The Lone Biotech Bear?

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Judging from the atmosphere at last week’s JP Morgan Healthcare conference in San Francisco – which industry veteran and long-time participant Henri Termeer described as the “most optimistic” he had every experienced – the industry’s well-documented problems are clearly behind us. After a decade in the doldrums, the biotech market is on a bull run stretching back more than a year, and everyone, it seems, is brim full of confidence.

But its not that long ago (no more than ten short months) since the long term problems of the drugs industry played heavily on everyone’s mind. When Senator Waxman weighed into the Solvaldi™ pricing debate early last year, the bulls were clearly out to pasture.

So its worth examining the foundations of the current spate of unbridled optimism.

I can identify five major sources of positive sentiment, one of which has nothing to do with the state of pharmaceutical R&D, but four of which do:

Biotech stocks are delivering returns. If you make people money, they are likely to come back to the table for a second helping. And keep coming back as long as the returns are there.

This kind of success is self-re-enforcing: if returns are there, in a world where earning any return on capital is challenging, then demand for an asset class will grow. Growing demand drives up prices, delivering returns.

This is exactly what we have seen with the class of 2014 initial public offerings, which have (more often than not) delivered quick wins to their institutional backers, keeping the window wide open for the next cadre of hopefuls.

Returns driving demand driving returns, though, has an element of Ponzi scheme about it. Certainly, it does not necessarily reflect any positive change in the underlying fundamentals of the drug discovery and development industry. It is a classic “bubble.”

Rare disease strategy is paying off. The realization in the early part of this Century that ultra-high margin products in small markets could deliver as much (or more) profit than traditional blockbuster candidates has lead to a rich seam of billion-dollar plus drugs treating serious, but uncommon, diseases.

These rare diseases, more often than not, are well understood with a single genetic defect identified by classical genetics. As a result, targeting that mechanism can lead to profound patient benefits – in some cases resembling a cure.

For a number of years, it was straight-forward to justify high prices for such life-changing efficacy. Sufficiently few patients were involved that even at high prices these ‘rare miracles’ consumed a tiny fraction of the total drugs budget. But things are changing: while each individual rare disease is, tautologically, rare, when you consider all rare diseases together more than one in ten of the whole population has one. As approvals for rare disease treatments mount up, therefore, so does the impact on overall healthcare budgets.

This was brought to a climax in 2014 with the launch of Sovaldi™ from Gilead. Here was a drug that delivered rare disease-like levels of efficacy, commanded rare disease-like pricing, but treated a (relatively) common condition: hepatitis C infection.

If you see the glass half full, then the spectacular sales of Sovaldi™, so quickly after approval, represent a paradigm for “next generation” drug launches.

Immuno-oncology. After three decades of steady gains in cancer survival rates, recent trials of strategies that co-opt the anti-tumour capabilities of the immune system offers the prospect of a step change in outcomes. The first checkpoint inhibitors approved (Opdivo™ from BMS (NYSE:$BMY) and Keytruda™ from Merck (NYSE:$MRK)), which interfere with the mechanisms tumours use to suppress an immune response against them, are delivering something resembling a cure in at least a proportion of patients.

Recent results have expanded the initial promise in melanoma into other solid tumours, such as non-small cell lung carcinoma (NSCLC) demonstrating beyond doubt that the rich seam of winners is far from being exhausted.

On the back of the successes with checkpoint inhibitors has grown an industry of strategies that also exploit the immense potential of the immune system to overcome tumours. Leading this pack are the engineered T cell (CAR-T) companies, Juno (NASDAQ:$JUNO), Kite (NASDAQ:$KITE), Cellectis (Paris:$ALCLS) and others. These new entrants have raised vast sums of capital at eye-watering valuations to progress their products into the clinic, thanks to a feeding-frenzy among investors eyeing a piece of what is likely to be a vast new market.

Search-and-Develop has created insatiable demand for validated assets. Over the last five years we have seen most of the global pharma companies increase the proportion of their pipelines that they acquired from outside, as opposed to discovering in their internal R&D facilities. Although none of the top 20 have gone over completely to a “Search-and-Develop” strategy (Activis (NYSE:$ACT) and Valeant (NYSE:$VRX) are probably the nearest and largest to pure-play “Search-and-Develop” houses), this has created a huge increase in the demand for assets to acquire.

At the same time, those potential acquirers have settled on a similar definition of the degree of validation they need to see to be convinced to make an acquisition. And that level of evidence is appropriately high.

As a result, the supply of such validated assets in biotech has been largely “harvested”, and the trickle of new ones are selling for higher and higher prices. The emphasis on Search-and-Develop among the biggest players, therefore, drives up biotech valuations through the simple laws of supply and demand.

Platforms are about to deliver. After more than a decade of promise and potential, we are now seeing dramatic progress with “new modalities”. The first gene therapy product has been licensed, and a range of others are marching through the clinic with a new-found belief.

RNA-based products are also delivering wins in the clinic, with Isis (NASDAQ:$ISIS) and Alnylam in the vanguard for knock-down strategies and Moderna carpet-bombing the industry with collaborations on its mRNA programs. There are still limitations (the liver is still the only organ where nucleic acids can be reliably delivered), but after so long as the Cinderella technologies, investors are encouraged to see them arriving at the steps of the ballroom.

Stem cells are viewed by some as next in line to step on to the big stage, and their prospects are likely boosted by the spotlight on the immune-oncology cell-based products – which will solve some of the technical, logistical and regulatory hurdles that hamper deliver of cell-based products today.

Investors, looking for reasons to be optimistics, see the industry on the brink of a new era, ushered in by new delivery technologies much as monoclonal antibodies and other “biologic drugs” opened up a whole new dimension, packed with previously “undruggable” targets.

Superficially at least, the industry is in the epicenter of converging tailwinds: huge capital in-flows from generalist investors, driven by macroeconomic factors completely outside of the healthcare business arriving just as the industry crosses a rubicon, delivering step changes in efficacy in rare diseases and in cancer at a rate not seen since the 1980s.

Small wonder then we are seeing a sustained bull run not seen since the turn of the century.

But do these underlying factors really support such a rosy view?

There are two entirely different ways to make money as an investor. The traditional way is to identify structural changes in a market that will lead to growth prospects and provide the capital to finance that growth. But that takes a long time (even in conventional industries – all the more so in drug discovery and development). The modern trend therefore has been to make money by guessing what other people will do. In this way, by investing in asset before it becomes ‘hot’ you can turn a profit by selling later whether or not that asset eventually proves its worth.

Much of the froth, then, in the biotech market can be attributed to this second kind of investment. The majority of these investors will have sold long before the most of the assets they are currently invested in have proved their worth in front of the regulators let alone in the commercial marketplace.

Returns driving demand driving returns (more commonly known as a bubble) is not built on any intrinsic properties of the biotech industry in 2015.

The other four tailwinds, though, are ‘real’ enough. The question there, however, is whether they justify current valuations (and indeed more growth).

Lets start with the rare disease strategy. Like many strategies is works very well while it is the minority play, but new problems have arisen as it has become mainstream. Pressure from payers is halting price increases and seems likely to exert even greater downward pressure in the future. High price drugs have become a political issue, and its hard to believe that the total spend on drugs will increase dramatically from its current levels over the coming decade.

On the other side of the equation, the playing field is becoming crowded: take muscular dystrophy where half a dozen companies are going toe-to-toe. Who will win? Or will they divide the market between them, driving down prices much as the arrival of Viekira Pak™ from Abbvie (NYSE:$ABBV) has made the entire HCV market smaller by eroding the monopoly pricing of Sovaldi™ and its combos.

Arguably – thanks to this ever-increasing payer pressure – we are seeing peak returns to rare disease players in 2015, so hardly an unambiguous driver for future growth.

What about immune-oncology? The stars are better aligned there, surely? The current optimism for a step change in cancer outcomes does indeed seem justified. But just as success with the rare disease strategy spawned fast-followers – so too has immune-oncology (and even faster). The amount of activity in this space is truly staggering.

So much so that the inevitable competition has to be taken into account when valuing these assets. There are so many checkpoint inhibitors in development, with little yet obvious to differentiate between them, that while the eventual market will likely be huge, the share for each of the participants may be much more modest.

And with many broadly equivalent players, pricing competition will be high. So even if the clinical benefits are substantial the market size, once equilibrium is reached, may be squeezed.

The attraction of a drug like Soliris™, the anti-C5a antibody from Alexion (NASDAQ:$ALXN) used to treat the super-rare condition PNH, is that – with so few patients who are now so well treated – there is little incentive for anyone to develop a competing treatment (or even a biosimilar version of Soliris™). Such products look safe for a long run of high revenues.

But the vast market for immune-oncology products is a very different – both in scale and complexity, offering lots of encouragement to competitors. With dozens of competing products already in the clinic, many will fail altogether and even the successful ones will find themselves fighting for market share.

Again, it comes down to a macro-level argument: even if immune-oncology products revolutionize cancer care, will drug budgets be able to increase enough as a share of national economies to fund a major new market on top of existing sales? Probably not. Some growth, yes, but mostly at the cost of existing treatments.

Similarly, the New York Times today highlighted the “over-heated” market for companies in the CAR-T space, the next wave of immune-oncology products beyond checkpoint inhibitors. They rightly noted that these technologies are still at an early stage, and their potential is counter-balanced by the risk (not least because these powerful immune-boosters come with side-effects that can kill if not perfectly controlled).

Immuno-oncology, then, will deliver patient benefit and rewards for some of its backers. But its impact a growth-driver for the industry as a whole must be kept in context.

The growing importance of Search-and-Develop is boosting asset valuation among smaller biotech companies, queuing up to sell themselves or their assets to global pharma companies seeking to fill or expand their pipelines. But this, too, is more of a redistribution of returns than a source of fundamental growth in the sector.

Unless smaller biotechs are fundamentally more efficient at discovery and early-stage development than large pharma companies, a switch from R&D to S&D is essentially a zero-sum game. Higher asset valuations benefit investors in those doing the selling but represent a growing cost burden to investors in the acquisitive companies.

Prior to the latest boom, there was some sign of structural changes that promoted efficiency: a shift towards ‘asset-centric’ development that decoupled assets from the infrastructure necessary to develop them – a move that promised improved returns on innovation capital. But those gains are put at risk by the inflation of a biotech bubble. Ready availability of cheap capital risks promoting unhealthy behaviours – putting large chunks of capital behind early stage projects still loaded with risk.

Indeed, we are seeing the return of the “mega-round” financings that have been all but absent in the late 2000’s, with a rash of $30+ million dollar Series A rounds in companies with preclinical assets (and not just in immune-oncology). Securing returns on these large bets will be challenging, and likely lay the foundation for the next cycle of disappointment and despair once the days of free-and-easy capital are behind us.

And, of course, the platforms about to deliver argument is the perennial favorite of the bulls. This “next year is the year when…” sentiment is never very far away from the headlines.

History paints a rather different reality: broad new capabilities that deliver paradigm shifts do so more at the pace of moving tectonic plates than exploding fire-crackers. Many years, even decades, pass from the proving of a new technology to the delivery of material returns – and when those returns come, more often than not they do not accrue to the backers of the original breakthroughs. Content, and not platform capabilities, remains king – and the majority of spoils for gene therapy, RNA drugs and cell therapies are unlikely to accrue to any of today’s players in these spaces.

De-bunking – or, more accurately, putting into context – the sources of optimism that are driving the current bull run doesn’t make me a bear.

I believe that the current bubble – for that is what history will show this to be – will continue to inflate for as long as there is an excess of cheap capital looking for the promise of returns.

The concern is that industry as a whole believes the hype, and returns to the bad old ways. The mentality of “gold-rush economics”, where finding a winner at any price drives ever larger bets and lowers the stringency of decision making, will lay the foundations for the next biotech drought.

As Kevin Johnson, my partner at Index Ventures said, “There is no selectivity in abundance. With enough fertilizer, everything will grow – weeds and all.” When the wind changes, and oxygen of capital is once again rationed there is a very real risk that much of what today’s easy dollars have been spent on will turn out to be chunks of worthless rock in pretty wrapping paper. And the only winners will be the speculators harvesting unjustified returns all the way up to the top of the bubble.