Thursday, September 18, 2008

Hurricane Devastates Galveston; Heads for Biotech

At the end of this unprecedented week we are still too shell-shocked to have probed deeply into the implications of the Wall Street meltdown on our corner of the economy.

But we’ve done enough thinking to disagree with the majority of respondents to our IN VIVO Blog poll, 83% of whom think the effects on their companies will be merely mild to moderate. And disagree too with those still-in-denial private-equity investors our fellow blogger visits with here, who apparently think that our industry is a nice, safe place to put their money.

OK, that may be true for Big Pharma. After all, as in previous times of market turmoil, investors may vote Pharma because they see the companies as defensive plays, where demand for products is relatively independent of the economy. And indeed most drug firms have done, during this disastrous week, a bit better than the S&P 500 (though pretty much everyone is still down).

But Pharma looks a lot less defensive than it used to be. The generic cliff is way too steep and R&D way too unproductive. The traditional side-benefits of pharma investing, too, look kind of iffy. With cash flow likely to shrink, dividends are at risk – even more so the absurd stock repurchase programs into which, like some vast currency shredder, drug companies have continued to throw their money. And just a small issue: the dollar has been gaining value, and is likely to gain more. That means US companies won’t be able to simply rake in some incremental revenues. So maybe pharma is a better short-term bet than much of the S&P – but better ain’t great.

Far more worrisome, however, is biotech – which to some degree looks a lot like these incomprehensible derivatives. Like the buyers of subprime mortgage securities, buyers of biotech stocks have by and large invested on faith. Our bet is that few investors really understand the science they’re buying. Hell, we’ve met too many biotech CEOs who don’t understand their own science. How else, other than faith, do you explain why people continue to invest in an industry which over three decades has swallowed a lot more public money than it's returned?

And in a world in which investors will shun risk for a good long time, particularly risk they don’t understand, biotech is about as attractive as Galveston after Ike. Like other high-risk/high-return businesses, biotech attracts the extra cash investors have in their funds. And there’s going to be precious little excess cash for at least the next several months. And the fact that there are now three fewer banks to help biotechs with funding, stock coverage, and M&A advice isn’t particularly happy news, either. (Anybody want to bet how long Morgan Stanley is going to remain free-standing?) An IPO year which has started out as badly as any in recent memory – just two US biotechs managed to raise money, and paltry money at that -- will finish as the worst since the late 1980s.

Not that history is going to provide any answers, says Fred Frank, the vice-chairman of Lehman Brothers and soon to be a Barclay’s employee. This isn’t 1998 or 1988, he told us in a phone call today. “This is a whole new day for biotech. Don’t interpret by [historical] analogy; interpret with analysis.”

So here’s what we see. At the top end of the valuation pyramid, we’d bet PEs like Celgene’s – 51, at last viewing – are pretty vulnerable. Maybe those companies will recognize their currency is overvalued and will use it to buy some real cash-flow producing assets. (Not cash-starved early-stage biotechs, incidentally).

At the other end, what has been a relatively steady flow of start-up activity will slow to a trickle. Start-ups have been a tough investment argument in any event, given the dismal IPO market. But at least acquisitions have provided some fine returns over the last three years. The problem is that even before the Wall Street tornado hit, the M&A door had begun to close, (for our in-depth analysis of returns from acquisitions of private biotechs, see this Start-Up article). We suspect you’ll see health-care VC move towards devices and maybe services – avoiding new investments even into the kind of biologicals platforms Big Pharma has been snapping up over the last few years (for example, check out our write-up of the Bayer/Direvo deal here).

And in the middle: we have now come around to the notion that we’ll finally see a significant number of biotechs just close their doors. (Neose, for example, sold off its assets today.) Like everyone else, we’ve been amazed at the ability of many end-of-life biotechs manage to raise just a bit more money to keep the lights on and a program or two bubbling along. But we just don’t see that in the climate ahead. The investors won’t be there. Like the sensible Galvestonians, they’ve fled to higher ground.

Image from flickr user juliemwood used under a creative commons license.

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