Listed-Australian biotechnology companies can be split into two groups, drug development companies and medical device companies.
A product is usually a drug if the primary intended use of the product is achieved through chemical action or by being metabolized by the body, according to the US Food and Drug Administration (FDA).
A medical device is more or less what it sounds like, although they are diverse. They range from things like Impedimed’s (IPD) L-Dex to Genetic Signatures’ (GSS) EasyScreen diagnostic tests on to Sirtex’s (SRX) SirSpheres.
The group a company sits in is important because it largely defines the company’s risk/return profile. Drug development companies are high risk, high return companies, while medical device companies are relatively moderate risk, moderate return companies, in general.
The risk-return nature of these companies stems from the fact that the drug and medical device industries are extraordinarily heavily regulated in most countries, particularly in the United States and European Union. These are not free markets.
The FDA will not allow a drug on to the market, unless the company can supply substantial evidence of its safety and efficacy, where safety refers to a drug’s side effects and efficacy refers to whether the drug adequately does what it is claimed to do.
Generally, the FDA defines substantial safety and efficacy as positive results from two large (often greater than 500 patients each), well designed, clinical trials. These are termed phase III trials and their price tags are high, often more than $100 million.
A company can’t just go straight into phase III trials with its drug. Rather, the company will generally have to follow the path given in figure 1.
Usually, this begins with a phase I study in a small number of individuals, the aim being to understand how the drug moves through the body and to initially assess its safety.
If the drug is suitable for further study, it will then progress into phase II studies, where the focus stays on safety, but, also, looks at efficacy.
Only one to two drugs out of 20 that start clinical trials, will eventually be approved, often 10-plus years later. And, herein lies the vast majority of the “high” in the high risk nature of drug development.
The development of medical devices also follow a defined pathway, although, the pathways are generally much less rigorous and vary considerably given the exact nature of the device.
It is the less rigorous development pathway for medical devices that largely explains the moderate risk nature of medical device companies.
So, what is responsible for the high/moderate return that compensates investors for taking on the levels of risk associated with drug and medical device development companies?
Starting with that question, we will take a look at a selection of recent events relating to ASX-listed Australian biotechnology companies.
Mesoblast Limited (MSB) is a company that Lodge Partners floated in 2004 and is one that we continue to like. The company, which is focused on developing adult stem cell products for various diseases, released its results from a phase II trial using its stem cells to treat rheumatoid arthritis (RA). The results look very solid and they caused the stock to run from around $1.13 to $1.80 in the days subsequent to the announcement.
Mesoblast has products in phase III trials for congestive heart failure, chronic lower back pain, graft versus host disease and Crohn’s disease. The quality of the RA results suggest that program will be headed to phase III studies, as well. The company also has several programs in phase II. Mesoblast is clearly the most advanced adult stem cell company in the world and, when you compare the maturity of its pipeline to those of other companies, at a market capitalisation of $511 million, Mesoblast is trading at multiples below where it should be.
Acrux Limited (ACR) has developed several products based on its transdermal drug delivery technology. Its most successful product by far is Axiron for testosterone deficiency, which is partnered with Eli Lilly and Co (NYSE: LLY). Axiron generated $25.3 million in royalties for Acrux in FY16 and just slightly less than that in FY15.
It hasn’t been all beer and skittles for Acrux, though. Worries about the overall safety of testosterone replacement therapies (TRT) a few years ago hit the stock hard. In August of this year, a US court invalidated key patents protecting Axiron. The so called “axilla patent” meant that only Axiron could be delivered to the armpit, which significantly differentiated it from other TRT products. The axilla patent provided Acrux with protection out to 2027. The court also invalidated Axiron’s formulation patent, even though that one has almost already expired (expiry 2017). The net result of the court’s rulings is that Axiron is likely to begin to see fairly direct generic competition much, much sooner than expected. The news saw Acrux’s share priced halved, from 72 cents to 35 cents.
Products like Axiron generally have very large gross profit margins of 70% to 80%, so when a patent expires or is invalidated, generic manufacturers rush in to compete. It is not uncommon for sales of patented products to decline by 50%-60% in the first few months after they face generic competition. This why Acrux has only a $62 million market capitalisation, despite earnings of $18.1 million in FY16.
Acrux and Lilly have announced that they will appeal the court’s ruling, but betting on the outcome of an appeal would require a very large amount of work. In the end, you probably just don’t need to be there.
That’s it for this month. In my next piece I will continue to look at recent major company events.