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The biotech paradigm.

This is CE's third biotechnology roundtable - the first one was held in 1987 - and in many ways, the concerns of participants have changed. Fears that biotech wizards would be unable to push ideas off the drawing board and into the marketplace have waned as giants such as California's Genentech and Amgen have proved themselves skillful researchers, marketers, and distributors. Similarly, concerns have faded that the international partners of some U.S. firms will funnel key technology abroad, robbing the industry stateside of its competitive advantage.

But in a business that manipulates genes to fight cancer, enhance the nutritional value of food, and create pale-colored trout that are easier for fishermen to see, one concern remains as vexing as ever - the painful shortage of capital needed to bring products to market. Genentech CEO Kirb Raab says the R&D price tag may run some $300 million over a minimum seven-year period. Exacerbating the matter, Wall Street's relationship with the industry continues to blow hot and cold: Periodic buying frenzies seem to alternate with near neglect or disillusionment. With conventional funding channels blocked, biotech companies are pursuing alternatives, such as private placements. Margaret B. McGeorge, a biotech analyst for San Francisco-based Sutro & Co., notes an uptick in such arrangements, under which companies sell shares at a discount to market value of up to 20 percent.

"As capital markets open and close, I breathe sighs of relief or shed tears destruction," says roundtable participant Kenneth I. Moch, president and CEO of New York-based Biocyte, a pioneer in blood collection and storage technologies and cancer and immune disorder therapies.

"I get up every morning, look in the cigar box, and know exactly what I have to do before the end of the day," quips George Ebrigbt, CEO of commercial research lab Cytogen.

The funding pinch also is helping to drive consolidation in an industry that presently comprises 1,120 companies with $5.9 billion in product sales and $13.6 billion in shareholders equity, according to Ernst & Young. Most expect the number of companies to plunge over the next several years. Roundtable discussion leader Frederick Frank, senior managing director with New York-based Lehman Brothers, foresees more companies junking plans to become fully integrated pharmaceutical companies, instead recasting themselves as the providers of research and technology for large pharmaceutical firms.

Meanwhile, the industry also faces the dragon of health-care reform. The costs of treatment, not just their efficacy, are coming under greater scrutiny, particularly as health-care buying power becomes concentrated in government and in managed-care providers. Perhaps worse, the Clinton Administration also has flirted with the idea of capping drug prices, an approach some industry observers argue would have a chilling effect on new product development.

"Investors have to see the opportunity to get above-average returns in exchange for taking above-average risk," says Sutro's McGeorge. "If they don't, they won't invest. Pricing is one way biotech firms recoup their R&D expenses and provide such returns."

In a sign of the times, San Francisco's Chiron Corp. is introducing a new bio-technology drug at different price levels for the rich and the poor, the insured and the uninsured. Betaseron, a drug used to treat multiple sclerosis, is slated to bit the market soon. The price for a year's supply of the drug will run nearly $10,000, But Chiron promises to provide free prescriptions to uninsured individuals who earn less than $20,000 a year and who are without health insurance or access to Medicaid.

Despite such self-regulation, says McGeorge, the conflict over pricing will endure until legislators and regulators forsake "a line-item approach" for a "more comprehensive view." Adds roundtable participant Bob Easton, president of medical consulting firm The Wilkerson Group: "Until we put a value on saving a life or living without pain, we won't solve the pricing problem."


Frederick Frank (Lehman Brothers): over 220 publicly held and 900 privately held biotechnology companies operate in the U.S. In general, biotech companies are capital short and opportunity long. Capital formation in this industry always has come at odd years, starting in 1983 and ending in 1991. The aberration came this year when a new princess, Hillary Clinton, arrived in Washington armed with health-care proposals that will make capital even scarcer than it is now.

Until recently, capital has been provided by a series of partners. The first were venture capitalists. The next were corporate collaborators. The third, and by far the most generous group of partners, was the public. But unlike the venture capitalists who have realized enormous risk-adjusted rates of return as investors in this industry, the public has experienced a negative rate of return. That's the nub of the whole problem.

In recent years, venture capitalists have invested in start-up biotech companies two years before they went public. That means they pay less than the general public. Therefore, if a company goes public at 10, and the stock goes to 6, the venture capitalist with the $2 cost has still made three times his money, while the public has lost 40 percent.

My thesis is that there will be a fourth source of capital, a "force majeure": a partnership between biotech and pharmaceutical companies - really more of a shotgun wedding with the market holding the trigger. Pharmaceuticals are capital long and product short. In contrast, as I mentioned before, the biotech puppies are capital short and product long. They can leverage one another's accomplishments very well. Previously, biotech companies strove to become fully integrated pharmaceutical companies such as Syntex and Marion Laboratories. However, most companies have discovered that goal is not realistic, since it requires duplicating the extensive manufacturing, marketing, and sales infrastructure that exists in the pharmaceutical industry.

The new structure will be comprised of just-in-time companies. JITCO structures return to basic economic theory: Optimize comparative advantage. Biotech companies need to marshal their brains, their resources, and their energies to focus on their expertise - discovery, research, and development. Biotech firms need to become JIT providers of products or technologies to the pharmaceutical industry.

To illustrate, ALZA wanted to become a fully integrated pharmaceutical company. Alex Zaffaroni thought the drug delivery methodology would generate enough revenues to do so. Well, Alex had his derriere handed to him after his first product, and he decided technology should be the driver, not integration. Today, ALZA is a successful JITCO company with a market value of $5 billion plus.

Kenneth I. Moch (Biocyte): After the 1987 stock market crash, everybody thought there'd be lots of mergers, and the biotech industry would die, but that didn't happen. So how can you be so sure mergers will take place today simply because of a lack of capital?

Frank: Good question. In 1987, the markets bounced back quickly. And there were some positive industry advances in technology around that time. If you look at biotech now, there aren't many positive events happening. Take the expectations about health-care reform, which I hope we spend some time talking about today. That's a cloud looming over the heads of biotech, pharmaceutical, and other related companies.

Even if there were cause for optimism, creating success in a short period of time is almost impossible. Wall Street raises expectations beyond reality, stocks sell like crazy, and the problems start. After moving a product from the growth phase to maturity, you can't tell the research department to come up with the cure for the common cold 18 months from now to satisfy stockholders.

The other problem is the approval process. Say the FDA approves about three times as many products per year than it did previously. Take the number of approvable products, divide it into the number of companies striving to get into the approval queue, and we come up with the average number of years between approvals for a given company. The answer will add a lot of impetus to the merger thrust. There will be a hell of a lot less than 220 companies left when this is all over.

George Ebright (Cytogen): If somebody is going to engineer a way to bring together biotech and pharmaceutical companies, it is not going to be a simple, straightforward transaction with the pharmaceutical company buying all or a major piece of the biotech firm to get access to its pipeline. Young people in biotech can smell a large corporate embrace six months away. And they will flee for their lives.

Frank: I don't think we will see pharmaceutical companies acquiring biotech companies. They don't want to take the risk of acquiring human assets they can't control.

It's going to be biotech to biotech. However, there will still be people problems because of new management alignments and deciding which projects to keep, sell, or terminate. I saw a potential merger between Liposome Company and Liposome Technology collapse because of people problems.


Michael A. Romansky (McDermott, Will & Emery): Let's look at biotech against the broader background of overall health-care reform. I've been following health-care issues for about 20 years. Health-care reform often covers a multitude of areas: reducing the deficit, saving money, providing care for the uninsured. President Clinton also sees health-care reform as a means of revitalizing the economy, creating jobs, making America more competitive in the global marketplace.

These are lofty objectives, especially since the decision-making process in Washington is so bizarre. To begin with, Hillary Clinton's task force has no supplier and provider representation. We've been promised the opportunity to look at the recommendations and indicate whether or not they're realistic politically and administratively, but we haven't seen anything yet. The process has been operating behind closed doors.

Roughly 25 committees in Congress will have jurisdiction over this issue - and one-quarter of Congress is new to Washington and relatively new to health-care issues. The Democrats are divided into different camps on health care. California Congressmen Pete Stark and Henry Waxman would like to see a government-managed system - Medicare for all - something that looks like Canada's. Maine Senator George Mitchell wants the government mandate approach, "pay or play." President Clinton wants a government guidance system - managed competition.

Some of the health-care reform principles we talk about aren't really as radical as we might think. Often, they simply intensify and accelerate processes that are already taking place, such as the movement toward prospective payment systems, outpatient care, managed care, fee schedules in pharmaceutical products, and outcomes research.

Originally, concern for the 37 million uninsured in America built the momentum behind the health-care project. However, cost containment is clearly paramount now, and it is providing the justification for potentially draconian cost controls over the next couple of years. Access will be phased in over many years. In terms of biotech, such controls will crimp funding even further, take a bite out of profits, force the abandonment of certain projects, and severely curtail operating freedom.

Other reforms may focus on limiting year-to-year increases in drug prices, expanding the rebate program, targeting some drugs such as Amgen's EPO, and implementing higher user fees. These are not really relevant to overall systemic reform, because drug prices don't make a big amount of difference in the whole scheme of things, but it's a popular issue, because consumers are paying for drugs.

Moreover, in an increasingly budget-conscious environment, the government will mandate that companies demonstrate that their products are not only safe, but also cost-effective and provide some compelling qualitative benefit. This is called outcomes research. It's not going to be enough just to have FDA approval.

Ebright: We're a $160 million commercial research laboratory. We began operations in 1980. We finally got our first products approved in December 1992. The sticking point was showing in our clinical studies how they would change the practice of medicine.

Sandford D. Smith (Repligen): Australia created a system of pharmacoeconomic justification as a separate process of approval. Will we have a similar situation?

Romansky: Outcomes research is still more of an art than a science. I think the idea is that an agency for health-care policy and research will look at some of the big technologies, and from that practice guidelines will be developed. But there isn't a centralized agency or mechanism for this type of research. And the FDA certainly doesn't have the background to do it.

Another thing about the FDA: Getting its approval doesn't mean you're going to get payment for a product or technology. There's still a wide gap between approval and commercial success.

Smith: in a discussion we had in a small group with Commerce Secretary Ron Brown, Bill Clinton, and others before the election, they were talking about the concept of creating a two-step drug approval process. The first step would determine the safety and efficacy of the product under the normal auspices of the FDA. In terms of the second, another agency would determine cost savings in health care projected over some 20 years, relative to the patient's treatment.

Mitchel Sayare (ImmunoGen): It would be a bleak situation if they use the results of your outcomes research to determine an economic value of your product and set an introductory price. You never can intuitively know whether an idea is economically viable. At the development stage, this approach likely would chill the new product process to a point where it may become moribund.

Robert Easton (The Wilkerson Group): You're right, Mitch. Until we put a value on saving a life or living without pain, we won't solve the pricing problem.

William W. Crouse (Ortho Diagnostic Systems): We just launched a product over the last few years that prevents the spread of one of the deadly forms of hepatitis in the blood supply. Normally, this doesn't turn into a chronic or debilitating illness for 20 years. But when it happens, there's a huge downstream cost to the system. There's enormous payback eventually for preventing the infected blood from getting into the system. But even if you use discounted cash flows, and net present value, it's difficult to put a price tag on the future value of a biotech product. Outcomes research isn't a science.

James Grant (T Cell Sciences): If you go back about three or four years and look at septic shock, the three companies racing to come up with a treatment - Centocore, XOMA, and Synergen - would never have spent the money to develop the technology if they thought an FDA efficacy-oriented outcomes model would determine who was going to get approved. They were all willing to take the market risk, they were all willing to gamble: Let three of us get approved, and we'll compete against each other. But they never would have made that investment if they had to deal with outcomes. That scares me.

Ebright: That's an excellent point. Look at Alzheimer's. Who the heck is going to take a risk on that if they think an unrealistic cap will be put on the price?

Bernard J. Korman (MEDIQ): Under managed care, none of that would be relevant. Absolute cost would be the relevant factor. We will have to ration to contain cost. That may lead to less technology and fewer products.

Easton: The minority view might be that the U.S. spends 14 percent of GNP on health care, while Germany spends 8 percent, and yet, the outcomes are the same. That suggests there may be 6 percent of GNP that's wasted.

Ebright: I think it's debatable whether the outcomes are really the same.

Easton: They are, George.

Crouse: We're not counting apples and apples either when we look at that 6 percent versus 14 percent.


Romansky: Bernard, you mentioned managed competition a few minutes ago. That's the buzzword in Washington today. For those of you who sell in hospitals, this system will, affect your customers. It's going to decide how they are paid, how much they're paid, and ultimately who they buy from. The system will have a tremendous impact on biotech companies in particular.

Managed competition seeks to integrate the free market principles of the Republicans and the regulatory concepts of the Democrats in order to control cost by creating a more competitive health marketplace.

Managed competition would consolidate the purchasers of health insurance into a regional or state entity called a Health Insurance Purchasing Cooperative. The HIPCs would buy from an Affordable or Accountable Health Plan, a government-approved entity that would integrate the provision and insurance of health-care services. It would be akin to a super HMO. The AHPs would be comprised of large hospital groups, large group practices, and insurance companies.

The AHP would offer the HIPC a set benefit package, and it would compete with other AHPs in the neighborhood on the basis of cost, outcomes, and patient satisfaction.

Shared risk would be the key to cost control. The HIPC, which would act as a broker for employers and others who buy health insurance, would pay a fixed premium to the AHP. The AHP then would contract with doctors, hospitals, and pharmaceutical dispensing entities.

However, there must be some incentive for the ultimate buyer - the consumer - to choose the AHP. The only real carrot or stick the government has is to limit the tax deductibility of health insurance to those plans. You only get your health insurance deducted if you participate in or buy from an AHP.

If an indemnity plan still exists, managed competition falls apart at the seams, because there's absolutely no reason to go to an AHP, which has built-in risk sharing and cost controls.

Easton: But most of us are insured through companies, not individuals.

Romansky: The question is, if the plan is not deductible, will the company continue to provide the tax-free benefit to the employee?

Easton: You're right if they gross it up. But if they don't gross it up, then the consumer takes a hit.

Romansky: Ultimately that's what going to happen.

Frank: If you want anything over the basic package, then the employer pays for it, and it's not tax deductible.

Romansky: You have to be willing to say to the consumer that if you get a larger or more expensive package, you're going to lose your tax deductibility.


Easton: There's a lot of room to save money in the system with a more rational approach to health care. I think managed competition is going to happen. But what if it doesn't?

Romansky: I have a whole page of reasons why some observers say managed competition probably won't work. But when you consider the alternative - a single-payer system such as Medicare - managed care begins to look good. if we are patient enough to let managed competition kick in without demanding savings from it inside of five, six, or seven years, it's a system that makes sense, at least on paper. But I don't know if we're patient enough to wait.

Grant: With or without managed competition, the FDA cannot approve biotech and other products fast enough. That means investors will lose faith in certain stocks. I am worried that this will continue to be a trend in whatever health-care program is established.

Frank: Cost is also a factor in the approval process. If you come out with a product that has some benefits, but they're marginal, and the cost is about $2,000 per treatment, you're going to have a harder time getting it approved.

Romansky: I think we'd be lucky if the FDA were the arbiter. Ultimately, the arbiter is going to be the AHP, the insurer, the HMO. It's not going to be a government entity. You're going to have to make the sale to the person buying the technology or product.

Crouse: I agree. It's going to be good business to document the value of what you're doing.

Smith: Right now, Eli Lilly has a department of about 20 people who do nothing but this.


Ebright: Outcomes research is a controversial topic, but there's another sensitive issue at stake in health-care reform as it applies to biotech companies and products - limiting new product pricing.

Let me give you some background. For many years in the pharmaceutical industry, product price increases have been far below the consumer price index. Then, in the late '80s and early '90s, price increases of existing products far exceeded the CPI. Why? The new product pipeline in the old pharmaceutical industry dried up. As long as there was somewhat of a flow of new products, the pharmaceutical industry didn't have to raise prices on existing products. It priced new products at a fair rate and maintained profitability. So to an extent, I have to say with some reluctance that the leaders of my old industry brought the government attention on themselves.

At the same time, however, there is a fair amount of politics being played here. While health care overall in the U.S. takes up about 13 percent of GDP, the pharmaceutical, biological, and biotechnology contribution to that is less than 7 percent. In fact, all pharmaceutical profits would be only 1 percent of the health-care bill. Why then has Clinton chosen to make this such a highlight of his attack? To form a constituency that says, "Boy, he did something. He has found a gold mine." One of the few things the older people of the U.S. pay for out of their pockets is the pharmaceutical product they pick up from the drugstore. Virtually everything else is paid for by a third party.

I think there is room for some price squeezing in the pharmaceutical industry. There are excesses, and the pharmaceutical skirts aren't altogether clean. However, there will come a time when even the wealthy pharmaceutical companies must rely on capital investment from some part of society. If the government caps pricing flexibility, it will be difficult for pharmaceutical companies to function and make a contribution.

Romansky: So far, the focus in Washington has been much more on the year-to-year increases on existing drugs, rather than prices on new drugs. I can't imagine reform changing that significantly.

Kenneth F. Tempero (MGI PHARMA): The European pricing model is much more tightly controlled. American companies are freer to get full market value sooner. Which of the two models is better?

Ebright: I don't know. European companies survived. One of the reasons they survived is probably because they operate in a market separate from their own where there is free pricing opportunity. It's sort of like the cost shifting that you hear hospitals talk about. If they get squeezed down and don't cover their costs with a reimbursed segment, somebody else pays a little more.

Easton: Every one of those companies makes more money here than it does in its home market. And it's making more money here than American companies are there.

Ebright: There was a time when the pricing structures in Western Europe weren't always as tight as they are now. Only later, particularly in France, did countries make it difficult to get a decent price for your product even after you had it approved scientifically.


J.P. Donlon (CE): What critical adjustment will your company have to make over the next year to 18 months in light of expected health-care reforms?

Crouse: Whether we're talking about suppliers or providers, biotech or pharmaceutical or diagnostics companies, or other types of medical products companies, we have to work more in partnership and use the existing resources to commercialize our new technologies. In that way we can drive both quality and cost containment.

I believe health-care technology is in a huge growth cycle. Part of the increased profits we've seen in the '80s is due to the new technology that's been introduced. When you couple that with the unmet needs of the uninsured and the aging population, I think we have a bright future. The demand for quality in health care and cost containment - which are both needed - are not contradictory goals.

Moch: I'm the president and CEO of Biocyte, a cellular transplantation company. I call biotechnology companies such as mine R&D pipelines unencumbered by revenue. As capital markets open and close, I breathe sighs of relief or shed tears of destruction. I've been living this way for a decade, and it's never been any fun. But right now I have even less control.

The health-care reform process is going to take years. And as long as the uncertainty lasts, it will affect the imputed returns of the industry. In turn, these returns affect the willingness to commit capital, and the willingness to commit capital affects survival. So, the riskier the situation, the more companies die, and the less new ones are created. Frankly, mine might be one of the casualties.

Robert Serenbetz (DNA Plant Technology): I also am concerned about financing my company's future growth. I represent the agricultural biotechnology sector. This sector has gone through a consolidation over the last 10 years. Probably only 10 companies have survived. DNA Plant Technology probably will need some financing within the next 18 months. We'll probably have to make some cutbacks, which isn't fair to those shareholders who have stayed with us.

Ebright: No major changes in our initiatives at Cytogen. Life is very simple for the CEO of a biotech company that is not yet financially independent. I get up every morning, look in the cigar box, and know exactly what I have to do before the end of the day.

Tempero: My company, MGI PHARMA - which is a developmental-stage biopharmaceutical firm - has been fairly well capitalized, and we've run like crazy trying to remain that way. The single most important adjustment is going to be the selection of projects in the pipeline. In a rather cowardly way, we are going to select those that appear most likely to succeed.

Smith: At Repligen, we're going to be less expansive in the number of protocols we run for clinical trials and in the amount of additional research we do. We'll look at more innovative financing schemes and rely heavily on mergers. And ultimately, we'll probably end up with less control of the company than we would like.

Sayare: As a biotech company involved in cancer research and treatment, we don't want to get scooped up. Thus, we've put most of our resources behind the products we have in the clinic and forgotten about the pipeline.

We also won't have the same volume of academic research. Hillary is talking about a 10 percent reduction in the federal budget for the National Institutes of Health, and a 40 percent reduction in indirect costs. Without academic institutions, we won't have the research to maintain the biotech momentum.

Korman: Fortunately, we are a health-care services company, not a biotech company. We're all going to live with cost containment, possibly in the form of price caps. The result may be the rationing of health-care services. Ultimately, technology will be restrained by shortage of capital.

Robert A. Vukovich (Roberts Pharmaceutical): My company is something in between a biotechnology and a pharmaceutical concern. We're managing our risk by looking at products that have had some of the R&D risk taken out of them.

Though pharmaceuticals is our core business, we've looked at some diversification, as well. For example, we just launched a home-care medical products division. We also have a blossoming contract research business.

We have not focused on biotech products or blockbuster drugs. We believe there are ample opportunities for drugs with sales in the $200 million range - niche products - which would make a significant contribution to the profitability and growth prospects of a small company.

In addition, we are seeking opportunities outside the U.S. We have products we were able to get approved for the overseas market before we could get them on the market here.

Stephen Turner (Oncor): We must accept that we're in an era of outcomes research, and do more thorough front-end planning. in an era of tight capital, R&D must generate maximum bang for the buck.

Biotech companies also have to speak out more. We are at a crossroads for American technology leadership. If we take the wrong fork, we'll regret it for generations.

Romansky: I don't think you're an industry that's been heard in Washington.

Grant: That may be so, but our future is not under our control; it's in Washington's hands.

Eugene F. Wilcauskas (Akzo America): Like most European companies, we're a little late getting into biotech. We don't have a real capital problem, but we have to recognize that in the U.S. we will be operating in a new environment dictated by Washington. In the end, we simply will have to be as cost competitive as we can.

Frank: For a number of you in biotech, the choice will become, pick your partner or it will be picked for you. All of those 220 companies aren't going to survive. You're going to have to do a lot of soul searching. The early people who go through an amalgamation, prioritize their projects, and utilize their resources more intelligently will survive and succeed.

Gaynor N. Kelley (Perkin-Elmer): Perkin-Elmer Elmer has made a big bet into biotechnology in recent months. And I believe it will pay off in the long run.

If heavy-handed government slows biotech research, the U.S. may lose forever its technological advantage. And if we lose that edge, we will be relegated forever to play a less significant role in the most significant industry of the early 21st century. I think that would be a damn big mistake.
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Title Annotation:CE Roundtable; biotechnology industry
Publication:Chief Executive (U.S.)
Article Type:Panel Discussion
Date:Oct 1, 1993
Previous Article:Reformation redux.
Next Article:The Clinton scorecard.

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