MaRS Best practices: Valuations in the biotech industry - Wayne Schnarr

MaRS Best Practices
Series
Special
Valuation
Series
Nov. 12th, 2010
MaRS Best Practices
Special Valuation Series
Friday Nov 12th @ Noon
Raymond King,
Senior Manager
Toronto Stock Exchange
Wayne Schnarr,
Analyst, Equicom
Toronto Stock Exchange

Disclaimer & Disclosure
The information contained in this presentation has been compiled by Equicom and/or Wayne
Schnarr from sources believed to be reliable, but no representation or warranty, express or
implied, is made by TMX Group, Equicom, its affiliates or any other person as to the accuracy,
completeness or correctness. All estimates, opinions and other information in this
presentation are subject to change without notice and are provided in good faith but without
legal responsibility or liability. Additional information may be available to Equicom or its
affiliates that is not reflected in this presentation.
This presentation is provided for informational purposes only and does not constitute an offer
or solicitation to buy or sell any securities discussed herein in any jurisdiction. This
presentation is not, and under no circumstances should be construed as, a solicitation to act
as a securities broker, dealer or adviser in any jurisdiction. This presentation is prepared for
general circulation and to provide an overview of investing in healthcare. This presentation
does not consider the investment objectives, financial situation or particular needs of any
particular person. Investors should obtain professional advice based on their own individual
circumstances before making an investment decision. To the fullest extent permitted by law,
neither The TMX Group, Equicom, its affiliates nor any other person accepts any liability
whatsoever for any direct or consequential loss arising from any use of or reliance of the
information contained in this presentation.
Equicom may have advised or provided services to, or may in the future advise or provide
services to companies, entities or persons referenced in this presentation.

Valuation and financial
modeling
is a qualitative and numerical
assessment of
risks and potential rewards

 Each biological target, product and
company has a unique set of risks and
potential rewards.
 Despite the uniqueness of each product
and company, it is possible to establish a
general valuation process in biotechnology

First,
a little
introduction to
capital markets

Where is valuation important?
 Investing
 Financing
 Partnering
 Selling

Who invests in these companies?
 Angel investors
 Venture capital
 Canada
 US
 Institutional funds
 Canada
 US, EU, ROW
 Retail investors
 Canada
 US

Investors establish valuations
The value of a company is the price the next
investor is willing to pay
 Private company – price set by the VC willing to
lead the next round
 Public company:
 Daily basis – set by the next trade
 Financing – set by the lead investor

Why would you buy shares of a company?
Mature Healthcare
 Capital gains from an
increase in share
price
 Income from
dividends and
distribution

Why would you buy shares of a company?
Mature Healthcare
increase in share
price
 Income from
dividends and
distribution
Biotechnology
increase in share
price

Investors also want liquidity
 IPO
 Last one in Canada was IMRIS in late 2007
 Sale or acquisition of the company
 Breakup of MDS
 2009: ViroChem by Vertex
 BioChem Pharma, ALI Technologies, ID
Biomedical, AnorMED, Arius Research (2008),
CryoCath (2008)

What impacts daily buying & selling?
 Valuation
 Liquidity
 Some institutions may only buy deals
 News flow
 Clinical events which can impact share prices
 Development partners
 Competitive products
 Broad market performance
 Sector preferences
 Rising resource commodity prices attract
high risk money

Investors in mature companies pay for growth
Investors in mature companies pay for growth
from:
 An increase in sales of products or services;
and / or
 An increase in profitability (earnings per share
or eps); and / or
 An increase in dividends or distributions.

 Share prices in development stage
biotechnology companies should be impacted by
clinical, regulatory and financial events
 Investors pay for:
 Reduced risk; and / or
 Increased potential reward.
Biotech investors also pay for growth

How do stock analysts value a biotechnology company
that is several years from product approval and
profitability?
 Discounted earnings / cash flow
 Comparative valuation
 Event-based stock movement
Valuations by stock analysts

Now,
the easy part -
number crunching

Financial modeling – the basics
The components of financial modeling in
increasing order of importance are:
The Excel spreadsheet
The assumptions for the spreadsheet
What you do with the numbers

Financial modeling – create the numbers
The first step is creating the numbers, no matter what
method is going to be used to analyze them
 Create a large spreadsheet or a series of linked
spreadsheets
 Horizontal – number of periods over which cash
flows will occur (months, quarters, years)
 Vertical – all cash flow categories, both expenses
and revenues
 Fill in all of the boxes

Valuation Tools – How To Analyze The Numbers
 Net Present Value (NPV)
 The preferred valuation tool
 Risk-Adjusted NPV
 Risk adjustments can be done here or at the
portfolio level
 Internal Rate of Return (IRR)
 Uses the same spreadsheet and assumptions
 Payback Period
 Very useful in manufacturing projects
 Monte Carlo Simulation
 A structured sensitivity analysis

Net Present Value (NPV)
A project or product cash flow analysis that takes into
account the fact that $1 received or spent in 2010 is
worth more than $1 received or spent in the future
 NPV = C0 + C1/(1+R)1 + C2/(1+R)2 + … Cn/(1+R)n
 C = cash flow in the specified financial period
 R = cost of capital (risk free or risk adjusted)

NPV – $100 received in the future
What is the value today of $100 received in
future years (risk-free discount rate of 5%)?
Year NPV
2010 $100.00
2013 $86.38
2018 $67.68
2023 $53.03
2028 $41.55

NPV – effect of risk-adjusted discount rates
What is the value today of $1 billion received in
8 years using risk-adjusted discount rates?
Rate NPV
10% $466.5 M
15% $326.9 M
20% $232.6 M
25% $167.8 M
30% $122.6 M
35% $90.6 M

Using financial models
 These models are usually based on little information
and many assumptions
 The quality of your financial model will depend
upon the quality of your assumptions
 Better assumptions result from asking the right
questions
 They are generally not useful for absolute valuations,
unless they are based on historical sales data
 What can you do with the financial models?
 Compare NPVs for different deal structures for the
same product
 Compare NPVs and risk profiles for different
products

The hard part –
assessing risks
and
potential rewards

Risks & Rewards
 ‘only about 10% of the drugs which enter
human clinical trials will eventually be
approved’
 The development of novel healthcare products
is a high risk business
 Neither big pharma nor stock analysts are
good at picking winners
 Risk cannot be eliminated
 Risk can be mitigated by larger companies
through portfolio management
 Risks can be assessed

Risks & Rewards: A Balancing Act
 Assessment of risks is much more important at
the earlier stages of the development process
 Assessment of potential rewards, based on
product sales, becomes more important as the
product progresses through clinical
development
 The only justification for taking these high risks
is the potential large reward from successful
product development
 Risks and potential rewards change with time
and must be continuously assessed and
balanced

Risks & Rewards: Three Stage Process
 Approval Risks
 What are the risks which could impact the
approval of this product?
 Market Potential
 What is the market potential for this
product?
 Market Risks
 What are the risks which could impact the
market potential for this product?

 Financial: Capital Markets, Partnerships
 Regulatory
 Manufacturing
 Clinical
 Scientific
Approval Risks

Money is the scarcest asset
 Money has been, and is likely to remain, the
scarcest asset for Canadian healthcare
companies
 Funding must be continuously obtained from
two primary sources
 Capital markets
 Partners
 Supplementary funding is also available from
other sources
 Governments
 Disease associations

Show me the money!
 Canadian healthcare companies have
historically been able to get sufficient funding
from private and public capital market sources
 Liquidity was also available from periodic IPO
windows
 In this context, companies preferred to
periodically get financing in the public markets
and continue development without a partner as
long as possible

Show me the money, PLEASE!
 The markets and financing strategies changed
dramatically starting in the fall of 2007
 Financing was more difficult
 Valuations plummeted
 IPOs were almost impossible
 Companies have been forced to consider all
strategic and financing options
 For many small biotechnology companies, the
focus became survival

Venture Capital Investment in Canadian Life
Sciences Companies
Source: www.cvca.ca
Year Amount Financings
2004 $463 M 120
2005 $438 M 100
2006 $493 M 89
2007 $633 M 82
2008 $359 M 86
2009 $215 M 70
2010 (H1) $156 M

Investment in Public Development Stage
Canadian Healthcare Companies
Source: Equicom Healthcare Reviews
Quarter
2005-2007
(average)
2009 2010
Q1 $378.4 $64.5 $115.2
Q2 $270.6 $177.5 $72.7
Q3 $97.3 $103.4 $65.5
Q4 $292.2 $152.8
Total $1,038.5 $498.2 $253.4

Critical Questions
 Does the company have the financial resources
to get to the next critical value-creation event,
with a little breathing room?
 If the answer is no, can the company obtain
that financing?
 If the answer is yes, and the event is
positive, can the company then obtain
additional funding either from the capital
markets or a partner?
 Information sources
 www.sedar.com
 http://www.sec.gov/edgar.shtml

Partnering
 Big pharma:
 Has cash and infrastructure
 Needs products
 Small biotech:
 Needs cash and infrastructure
 Has products
 Partnerships will continue to be signed

Risks: Partnering Deal Hurdles
 Buyer’s perspective:
 Buyers see thousands of opportunities every
year
 Buyers are risk averse
 NIH (not invented here) syndrome by internal
R&D teams
 Detailed due diligence is expensive
 Valuation and deal terms
 Seller’s perspective:
 Loss of control
 Valuation and deal terms

Risks: Partner or Buy? (1)
 When partnership discussions start, an
acquisition is always on the table
 If the junior partner is a private company:
 VCs historically have preferred an IPO
 Sale of the company is now the preferred
option
 The sale price can be split into up front cash
and success payments
 If the junior partner is a public company, it is
potentially for sale every day to other SMEs,
larger biotechs and big pharmas

Risks: Partner or Buy? (2)
 From the potential partner’s (buyer’s)
perspective, partnering is preferred because:
 There is a lower initial financial risk
 There is the same level of control over
product development
 There are no HR or other problems when
shutting down local operations

Regulatory Risks: The Critical Question
The critical event prior to generating revenues
from sales is regulatory approval.
“Is there is a pathway to regulatory approval?”
The starting point in assessing regulatory risk is
the end of the process – regulatory approval.

Basic Approval Requirements
 Two adequately controlled clinical studies which
have been designed to prove the safety and
efficacy of the new drug for a specific
therapeutic indication
 A single trial is acceptable for certain diseases
such as cancer

Regulatory Approval Risks (1)
 Therapeutic indication
 Is this the first product which the FDA will
assess for this therapeutic indication? If yes,
is there a scientific or medical consensus on
how to assess the product?
 If there have been unsuccessful pivotal
studies, was it the product, therapeutic
indication or the clinical design?
 Is the proposed indication a new
monotherapy, an addition to the current
therapy or a therapy to be used only when
there is no response to current therapies?

 Clinical Design
 Are there any differences in clinical design
for this new product versus clinical trials
conducted for approved products?
 Are there any differences in clinical design
for the Phase 3 study and the preceding
Phase 2 study?
 If there are differences, what are the
justifications for these changes?

 Standard of Care
 Is there a single FDA-approved standard of
care for the chosen therapeutic indication?
 Is there more than one FDA-approved
standard of care for the chosen therapeutic
indication?
 If there is not an FDA-approved standard of
care, is there a standard of care accepted or
approved by the relevant medical groups?
 Are there products currently under
regulatory review or in pivotal trials which,
if approved, would result in a new standard
of care?

 Primary clinical endpoint
 Is there a clinical endpoint accepted by the
FDA for proving efficacy in this therapeutic
indication?
 If not, are there clinical endpoints accepted
or approved by the relevant medical groups?
 Are there any difficulties in the acquisition
or interpretation of these endpoints?
 Is the primary clinical objective a superior
safety profile and non-inferior efficacy?

 Statistical analysis
 What are the statistical assumptions used in
the design of the clinical trial?
 How are patient withdrawals handled?
 Is there any history of large placebo effects
in this type of clinical trial?

 Statistical versus clinical significance
 A result can be statistically significant but
the clinical benefit can be so small that it
may not be clinically significant
 For example, is a statistically significant 2-
week increase in survival also clinically
significant when survival on the current
standard of care is about 6 months?
 This result may previously have only
impacted potential sales but clinical
significance is now being discussed at FDA
advisory committee meetings

 Safety profile
 The safety hurdle has been raised at the FDA
 The safety concern is highest for drugs which
are intended for chronic use and for drugs to
treat patients with medical conditions which
are not immediately life-threatening

Manufacturing Approval Risk (1)
 Manufacturing is a critical regulatory
component
 The manufacturing process has to meet GMPs
 The facility has to meet GMPs and be
inspected
 Companies may face the following situation
 If the process or facility used for Phase 3 / approval is
not commercially viable, changes need to be made
before significant sales can be developed
 However, the cost of getting to a commercially viable
process and facility prior to Phase 3 can require
substantial scarce resources before knowing whether
the product can be approved

 GMP processes must be reproducible and
validated
 Chemical synthesis of small molecules is usually
not a problem
 Isolation of natural products from a biomass can
usually be controlled
 Recombinant manufacturing of proteins is
complicated but controllable
 Upstream production
 Downstream purification
 Finished dosage form

 Manufacturing facilities are expensive
 Small molecules
 API – contract manufacturing
 Finished dose – contract manufacturing
 Biologics
 Capital cost of fermentation or cell culture
facilities is enormous
 Contract manufacturing is available
 Changes in manufacturing scale and facilities
can change the clinical activity of a biologic

Scientific Risk
If the answers to the following five questions are
yes, there is probably an acceptable level of
scientific risk.
 Do we know how the drug works?
 Do we know what causes the disease and how the
disease progresses?
 Is the drug’s target a key factor in disease
progression?
 Are the animal models predictive of human
results?
 Does the preclinical data show that the drug is as
effective as or superior to currently approved
drugs or drugs currently in clinical development?

Manufacturing costs
 COGS (cost of goods sold) are an important
component of due diligence conducted by
potential partners and investors
 Rough guideline for COGS at commercial scale:
 COGS for biologics should be less than 10% of
the selling price and preferably below 5%
 COGS for small molecule products should be
less than 5% of the selling price and
preferably less than 2%

Market Potential: Two Approaches
 There are two basic approaches to estimating
the market potential for a new product
 The starting point for one approach is the
number of patients with the medical
condition, which is further refined by
considering factors such as the number who
are diagnosed, the number who are treated,
success of current therapies and disease
progression
 The starting point for another approach is
the sales of drugs currently used to treat
patients with this specific or similar medical
conditions

Patient-Based Approach (1)
 Estimated incidence of a specific medical
condition in the general population
 Number of patients diagnosed
 Unless a patient is diagnosed, they cannot be treated
 Diagnosis by disease severity
 Treatments for Stage 1 through 4 cancers are
dramatically different
 Treatment for a specific disease stage
 How many patients receive first-line therapy?
 How many are cured, how many die and how many
relapse and receive second-line therapy?

Patient-Based Approach (2)
 To go from an estimate of the number of
patients treated annually to a market potential,
you need to multiply by the annual drug cost
 Information on drug costs can be obtained from
various free sources
 Some companies do publish an approximate cost per
month or course of therapy
 Drug benefit formularies (e.g. ODB Formulary)
 Government studies (e.g. http://www.nice.org.uk)
 Purchased information
 http://www.micromedex.com/products/redbook

Sales-Based Approach
 Some information is available for free
 Financial reports by public companies
 Analyst reports
 The most detailed information must be
purchased and can be very expensive
 http://www.imshealth.com/portal/site/
imshealth
 http://www.decisionresources.com/
 http://thomsonreuters.com/
products_services/healthcare/
healthcare_products/
 Canadian data - http://www.broganinc.com/ GWS-BIO

 Approval Timing: First-In-Class
 Clinical Data: Best-In-Class
 Competition
 Reimbursement
 Patents
Market Risks

Market Risks: First-In-Class
 Where several new drugs are structurally
related, have the same biological target and
similar safety and efficacy profiles, first-in-class
(first approved) should have a market
advantage
 If the new drug is going to be a second or later
market entrant, how is it going to take market
share?

Market Risks: Best-In-Class
 Where several new drugs are structurally
related and have the same biological target,
best-in-class (superior safety and/or efficacy)
should become the class sales leader even when
it is not first-in-class
 If a new drug is not going to be best-in-class
and it will reach the market after the superior
product, should product development be
terminated?

Market Risks: Three Levels of Competition
 There are three levels of competition:
 Currently approved drugs
 Drug candidates at the same stage of
development
 Drug candidates at an earlier stage of
development

Competition: Currently Approved Drugs (1)
 Currently approved drugs are competition only
if the new drug is attempting to replace one of
the currently approved drugs
 Currently approved drugs are not competition if
the new drug is going to be used in combination
with the currently approved drugs or will be
used only after the currently approved drugs no
longer provide the desired clinical benefit

Competition: Currently Approved Drugs (2)
 Information sources
 Drugs@FDA http://www.accessdata.fda.gov/
scripts/cder/drugsatfda/index.cfm
 Physicians’ Desk Reference http://www.pdr.net/
home/pdrHome.aspx
 Compendium of Pharmaceuticals &
Specialties http://www.pharmacists.ca/content/
products/ecps_english.cfm
 Textbooks
 Courses
 Purchased reports

Competition: Drug Candidates (1)
 Information sources:
 www.clinicaltrials.gov
 Analyst reports
 Purchased reports

Competition: Drug Candidates (2)
 Drug candidates at a similar stage of
development can be categorized and the
competitive threat assessed with respect to:
 The biological target
 Drug of the same chemical class, different
chemical class or biologic
 Comparative safety and efficacy in similar
clinical trials
 Drug candidates at an earlier stage of
development are less important from a risk
perspective but their development should be
monitored

Market Risks: Reimbursement
 Obtaining reimbursement for new drugs and
medical procedures used to be a simple case of
submitting paperwork
 The pharmaceutical industry is fighting
constantly to prevent restrictive formularies
and comparative therapeutic testing
 Launching new medical devises and diagnostics
is much easier if the new products can be
covered by existing payment codes

Market Exclusivity: Patents
 The basic patent life is 20 years from date of
filing
 Patent life extension is available in the U.S. to
account for regulatory delays and compensate
for pediatric testing
 Data exclusivity now provides periods of
exclusivity during which a generic product
submission cannot be filed or approved if it
relies in any way on the regulatory filings of the
originator product

Patent Risks: Critical Questions
 Are there issued or filed patents which will
provide a period of market exclusivity?
 Would the product infringe on other patents
(freedom-to-operate)?
 Assuming product approval in year 20xy, how
much market exclusivity is provided by both
patents, patent extensions and data exclusivity?

Conclusion
Valuation and financial modeling
is a qualitative and numerical assessment of
risks and potential rewards
 Anybody can crunch the numbers
 Better assumptions lead to better numbers
 Better assumptions come from asking the right
questions

MaRS Best practices: Valuations in the biotech industry - Wayne Schnarr

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