The ideal in the biotech and pharma world may be for a company to develop a strong internal R&D engine that regularly churns out potential blockbuster compounds, but the reality is that most companies have to turn to partnerships and acquisitions to manage risk and maintain growth. Shire (NASDAQ: SHPG) built itself into a significant biotech/pharma company on the basis of strong internal CNS and rare disease R&D efforts, but has more recently turned to M&A to improve its prospects. With Shire likely to generate considerable cash flow in the coming years, the question stands as to whether investors would be better-served with additional M&A transactions or a reinvestment into its own internal R&D capabilities.
A powerful one-two punch
Shire generates upwards of 70% of its revenue from two broad therapeutic classes – CNS and rare diseases. Shire built upon the success of Adderall XR in ADHD with Vynase and is now really the only company actively marketing in the space as most other competitive compounds have gone generic. Litigation is starting to heat up over the patents covering Vynase, but the company continues to develop follow-in indications. Vynase failed to show efficacy in major depressive disorder (MDD), but binge eating looks like a more promising indication that could add $500 million to peak sales for a drug that is over $1 billion in annual sales and still growing strongly.
Shire also made a major commitment to rare disease drug development and the company is reaping the fruits of those early investments. Between Elaprase for Hunter Syndrome, Replagel for Fabry, Vpriv for Gaucher, Firazyr for acute hereditary angioedema, and Cinryze (acquired in the ViroPharma deal) for hereditary angioedema prophylaxis, Shire has a portfolio that will likely generate more than $2 billion in revenue in 2014 with competition ranging from virtually non-existent to moderate.
A pipeline with a lot of questions
Shire's pipeline productivity does not appear particularly compelling at present, as it seems that the company has to spend considerable resources just to "hold serve" and has had to turn to M&A to supplement a lack of internal productivity. What's more, while Shire's pipeline includes drugs with significant upside potential, there are a lot of questions about some of the more promising drugs.
Lifitegrast was acquired in the SarCode deal and could be the first prescription competitor to Allergan's (NYSE: AGN) Restasis. The clinical development of Lifitegrast has been difficult, as both the OPUS-1 and OPUS-2 studies met some endpoints and missed others (and the two studies met/missed different endpoints). Safety does not appear to be a problem, though, and the company seems optimistic that it can file for approval based upon the data it has today. Even if the FDA approves the drug (not a guarantee by any stretch), count on Allergan to market aggressively against that questionable data set, and don't forget that Allergan has its "Restasis X" product in development as well. Lifitegrast could be a $1 billion-plus drug for Shire, but there are more risks than normal for this program.
Shire's SHP607 is a tricky drug for a different reason. Acquired in the Premacure deal, SHP607 is a protein replacement therapy that addresses retinopathy of prematurity, a condition that causes blindness in children born before term (it caused Stevie Wonder's blindness and perhaps Ray Charles' blindness as well). About 10% of all births are premature and 2% occur before 32 weeks, where the risk of ROP is greatest. The addressable market for this drug could include 60,000 or more babies a year, generating more than $1 billion in revenue, but adequate screening will be vital to patient identification.
After these two lead compounds, the sales prospects of the pipeline dim and the mid-stage assets are largely attributable to the $4 billion-plus deal for ViroPharma in 2013.
Buy or build?
Shire has not done a great job of developing a consistent stream of promising clinical candidates through its own R&D efforts. Even so, the success of drugs like Vynase, Elaprase, and Liada, coupled with an aggressive cost restructuring program, has put the company in a position where it generates substantial free cash flow – over $1 billion in each of the last two years and likely $2 billion or more for the next three years.
That cash flow gives the company a lot of options. Valeant (BHC -0.92%) is building itself into a Big Pharma company through serial acquisitions, and like Shire does not enjoy the best reputation for pipeline productivity. Forest Labs maintained itself for years on the basis of acquiring/licensing in other companies' compounds, and Johnson & Johnson (JNJ 0.22%) rebuilt its drug business through deals. Through licensing agreements with Bayer and Mitsubishi Tanabe and the acquisition of Cougar, and more recently the partnership with Pharmacyclics and acquisition of Aragon, Johnson & Johnson added Xarelto, Invokana, Zytiga, Imbruvica, and ARN-509, all of which are or could become blockbusters.
Nobody seems to really hold it against Valeant that the company has bought in the large majority of its revenue. Likewise nobody is really second-guessing the revenue Zytiga has generated just because it did not originate from Johnson & Johnson's internal R&D efforts. Shire will certainly have competition for assets, from Valeant if it targets established companies and Johnson & Johnson (among many others) if it targets development-stage companies, but billions of dollars can do a lot to back-fill that pipeline.
The bottom line
I do not object to the idea of Shire using M&A to augment its internal efforts, but it does add some uncertainty to the model. The good news is that expectations are not all that robust for Shire right now, at least relative to the sector. If Shire can grow its revenue at a long-term rate of just 4% and improve its FCF margin to the high 30%'s/low 40%'s (supporting FCF growth of 8% to 9%), a fair value of $160 is reasonable today. As those projections include fairly hefty risk discounting for Liftegrast and SHP607, there is definitely potential upside for those programs.
The sell-off in biotech will start to create some apparent value if it continues, but investors will then be dealing with a headwind of skepticism and negativity around the sector. Shire's position in that grey area between pharma and biotech may offer some protection, and the valuation isn't bad, but between a weak internal R&D program, late-stage programs with some questions, and patent litigation risk, it would not be my first pick unless it got meaningfully cheaper.
