Drugbaron Blog

June 2, 2014 no comments

Cometh the saviour? Casting Valeant’s J. Michael Pearson in a new role

There has been much written about the proposed acquisition of Allergan by Canada’s Valeant – most of it doom-laden.  Much of the commentary paints a picture of a post-apocalyptic landscape, with marauding capitalists slashing and burning cherished R&D facilities.

 

And the villains of the piece are Valeant’s CEO J. Michael Pearson, playing Darth Vader to Pershing Square’s Bill Ackman as the Emperor Palpatine.

 

What did they do to unleash such a barrage of criticism and predictions of doom?  Was it anything more than point out the unsustainable inefficiency of drug discovery and drug development as practiced by sizable pharmaceutical and biotech companies?  If so, then DrugBaron is the next Anakin Skywalker following in their footsteps, guilty of the same indiscretion.

 

At the heart of the case against them is the charge of “short-termism” – that their strategy will yield a fast buck for their shareholders today, but will ultimately destroy the essential infrastructure for innovation, harming patients and – in the long run – healthcare investors.

 

Its an argument that’s been made before to defend entrenched but uneconomic practices in other industries: car manufacturing in Western countries resisted the arrival of robotic efficiency from the Orient for decades, citing the need to protect jobs and local manufacturing capability.  But these latter-day Canute’s cannot resist the rising tide for ever, and eventually a seismic shift in manufacturing took place anyway.

 

Pearson, then, is not the destroyer of a magnificent pharmaceutical industry, but its saviour.   Only by deconstructing uneconomic R&D infrastructure and strategies is there any hope for societies continued investment in healthcare innovation.

 

It may be a convenient journalistic artifice to tag Pearson as “R&D averse”, but the shorthand disguises a more nuanced picture, as the latest chapter in Valeant’s pursuit of Allergan clearly demonstrates.  The decision to ear-mark $400m for the continued development of the anti-VEGF darpin, under license from Index Ventures’ portfolio company Molecular Partners, is not just a sop to Allergan investors worried about the future direction of the company.

 

It is a recognition of value.

 

With forecast sales of $20+ billion over a decade, the risk-adjusted returns justify the continued development.  The realities of market economics ensure that Pearson cannot just discard value recognized in the Allergan stock price without making the entire acquisition a poor deal for his own stakeholders.

 

But the converse is also true.  The parts of R&D that Valeant would shutter on completing the deal cannot have the kind of value hinted at by the protestors, at least not recognized in the enterprise value of Allergan as a whole.  If the current investors really valued that R&D infrastructure, Allergan would be too expensive for Valeant to afford UNLESS they also valued the R&D capabilities.

 

“Early stage drug discovery projects are ‘liabilities’ not ‘assets’ – they cost money to prosecute but, as yet, have no proven value”  Francesco De Rubertis, Index Ventures

 

The bottom line is clear: investors value pharmaceutical stocks on near-term revenues and the dividend yield.  Product candidates that are more than a year or so from market rarely if ever reflect in a material increase in value of the business as a whole.  Look, if proof was needed, at the share price of Gilead in 2013 – it more than doubled as the potential for Sovaldi™ revenues moved into that one year window.  That same potential was not recognized when Gilead paid almost $11billion to acquire the drug candidate from Pharmasset.

 

The reason for this late recognition of value is obvious enough: too many things fail, even in late stage development (or, worse still, in the marketplace after launch – as the investors in Dendreon painfully discovered).  Its difficult to put a proper figure on late-stage failures, because so many late stage trials are effectively line-extensions of products (or at least mechanisms of action) that are known to work.  But even including these “slam dunk” trials (which may be the majority), the chance of success is only around 50%.  For a new mechanism of action, that must fall considerably.

 

And these measures of late stage success refer only to the clinical trials themselves.  That’s before the regulators have had their say (we are seeing more and more FDA rejections for NDAs built around statistically positive pivotal trials).  And only then can the battle to win real sales begin, which at best can take years and at worst can fail completely.

 

If public market investors can, and often do, discount late stage products almost to zero, then the fate of earlier stage projects (before human proof of principle, for example) is even worse.  As Francesco De Rubertis, founding partner of the Index Ventures life sciences practice, says: “We should call early stage drug discovery and development projects ‘liabilities’ not ‘assets’ – they cost money to prosecute but, as yet, have no proven value”.

 

By a simple extrapolation of the maths, if the late stage products are valued close to zero, and the early stage R&D efforts are worth considerably less we are in negative value territory.

 

By this analysis, Pearson and Valeant are acting entirely rationally.  If markets (rightly it seems) do not value R&D then the less you spend on it, the greater will be the returns to investors.  It is difficult to argue with their approach – at least while public markets continue to attribute so little value to “pre-revenue” assets.

 

The dissent comes when this strategy is taken to its logical extreme: close down all the R&D capabilities because they only deliver value on a longer time horizon than that recognized by the typical public market investor.   Detractors argue that will result in a complete lack of new innovations to sustain the industry a few years down the line.  That it is, in effect, asset-stripping: Valeant-style investors harvest all the cream (revenues from today’s blockbusters), paying it out as dividends without ‘wasting’ a penny on R&D activities, in full knowledge that in a few years from now the well will run dry.

 

That doomsday scenario, though, makes some huge assumptions.  It assumes, for a start, that R&D investment by revenue-generating drug companies is the major source of new innovations.  For sure, it is the lion’s share of the R&D dollars, but increasingly often new medicines spend most of their early life outside conventional pharma houses.  If pharma (defined as profitable companies selling drugs) stopped all R&D tomorrow, its not at all clear how big an impact that would have on global output of innovative new treatments a decade from now.

 

In the end, the discussion comes down to how innovation should be funded

Today, the bulk of it is funded by public market investors in large pharma companies, who effectively forego a material fraction of the dividend that those revenues would yield, but do not recognize any value in the activity (until it translates into real sales).

 

And that arrangement is at the heart of the problem with R&D productivity in pharma

Because the market does not attribute any value to R&D (as opposed to revenues) there is no mechanism to gauge efficiency.  Cost and output are completely uncoupled.  In effect, R&D spending is just like a government levying tax: we hope they spend it on sensible things, but the act of taxation and act of public spending are entirely separate.

 

At some macro level, investors may judge the pipeline of one company to be somewhat superior to another, but these assessments have minimal impact on valuations which instead depend on revenue forecasts and dividend yields.  They certainly don’t have any power to drive R&D strategy in one direction or another – since the investors were hardly valuing the R&D activity in any case, there is little scope for the market to pass judgement on the subtleties of R&D strategy.

 

This uncoupling has led to the massive increase in R&D spending over the last decade, while at the same time presiding over a decline in the number of genuinely first-in-class new medicines to be approved.  In effect, a dramatic collapse in R&D productivity.

 

What is the solution?

The simple solution is not to do early stage R&D in the same economic entity as drug sales.  Since it is drug sales that determine the value of large pharma, then they should focus on maximizing revenues and minimizing costs, with the same horizon as their public market investors.

 

There would no longer be a tax on revenues, and dividend yields would rise.

 

Early stage R&D would still be funded – just not through these “mixed” economic entities.  Instead, dedicated early stage R&D operations – which already exist, of course, in the shape of pre-revenue biotech companies and venture capital portfolios like Index Ventures – would grow to fill the void.

 

The advantage of this arrangement is simple: the products of those early stage R&D activities would need to be sold to the pharma sales companies, who would rely on them for their future revenue growth.  That transaction puts quantifiable value on the R&D activity.  More importantly, it is then very obvious how that value generated related to the cost of creating it.  In other words, in companies engaged only in R&D, there is a clear measure of efficiency.

 

And with a measure of efficiency comes the possibility for competition between different R&D strategies.  We can see this already: the asset-centric model, with a single drug product candidate in each company, and largely virtual operations using out-sourced infrastructure, pioneered at Index is in direct competition with the classical model of biotech company building, with pipelines and infrastructure.  Its too early to be sure how the returns will be impacted by adopting an asset-centric approach but at least any gains there are will one day be crystal clear.

 

Most privately-held biotechs (and even pre-revenue companies on the public markets) are considerably more resource-constrained that a large pharma R&D organization.  Furthermore, the capital they do expend is usually (and rightly) much more expensive than investment-grade debt or blue-chip public market equity.  That makes managers think hard before expending the next dollar – a discipline that is still extensively lacking in big pharma R&D.

 

A good analogy, once again, comes from tax.  Few, if any, economists think that ‘hypothecation’ (that is, spending the tax raised on a particular activity in the same general area) makes sense.  Factors that determine the levels of motoring taxes have nothing to do with the demands for investment in roads.  It makes much more sense to raise a total tax pot, and then spend it on the most pressing priorities.

 

The same is true of pharma R&D – why do we believe that the best way to fund medical innovation is through a ‘tax’ on drug revenues?

Insistence on funding innovation that way is allowing untold billions to be wasted on inefficient and unproductive R&D strategies, unchecked by a market that attributes little or no value to the activity.

 

If DrugBaron’s analysis is accurate, then J. Michael Pearson and his Valeant team will come to be seen as the saviours of an industry that is ever increasingly facing the pinch of public angst at drug prices driven higher by the inefficiency of the R&D process.

 

The Valeant model, applied across the industry, would see the grossly inefficient R&D behemoths of the revenue-generating pharma companies disassembled – either directly, as the companies are taken over by investors who want to cut the R&D ‘tax’ on their dividend yield, or indirectly as management fearing such a take-over take a knife to their own R&D budgets.   Large drug sellers devoid of much R&D activity at all (of which Valeant is an excellent example) would emerge from within the chrysalis of each large pharma.

 

Separately, in vehicles that make transparent the return on investment of drug discovery and development, the R&D industry outside of large pharma will thrive, and evolve as different approaches are set against one another.  At last, an environment will emerge where markets CAN regulate R&D efficiency.

 

Arise, Sir Michael – Valeant knight, and saviour of the pharmaceutical industry.

 

 

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