During my last post I covered a majority of the information I wanted to cover on A.P. Pharma’s anti-emetic drug, APF-530. Now I would like to conclude my analysis and present my thesis for investing in APPA.

Here are the key reasons for investing in APPA:

1.) The active compound in APF-530 (granesitron) has a long, favorable safety and efficacy profile for treating CINV of more than 15 years.

2.) The market potential for APF-530 is relatively large (extremely large for a company the size of AP Pharma) and easy to calculate based on current sales of Aloxi and the total market potential of more than $1-1.5 billion for this class of drugs. If approved, APF-530 would be the only drug on the market for treating highly emetogenic patients in delayed onset CINV, therefore differentiating itself from Aloxi.

3.) A.P. Pharma has designed a simple phase-3 trial going head-to-head with the best-in-class market leader Aloxi. This helps to remove any doubt as to its superiority in treating delayed onset CINV in highly emetogenic patients. A trial design of any type other than this one would lower my confidence in a final FDA approval as well as the company’s ability to capture market share from Aloxi.

Investment conclusion:

I consider the risk-reward profile of investing in APPA  to be very favorable at its current valuation. The company’s market cap is a mere $45 million with enough cash on hand to complete their phase-3 trial and file an NDA with the FDA.  The company’s management does very little to market or to get the word out about their product. I understand that some investors are uncomfortable with the appearance of management’s lack of confidence in their product, but I’m of a different opinion. Having attended countless investor conferences, presentations, and personal meetings with management, I’ve concluded that the majority of managers are great at giving investors the positive ”spin” on their products’ market potential. I’m o.k. with a subdued approach that management takes with investors as long as the company is conducting a properly designed trial with meaningful and achievable end-points. I’ve personally spoken with both the CFO and the VP of R&D about various questions I had.

To give you an example of what kind of value we are looking at with A.P. Pharma’s anti-emetic product, we can use Aloxi as an example since MGI Pharma was sold to Japanese drug maker, Eisai, less than 10 months ago for $3.9 billion in cash.

Considering that MGI Pharma reported total sales of $343 million in 2006 and of this total, $270 million was derived from sales of Aloxi, we can roughly determine what Eisai thought Aloxi alone was worth. Conservatively speaking, Aloxi appears to have been worth about 75% of what Eisai paid for MGI Pharma. Without getting too far into growth rates or market potential of the individual products of MGI’s pipeline, we can estimate that of the $3.9 billion Eisai paid to acquire MGI Pharma, approximately $2.9 billion was attributed to revenue derived from Aloxi.

Once you break these figures down, you can begin to see that something doesn’t make much sense here in terms of AP Pharma’s current stock price. Assuming that APF-530 truly has the potential to capture a large portion of sales from Aloxi, we have a situation that seems to suggest several possibilities. Either Eisai paid a huge premium for Aloxi in their purchase of MGI Pharma or that AP Pharma is being completely overlooked by investors. Another possibility is that investors are aware of APF-530 but don’t have much faith in the ability of this drug to steal market share from Aloxi.

Once again, AP Pharma’s market cap is currently $45 million. Lets stay with conservative figures and discount almost $1 billion off our calculated figure of what Eisai paid for Aloxi. Now we’re somewhere in the $2 billion range. Lets also assume that APF-530 only captures 50% of market share as only oncologists administering aggressive, highly emetogenic regimens would prescribe this drug for their patients. Now we’re somewhere in the $1billion range as a valuation for APF-530. In light of these assumptions, AP Pharma’s stock could be worth more than a factor of 20 today. Seems ridiculous, I know, but it wouldn’t be the first time I’ve seen a price anomaly like this.

Of course time will tell how this plays out. I like the odds of betting on this product and willing to risk a specific amount of my capital for the probability to win big. The magnitude of the return on this investment is what I’m most interested in. There’s also a high probability that AP Pharma would be an immediate take over candidate upon FDA approval. Who knows, maybe Eisai would be interested in APF-530 in order to dominate the entire anti-emetic market or to hedge any potential loss of revenue on Aloxi.

The presentation was a no-nonsense review of the company’s pipeline along with an overview of their management team which often gets a bad rap by shareholders. This is often the case when a company’s stock is in the gutter, but if things turn around, management is then viewed as competent, visionary, or whatever other positive adjectives you want to label management.

A couple points to mention about today’s conference was that management reaffirmed the filing timeline for their Fusilev sNDA in CRC by October of this year. Also mentioned was that Fusilev represents a market potential of approximately $100 million if they are granted FDA approval for the CRC indication. If the company achieves sales even close to this range, they will be wildly successful as revenue will go straight to their bottom line. They haven’t mentioned any plans on co-marketing this drug so I have to assume that all revenue stays in their pocket.

The other bit of information worth mentioning was related to EOquin, the company’s other late-stage drug for treating bladder cancer. Management stated that there were more than 250,000 TUR surgical procedures performed each year. Some of these are attributed to newly diagnosed cases of SBC and others due to the high relapse incidence with SBC patients. This type of bladder cancer is considered very expense to treat because it so frequently relapses and to date there haven’t been any newly approved therapies for 30 years.

The primary end-point of the two trials Spectrum is conducting is the rate of tumor recurrence by year two, so it will be some time yet until we see important data. What I like about the trials they are conducting is that they have a well-defined registrational path meaning they’ve received what’s called a “Special Protocol Assessment” or SPA from the FDA. Reaching an agreement with the FDA on an SPA basically provides that, upon request, the FDA will evaluate within 45 days certain protocols and issues relating to the protocols to assess whether they are adequate to meet scientific and regulatory requirements identified by the sponsor. This by no means assures final FDA approval of a drug, but it does provide for what could be considered a strictly adhered to clinical trial protocol which may result in fewer mistakes along the way.

In the meantime we will await news on what kind of partnering deal Spectrum negotiates with another pharma company. Hopefully, as management has stated, we will hear something by year end. I will continue to update readers as new events unfold.

Disclosure:

I hold shares of Spectrum Pharmaceuticals.

A small cap biotech company that I’ve had an interest in for the past 18 months (yes, this means I’m a stockholder) is A.P. Pharma, stock symbol, APPA, from Redwood City, California. The company is currently conducting a phase-3 double-blinded trial of their product APF-530 (granisetron) for the prevention of acute and delayed chemotherapy-induced nausea and vomiting (CINV). This product belongs to a class of drugs called anti-emetics, specifically involving a class of receptors located in the CNS called 5-HT3 inhibitors.

Let’s take a look at some key statistics of APPA:

The company’s patient enrollment in their phase-3 trial for APF-530 is now fully enrolled (1400 patients) and trial data should be available by Q4 2008. Although management states that an NDA could be filed by the end of this year, I wouldn’t expect filing until Q1 2009 at the earliest.

Classification of CINV:

CINV as previously stated remains one of the most debilitating side-effects of chemotherapy and is classified into two separate phases: acute and delayed. An estimated 70%-80% of patients receiving chemotherapy experience CINV and of these patients, 80% are classified as delayed. Acute CINV is defined as nausea and vomiting that occurs within the first 24 hours after receiving chemotherapy, whereas delayed is defined as nausea and vomiting that occurs after 2-5 days of receiving chemotherapy. In addition to the classification of acute vs delayed CINV there is also the issue of classification of strength or degree to which the chemotherapy causes emesis. Therefore, the terms given to chemotherapy agents are said to be either moderately emetogenic or highly emetogenic.

Competitive profile:

The biggest breakthrough in treating CINV was the development of 5-HT3 inhibitors in the 1990’s. The current market leader is MGI Pharma’s Aloxi which was the first approved drug in 2003 in its class for the prevention of delayed CINV. Sales of Aloxi in 2006 were somewhere in the range of $270 million and the market for anti-emetics is estimated at $1-$1.5 billion. The success of Aloxi is due to the fact that it’s the only drug approved for delayed CINV which makes up the majority of all CINV cases.

The key point to make here is that Aloxi is only approved for patients that are classified as moderately emetogenic and not for patients that are highly emetogenic. There is currently no approved drug on the market to treat CINV in patients following highly emetogenic chemotherapy. Since the emetogenic potential of various chemotherapies increases with combination therapies, there is a clear need for a drug that can treat patients receiving highly emetogenic chemotherapy. Oncologists are able to pursue more aggressive cancer treatments without worrying about an increase in adverse side-effects experienced by their patients. A.P. Pharma’s product appears to have a competitive advantage over the current market leader because of this feature and should be able to capture market share from Aloxi if approved.

I know some readers may ask why I haven’t mentioned another competitor’s product, namely ProStrakan’s granisetron transdermal patch. The name of the product is Sancuso and the company submitted an NDA for this patch in June, 2007. ProStrakan is a public company that trades on the London Stock Exchange so there is little known about the company. For that matter, AP Pharma is hardly known so that’s no excuse for ignoring a potential competitor. There are other reasons why I’m ignoring ProStrakan’s patch as a competitive threat to APF-530. First, and most important is the fact that their patch is only indicated for acute CINV and not for delayed onset in CINV. I’m not interested in investing in new therapies for acute CINV as there are several other existing drugs that I won’t bother mentioning that work fine. Secondly, the concept of transdermal patch utilization as a mode of delivery appears attractive but has a couple important issues that complicate its use. The most important issue is that of variability in dosing. The research that I’ve conducted suggests that bioavailability is not constant and that a three-day ascending pattern is observed. It would be terrible for a patient to not have continuous protection from CINV because inadequate levels of the drug were absorbed. The patch is supposed to be applied to the patient 24 hours before administering chemotherapy. This can also be a problem as many patients decide to change their starting date of chemotherapy to another day. The patch also has problems with how likely it is to stay properly positioned on the patient, which is something a patient shouldn’t have to be concerned with.

There’s another issue worth mentioning related to competitive threats by transdermal patch proponents. The most significant benefit with the more recent 5-HT3 inhibitors in preventing delayed CINV is primarily is due to their longer half-life and high receptor binding for the 5-HT3 receptor. Other drugs for the treatment of CINV typically have half-lives in the range of 10 hours whereas Aloxi and APF-530 maintain therapeutic blood levels for four to five days. Patch proponents therefore argue that if it’s all about half-live, then transdermal patches can provide the same benefit as APF-530. But as I discussed in the previous paragraph, the argument against the patch isn’t about half-life but variability in dosing and inconvenience of its application.

AP Pharma’s other product:

AP Pharma also has one other product worth mentioning, APF-112 for extended post-surgical pain relief. The company expects to initiate a phase-2b trial in Q4 2008. Since the results released in 2004 were difficult to interpret whether there was a differentiating therapeutic effect, the company has designed an improved clinical protocol. Although this product could offer advantages to existing analgesics for post-surgical pain relief, I don’t feel comfortable factoring this product into the company’s current valuation at this time. Therefore, we can only measure the risk-reward ratio based on investing in APF-530.

Closing comments:

I will have to complete my discussion and give you my final thoughts of AP Pharma in my next post as this is becoming too lengthy.

Disclosure:

I hold a position in A.P. Pharma.

Levoleucovorin (Fusilev):

Fusilev was approved in March 2008 as rescue therapy for osteosarcoma patients after receiving high-dose methotrexate (chemotherapy). Osteosarcoma is a malignant bone cancer afflicting individuals under the age of 30. High-dose methotrexate is the most commonly used regimen in treating osteosarcoma. Fusilev neutralizes the toxic effects from methotrexate therapy in order to prevent serious side effects. Although the osteosarcoma market is small at 900 new cases a year, approximately 1/3 of these patients die each year.

Spectrum plans to file a supplemental New Drug Application (sNDA) with the FDA for treating colorectal cancer (CRC) with patients receiving 5-fluorouracil (5-FU) regimens (another chemotherapeutic agent) by October of this year.

Unlike Fusilev’s indication for osteosarcoma patients, in CRC patients Fusilev enhances the effectiveness and binding of 5-FU to an enzyme inside cancer cells called Thymidilate Synthetase, thereby prolonging the life span of 5-FU within cancer cells. Note that the life span of 5-FU in tissue cells is normally very short therefore limiting it’s anti cancer effects.

The company does not anticipate conducting additional clinical trials for the indication in CRC. Approval timeline for this indication would be about a year which would be October 2009. Approximately 150,000 patients are diagnosed each year with CRC and the estimated market for Fusilev is in the range of $100 million.

Management is hesitant in responding to any questions pertaining to revenue projections from sales of Fusilev until the FDA responds to their sNDA filing for CRC. I suspect this is because any sales generated from the osteosarcoma market would be miniscule, at most helping to reduce the company’s burn rate and preserving their cash position.

EOquin:

EOquin is a novel chemotherapy drug that represents a therapeutic advancement in treating superficial bladder cancer (SBC) in an important area in which there’s an unmet medical need. EOquin is currently being tested in two phase-3 double-blinded, placebo controlled, randomized trials. The majority of all bladder cancers are of the SBC type, or tumors which have not yet invaded the mucous membrane of the muscle tissue of the bladder. The recurrence rate in SBC is high resulting in the need for additional surgeries for patients.

EOquin is considered a more selective or targeted treatment approach because it’s a prodrug that is not activated until a certain enzyme found within bladder cancer cells activates EOquin. Since EOquin is a large molecule, it cannot pass through the bladder lining, therefore no detectable levels are found in systemic circulation. Because this is a targeted therapy, the side effect profile is much more favorable relative to other chemotherapeutic agents. EOquin is administered immediately following a surgical procedure called “transurethral resection” or TUR in which the tumor is first removed.

Current treatment for SBC consists of surgical removal of the tumor followed by the administration of mitomycin C or bacillus Calmette-Guerin, an immunotherapeutic vaccine. Recurrence rates are expected in 50%-70% of cases in which tumors flare up again after a short period of time so this is considered nothing more than a maintenance therapy to delay the next recurrence. So, there is a great need for new therapies that prolong the recurrence of tumors.

The prevalence of bladder cancer in the U.S. is 50,000-60,000new cases per year in which 70-80% are non-invasive or of the type superficial tumors. Internationally, the incidence varies substantially with the highest rates in Europe and North America. Smoking is the strongest risk factor associated with the development of bladder cancer.

EOquin trials should be fully enrolled by the end of 2009 and Spectrum should be announcing some form of partnership for by the end of this year. According to management, there are several potential partners interested in this drug.

Ozarelix:

Ozarelix is being developed for the treatment of benign prostatic hypertrophy (BPH) or enlarged prostate. As mentioned earlier, their phase-2 clinical trial released disappointing data from their U.S. trial. The previous Eastern Europe trial results were more favorable as the data point called IPSS (measures strength and frequency of urination) produced a score of 8. Spectrum states that some irregularities in the conduct of the trial resulted in removing various clinical trial sites therefore leaving the number of patients in the protocol group at a total of 44, which is a number totally meaningless as it’s too small of a number to draw any conclusions from. Spectrum will now have to conduct another phase-2 trial and is currently writing a new protocol before starting which is expected to commence again before the end of this year.

The market for BPH is huge at approximately $4 billion per year. Current treatments are once-a-day pills such as Flomax or Avodart. Ozarelix is an injection that is administered twice a year which offers freedom from having to take a daily oral medication. Although the time-lines on this program have been delayed, the potential is still there.

Stock catalysts over the next 12 months:

• FDA review of Spectrum’s sNDA for Fusilev in treatment of CRC
• Any meaningful revenue from sales of Fusilev in osteosarcoma market
• Signing of partnership for EOquin
• No need for raising capital in the near future

There are additional early stage programs that Spectrum is developing as well, but the ones I’ve mentioned are the ones that will impact the company’s valuation over the next couple of years. For investors that aren’t patient enough to allow the company to move forward and develop their programs, you may want to move on to another company.

My thesis for investing in Spectrum is twofold. First being that the company has several mid to late stage programs in development in significantly unmet markets, and secondly because the technology value of the company has zero value assigned to it by investors. I like the fact that no expectations are priced into the stock. This provides a relatively low risk profile for investors while providing significant upside potential on any positive news for any of the company’s various drug programs. Any revenue generated from Fusilev will significantly impact the company’s valuation as the current market cap of the company is only $53 million (the stock has increased over 20% since the first post). A partnership announcement for EOquin in SBC would probably amount to more than the entire value of the company today.

Closing comments:
Valuations such as this are not commonly found even with small cap biotechs that burn millions of dollars per year. Future companies I write about will doubtfully have a profile like Spectrum. I will continue to update and give you my thoughts on Spectrum as developments unfold.

Disclosure:

I hold shares of Spectrum Pharmaceuticals.

Spectrum has encountered some recently tough times as the company’s valuation indicates. Their phase-3 trial with Satraplatin for the treatment of hormone refractory prostate cancer (HRPC) failed to show an overall survival advantage last October. Then in April of this year, their phase-2 product Ozarelix for benign prostatic hyperplasia (BPH) or enlarged prostate, produced disappointing clinical data. Although Ozarelix is by no means a dead drug, the company will have to conduct another phase-2 before moving forward. On the brighter side, Spectrum was able to gain approval in March of this year for Levoleucovorin (Fusilev) as a therapy for osteosarcoma and expects sales to begin sometime this month. Additionally, Spectrum collected $20 million in cash from Par Pharmaceutical by selling their royalty stream on Sumatriptan, an injectable generic migraine drug.

Despite the negative events the company has encountered, Spectrum still has a pipeline of other products in development worth considering. The company will also start booking revenue on sales of Fusilev, albeit small. Although the osteosarcoma market is small, the company plans on filing a supplemental New Drug Application (sNDA) this year for treating colorectal cancer (CRC) which would give the company a significant boost in Fusilev sales if approved for this indication.

To get a better grasp on Spectrum’s valuation in order to determine the risk-reward profile for investing, we need to conduct additional research on the company’s individual programs and the markets they are serving. Having said that, I think it’s best to review only their most significant programs as these are the ones that will matter to the company’s valuation, at least over the next couple of years.

In my next post, I will review Spectrum’s drug programs individually and then provide a commentary to sum up my thoughts on the company’s valuation.

Disclosure:

I own shares of Spectrum Pharmaceuticals.

The offer was a 30 percent premium over Wednesday’s closing price of $46.44 per share. Shares of Imclone closed at $63.93, up 38 percent and almost $4 higher than Bristol’s offering price, reflecting investor expectations that Bristol would ante up more for the company. Shares of Bristol closed down about 2 percent on the news.

Although I stated in a previous post that I would not bother writing the same information that readers could get from press articles, today’s announcement is relevant to my overall thesis on biotech and big pharma and therefore worth discussing. Bristol’s acquisition announcement is the second occurrence over the past two weeks in which big pharma has demonstrated their appetite for biotech products, Roche’s offer for Genentech being the first (see previous post on this). More importantly though, is what I stated about which side investors might consider placing their bets in order to capitalize on these events.

Today’s event further demonstrates which side has the leverage in terms of negotiating. Bristol’s stock price closed down 2 percent, while Imclone stock closed up 38 percent. It seems quit obvious as to which side gets the better end of the deal.

Here are few statements made by Bristol-Meyer’s CEO, James Cornelius that are worth noting:

• The acquisition should boost Bristol’s financial performance by around 2012-2013, when the company expects big decreases in sales of its blockbuster Plavix.
• The acquisition is meant to build value for shareholders by getting approvals to sell Erbitux (Imclone’s main product) for other types of cancer.
• “Should we not be successful on this one, we will move on to the next one (acquisition target) on the list”, noting that Bristol remains committed to acquiring more biotech companies.

These statements are nothing more than your classical CEO responses to shareholders upon acquisition announcements. Talking about additional approvals in the future for Erbitux, and improving financial performance by 2012-2013 somehow doesn’t come across as a very good argument for staying invested in Bristol. Essentially, Bristol purchased one drug as the remainder of Imclone’s pipeline is either in early or mid-stage of development.

What else would you expect a CEO to tell it’s shareholders other than the acquisition was meant to create value? This is exactly the predicament that big pharma is currently in. Biotech acquisitions are mandatory in order for big pharma to stay afloat. Forget about internal/organic growth strategies at this point of the game. Their are no blockbuster drugs coming out of the pipeline coming to market anytime soon. Besides, the “one drug fits all” mentality is history. The future is about smaller niche markets, targeted therapies and the development of personalized medicine through molecular-based drugs designed for specific genetic profiles. This technology and existing drugs in the pipeline are being developed by the biotech industry.

So if you are thinking that big pharma is a value play because the majority of companies are trading near their five-year lows, you might want to think again. Not a day goes by that I don’t listen to some large fund manager giving his two cents worth about how cheap big pharm is. In my opinion (my two cents worth) the industry is going through a transition period that will take years to resolve. Considering the pace at which drug development takes place, I’m thinking another decade.

If you’re happy with a 5 percent dividend payout by some of the big pharma companies, then you can ignore much of what I’ve discussed here. In defense of big pharma valuations, the negative events that the industry is facing appear to have already been priced into the stocks. Any downside on holding equity positions seems to be limited at this point, as much of the damage has already occurred.

Disclosure:

I am not invested or hold any positions in either BMY or IMCL

To reiterate, there were two important pieces of information that I found useful after completing my study. First, the loss in market cap amongst the small cap companies comprising the NBI and second, the large loss in market cap sustained by the pharmaceutical companies in the DRG.

The loss of market cap in the pharmaceutical industry over the past couple years underscores the need and pressure these companies are under to fill their pipelines. There will continue to be expiring patents on blockbuster drugs over the next few years and if my memory serves me well, the total revenue lost due to patent expiries, will reach approximately $90 billion. This is a significant sum of money, even to big pharma. Scientific research and drug development are lengthy processes so I don’t think their revenue streams will be replaced anytime soon.

Although big pharma companies are touted by some analysts as being “dirt cheap” at the moment, I personally remain uninterested as an investor. I prefer to remain on the side of being “courted”. What do I mean by this? That the fruits of your investment strategy would be much better served by investing in potential companies in which big pharma has an interest in acquiring. I would go so far as to say that in the majority of companies engaging in merger and acquisition (M&A) activity, only one winner emerges… the company being acquired. It’s also typical to see large premiums paid by the acquiring company to small cap biotechs, or to any size biotech for that matter.

Growth via acquisition rarely creates shareholder value, so this is the main reason I prefer not to invest in big pharma. Genentech became the largest biotech in the world and created enormous value for its shareholders via organic or internal growth. The only exception to creating growth via acquisition (at least in drug development) would be if a big pharma company acquired a portfolio of drugs from a small biotech company which later turned out to be some breakthrough therapy for a large disease indication like Alzheimer’s.

At this point, you might be asking the question, then why would M&A activity occur if this were true? The short answer would be - to prevent the company from completely falling by the wayside, at least competitively speaking. I believe M&A activity initially evolves due to the need for consolidation to take place within an industry because of contracting earnings multiples, redundancies in operations, stifled innovation, and just simple inefficiencies. At least these are the reasons CEO’s generally state during conference calls to shareholders upon merger announcements.

In order for big pharma to replenish pipelines and gain access to new technologies being developed by the more innovative biotech companies, they will either have to engage in outright acquisitions, or negotiate partnership deals with biotech companies. In any event, any leverage in the market place in terms of deal-making, lies on the side of biotech companies.

So how do we sum all of this up? To some readers well versed in biotech investing, I understand what I’m about to say will sound almost “cliche” as you’ve heard this before, but I’m going to say it anyway. Bottom line is that - big pharma is at the crossroads in terms of accessing new drugs and technology and faces the reality that there is no solution other than to either acquire or partner deals with biotech (the innovators). Additionally, small cap biotechs (as a group) currently trade at valuations more attractive than they were during the bear market in 2002. For investors in small cap biotechs, this bodes well as there’s larger potential spreads for premiums to be paid to the companies being acquired. My theory on this idea stems from what I’ve observed when there was a flurry of acquisitions by big pharma beginning in 2002.

Obviously, the difficulty lies in knowing which companies currently possess unrecognized value. And of course this cannot always be known until further development of the technology or drug takes place. The key to investing in the biotech industry is understanding that which can be known, and then applying probabilistic measures to that which we cannot know or predict with much certainty. If your familiar with the application of using a Monte Carlo simulator, that’s great. I myself tend to shy away from the model’s mathematical approach in the prediction of possible outcomes, and instead rely on my intuitive thinking, which hopefully also possesses some innate characteristics of logic and reason in the face of uncertainty.

Now that we’ve discussed the method which I use to value development-stage biotechs, and reviewed the current situation with big pharma and how it fits into the picture with biotech, we can move on to analyzing specific companies in which I believe warrant coverage.

The purpose of the research was to get an idea of where the biotech industry lies in terms of valuation over a specified period of time. I gathered all the component companies market cap values for each of the appropriate indices in order to calculate a total value for each index. In the study I also wanted to determine the total change in market cap of the 15 companies comprising the AMEX Pharmaceutical Index (DRG) for reasons I will discuss in my next post.

The two biotech indices again are the NBI and BTK. The NBI is currently comprised of 156 companies while the large cap BTK includes 20 companies. Remember, that for our purposes, we specifically want to determine the total change in market cap of the small cap biotechs. Although some investors like to refer to the NBI as the small cap biotech index and the BTK as the large cap biotech index, it’s not accurate to make any assumptions in valuations simply by using index values. This is because all the companies that comprise the BTK are also included in the NBI (except Genentech). In order to extract and analyze the information that’s of value to us, I subtracted out the market caps of the large cap biotechs in the NBI so that we can truly isolate the approximately 136 companies that remain in the NBI. Hopefully I haven’t totally confused readers at this point.

Now lets take a look at the graph and table and try to make some sense out of the information.

Lets look at the values of the indices:

• BTK - during the two year period the results indicate the index increased 3%.
• NBI - during the two year period the results indicate the index decreased 5%.
• NBI minus BTK- during the two year period the results indicate that after subtracting out the market cap of all the large cap biotechs the remaining value of the companies in the index lost a whopping 24%. It should be apparent by now that any loss in value to any company comprising the NBI was attributed solely to the small cap companies of the NBI. In fact, the total combined market cap of the small caps decreased about $28 billion during this period from $117 billion in August, 2006 to $89 billion in June, 2008. Now you can see why solely looking at the NBI as a measure of how well the small caps are doing is very deceiving as the index was only slightly lower (down 5%) than it was two years ago. That’s because the NBI is a market cap weighted index (actually a modified model) which dramatically overweights the large cap biotechs in the NBI. Any losses sustained to the small cap biotechs (in this case, $28 billion) aren’t reflected significantly when viewing the index as a whole. The current combined market cap of the small cap companies is slightly lower than it was during the bottom of the bear market in 2002 which needless to say is quite low.
• DRG- during the two year period the results indicate the index decreased 19%. The 15 companies in the index also sustained a combined loss in market cap of more than $230 billion, more than ever lost in the history of the industry. Of course there’s no secret as to why the industry is in the gutter- patent expirations on blockbuster drugs that once brought billions in revenue.

The two bits of information that I find important and interesting are the loss of market cap amongst the small cap companies comprising the NBI and the massive loss in market cap sustained by the pharmaceutical companies in the DRG. I will save the discussion on the usefulness of this information for my next post.

Keep in mind that Biotech Informer focuses on small cap biotechs which have yet to achieve profitability. Therefore, traditional valuation metrics such as P/E and PEG ratios don’t apply. Instead, the fundamental component we use to develop a valuation metric will be “technology value”. Tech value is an appropriate component of a company’s valuation as it represents what the market is willing to pay for a company’s pipeline of products. With small cap biotechs, the drug pipeline is the basis for making an investment in the company as it is the drugs that will create value (or destroy) for the company.

Although tech value IMO is the most important component in the valuation assessment, there are other factors to consider when valuing a specific company. Similarly, when valuing profitable biotechs, we wouldn’t want to use only the simplistic P/E and PEG ratios. However, when taken in aggregate across large numbers of companies (as we will see with the companies comprising the NBI and BTK), our metric of “tech value” provides insightful information as to how the industry is valued during a specified period of time.

So how do we define tech value?

Technology value as I define it, is market capitalization minus net cash. I prefer to focus on net cash when conducting analysis on balance sheets as this is the most important variable when determining the financial strength of the company. Therefore long term debt must be subtracted from cash. To determine how critical the long term debt figure is, I generally don’t subtract from cash any convertible bond debt if the maturity date is more than five years in the future. Why? because so many other events could occur before that date that might give me reason to change my view on the company’s technology such as clinical trial failure or competitive threats. Conversely, good trial results on drugs for unmet medical indications in large markets could mitigate convertible debt financial obligations.

Tech value therefore is the aggregate value of a company’s non-cash assets such as it’s pipeline of drugs and intellectual property. Because these assets are difficult to value, tech value fluctuates dramatically with changes in market sentiment towards biotech stocks. It is for this reason that tech value makes for an ideal variable for the development of a relative valuation metric.

Tech value fluctuates rapidly between different periods of market sentiment. During optimistic periods, news from a phase 1 drug can cause dramatic rises in pipeline value while in highly negative environments even positive news on a phase 3 drug may not be awarded much value. So, the magnitude of tech value is dependent upon what investors are willing to pay for pipeline of drugs at different points in time and this is why it’s a useful tool to know the history of tech values over time.

An interesting point to make is that net cash is not nearly as important a component of market capitalization as tech value (at least in my findings). Tech value is always a larger component and it is only during extremely negative market sentiment where tech value and net cash approach equivalence.

Now that I’ve discussed a bit on the methodology used in valuing small cap biotechs, I will address the results of my study on the biotech indices and the industry’s aggregate market cap in the next post.