Large Pharma and Small Biotech Deals Expected to Increase in 2010

Andrew Baum, a health care investment analyst from Morgan Stanley, issued a report last week titled "Exit Research and Create Value" advising large pharma companies to drastically cut back on their in house R and D spending in favor of in-licensing drugs from biotech firms that have reached later stage studies. The report mentioned large pharma firms such as AstraZeneca (AZN) and Sanofi-Aventis (SNY) which he believes should turn from the costly high failure rates of their experimental drugs by expanding the pace of licensing agreements with biotech firms that often provide experimental products at a fraction of the cost.

From the Morgan Stanley report:

Reinvestment of internal research savings into in-licensing will yield three times the likely return, we calculate. Under in-licensing deals, downside risk for pharma companies is currently materially lower than for internally developed drugs. Although upside is also capped by pay-aways and milestone obligations, the net present value of these payments is more than offset by the lower risk-adjusted invested capital. Over one-third of pharma R&D spend is in pre-phase II, where the probability of reaching the market is <10%. Our proprietary analysis indicates that, unless the probability of an in-house molecule reaching the market is 30% or more, the risk-adjusted economic value added, or EVA, is three times higher under the external research model, with a greater predictability.

This scenario is also playing out with Pfizer (PFE), where the belief that partnering or licensing products from smaller biotech firms would cut failure rates and boost profits while improving safety during the development stage. Pfizer executives stated last week that the company expects to spend between $9.1 and $9.6 billion on R and D in 2010, which is less than Wall Street analysts had expected.

Also, Pfizer offered guidance that it expects R and D spending falling between $8 billion / $8.5 billion by 2012. As Morgan Stanley notes, these bloated pharmas spend approximately 1/3rd of their overall budget during the earliest stages of product development with only 10% of these early experimental drugs making it to market. However, the odds increase to 20% for drugs in Phase II testing and closer to 50% for developmental drugs in Phase III.

This surely makes the case as to why smaller biotechs with promising products in Phase II and Phase III testing are worth a gamble by diligent investors. One thing that will not change is the risky nature of investing in smaller biotechs, and any investor should complete their own strong level of due diligence before following the recommendation of a professional analyst, never mind a non-expert blogger. I believe an investor in risky plays should only invest what they can afford to lose.

I am a shareholder in a small biotech, market cap $150 mil, that has a buccal insulin spray in US Phase III testing. The insulin spray has been approved in a handful of countries, and recently the FDA granted the first ever diabetes related Treatment IND approval to this potential blockbuster.

To be clear, Morgan Stanley researchers did not mention my speculative biotech in their research report, however their reasoning for large pharma in-licensing from biotech firms brought me renewed confidence in my own analysis. The biotech is Generex Biotechnology (GNBT) and their buccal insulin spray is named Oral-lyn.

I previously reported here that Oral-lyn buccal insulin had been the proposed subject of a Single Technology Appraisal by the UK's National Institute for Health and Clinical Excellence with a scoping workshop set for November 2009. In an update, the Ministers at the UK's Department of Health formally referred the topic to NICE commencing the work programme to set official guidance for buccal insulin within its licensed indication for the management of type 1 diabetes. The listed January 2010 NICE work programme referrals from the Ministers at the UK's Department of Health can be seen here.

Generex also has a wholly owned cancer vaccine unit, Antigen Express, that has a synthetic peptide vaccine for her2/neu breast cancer in US Phase II testing in conjunction with the United States Military Cancer Institute. This vaccine just illustrated its efficacy in the interim results showing no recurrences for patients taking this vaccine at 13 months. This vaccine is named AE37 and the company is planning a Phase III study later this year. Generex and Antigen Express are also currently planning a Phase II study for the AE37 vaccine for prostate cancer patients after reporting successful Phase I results at ASCO in 2009. There are zero safety issues reported for either of Generex's top two new drug candidates.

Generex also has developed a patented drug delivery system, called Rapidmist, that enables large molecule drugs that are currently prescribed by pill to instead be sprayed into the mouth cavity where the drug is absorbed through the mucosa lining of the inner cheek wall. The technology behind the Rapidmist delivery system is being validated by the positive clinical results reported for Oral-lyn buccal insulin. Such a novel drug delivery system may not only improve patient compliance, but also help large pharma firms extend the patent protection of their blockbuster drugs. A large pharma with a blockbuster drug facing patent expiration may consider novel drug delivery options, such as Rapidmist, to extend the life cycle of their blockbusters via newly issued patent protections.

Since a small biotech such as Generex has fully funded their promising drug candidates to late phase trials on their own, they have eliminated the main risk for any potential partner(s). The small biotech shouldered the full R and D costs and as a shareholder I can tell you that process is often painful. Since the trend towards large pharma either partnering or in-licensing with promising small biotechs is clearly increasing, the odds may have also increased that a great reward will come our way.

Disclosure: The author is long GNBT.