The biotechnology industry is undergoing massive consolidation. In 1998, the number and value of merger and acquisition transactions exceeded that of initial public offerings. In the first nine months of 1999, $20 billion worth of M&A deals were consummated (41 deals), as compared with $340 million worth of deals (seven transactions) in the comparable period in 1998.
Why is this occurring? The first reason is the still moribund state of the public markets for biotech stocks, except for companies with late-stage products.
More than 80 percent of public biotech companies are currently valued at less than $200 million; less than 5 percent of public biotechs (21 companies) are valued at more than $500 million. There are only 21 profitable biotech companies. These statistics have led institutional investors (the primary buyers of public stocks) to invest only in large cap ($500 million plus) biotech companies. These large cap stocks have generally outperformed market indices, gaining 17 percent in the third quarter and (to date) 30 percent for the year.
These are pretty good numbers, but it pays to drill a bit deeper.
Small-cap stocks (those valued at less than $500 million) have dropped an average of 24 percent since the beginning of the year. In addition to poor valuation, small cap biotech stocks offer poor liquidity.
While the 25 largest biotech companies display an average daily trading volume of 700,000 shares, the next 25 biotechs have an average daily trading volume of only 220,000 shares. As a result, of the roughly $20 billion invested in public biotech stocks over the last year by institutional investors, only 3.5 percent has been invested in small cap companies.
As a result, analyst coverage is focused on the larger biotech companies. In addition, investment banks themselves have consolidated over the past few years, resulting in half as many analysts as there were three years ago. Hence smaller biotech companies without products cannot raise cash in the public markets, resulting in the additional statistic that more than 50 percent of biotech companies in the United States have less than two years' worth of cash.
So M&A activity is rapidly increasing. Several models predominate. The first and most successful is that of the large pharmaceutical company buying a significantly sized biotechnology company with late-stage products.
Examples of such deals so far this year are Warner-Lambert's acquisition of Agouron, Johnson & Johnson's acquisition of Centocor, and Pharmacia & Upjohn's acquisition of Sugen.
These deals benefit the biotech company's current investors, but not so much earlier investors. For example, J&J acquired Centocor a few months ago for $61 per share, a 42 percent increase in Centocor's stock price since January. When compared with Centocor's IPO price in 1992, however, $61 a share represents a modest decrease.
The pharmaceutical companies are clearly benefiting from this "OPM" (other people's money) strategy, as are the large biotech's current investors.
A second variety of M&A deal involves biotech-biotech mergers.
Unfortunately, among the selling biotechs, there are few winners and many losers. For example, so far in 1999, there have been five deals valued at more than $100 million, and 36 deals valued at less than $100 million.
The Millennium/Leukosite deal that transpired recently in Cambridge is a great deal for both parties - but, unfortunately, it is a rarity. Most biotech-biotech deals are transactions of last resort for the seller. For example, Massachusetts-based Transcend Therapeutics was sold earlier this year at a more than 80 percent discount to the trading high of Transcend's stock during the prior three years.
In these biotech-biotech deals, the consideration paid by the acquirer is typically its stock, which can be quite illiquid and can also be subject to significant price fluctuations between signing and closing. Often a material portion of the consideration paid by the acquirer is also contingent on future performance by the target company, such as profitability or obtaining necessary regulatory approvals.
Unfortunately, only large biotechnology companies have the assets that pharmaceuticals really want, namely late-stage products to fill in gaps in the pipeline of the pharmaceutical company.
Smaller biotech companies, which offer much earlier-stage products or, alternatively, tools to discover drugs, are of far less interest to the pharmaceutical company as potential acquisition candidates. Of course, some winnowing out of the less-promising biotech companies is not necessarily a bad thing, since it will permit analysts to concentrate their attention on fewer companies and it will reduce the number of companies simultaneously seeking access to the capital markets.
Consolidation yields larger companies that are more likely to attract the interest of institutional investors. Economies of scale in manufacturing and sales can be realized by larger consolidated companies.
When Napoleon was asked many years ago about his management techniques, he said to his officers that "the best way to motivate a troop is to shoot a few." While harsh, there is a certain brutal logic to this view.
Technology industries follow an evolutionary pattern, moving from first a "growth" stage, to a subsequent "maturation" stage, and then finally to a "consolidation" stage. Clearly, the Internet service providers are in a growth mode, where capitalists chase ideas rather than profit. Biotech is in a maturation mode, where investors' expectations for returns have increased and access to capital has become more difficult.
The latter part of this maturation phase includes laying the groundwork for major consolidation. Size matters today in the biotech field. Consolidation should be a constructive engine for the continuing evolution of the industry.
Reprinted with permission. All rights reserved. Mass High Tech 1999.
The content of this article is general in nature and is not intended as legal advice related to individual situations. Counsel should be consulted for specific legal planning and advice.
