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Two Things You Must Understand About Biotech Investing

By Todd Campbell and Kristine Harjes – Sep 11, 2016 at 11:03AM

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Revealing the difference between small-molecule drugs and biologics and illustrating why cash and equivalents is the most important line item on biotech balance sheets.

A multibillion-dollar market for drugs that work similarly to branded biologics is emerging, and investors might not want to miss out on the opportunity. Over $100 billion in brand-name sales of biologic drugs will lose patent protection over the next five to 10 years and various competitors are feverishly working to ensure that they're the ones to benefit. But do you really know why biosimilars are so different from generic drugs that have been on the market for years?

In this episode of The Motley Fool's Industry Focus: Healthcare podcast, analyst Kristine Harjes is joined by contributor Todd Campbell to explain the difference between biosimilars and generic drugs and to highlight the companies that are at the forefront of this budding industry. The duo also explains to investors why they need to know one line item in particular on a balance sheet before buying a biotech stock.

A full transcript follows the video.

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This podcast was recorded on Sept. 7, 2016.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's September 7th, 2016, so it's time for the Healthcare show. I'm your host, Kristine Harjes. Todd Campbell, our healthcare specialist, is calling in. Todd, how was your Labor Day weekend?

Todd Campbell: It was really good, relaxing, nothing too crazy. How about you?

Harjes: Mine was really good as well. I got to spend some time out at a lake in Maryland with a bunch of friends. It was good stuff. But, of course, summer has pretty much come to a close, unfortunately. It's always a little bit bittersweet. With that fall air rolling in, the Industry Focus team decided that this week's theme should be back to school.

Yesterday, Vince Shen and Asit Sharma dug into return on invested capital as their vocab term on the Consumer Goods show. Today, we're going to define the difference between biologic drugs and small-molecule drugs, which is really important in the healthcare space. Then, we're going to talk about some cash-related investing metrics that will hopefully be useful in all of your investing. Starting with the more healthcare specific of our two concepts -- Todd, want to kick us off with an elevator pitch-style definition of a small-molecule drug?

Campbell: Is everybody ready to go back to school? We're there. We're ready to learn.

Harjes: Are we ever really ready to go back to school?

Campbell: (laughs) My son was very sad this week because he had to return. He's in middle school, which is always a joy, for those of us who can remember our middle school days still.

Harjes: It gets better, I promise, all of our middle school listeners!

Campbell: That's what I keep telling him.

Harjes: So, small-molecule drugs.

Campbell: There's two ways that drugs are made. They're either made through the process of chemical synthesis, where chemical bonds are broken or formed over and over, and that's fairly repeatable and very easy to duplicate. And then, there's the other way of making drugs, which is through a biological process, where those drugs are actually created or derived from living organisms. They can come from human cells, animals, microorganisms, whatever. Those are far more complex. You have the less complex small molecules and the more complex biologics. The way that I like to explain that is, think of small molecules as kind of the widget you produce at a factory. Once you know how to produce that widget in a factory in Detroit, you can produce the same exact widget in a factory in Mexico or in Asia. It's much harder to do that with biologic drugs because of the living organism aspect.

Harjes: Exactly. There are some other important differences that arise because of how much more intricate your biologic drugs are. For one thing, they're much more expensive to develop. That being said, this is an interesting part of the story when you get over to creating generic versions of them. We have this whole field of biosimilars that has only recently started to take some of the spotlight in the healthcare sphere. These biosimilars are essentially generic copycat versions of biologic drugs, but they're a whole different class than your normal small-molecule drugs that has been around forever. And cost is really important here, too. Because it's so much more expensive to make a biologic drug, it's also much more expensive to make a biosimilar drug. With that, you're getting less competition from these biosimilars.

Campbell: Right. Think about this in the 90s. small-molecule drugs, at the time, biologics really hadn't come onto the scene the way that small-molecule drugs had. The technology for biologics was really advanced in the 90s and 2000s. So, most of the drugs at the time were small-molecule drugs. Easily replicable, just like the widget. So, when patents were lost on those small-molecule drugs, generic drug makers were able to go out and open up a factory in India or somewhere else, and be able to create generic versions of those drugs that were, essentially, identical. Because of their ability to create those as identical drugs, they were able to leverage all of the research that had been done by the brand-name drug, as far as efficacy and safety and everything else, to be able to get to the market faster without all of those costs you mentioned that are associated with development.

Now, fast-forward to the biologic drugs, where so many more drugs, a larger proportion every year, that are in development are these more complex biologic drugs. And because when you flip the switch and the patents expire, and you want to try and start making copycats of them, because you can't copy them identically, you need to actually do efficacy and safety studies, which are pricey, before you can win FDA approval. And that has kept a lid and slowed the access to them here in the U.S.

Harjes: So, if you were a drugmaker, do you think you would prefer your lead drug to be a small-molecule drug that is maybe a little cheaper to make, but will be exposed to competition faster and at a cheaper price, or would you rather have it be a biologic with a little bit less competition risk?

Campbell: You'd argue that's one of the reasons that so many of the drugs that are in development now are still biologics, because they are more complex. They are harder to create. That could provide you with more insulation against competition down the road when patents finally do expire. You have to remember that biologic drugs, because of their complexity, are some of the most expensive and pricey drugs in the world.

Oftentimes, these drugs are used to treat very common and conditions, autoimmune disorders like rheumatoid arthritis, and those kinds of things. And yet, they carry these $50,000-60,000 per person in annual cost. So, these drugs rake in billions and billions of dollars per year. They're obviously very big moneymakers for drug companies. You have drugs like Humira, for example, pulling in $14 billion a year as, arguably, the planet's best-selling drug.

Harjes: But they're also extremely effective. That's another thing that's worth pointing out here. You mentioned rheumatoid arthritis. That disease was transformed from one in which you were just managing the symptoms to one in which you can actually shoot for disease remission, because of the capabilities of biologic drugs. So, we also have, on the other hand, psoriasis. You have Amgen's (AMGN -0.30%) Enbrel and Johnson & Johnson's (JNJ -0.36%) Stelara. These are two biologics that treat psoriasis. But most biologics cannot be taken in pill form. In fact, I don't think any of them can, that I can think of, anyway. That's because they're proteins. If you were to take them as a pill, it would be digested just like any other protein. So, they're largely infused or injected. But, if you can have a pill that treats the same indication, that's going to be preferable. You will get Celgene (CELG), which has a small-molecule drug called Otezla, that's taken via pill, and that's going to steal market share.

Campbell: Yeah, it absolutely will and it is. Projections for Otezla are for it to be a multibillion-dollar drug, and sales are growing at triple-digit annual year-over-year growth rates. Without a doubt, people would prefer to take a pill, then have to get the drug infused or injected. That being said, there's still a massive market for these drugs, and many of them are coming off patent. Pfizer (PFE 0.05%) estimates that $100 billion in branded sales will come off patent in the next five to 10 years for biologic drugs. As a result, they spent $17 billion last year buying Hospira so that they could become one of the leaders in this burgeoning or emerging biosimilars market.

Even if you start losing some amount of sales to these other small-molecule drugs that are coming on the market, there's still a tremendous opportunity for biosimilar drug makers to go out and be able to hopefully win over FDA support. It's starting to happen. We've had a few different drugs, now, win FDA approval. We have a biosimilar to the multiple sclerosis drug Copaxone that's won approval. We have a biosimilar to the anemia drug Neupogen that's won approval. And we've also seen a drug from Pfizer that is a biosimilar of Johnson & Johnson's top-selling Remicade win approval. It hasn't launched yet. So, there are a lot of approvals that are starting to flood in, and that has some people thinking that this could be a $20 billion global market in the next five years.

Harjes: So, as an investor looking at this blossoming, early-stage market, what do you think is the best way to play it?

Campbell: There's a few different interesting ways to play it. I guess I'm not sure which one is necessarily the best. You could go pure play with a company like Momenta (MNTA), which is a relatively small company that's working on biosimilar drugs -- the symbol there is MNTA -- but you're exposing yourself to a lot more risk. You could go the other side of the coin, you could say, how about Pfizer, $50 billion in sales, and global distribution, and with Hospira now, potentially a leadership play in biosimilars. That's an option. Then, you also have to consider that a lot of the companies that are working on biosimilars are actually the producers of these biologics in the first place. You've got companies like Amgen and Biogen that are also developing biosimilars, because, obviously, they have the know-how, over the last 20 years, of being able to create these drugs relatively efficiently. Those companies are going to be involved in it, too.

Harjes: Great. Our next lesson is something that applies to all sectors, beyond just healthcare. That is cash and equivalents. This elevator pitch here -- it's basically the very top line on your balance sheet. It's the most liquid thing on the balance sheet. It means everything that can be converted to cash immediately. That could be actual cash, but it could also be your bank accounts and Treasury bills or government bonds that have a maturity date of three months or less. It could be money market holdings. There are a whole bunch of things that fall into this category. But the thing to remember is that it's your cash and things that are equivalent. It's things that are pretty much cash, because you could turn them into cash so quickly.

Campbell: Right. Not only is it the top line of the balance sheet, but it should be top of mind for investors. I don't think there's a stock that I invest in that I haven't taken a look at the balance sheet to evaluate how much liquid money they have available to them. That's really what we're talking about when we're talking about cash and equivalents. We're talking about the money they can free up within 90 days or less and be able to use to take action, either paying debt, paying costs associated with running their business, whatever. Cash and equivalents is must-know news for any stock, but it really comes into play and is of particular interest is for healthcare investors.

Harjes: Absolutely. One of the reasons that this matters is so much to healthcare, and why were talking about it on any of the shows it's because of cash burn and biotech. If you're a company that doesn't have a product on the market, you need to watch how much money you're spending every single quarter really, really closely. The change in balance of your cash from quarter to quarter is explained in the statement of cash flow. Cash burn is basically how much that balance is decreasing. This is really important, because it can be used to calculate your runway, which is cash balance divided by cash burn. Say you have a million dollars in cash on the books, and you're spending $500,000 a year. That means you have a runway of two years before you're out of money. This can make or break a company.

Campbell: This is a huge issue for biotechnology companies. Previously, we were talking about the complexity associated with developing many drugs, biologics especially. That complexity equals cost. Developing drugs is very expensive. There's so much failure in drug development. 90% of drugs that have begun trials in humans have ended up being discarded rather than making their way to pharmacy shelves. The failure rate is incredibly high, the cost is incredibly high. So, when you have a brand-new biotechnology company that's going out there, they're not only investing big money, but they're investing it over the course of a number of years as they conduct phase 1 trials, and phase 2 trials, and phase 3 trials, and try to convince the FDA to get to the market. Then, of course, they have to spend for marketing, and the feet on the ground to build up awareness for that medicine.

There are so many costs that are associated before you can begin generating commercial revenue from a drug. Historically, the way that biotechnology companies have gotten that funding is going out to venture capitalist or angel investors, and then eventually they've gone public and issued shares. By keeping a very close eye on cash burn, people can get a very good indication of whether or not it's likely that the funding will run out before trials are completed that could actually get the drug to the market. Thus, that would force these companies to go out and either to a dilutive offering, to dilute your ownership by selling more shares in the marketplace, or they'd have to go to banks or private lenders and borrow money at interest rates that may not be favorable. So, you have to keep a close eye on the quarterly cash burn, and make sure you don't end up investing in a company that's going to run out of money too quickly.

Harjes: Right. And the devil is kind of in the details here, because cash can come from a variety of different places. You can have, say, a milestone payment coming in from a partner company. So, definitely, you want to dig in and figure out where that cash is coming from, and the different places that they hold the cash that is on the balance sheet. I'll give one example here.

This is not a company that is of concern to me, but it is an interesting point to note, and we talk about it all the time -- Gilead Sciences (GILD -0.43%). Their press release for the second quarter claims that they have $24.6 billion in cash, cash equivalence, and marketable securities. But if you actually look on the balance sheet and start breaking it down, their total cash and short-term investments line item is $8.8 billion. That is composed of $6.5 billion in cash and cash equivalents, plus another $2.6 billion in short-term investments. That is a big way off, that $8.8 billion, from the $24.6 billion in the press release. And the difference there lies in, they have $15.9 billion in long-term marketable securities. So, whether or not that counts as a cash equivalent or not, it could go either way. My point here in telling this story is that you want to stay consistent when you're defining your metrics, just for the purpose of comparison, and you also do want to actually look at the balance sheet and figure out, where is their cash? Where is it coming from? Where is it going out to on a quarter-to-quarter basis?

Campbell: Yeah, doing that will help to protect you from a lot of risk. This is a risky enough industry to be investing in on its own, we don't need to encourage even more risk. The street is littered with biotechnology companies that burned through their cash too quickly, and that caused significant problem for investors. I can think of two right off the top of my head. Dendreon was one, they developed a prostate cancer drug called Provenge. The other more recent one would be, of course, MannKind, which developed an inhalable version of insulin, but they spent so much money, their cash burn was so much greater than the revenue they generated off of that drug, or have to this point.

Harjes: So, those are two examples of companies that historically, in the past, have run into these issues. Are there any on your watch list that you think might be in jeopardy of running out of cash soon?

Campbell: A lot of attention in the past year or so was focused on companies that are developing drugs to treat Duchenne muscular dystrophy, which is a muscle-wasting disease that unfortunately shortens patients' lives. There's a massive need for new drugs to address this condition. Two companies that are working on those drugs are Sarepta Therapeutics and PTC Therapeutics. Those two companies have drugs that work in very novel and unique ways. However, developing those drugs has been incredibly expensive, and both of those companies have raised my eyebrows in terms of what their cash outflow has been relative to what they actually have on their books.

Harjes: Right. So, the lesson here is, if you're looking to give yourself a little bit more safety in your biotech investments, keep an eye on that cash burn. Todd, or, Professor Campbell, thank you so much for all of your thoughts and lessons today. Folks, I hope you enjoyed today's episode, and will continue to listen to the rest of back to school week.

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. For Professor Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes owns shares of Gilead Sciences and Johnson and Johnson. Todd Campbell owns shares of Celgene and Gilead Sciences. The Motley Fool owns shares of and recommends Biogen, Celgene, Gilead Sciences, and Johnson and Johnson. The Motley Fool has the following options: short October 2016 $95 puts on Celgene and short October 2016 $85 calls on Gilead Sciences. The Motley Fool recommends Momenta Pharmaceuticals. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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