Is The Risk Worth The Reward?

It should be no surprise that pharmaceutical companies – and even some large biotechnology companies – are in need of drugs to fill their product pipelines and to maintain the earnings growth demanded by investors. Companies have shown that they are willing to pay a significant premium for developmental stage products. According to Burrill and Company, valuations for licensing deals during the first quarter of 2006 have increased over 75% relative to the same quarter in the previous year. Not only has the number of M&A transactions grown, but the premiums paid to acquire companies have also increased. One of the reasons for the growing number of in-licensing and M&A deals is the fact that internal R&D has been unsuccessful at keeping up with the demand for new products. McKinsey & Company estimate that in-licensed drugs have twice the likelihood of making it through clinical trials than internally developed compounds. The growing costs of developmental stage products will unlikely change as competition for them only gets worse.

The recent Merck acquisition of Sirna highlights the incredible valuations that are being demanded by biotechnology companies for their products. Merck paid about $1.1 billion, a premium of around 95%, to acquire Sirna, which develops RNAi technology but has only one product in early clinical development for treating age-related macular degeneration. In the Pipeline puts the acquisition into perspective comparing Sirna to Isis Pharmaceuticals. Isis, which also develops RNAi products, first started developing antisense oligonucleotides more than 10 years ago and has yet to launch a drug onto the market. In contrast to the Merck acquisition of Sirna, Lilly recently sought to acquire Icos for approximately $2.1 billion, at a premium of only about 25%. But Icos already has a product on the market, Cialis, which is used to treat of erectile dysfunction. The run rate for Cialis sales is almost $1 billion for 2006. Lilly was already accounting for half the sales of Cialis prior to the acquisition, so the company essentially paid for the remaining half of Cialis sales.

One thing to keep in mind is that the higher premiums are only part of the picture. It is often overlooked that pharmaceutical companies are also doing more earlier stage deals that are inherently much riskier than later stage ones. The October issue of In Vivo from Windhover, looked at clinical stage licensing deals valued over $20 million in 2002 and 2003. Not surprisingly, the deals involving Phase III products had the best success rate: 12 of the 17 Phase III products were still undergoing development and five had been approved. Of the Phase II products licensed, only 7 of 14 are still in development. Although the rate of Phase I products still in development is 60% (6 out of 10), the sample size is small enough to safely assume that the success rate was the same as that of Phase II products. Ideally, when making an investment of any nature, one would want reduce the risk when more capital is spent. But instead, pharmaceutical companies are now taking on more risk at higher costs. It remains to be seen whether taking greater risks will eventually pay off.

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