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Derek Lowe The 2002 Model

Dbl%20new%20portrait%20B%26W.png After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases. To contact Derek email him directly: Twitter: Dereklowe

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December 21, 2004

Optioning the Drug Portfolio

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Posted by Derek

Howard Simons of has a column today on the drug industry that I can't quite place: is it a stroke of genius, or is it the product of a diseased Wall Street mind? I'll lay it out here, and we'll see what the readership here thinks. He's not TheStreet's regular pharma industry guy, but he gives a competent review of the problems we face:

"First, let's remember this sector's importance to us as investors. The S&P Pharmaceutical index is the largest of the 132 index groups comprising the S&P 500. It accounts for 6.879% of the market's capitalization, so given the prevalence of indexation strategies, it is highly likely that you own these firms in one form or another. . . Second, the pharmaceutical industry is as much of an intellectual property business as software and entertainment are. Just as the first copy of a new operating system costs hundreds of millions of dollars to design and test and the second copy costs about 15 cents to stamp out on a CD, pharmaceutical firms have massive initial fixed costs and minuscule variable costs of production. While their products are not stolen and counterfeited as often as software or music, they face myriad global price controls, third-party payer policies and regulations. . .A third industrial parallel for the pharmaceutical industry can be found with natural resource exploration and production. Each winner has to pay for as many as 20 losers, a daunting proposition. It is a small wonder indeed why firms in this industry spend as much time as they do in wringing out the profits from their few winners and developing me-too drugs."

(I'd add that that "20 losers" figure is just the stuff that makes it into the clinic - if you go back to the preclinical world, the ratio is far worse. Of course, from a financial point of view, each of those clinical losers adds up to more money down the chute, but the total preclinical losses are nothing to ignore, either. That's where I've been spending money since 1989.)

Simons specializes in writing about options, and he has a put-and-call man's perspective. He points out that when you buy a drug stock, you're buying the present portfolio of marketed drugs (where all the profit comes from), which is a wasting asset due to patent considerations, and you're buying the potential revenue from the stuff in the research pipeline. That pipeline, from his perspective, is a portfolio of out-of-the-money call options.

And y'know, he's got a point. Both the options and the drug candidates have a good chance of ending up worthless, but can potentially pay off at many times their existing price. And if you're going to invest in either one, you're better off with a list of them spread across different situations, because you've got enough risk on your hands as it is. (I speak as a drug industry guy and as someone who's lost money in options trades - everyone who's ever traded options has watched some of their money evaporate at some point.)

Perhaps some of you will have seen where his mind is going. Here's the pitch:

"The time has come for the pharmaceutical industry to securitize the options embedded in its product pipeline. Investors already own these options as a portfolio when they own the various stocks, so how much of a stretch is it to separate out each individual drug in the pipeline and sell it as a call warrant or option-embedded structured note to investors? The risk of each individual drug in the pipeline can then be confined to those seeking a portfolio of securities with very high risk but very high returns."

Never thought of that one, I have to say. It might fly - Simons points out that this is already how parts of the movie and petroleum exploration businesses work. A colleague of mine down the hall points out, though, that these industries are necessarily a bit more transparent than the drug industry. Would a drug company be able to provide enough information when a drug goes into Phase I, he wondered, for investors to make an informed decision?

It's a good point, but my reply was that many of the people investing in the industry already aren't all that much better informed. Actually, if you're buying small companies whose future is riding on one big approval, you're buying a single-candidate security anyway, and people make portfolios out of those. Each large drug company would transform itself, in the stock market, into a range of them with different maturity dates.

The other question is: just how much more money would we bring in by breaking out the portfolio this way? Presumably we could get more funding this way, but how much more? This plan would require more transparent bookkeeping to assign costs to the various development candidates, and investors would no doubt expect more regular updates on how things were going. You'd also have to figure out how these securities would pay off - when the drug gets approved? When the patent expires? (I sure wouldn't have wanted to be holding Vioxx warrants, that's for sure.) But there might be some real money to be made, and risk to be shared. We've got plenty of that to go around. . .

Comments (8) + TrackBacks (0) | Category: Business and Markets


1. qetzal on December 22, 2004 11:46 AM writes...

Interesting idea. Could the payoff come in a dividend form, from revenues that come in if/when the drug reaches the market?

An issue that comes to mind is that, if all drug candidates went this route, might there be even less incentive to pursue risky or small market drugs? Sure, plenty of biotechs pursue such drugs as their first shots, and they get funded. But often, biotech investors are backing a platform technology; the idea being that, if the first drug succeeds, it validates the technology and "proves" that there will be lots more.

Would that change if most/all drug candidates were funded individually? Would it be a bad thing if it did? I'm not sure.

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2. SRC on December 22, 2004 12:24 PM writes...

I proposed this once to a former employer, but with a slightly different twist, namely, doing it with institutional rather than individual investors (and perhaps including companies either contemplating a future strategic partnership, or those wanting to lay off risk by diversifying future revenue streams). In fairness, the idea was to dilute out the impact of, shall we say, "quixotic" internal management by involving potentially more rational backers.

It was a little too far out there, and would present accounting (and perhaps anti-trust) problems, but could possibly be made to work. Phantom (or another class of real) stock might be a way to make the investment more liquid, and therefore more desirable.

Taken to its logical conclusion, the company would have fragmented into a series of one product startups. No bad thing, IMO, but they probably had some inchoate understanding of that, and nixed the idea.

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3. Joss Delage on December 22, 2004 1:43 PM writes...

Interesting idea. What I'm really interested in is whether this would result in better investments and eventually more / better drugs. I.e., can a market decide to allocate financial resources to various drug candidates better than committees inside large drug companies? I suspect it would.

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4. Linkmeister on December 22, 2004 2:18 PM writes...

If this were actually done you might want to call the conversion the Accounting/Bookkeeping Employment in Perpetuity deal for one of the industry's cost centers. Yikes!

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5. qetzal on December 22, 2004 5:41 PM writes...

For the accounting, I would try to set up something like this. The investors, or their representatives, would have to pay for all the development work. Dept's within a given pharma would become, in essence, CROs, charging every project equivalent fees for equivalent work. Done properly, it seems like that would create an efficient market system where only the projects deemed by the investment market to have the highest risk-adjusted ROI would be pursued.

Of course, as Derek's already pointed out, lots of biotechs look very much like that when you strip away the trappings.

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6. SRC on December 22, 2004 8:17 PM writes...

In the last analysis, the only way to get it to work is probably to go to a series of one product startups to keep the accounting clean, and to hire the pharmco's service departments as CROs, as qeztal suggested.

That was exactly the plan. Whether they nixed it because they realized that that was the plan, or because of the bureaucratic inertia I was trying to escape, I never found out.

The problem with committees in a big company can be that members don't clearly perceive how their participation bears on the company's fortunes, and so sometimes place their own agendas (or inertia) ahead of the company's interests.

Small companies can't afford that sort of stuff.

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7. jeet on December 23, 2004 12:23 PM writes...

so who owns the sales force? how do you compensate the employees? do you pre-fund each product with enough cash to take it into Phase III, or does some higher group make that decision later?

should the spin-out be obliged to work with the big pharma's clinical research arm? what happens if there is better or more cost-effective CROs?

this just sounds like an incredibly complicated way to out-license your portfolio. just spin them out and be done with it.

as investors they should invest in a series of biotechs with a diverse set of products. same idea without the hassle of trying to turn a large integrated pharma company into a group of start-ups.

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8. Mark Hovde on December 23, 2004 5:36 PM writes...

This is an old idea that has some merit in cases where the pieces are worth more than the portfolio, after considering transaction costs. It was done in the early days of Centocor, when investors had an opportunity to buy individual securities for particular diagnostics and therapeutics, and was considered a success at the time. Today, one-product or one-idea biotechs offer this kind of pure play investment. If such an approach were used to disaggregate major pharma portfolios it might allow investors to pursue new strategies...for example, investing just in the alzheimers across several companies.

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