Ugly lessons from Biotech: Exelixis
In June 2007 Exelixis was riding high with a market cap well over a billion dollars, despite having no marketed products and in fact never having progressed a developmental compound to a phase III trial. The apparent reasons for the premium Exelixis enjoyed over other small biotechs were the sheer number of early stage products in the pipeline, as well as the company's ability to generate partnerships with larger pharmaceutical companies. Two major collaborations were with Genentech and Glaxo. The Glaxo deal seemed particularly significant as it allowed Glaxo to license several of Exelixis's early stage compounds. Ultimately, Glaxo only decided to continue the collaboration on one compound and walked away from the remainder of the deal. In 2008 Exelixis stock began a stuttering decline with intermittent rebounds at successively lower peaks. The decline accelerated with the broad market collapse in October and Exelixis now trades at a 350M cap, a 70% decline from recent highs. The Genentech collaboration remains intact on an early phase compound.
Now, I would never claim that a partnership with a large pharmaceutical company is a bad thing. After all, it can result in an upfront payment and possibly a lightening of development costs. But a careful evaluation of these agreements reveals them to be typically backloaded, with milestone payments and royalties that obviously depend on success of the compound in late stage trials and marketing. It's easy to be entranced by the hundred million dollar deals trumpeted by the small cap biotechs, but very few of these big payoffs ever occur. One thing a partnership with a large pharma cannot do is increase the likelihood that a compound will actually work. While a partnership may seem like a stamp of legitimacy on a compound in development, in fact these compounds don't seem to have a track record much different from those developed independently. Myriad was able to sell ex-US rights to their doomed Alzheimer drug Flurizan for 100M up front just a month or two before the phase III study was a failure, despite widepsread skepticism about Flurizan's prospects for success. Big Pharma often seems to have just as much difficulty as retail investors in distinguishing the wheat from the chaff in baby biotech. But when trials fail, the large company can simply walk away relatively unscathed while the baby biotech has to face the music the same as if the partnership never happened. And certain companies such as Exelixis seem to seek out partnerships as a primary goal, rather than advancing their compounds into late stage trials. This is a short-term strategy that pumps up the share price in the short term but ultimately proves to be unsustainable.
Several other small biotechs are notable for partnerships that didn't go anywhere. Altus was coasting on a partnership with Genentech on extended release growth hormone ALTU-238 until Genentech suddenly decided to walk away. A couple of other failures later and Altus trades in the pennies. ArQule is struggling despite a partnership with Roche on E2F-1 inhibitors that could be destined for the junkheap of history at the end of 2008. A partnership with Glaxo hasn't kept Epix stock out of the toilet. And a partnership with Pfizer that doubled Avant (now Celldex) stock in early 2008 didn't stop it from dropping 70% later in the year. Of course, our old favorite Nastech is another excellent example of what happens when trials go sour and partnerships vaporize. What we are left with is Biotech Rule #7: Do not buy a baby biotech's stock just because of partnerships and collaborations.
Exelixis's share price in 2008 provides us with another extremely valuable lesson. Despite trading relatively consistently in the 8-12 range in 2007, they've managed to find their way to new lows in 2008 without an obvious change in their fundamentals. An investor attempting to ascribe an objective valuation for Exelixis and setting an apparent low entry price of 6 or 7 might have jumped on the opportunity to buy in at that price. But he would have found himself watching his investment cut by another 50% as the stock dropped to its current 3.5. While setting a buy-in price may be a useful practice in other sectors, it's dangerous in baby biotechs with downward momentum. It's a principle somewhat related to that of being fearful when others are fearful, and that of cheap stocks getting cheaper. It's never possible to call a bottom in any stock, but in baby biotechs it pays to look carefully at the year chart. If the trend is steadily downward, the chances are that trend will continue. Examples of this in 2008 are too many to name, but Anesiva and Advanced Life Sciences are typical. Continuing selling pressure is not suggestive of a buying opportunity, but rather of fundamental problems in the company often related to information not available to the general public and retail investor. This leads us to Baby Biotech Rule #8: He who hesitates is saved. No matter how juicy a stock looks at a depressed entry price, avoid buying until the downward trend has clearly reversed.