuum and are not separated in some quantum way." For example, anticipating the patent expiration of its cash cow Adderall, in 2005 Shire partnered with New River Pharmaceuticals, which was developing a next-generation, abuse-resistant ADHD drug called Vyvanse. The original deal terms called for Shire to pay hefty royalty payments to copromote the product. But in a deal that closed early this year, Shire decided to buy out New River for $2.6 billion, which gave it access to Vyvanse without the royalty payments.

In addition to a financial advantage, this deal step therapy also gives companies an information advantage. "You will truly know the quality of the management team, because you're working with it," says Larson. "You'll also know the platform and technology—and have the knowledge about what other opportunities there might be for that program beyond what the drug is being developed for."

Although most companies have developed sophisticated clauses in their deal terms to provide for the changing of hands of a company's ownership, extensive licensing does complicate things. It's important to understand how licensing can position a company, says Ben Bonifant, vice president of Campbell Alliance's business development practice. "None of the Big Pharma companies want to buy a small company's position in a bunch of outlicense deals," he says. "Once you've done that big license that covers many of your assets, you've identified who your potential partner is going to be."

The world of small drug-discovery-and-development companies is a complex and ever-growing maze. To give you a taste, we sample three distinct categories focusing on established, semi-established, and brand-new areas.

ONCOLOGY: STRONG SURVIVORS

Cancer drugs is one of the most competitive markets. At the American Society of Clinical Oncology (ASCO) this past June, Onyx unveiled the results of the Phase III data for Nexavar, an oral RAF kinase inhibitor that was the product of a 15-year-old drug-discovery deal with Bayer. The study found that Nexavar was so effective in treating liver cancer that the trial was terminated early so the placebo group could also receive the drug.

While Nexavar was the darling of the 2007 ASCO meeting, less discussed is the bubble in the pipeline of oral targeted treatments like Nexavar—and how they are set to change the face of cancer. "They give big companies an opportunity to extend their franchises by combining targeted therapies with some of the older and well-established injectible chemotherapy agents," says George Zavoico, an analyst with Cantor Fitzgerald. "You will see more of this type of combination therapy coming."

Bayer currently comarkets Nexavar for advanced kidney failure, but it is not saying if it will acquire Onyx on the promise of the pipeline indication. Perhaps it is waiting for further proof of its uses, especially since Onyx's whole R&D effort is focused on line extensions for the drug.

Several smaller companies have robust pipelines full of oral oncologics. Of those, Exelixis has 13 cancer compounds in development, the highest in the industry. The company is earning a reputation as an efficient drug developer and some analysts even refer to it as the "baby Genentech."

"If I had to pick a stock in my universe that had a chance of becoming the next big thing, I'd pick Exelixis, because it has so many shots on goal and in part because it is doing great science," says Eric Schmidt, a senior analyst for Cowen. "If the compounds work, it could be the next $10 to $20 billion biotech company." Exelixis has research alliances with many companies, but its most far-reaching deal is with GSK. The partnership includes 12 programs in clinical development, and GSK also retains exclusivity rights to 32 specified targets.

Eun Yang, a biotech analyst at Jeffries & Company, sees more opportunity for new alliances with Boulder, CO–based Array BioPharma. The company has several partnerships, and it is developing its lead Phase II oncology compound with AstraZeneca. According to the Motley Fool, Array plans to have 10 compounds in clinical-stage testing by the end of 2008. That will include ARRY-380, an oral breast cancer drug that targets ErbB-2, the same pathway targeted by Herceptin. Array is hoping that it will show improved efficacy and be more convenient for patients. According to published reports, Array plans to pick up one more partner by year's end.

Sunesis offers other promising oncologics. Its platform is based on "tethering"—a process whereby a target protein is engineered to facilitate the binding of small drug fragments, offering a new mechanism to tackle cancer. The company has deals with Johnson & Johnson, Biogen Idec, and Merck, but it is still seeking a partner for SNS-595, a novel drug in Phase II for small-cell lung and ovarian cancer. The drug is undergoing Phase I/II trials for leukemia, which results show reduces bone marrow blasts by more than 95 percent and even demonstrates complete remission of the disease.

Other investors are excited by the new pathways that cancer drugs in development are targeting. "It's not just picking products against the target, or improvement in products that have already been established," says Campbell Alliance's Ben Bonifant. "It's about figuring out which pathway and where in the pathway the real efficacy is going to be found."

Woburn, MA–based ArQule is setting its sights on the c-Met target with its compound ARQ-197. Some have speculated that this c-Met inhibitor can emerge as a best-in-class drug because of its superior safety and broad activity profile across several cancers, including colorectal cancer. "They presented the Phase I data at ASCO, and it was very exciting," says Cantor Fitzgerald'sZavoico. Although the company has partnered with Kyowa Hakko Kogyo, which will sell the product in Japan and Asia, it has retained the rights in North America and is currently searching for a partner.

DIAGNOSTICS: BEYOND BLOOD TESTS

Diagnostics—and, in particular, molecular diagnostics that analyze an individual's genotype—are seen as the key to unlocking the paradigm of personalized, and, one day, preventive, medicine.

Certainly, of the Big Pharmas, Roche has had the dominant foothold in the area. In 2007 alone, the company added Bioveris, 454 Life Sciences, and Nimblegen, which gives it new capabilities in molecular diagnostics, including the ability to quickly sequence individual genomes.

Novartis got into the game when it acquired Chiron in 2005 in a $5.4 billion deal. It has charged its diagnostics chief with developing molecular diagnostics—a business it plans to grow by at least 40 percent in head count in the coming year.

All diagnostics, however, are not created equal. The deal market is directed at companies with genomic screening capabilities. Just ask GE Healthcare, which made an $8 billion bid to acquire Abbott's diagnostic business without its molecular diagnostics division—only to back out, according to several sources, because there wasn't enough value in the deal.

Instead, acquisition targets are more likely to be the molecular diagnostics companies that have the tools to create personalized medicines. Ones to watch include Illumina, CardioDx, XdX, and Beckman Coulter. These companies specialize in determining variation in genetic sequences, finding which proteins are present in cells and how they interact, and helping to identify which patients will benefit most from a particular therapy.

Genomic Health is also a standout in the field, with their Oncotype DX test on the market to predict the probability of breast cancer recurrence and one in development to predict the possible resurgence of colon cancer. But unlike the rest of cash-hungry pharmas, the company is not interested in selling. "There is tremendous value in Oncotype DX in that it also predicts chemotherapy benefit, which its competitors do not," says Zavoico. "They've figured out a business plan that works, they're thinking outside of the box, and not licensing anything out. They want to proceed on their own."

Another big opportunity for companies comes from leveraging companion diagnostics through better partnerships. "The pharma industry spent the last 25 years trying to get rid of diagnostics and focus on therapeutic drug areas, and now it is reintegrating diagnostic areas," says Steven Burrill. "It is saying we are going to live in a world of 'theranostics' where the Dx is tied to the Rx to get a drug approved and into the market."

Theranostics are interesting because they provide marketing synergy. Physicians are more likely to give a rep time if he has novel assays to offer, and diagnostic tests can better prove the pharmacoeconomic value of a drug to payers.

Case in point is Maraviroc, a Pfizer drug, which received FDA approval to treat patients whose HIV virus enters cells using the CCR5 co-receptor. Patients can now take a test called Trofile from Mongram Bioscience, which lets them know if Mavarivoc would work for them.

The deal is interesting because it includes terms for Pfizer to sell the test outside of the United States and make the most of the relationship between it and Mavirivoc. Roche tried a somewhat similar partnership in June, when it attempted a $3 billion hostile takeover of Ventana Medical Systems to gain access to a test for the HER2/neu gene, which identifies appropriate candidates for Herceptin. At press time, Ventana's Board had rejected the deal. However, if Roche could gain control, it could market the test as a companion diagnostic to the drug itself.

RNAI: IS THERE LIFE AFTER SIRNA?

In late 2006, RNA interference (RNAi) came of age. It was then that the Nobel Prize was awarded to Andrew Fire and Craig Mello for their discovery of RNAi, or gene silencing by double-stranded RNA. The discovery enjoyed the fastest recognition by the Nobel Prize committee ever—the duo had published their research less than a decade before winning the coveted prize.

Now, there had been several RNAi partnerships before 2006. Merck, Novartis, Biogen Idec, and Medtronic all had deals with Alnylam, for example. But in some ways, the Nobel Prize was the tipping point: Just one month later, Merck made the bold move to acquire Sirna Therapeutics for a whopping $1.1 billion. More recently, Roche put a huge stake in RNAi in a $1 billion-plus deal with Alnylam, which allows it to license Alnylam's RNAi technology and also to buy Alnylam's research site in Germany, which will become Roche's Center of Excellence for RNAi.

"To help us get to the end game, we are partnering on a target-by-target basis with the pharmaceutical industry," says Alnylam's CEO John Maraganore. "Today, there are six RNAi therapeutics that are in clinical development. By the end of the year, there should be at least 10."

Sirna and Alnylam have built a powerhouses of partnerships, which help to validate their technology. But what analysts want to know, given the two companies' stronghold on RNAi: Is there life after Sirna and Alynylan?

"There's a big dropoff in terms of scale, scope, and quality," says Cowen's Eric Schmidt. "Our question is: Is RNAi in the first or the third inning? We're at least eight years away from getting anything commercially viable out of that platform. You have to be really patient there."

Philippe Chambon, managing director for New Leaf Venture Partners (which was an early and major investor in Sirna), has additional doubts about the companies cropping up in the space. "The intellectual property is consolidated in the hands of Alnylam and Sirna," he says. "Until companies come out with different IP, it is going to be limited."

Indeed, no other RNAi companies have the kind of name recognition or price tags as Sirna and Alnylam, but smaller deals are being made. In July, AstraZeneca moved forward on partnering with Silence Therapeutics for a three-year R&D deal focused on respiratory diseases, with payments of up to $400 million plus royalties on product sales. Silence has also sublicensed other technologies to Pfizer through its partner Quark Biotech, for the treatment of age-related macular degeneration and a number of other indications.

Despite the deals, no company has solved the delivery issue on how to get RNAi into the target cells, though there are a few promising and novel approaches.

Nucleonics, a biotech incorporated in 2001, is pioneering an approach based on "expressed, interfering RNA," or eiRNA, which it feels amplifies the RNAi mechanism. "There are probably another 10 or 20 companies in the space, of which we think Nucleonics is the best player," says Steven Burrill.

Kylin Therapeutics has also gained attention as an RNAi specialist. It has licensed from Purdue University packaging RNA, or pRNA, which is thought to overcome the delivery barrier and selectively deliver RNA-based therapeutics to diseased tissues. At press time, it still had no partner.

As growth potential in strategic alliances becomes a more viable option for Big Pharma, midsize players are finding that they, too, can have a piece of the pie. Traditionally, companies went public. But as the industry evolves into a more complex entity with new synergies and innovative technologies, many companies now see M&A as a viable alternative to IPO. The crunch on credit will affect the deal market. Look for companies to tap alternative financing streams to continue clinical development. Whatever the tactic, these new models allow companies to be more focused on developing products—and in the end, that's what makes a robust industry.