September 6, 2011
Identifying Compelling Investment Opportunities in the Biotechnology Sector
Healthcare is an important part of our national economy. According to the National Center for Health Statistics, which produces an annual report called Health USA, the annual economic activity related to healthcare represents approximately 16% of our Gross Domestic Product (or GDP). However, it’s widely recognized that the segment of the population over the age of 65, a group which typically uses significantly more in the way of healthcare resources, is rapidly expanding. According to the U.S. Census projections, between the years 2010 and 2030, there will be an ~80% increase in the number of individuals over the age of 65, as this segment of the population swells from 40 million, to more than 72 million people.
Data shows that as we age we require more in healthcare resources, because we are more susceptible to the impact of age-related diseases and conditions, such as heart disease, stroke, cancer, renal disease, chronic inflammatory conditions, and a range of others. Given the expected impact of aging related diseases and conditions, the overall level of healthcare related economic activity is expected to grow substantially in the coming years.
Some critics say that the Unites States already spends substantially more on healthcare than other developed nations, yet there is no meaningful difference in terms of life expectancy. However, such analysis ignores one very important element – the aggregate level of economic activity measured by the NCHS includes the substantial investment that the U.S. makes each year toward scientific research and development, which far exceeds the investment made by other countries. Ultimately, that investment has led to the development of new therapies, diagnostics, devices and other technologies that are used around the world.
But how does an investor measure the potential value of a new therapy or technology? From a financial perspective, the classical approach is to consider the following questions:
v How large is the potential market for a given product, in terms of number of potential patients, and potential dollar value?
v What is the current standard of care? Does current care adequately address the needs of the patient, or is there a substantial unmet medical need?
v Is the market expected to increase in size over time, or decrease? Realistically, how much of the market could be captured by a given product?
v What is the probability that a new therapy can be developed successfully?
v How long will it take to develop the product?
v How much will it cost to develop the product?
Once answers to these questions are obtained, then the investor can construct a financial model that calculates the risk adjusted Net Present Value (or NPV) of the opportunity, a standard financial analysis tool. If the NPV of the opportunity is positive and exceeds the value of the company’s stock, then it would suggest that the company is undervalued, and represents an attractive buying opportunity. For a company developing a portfolio of opportunities, each element of the portfolio should be evaluated similarly, to determine the overall value of the portfolio, and the company.
Using an Example – Valuing the Opportunity for a New Therapy to Treat Stroke
Let’s take a look at one example of how to value a hypothetical therapy to treat an area of significant unmet medical need – treating ischemic stroke. This example will illustrate the application of the techniques and approach described above to evaluate whether a particular opportunity is appropriately valued.
Stroke represents a leading cause of death and disability around the world. Globally, according to the World Health Organization (WHO), there are approximately 15 million people that suffer a stroke. While some stroke victims recover either partially or entirely, many individuals are left with substantial and permanent disability.
For valuation purposes, let’s examine the size of the opportunity in the core markets that most biopharmaceutical companies care about – the United States, Europe, and Japan. Within these markets combined, each year there are approximately 2 million individuals that suffer the effects of a stroke. Roughly 85 – 90% of these are ischemic strokes (caused by a clot or blockage that impedes blood flow to the brain), while the rest are hemorrhagic strokes (caused when a blood vessel bursts in the brain, due to an aneurism for example).
Unfortunately, for ischemic stroke victims, there is only one therapy that a physician can currently administer to help minimize the damage from the stroke – a clot dissolving drug developed by Genentech, called tPA. However, tPA must be given intravenously within several hours after the stroke has occurred. FDA guidelines specify that tPA should not be given to the patient after this window of time, because it can result in bleeding in the brain, which can cause significant additional damage or even death. As a result, only about 5% of ischemic stroke victims are prescribed tPA, because most simply don’t get to the hospital in time.
The vast majority of stroke patients receive what physicians call supportive or “palliative care”. While some patients may qualify to enter physical therapy and extended rehabilitation, many patients are left with substantial, and essentially permanent, disability. Some require extended hospitalization and/or permanent institutional care, and many others have to be cared for by family members. The economic impact of stroke care on the healthcare system has been estimated at approximately $73 billion per year, although this number does not reflect the impact on the quality of life of the patients, or their families.
So this begins to define the market opportunity: Roughly 2 million patients per year, and a rapidly expanding aging population that is expected to be increasingly at risk for stroke and other aging related conditions. It also defines the obvious limitations of the current standard of care: Roughly 95% of patients don’t receive the only available therapy, because they can’t get to the doctor in time. This would seem to provide an example of a significant unmet medical need, with a large and growing market opportunity.
If a new treatment were developed that could meaningfully improve clinical outcomes for stroke patients, it would probably be rapidly adopted by physicians and patients that care primarily about improving quality of life for the patient. However, in order to be rapidly adopted by Medicare, Medicaid and insurance companies (collectively referred to as “third party payers”), the treatment would also have to be reasonably cost effective. The costs of extended hospitalization, physical therapy and rehabilitation for stroke victims, can be substantial – over time these costs can be hundreds of thousands of dollars per patient. So in order to be cost effective, the new treatment would ideally have to reduce overall costs, while also improving outcomes and patient quality of life.
How do we incorporate this information to estimate value from a financial perspective? While traditional pharmaceuticals have failed to have a meaningful impact on stroke, many believe that emerging new biotechnology therapies can have a dramatic effect, and some have shown the potential to be administered in a time frame that is clinically reasonable – perhaps days or even several weeks after a stroke has occurred. One advantage of certain biologics therapies, such as stem cell therapy, is that they can provide multiple benefits in parallel, enhancing healing or tissue repair in ways that traditional pharmaceuticals or surgical intervention simply can’t achieve. However, biologics therapies also tend to be more expensive that traditional pharmaceuticals, and can frequently cost in the range of $30,000 per patient per year, or more.
For the sake of argument, let’s assume the cost of our new stroke therapy is half the cost of a typical biologic – approximately $15,000 per patient. If such a therapy had even a modest impact on reducing hospitalization, institutional care, physical therapy and rehabilitation costs, it would be viewed as cost effective by third party payers, and would likely be rapidly adopted.
So how large is a market opportunity is this? Well, if we conservatively calculate that only 50% of stroke patients would be eligible to receive this new therapy, and we only focus on the core markets of Europe, Japan, and the United States, this would suggest that the current market opportunity for such a treatment is approximately $15 billion per year. If we assume either a higher price point (e.g. because of greater reduction in downstream hospitalization and other costs), a larger percentage of patients that could be impacted, or a broader market opportunity (e.g. reaching into markets like Russia, China, Latin America, India or other areas of the world) then this number quickly escalates. If we combine the potential impact of just two of these factors, a higher price point (say $30,000 per patient) and greater market penetration (2 million patients per year), we see the market opportunity could be as much as $60 billion per year.
So how do we estimate potential value for a company developing a new therapy for treating stroke? The first question we have to ask is: What are the estimated odds of success for developing a new therapy?
Estimating the Probability of Success (or Failure) in Drug Development
Drug development is risky business. The vast majority of experimental therapies that enter clinical development ultimately don’t succeed. They may fail during clinical trials either because they aren’t demonstrated to be safe, or they don’t provide the desired therapeutic effect. In order to understand risk, and apply it to our valuation model, we first need to understand what the odds of failure or success are likely to be for an experimental therapy.
Fortunately, this is a question that has been studied extensively by groups like the non-profit Tufts Center for Drug Development and others. Earlier this year, the results from a comprehensive study (by BioMed Tracker) examined the overall probability of success or failure for 4,275 experimental therapies in clinical development in the United States during the period from October, 2003 to December 2010. The study concluded that on average, the overall probability of success (i.e. odds of achieving FDA approval for a therapy just entering clinical development) was approximately 9%. However, this risk assessment included drugs that were “repeat failures”, and therefore some that had a very low probability of success after the first (and in some cases several subsequent) failures.
A more refined analysis was conducted looking at the probability of success for a therapy for the first indication, (i.e. including the first failure, but not including the impact of the subsequent repeat failures). The numbers for these “lead indications” were better. The risk analysis also showed dramatic differences with respect to product type. While traditional pharmaceuticals had a success rate of approximately 14%, biologics had a much higher rate of success, of approximately 26%! This could be due to the fact that many biologics are actually substances that are based on natural factors found in the human body, and therefore tend to have fewer safety issues and are more likely to be therapeutically effective.
The study also examined where the failure typically occurs. The clinical development process is divided into multiple stages:
- Phase 1 testing (involving a relatively small number of patients, typically designed to primarily look at safety)
- Phase 2 testing (typically an intermediate number of patients, looking at both safety and effectiveness, or “efficacy”)
- Phase 3 testing (typically a larger number of patients, looking primarily at effectiveness, but also continuing to examine safety)
According to the study, the average failure rate for lead indication programs in Phase 1 was ~33%, while 59% of programs in Phase 2 failed to progress further, and 35% of programs in Phase 3 failed to subsequently advance to FDA filing. Furthermore, 17% of those programs that progressed to FDA filing were not approved (in other words, 83% of programs that made it through Phase 3 trials with applications submitted to the FDA for approval were successful). This yields an overall probability of success of approximately 14.8% (including both biologics and pharmaceuticals for lead indications).
So with this information, we can not only estimate the probability of success, but also estimate how the probability of success may change over time. A program that has already advanced to Phase 2 or Phase 3 testing is more likely to succeed than a program that is at the beginning of Phase 1 testing, and therefore will have a higher NPV.
Let’s use some conservative assumptions about risk, just to get a sense of the possibilities. If we assume an experimental stroke therapy that is at the beginning of the clinical development process, the estimated probability of success based on historical data is somewhere between 9% and 26% (depending on whether we want to include repeat failures, and whether the drug is a traditional pharmaceutical or a biologic). Let’s assume a Phase 1 program and an estimated probability of success of 9%. That would suggest that the risk adjusted value of the market opportunity is somewhere between $1.35 billion and $5.4 billion annually. If we assume a higher probability of success, for example because our experimental therapy is a biologic, it would suggest that the risk adjusted value of the market opportunity is somewhere between $3.9 billion and $15.6 billion annually.
Once approved, a typical biologic therapy could produce revenue and profits for an extended period of time (current law provides for 12 years of data exclusivity for biologics). This is viewed as appropriate because of the long development time for new medicines, significant risks involved, and the high cost of such development. Therefore, we can approximate what our stroke therapy might be worth over time once it has been approved. A crude approximation suggests that a decade’s worth of future revenue might be somewhere between $13.5 billion and $54 billion, if we are using the most conservative discount factor for risk, and between $39 billion and a whopping $156 billion if we use the historical discount factor for a biologic therapy.
Building the Financial Model
In order to build our model and develop a more precise sense of what the therapy might be worth, we also have to take into account how much the development process is likely to cost, and recognize that the future value of a given dollar amount must be discounted. Let’s focus on the latter point first.
One way to think about the financial discount factor is to consider what the value of an alternative investment might be. If we use a 10% annual financial discount factor (most people would take a 10% annual return on an average investment, particularly in the harsh investment environment over the past few years), and apply it over a typical clinical development timeline of 7 years, this results in a financial discount factor of approximately 48%. In other words, a payment received 7 years from now is roughly half as valuable as the same payment received today, if one assumes that payment could be invested over a 7 year time frame and earn a return of ~10% annually.
So we’re getting closer. But we still have to estimate and appropriately discount the future revenue stream, because some payments may be received very far into the future. Each future year of revenue will have to be discounted separately, since it’s a different period in time. So if a product were approved 7 years from now, and the net income in the first year is $500 million, it would be worth approximately half that amount, or $250 million today. Sales might increase in the second year, but we also have to discount by a bit more, since it’s further out in time. Without going through a detailed exercise here, we might estimate a sales trajectory for a stroke therapy that assumes modest penetration in the first year, that then grows over time to some maximum percentage of the patients that suffer a stroke each year.
The demand for a new treatment for stroke could be substantial, given the current lack of an effective therapy. For our model, let’s assume that 15% of stroke patients are treated in the first year, and that the number of patients treated each year grows each year until a maximum of 50% of stroke victims are being treated. Obviously, these assumptions could be made more or less aggressive. But if one considers the tremendous impact on quality of life, enormous costs of clinical care, long term institutional care, physical therapy and rehabilitation, these estimates feel appropriate for a safe and effective new therapy that can be administered to a stroke patient within a reasonable period of time (i.e. beyond a few hours).
If we model the future revenue stream in accordance with these assumptions, and apply the appropriate financial discount factors, we obtain something like the following:
|Year Post Approval||Projected Net Income||Compounded Discount Factor||Discounted Financial Value of Future Income Stream|
|1||$943 million1||0.90||$849 million|
|2||$1,214 million||0.81||$983 million|
|3||$1,564 million||0.73||$1,142 million|
|4||$2,013 million||0.66||$1,329 million|
|5||$2,592 million||0.59||$1,529 million|
|6||$3,337 million||0.53||$1,767 million|
|7||$4,228 million2||0.48||$2,029 million|
|8||$4,442 million||0.43||$1,910 million|
|9||$4,667 million||0.39||$1,820 million|
|10||$4,903 million||0.35||$1,716 million|
|11||$5,151 million||0.31||$1,597 million|
|12||$5,412 million||0.28||$1,515 million|
1Assumes 15% market penetration in the first year, with a 25% annual growth rate thereafter, and assumes a 20% net profit on sales.
2Assumes a maximum market penetration of 50% is achieved in year 7.
This results in a total discounted value of the projected future profit stream of $18,186 million. However, given that this profit stream would occur well into the future, we still have to discount for risk of development, projected cost of development, and time of development, as described above. When we apply the relevant discount factors for estimated probability of success (between 9% and 26%), and the financial discount for 7 years of development time (~52% financial discount, using a 10% annual financial discount rate), and subtract estimated clinical development costs for the project of $150 million, we can complete the analysis.
Using this approach we see that the estimated worth of the project is still a considerably high value of somewhere between $700 million and $2.27 billion – even after fully discounting for all costs, the “time value” of money, and development risk factors. If we assume an outstanding share count of 40 million shares for the company developing the therapy, we see that this should have a substantial impact on the price per share value. In fact, this project alone would yield a conservative value of approximately $17.50 to $56.75 per share. If we assume a higher price point, better profitability, faster or more significant market penetration, or lower discount rate, the value increases accordingly.
The financial analysis techniques described here may not be familiar to many investors, but they utilize standard valuation techniques to estimate value of a potential project, in this case, the potential value of a new therapy to treat stroke. These types of models can be constructed using Excel, or similar types of software, and the same techniques can be applied to estimate the potential value of new therapies to treat other significant unmet medical needs, like heart disease, other neurological conditions, inflammatory and immune diseases, as well as a range of others. When properly applied, these techniques should help investors make more informed decisions about the potential attractiveness of a given investment opportunity, and allow them to discount for the risk, time and cost of development. Applying these techniques carefully can help investors spot compelling investment opportunities.
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