A Biotech's Transition to Drugs

Last Friday, ArQule (Nasdaq: ARQL  ) announced that it had signed a drug development agreement with Swiss drugmaker Roche (OTC: RHHBY.PK). The deal is potentially worth up to $276 million, so, of course, this was well received by the market with ArQule up about 18% on the news.

From services to drugs
Some history on ArQule can put the importance of this deal into perspective. It was just 18 months ago that ArQule was primarily a services company that focused on the optimization of small molecule drugs for large pharmaceutical companies. While it had been pretty successful with this business model, it was clear, at least to me, that this was never going to be a profitable operation. Even when business was good in 1999-2000, the company still was not profitable. As those service contracts were coming to an end in 2002-2003, without new ones to replace them, it was time to change strategies.

So ArQule restructured and applied its chemistry expertise to its internal drug programs. Now, it's nice for a company to claim it's a drug developer, but that rings hollow without actual drugs in process. That's somewhat of a common theme amongst former biotech service providers turned drug companies, like Celera (NYSE: CRA  ) , deCODEGenetics (Nasdaq: DCGN  ) , and Incyte Genomics (Nasdaq: INCY  ) . ArQule wasn't quite that bad off, as it did have some in-house drug candidates. But the reality is that the company's drugs were in early animal testing and it would be a few years before any of the internal programs even entered clinical trials.

Story stocks
Small drug companies need to have a story to sell to the market because they're sure not valued on their profits and cash flow. Like it or not, it is the story that matters with these small caps. Without a compelling story, stock prices languish, and, with a stock price in the tank, it is difficult to raise money on good terms. Since drugs are incredibly expensive to develop, no money means no drug program. Without a drug program, a drug company may as well shut its doors. So the bottom line is that small drug companies need a story.

Not only was ArQule lacking clinical stage drugs, it was lacking a compelling story. And the stock was suffering for it. For much of 2003, the company was valued on cash alone, despite having over $50 million in revenue. That's not a good situation in an environment that saw biotech stocks do very well.

An acquisition that pays off
To become a real drug company, ArQule needed clinical stage drugs (as well as a story). Basically, management had two options. They could wait it out until their internal programs matured or they could acquire drug candidates. Wisely, ArQule went the acquisition route and picked up a private biotech company called Cyclis Pharmaceuticals in the summer of 2003. They paid $25 million for Cyclis, with $5 million of that amount paid in cash. While this move angered some nearsighted shareholders because it was dilutive, it brought in drug candidates while preserving ArQule's strong balance sheet.

At the time, I thought the Cyclis acquisition was a great move. It gave them a clinical stage oncology drug that worked by a novel mechanism. It even has a catchy name: "Activated Checkpoint Therapy Platform." The market loves that stuff. Acquiring Cyclis gave ArQule legitimacy as a drug developer while simultaneously providing a story that could keep the market interested in the company.

While ArQule's situation was greatly improved at this point, it is far from having what I would call a high-quality drug pipeline. Right now they have a phase 1 cancer drug and some pre-clinical drugs, all of which are based on a technology platform with a fancy name. So is this story just buzz or does ArQule have a product?

That's a very important consideration. While the story is important for near-term stock price and raising money, the long-term picture requires tangible products. Fluff only goes so far.

Worth watching
In a roundabout way, this history lesson brings us back to last week's Roche deal and why it is important. Roche's interest in ArQule's drug program suggests that ArQule's research program is not just a hollow story, but a legitimate effort that could potentially deliver tangible products. While the interest of a pharmaceutical company in a drug program does not guarantee success, it does indicate that there is at least something there that is good enough to merit watching. Until we start to see some of ArQule's clinical data, that is all we have to go on.

The Roche deal makes last year's Cyclis acquisition look even better. ArQule bought Cyclis for just $25 million, and within one year used those assets to strike a deal that is potentially worth up to $276 million. With the $15 million upfront payment it received from Roche, ArQule has more than recouped the original cash outlay it spent on the acquisition. Very, very nice.

While Roche's interest in ArQule is great, I do wonder if the market didn't get a little too giddy over the $276 million figure. That is not guaranteed at all. The only guaranteed payment is the $15 million upfront fee. All Roche did was buy an option that gave it the right to buy ArQule's drug program at a later date. It is going to wait until there is some evidence from phase 2 clinical trials that ArQule's drug works. If the trials are successful, then Roche will make a commitment and ArQule will start to receive some of that potential money. If not, Roche walks away without losing much.

The deal with Roche completes ArQule's transition into a drug developer. Now we watch and wait -- perhaps with a bit more confidence than before -- to see if there are real products here, or just an alluring story.

Now what?
Charly Travers is this month's guest analyst in Motley Fool Hidden Gems. Get your free trial now. Do you think the deal with Roche paves the way for ArQule's success? Share your thoughts on this company -- and any other biotech issue -- on our Biotechnology discussion board.

Fool contributor Charly Travers owns shares of ArQule. The Motley Fool is investors writing for investors.


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