Profit from biotechnology - the saviour of Big Pharma

Big Pharma has two big problems: finding new drugs and fighting off copycats. Biotechnology holds the answer to both, says James McKeigue. Here, he looks at the advantages of biotech, and picks three of the best ways to invest in the sector.

Big Pharma has two big problems: finding new drugs and fighting off copycats. Biotech holds the answer to both. James McKeigue reports.

For years the expensive complex of high-tech laboratories in Sandwich, on the Kent coast, represented the future of medicine. Hundreds of millions of pounds, sophisticated machinery and some of Europe's best minds churned out lucrative, life-saving drugs for Pfizer, the world's biggest drugs company. But now, with closure pencilled in for next year, the research centre is a symbol of the past.

The shutdown has caused anger and surprise and not just in Kent. How can a laboratory with the latest equipment and world-beating personnel become a relic? Yet despite some successes (Sandwich discovered impotence treatment Viagra, albeit by accident), the costly centre has failed to repay the massive investments made in it during recent years. Its fate shows how falling profits and share prices are forcing the pharmaceutical industry to make drastic changes.

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The challenges facing Big Pharma

Until fairly recently, Big Pharma (as the giants of the drug-making industry are collectively named) seemed to have a reliable money-making formula. During the post-war medical boom, pharmaceutical firms developed cures for common diseases, helping push up life expectancies across the world. These drugs made their makers billions of dollars, much of which was reinvested into research and development.

But in the last decade, the formula has come up against several challenges.The first was the growth of the generic industry. These upstarts copy the chemical formula of an established blockbuster drug and reproduce it for a fraction of the price. In the mid-1980s, a favourable legal ruling in America by far the world's most lucrative pharmaceutical market made it easier for generic producers to move in once a drug's patent had expired. That gave drug-makers 20 years to earn as much as they could from a drug before they were undercut by generic firms.

Twenty years might sound like a long time, but as many Big Pharma shareholders will testify, it's not always long enough. Moreover, several patents are set to expire soon. As GlaxoSmithKline chief executive, Andrew Witty, puts it, "an unprecedented number of branded medicines" are set to lose, or have already lost, patent protection, creating a "patent cliff', estimated to be worth a staggering $200bn over the period 2008-1012".

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However, the real problem for the drug-makers isn't that their best-selling blockbuster drugs are losing protection. It's that they haven't been able to replace them. This is partly because of tougher regulation. In recent years, US regulators have rejected more drugs on the basis that many new offerings made only slight improvements on their predecessors, rather than offering a fresh cure. The threat of lawsuits in an increasingly litigious society has also led regulators to impose stricter, and more costly, testing procedures. Winning regulatory approval for a drug now takes, on average, 15 years, while a global launch costs around $2bn, up from $150m 20 years ago.

Another reason for the dearth of new drugs may be although it's hard to get a definitive answer on this that most of the easy' discoveries have already been made. "That reflects the end of the mid-to-late 20th-century golden era for drug discovery, when first-generation medicines, such as antibiotics and beta-blockers to treat high blood pressure, transformed healthcare," says Andrew Jack in the Financial Times. Diseases and dangers that used to kill young people in their droves have been largely defeated, in the developed world, at least, leaving more complex diseases associated more readily with old age, such as cancer and heart problems.

Big Pharma has also made some mistakes, admits Witty. "The industry's misguided belief that it could industrialise' the research and development (R&D) process" resulted in declining productivity. Firms poured billions into advanced complexes like Sandwich, which then failed to give investors a decent return on their investment. That may explain why, across the board, Big Pharma has been shunned by investors for the past decade or more. In the last ten years Pfizer's share price is down by almost 50%, and Glaxo's by 30%.

Not everyone agrees that the R&D money has been entirely wasted. For Neil Woodford, the Invesco Perpetual star fund manager, who is heavily invested in pharmaceuticals, the sector is "being given away by the stockmarket" (see page 7 for more). Highlighting AstraZeneca, he notes: "Analysts are assuming [the company] will spend $50bn in ten years on the pipeline and get nothing back." This is a fair point. After all these years in the wilderness, Big Pharma looks cheap, regardless of its long-term woes. But large drugs companies are also right to be concerned about the state of their business models. And most see biotechnology as at least part of the answer.

The advantages of biotech

Conventional laboratories, like the one in Sandwich, use medicinal chemistry to form therapeutic molecules from chemical ingredients. But since the 1970s, biotechnology has offered another way. It uses living cells, rather than chemicals, to create potentially more effective remedies, which target the cause of the disease at the genetic level. Biotech drugs have many advantages over conventional remedies. Rather than having to design a treatment from scratch, or rely on good luck, scientists use genetic engineering and biological processes to manufacture appropriate and targeted treatments for example, antibodies that deliver drugs only to cancer cells, and not to healthy ones.

In the last 40 years biotech has grown from being an experimental science to become a large part of the commercial medicine market, says The Economist. "Although biotech-based drugs account for only a fifth or so of global drugs sales, they are projected to grow at double-digit rates as sales of many conventional drugs decline, especially with a large number of patent expiries coming. Add the fact that many biotech drugs produce enormous profits some treatments cost $100,000 or more per year and it is easy to see why the sector looks like a juicy target." Market research firm Evaluate Pharma reckons that genetically engineered drugs will account for 50% of the top 100 drugs in 2014, compared with 28% in 2008.

Of course, we've been here before. In the early 1990s, the success of early players, such as Genentech, attracted a flood of investors. Yet many got their fingers burned as it became apparent that making medicine by manipulating genes was a very complex process. "The biotech industry has great potential and has promised remarkable profits for more than two decades," notes David Fuller in Fullermoney. "However, much of what is promised remains in its infancy stage, and importantly the sector has so far failed ever again to attract the level of enthusiasm seen in the 1990s." But that may change. Biotech remains unloved, but "we are arguably approaching a time when some of the sector's potential will result in actual life-changing products and services being released onto the market".

Big Pharma's revenge on the copycats

More to the point, biotech drugs also offer Big Pharma a way to fight back against generic producers. Biotech drugs are more complex than conventional chemical compounds and are impossible to copy without having access to the original molecular clone, cell bank, or processes. That matters because the slightest differences in these drugs can have grave health consequences. As a result, the sale of generic biotech drugs or bio-similars is heavily regulated in Europe and until recently was largely banned in America.

However, a clause in Barack Obama's 2010 health reform has paved the way for bio-similars in the US. That means the worldwide market for copies of biotech medicines will grow to $3.7bn by 2015, from just $243m in 2010. Existing generic firms may struggle to get in on the act due to the complexity of developing and marketing bio-similars, but it's a huge opportunity for Big Pharma particularly as more than 30 branded biologics with sales of $51bn are set to lose patent exclusivity between 2011 and 2015.

As a result, the biotech sector has seen several acquisitions as Big Pharma has tried to buy its way out of trouble. These deals haven't always worked out well. AstraZeneca, Roche and Takeda have all found it hard to incorporate biotech firms, which "often have very differentcultures and business practices", says pharma blog In Vivo. Yet with current low levels of debt, acquisitions are likely to continue, says In Vivo. "It sure seems like Big Pharmas might be better off in the short term shelving R&D in preference for a more how shall we put it? transactionally driven approach."

The other, less glamorous part of Big Pharma's strategy is restructuring. Firms are cutting back on large research centres, such as Sandwich. "The last thing we need is a big pile of bricks with air conditioning," says Witty. They are now looking to outsource large chunks of their R&D to smaller firms, just as America's big three' car-makers split off parts of their manufacturing process in the 1960s and 1970s.

Heads of several Big Pharma groups have called for partnerships' with smaller firms. "Just as small, innovative drug companies benefit from turning to the marketing platforms of Big Pharma," says the Lex column in the Financial Times, Big Pharma is "realistic enough to admit it faces diseconomies of scale in R&D. It is better off milking expiring blockbusters and acting like a cash cow, while reserving the ability to cherry-pick promising late-stage drugs from smaller companies. It is also saving money on its remaining R&D through outsourcing."

Companies that undertake research or rent medical property and machines especially in the field of genetically engineered drugs should benefit. We look at some of the best ways to play the sector below.

The three best ways into the sector

Trying to back individual biotech winners is a risky business, especially if you are looking at small firms that are dependent on just one or two drugs. Last month, for example, shares in British biotech Renovo (Aim: RNVO) fell by 75% when its anti-scarring product, Juvista, performed poorly in clinical trials.

Obviously there is good money to be made from backing the right biotech, but with so much depending on results that even experts can't predict, investors should be keenly aware of the risks they are taking. One way to hedge those risks while still gaining exposure to the sector is by investing in a fund that holds several of them. Since my colleague, Right Side editor Bengt Saelensminde, tipped the Worldwide Healthcare Trust (LSE: WWH) investment trust in January, it has slipped back a fraction to 684p and looks good value. The firm is invested in a mix of big drug-makers and biotech firms. It currently trades on a discount to net asset value (NAV) of 9.6%. In other words, for every 90p you invest in the trust, you are getting around a pound worth of underlying assets, so now looks a good time to buy in.

One risky way to play Big Pharma's outsourcing drive is through BioMed Realty Trust (NYSE: BMR). The group owns and runs laboratories and office space in the US for pharmaceutical firms and biotechs. Its share price tumbled in 2008 as US property values fell. Yet it has more than doubled since then as investors have bought in to the outsourcing story. On a forward p/e of 70, it seems hugely expensive. But at $19.77 the share is well off its pre-crisis highs of around $30, and could still have further to go as it continues to recover. It's one for the brave.

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A less expensive play on the outsourcing trend is Icon (Nasdaq: ICLR). The firm uses a network of laboratories around the world to provide services to pharmaceutical and biotech firms. It helps companies to develop drugs and take them through clinical trials. The share price fell slightly recently on news that two of its research programmes are to be discontinued on safety grounds. Yet as JP Morgan analyst Tycho Peterson points out, the contracts were only worth $50m compared to quarterly sales of $233m and the market appears to have overreacted. On a forward p/e of 14, it's now trading at a discount to its peers. Icon is "currently undervalued given the high-quality franchise and what should be longer-term benefits from additional strategic deals, investments in Asia and cost control initiatives", says Peterson.

James McKeigue

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the Forbes.com London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.