Biosciences: High Risk, High Reward, and the Potential for “Real Chaos”

While bioscience researchers struggle to understand the workings of the human body, biotech managers and investors are searching for ways to better understand this complex and quickly evolving industry, according to Wharton faculty and lecturers.

 

At a conference last month entitled, “Value Creation and Destruction in Emerging Technologies: Lessons for the Biosciences,” sponsored by The Mack Center for Technological Innovation at Wharton, speakers took lessons from earlier technologies and applied them to biotechnology.

 

George S. Day, co-director of The Mack Center, listed some of the forces driving change in the biosciences. They include market conditions, such as an aging population, and value-creating innovations, such as predictive medicine and gene-guided drug development. Other forces are capital availability, a maturing pharmaceutical sector, pricing pressure, and ongoing consolidation and shakeout in the industry. “There are innovative, exciting business models in conjunction with all of these forces,” said Day.

 

Researchers, he added, studied the Internet boom and subsequent slowdown and found that while there were some new business models, such as e-Bay and search engines, the biggest impact was on established firms that used the web to cut costs and improve efficiency.

 

Managers should weigh whether a new technology’s effect will be non-linear, having an impact not only on the company but on the environment in which it operates, Day suggested. “We are poised at an interesting junction in the evolution of these sciences and we are asking ourselves, ‘Who will be the winners and who will be the losers? What will be the strategies that succeed or fail in this environment?”

 

According to Paul Schoemaker, research director of The Mack Center, in 1965 it would have been difficult to predict how the development of the personal computer would play out. Venture capital investors and managers in the biosciences now face that task. “It’s not entirely random, but it’s not highly predictable either. People in the VC world have to take positions. We argue they need to take multiple viewpoints and hedge a little bit.”

 

Schoemaker said there are many tools to measure uncertainty, but most of them, such as net present value analysis, are best applied to lower-risk, lower-reward scenarios. Newer tools, such as scenario planning, influence diagrams and systems dynamic modeling, may be more appropriate when thinking about the high-risk, high-reward business of biotech.

 

The Mack Center, which is attempting to better understand the industry through its BioSciences Crossroads Initiative, has come up with a broad approach to developing bioscience scenarios. The approach includes defining the scope, time frames and viewpoint for the scenario. It also accounts for internal and external forces, key stakeholders, and external trends and uncertainties. Planners should take these forces, and the different ways they may play off one another, into account in designing scenarios, Schoemaker said.

 

“The future well being of the biosciences as a family of technologies may well hinge on two main issues: How much technological progress will be made and the social acceptance,” he added. “Many other issues are nested in that framework.”

 

Transformational Change

According to Richard Foster, a senior partner and director of McKinsey & Co., the U.S. has nearly 800 bioscience companies, most of which can be grouped into four categories; specific diseases such as cancer; testing and diagnostics; basic science, such as genomics or proteomics; and drug therapy and delivery.

 

Foster, author of the books Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them and Innovation: The Attacker’s Advantage, compared biotechnology today to earlier times in the semiconductor and pharmaceutical industries. His research showed inflection points in the industries’ progress using a host of measures, such as total return to shareholders and return on invested capital.

 

There are factors that differ among the industries, he noted, particularly the roles of government and provider payers in the healthcare market, but there are messages from other technology industries for biotech.

 

For example, businesses have a limited lifespan stretching from start-up to growth to maturity, with each stage reflecting different trajectories. Investors often have trouble judging the trajectory because they distrust sky-high multiples. Biotech analysts themselves frequently adjust their projections for a “period of delightful surprises.” After awhile, the analysts build models based on such surprises. “By the time they do that, they way overshoot,” Foster warned. “Then there are negative surprise models.”

 

Technology companies, he pointed out, are often driven by both incremental and transformational change. Incremental change comes from the lower reaches of a company and can result in big change in a slower, more evolutionary way. Transformational change comes from a strong commitment by top management and can lead to huge leaps in a company’s technology and valuation.

 

The biotech industry’s complex patterns of change lead to more surprises in the market than other industries, Foster noted. “You are partners with the market and its forecast. You have to understand the underlying reality, which is the technology, and then you have to understand the misforecasting.”

 

Foster said it is important for biotech managers to develop the ability to “zoom in” and “zoom out” in their thinking. Zooming in focuses on details underlying the business and its core technologies. Zooming out is a sense of how those technologies will play out in the larger environment.

 

He expects a new period of rapid entry and exit in the biotech industry over the next five to 10 years. “We can do all the analysis we want but at the end of the day there will be real chaos.”

 

Pharmaceuticals and the Productivity Gap

George Milne, former chief technology officer at Pfizer, described the pharmaceutical industry as one that is facing a “defining watershed.”

 

The industry has been wrestling with declining productivity for several years. Research and development spending increased 43% between 1995 and 2001 but new drug approvals decreased 49%, according to research from Accenture.

 

The productivity gap comes at a time when new tools for technological advancement are as promising as they have ever been, said Milne. But drug makers are operating under increasing pressure from the public and governments to shake up their highly profitable business model based on research, intellectual property and pricing power.

“In the past we faced a series of changes that were adaptive and reinforced the business and market model,” said Milne. “Now we face a qualitatively different confluence of factors that could change the industry from a relative success story to one of survival.”

 

At the moment, the industry is losing the public relations battle, which could result in deeply disruptive changes for all those involved. Milne warned that a complete loss of public confidence could lead to socialized medicine, which would hurt the industry’s ability to innovate. “We are ourselves eroding our position with lawsuits and lobbying. It’s not a pretty picture.”

 

According to Milne, the industry’s current posture puts it at odds with patients, who are also voters. He suggested that drug makers align themselves with patients. “This, after all, is the natural sweet spot of the industry.” Encouraging wellness would be one way to create those alliances, he said. Milne proposed linking the drug and life insurance industries. Drug companies could offer life insurance packages to patients who guarantee they will follow lifelong wellness regimes, including medication.

 

The industry has not moved toward this patient-centered model because the old one has worked so well and has created entrenched stakeholders, he added. It will take strong and innovative leadership to take the industry down a new path.

 

The change must amount to a new business model, not just “an offshoot of your marketing operations. My profound worry is that you have an emerging set of political issues, such as the single-payer system, that will destroy the ability to engage in true innovation going forward,” Milne warned. “I don’t see yet the thought leadership to get us out of that.”

 

New View of Killer Products

Technology fuels new brands to sustain corporations and create growth in existing markets. It can also propel small outsiders into market leaders, said Gerard J. Tellis, a marketing professor at the University of Southern California’s Marshall School of Business.

 

He pointed to Gillette’s strategy with razors, a 100-year-old product. Gillette routinely kills off a brand of razor before it reaches peak market saturation in order to replace it with a new Gillette product before the older product fades and cedes market share to competitors.

 

According to Tellis, there are three types of technological innovation: platforms, which are based on scientific principles; components, such as materials or parts; and design. He presented data compiled from a range of technology-based industries that he said illustrate some challenges to the prevailing view of technological advancement.

 

Technological progress, plotted over time, often is thought to be S-shaped. Growth starts slowly then shoots up rapidly before flattening out as the technology matures. But Tellis’ research indicates that the shape of progress looks more like a series of steps with repeated plateaus followed by sharp growth spurts.

 

It is important to recognize the plateau pattern, he noted. “When there is a plateau you think you should quit, but what we found is after the plateau there is another spurt, so if you quit, you quit too soon.”

 

Another prevailing view is that attacks on existing technology usually come from below. Tellis’ research suggests attacks are likely to come from above, in the form of superior technology at a lower price, or from below as lower-priced competitors improve the quality of their products. “You can’t say for certain where the next attack will come from,” he said. “You cannot dismiss either [type].”

 

Tellis even challenged the notion of the killer product, which he said is viewed as a product that is superior in its primary technological dimension and offered at a lower price. “The popular view is that in this dual attack nobody can stop this guy.”

 

But when you look closer at such a product, for example Windows 95, there is often a long series of innovations that led to the ‘killer.’ “With Windows there were many missteps and many failures until Windows 95 finally took off and killed everything before it,” Tellis said. “What you see from the outside is the big jump, the big breakthrough, when in fact there are small improvements day by day.”

 

Boom and Bust Cycles

Steve Sammut, a venture partner with Burrill & Co. in Philadelphia and a senior fellow at Wharton, described “pin ball effects” for biotechnology investors.

 

Historically, venture capitalists have had to rely on initial public offerings to earn back their investments. But biotech’s boom-and-bust cycles have proved frustrating. “Venture capitalists have relied on irrational public markets every few years to take them out. It’s not a sustainable model.”

 

Biotech companies need to spend as much time engineering their capital structure as they do engineering genes, he said, adding that the industry lacks people who have had direct profit-and-loss responsibility because most people who work in large pharmaceutical companies or universities do not get that experience. “We can’t find [managers] with that full comprehensive management experience. It’s a tremendous problem.”

 

He noted that pharmaceutical companies are facing a huge number of patent expirations that could cost the industry $20 billion in sales by 2005. The expirations will continue to force big drug companies to align themselves with biotechs that have products in development. “These are career-changing numbers,” said Sammut. “They will cause a major [shift] in the way senior managers think about their future and will inspire a greater number of collaborations.”

 

According to Sammut, the 5,000 biotech companies around the world that are gathering up patents, along with university researchers, have created a minefield for investors attempting to value a biotech’s intellectual property. Added to that, he said, is a gap of two to three years in the U.S. Patent office. “From a VC perspective, the issue of patents has never been cloudier.”

 

A summer run-up in biotech stocks is encouraging for the industry which has endured a funding drought since 2000. This quarter, the industry has 11 initial public offerings on file, up from zero, Sammut said, adding that the fate of those IPOs will be a telling indicator of whether the industry is poised for an investment bounce-back. “This is an industry hungry for cash.”

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