MaRS Best Practices Series

Special Valuation Series Nov. 12th, 2010

MaRS Best Practices Special Valuation Series

Friday Nov 12th @ Noon

Raymond King, Senior Manager Toronto Stock Exchange

Wayne Schnarr, Analyst, Equicom Toronto Stock Exchange

Disclaimer & Disclosure

The information contained in this presentation has been compiled by Equicom and/or Wayne Schnarr from sources believed to be reliable, but no representation or warranty, express or implied, is made by TMX Group, Equicom, its affiliates or any other person as to the accuracy, completeness or correctness. All estimates, opinions and other information in this presentation are subject to change without notice and are provided in good faith but without legal responsibility or liability. Additional information may be available to Equicom or its affiliates that is not reflected in this presentation.

This presentation is provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities discussed herein in any jurisdiction. This presentation is not, and under no circumstances should be construed as, a solicitation to act as a securities broker, dealer or adviser in any jurisdiction. This presentation is prepared for general circulation and to provide an overview of investing in healthcare. This presentation does not consider the investment objectives, financial situation or particular needs of any particular person. Investors should obtain professional advice based on their own individual circumstances before making an investment decision. To the fullest extent permitted by law, neither The TMX Group, Equicom, its affiliates nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of or reliance of the information contained in this presentation.

Equicom may have advised or provided services to, or may in the future advise or provide services to companies, entities or persons referenced in this presentation.

Valuation and financial modeling

is a qualitative and numerical assessment of

risks and potential rewards

 Each biological target, product and company has a unique set of risks and potential rewards.

 Despite the uniqueness of each product and company, it is possible to establish a general valuation process in biotechnology

First,

a little introduction to capital markets

Global capital markets

Canadian capital markets

The pharmaceutical industry

Where is valuation important?

 Investing

 Financing

 Partnering

 Selling

Who invests in these companies?

  Angel investors

  Venture capital

  Canada

  US

  Institutional funds

  Canada

  US, EU, ROW

  Retail investors

  Canada

  US

Investors establish valuations

The value of a company is the price the next investor is willing to pay

  Private company – price set by the VC willing to lead the next round

  Public company:

 Daily basis – set by the next trade

 Financing – set by the lead investor

Why would you buy shares of a company?

Mature Healthcare   Capital gains from an

increase in share price

  Income from dividends and distribution

Why would you buy shares of a company?

Mature Healthcare   Capital gains from an

increase in share price

  Income from dividends and distribution

Biotechnology   Capital gains from an

increase in share price

Investors also want liquidity

  IPO   Last one in Canada was IMRIS in late 2007

  Sale or acquisition of the company

  Breakup of MDS

  2009: ViroChem by Vertex

  BioChem Pharma, ALI Technologies, ID Biomedical, AnorMED, Arius Research (2008), CryoCath (2008)

What impacts daily buying & selling?

  Valuation

  Liquidity

  Some institutions may only buy deals

  News flow

  Clinical events which can impact share prices

  Development partners

  Competitive products

  Broad market performance

  Sector preferences

  Rising resource commodity prices attract high risk money

Investors in mature companies pay for growth

Investors in mature companies pay for growth from:   An increase in sales of products or services;

and / or

  An increase in profitability (earnings per share or eps); and / or

  An increase in dividends or distributions.

  Share prices in development stage biotechnology companies should be impacted by clinical, regulatory and financial events

  Investors pay for:

 Reduced risk; and / or

 Increased potential reward.

Biotech investors also pay for growth

How do stock analysts value a biotechnology company that is several years from product approval and profitability?

  Discounted earnings / cash flow   Comparative valuation   Event-based stock movement

Valuations by stock analysts

Now,

the easy part -

number crunching

Financial modeling – the basics

The components of financial modeling in increasing order of importance are:

The Excel spreadsheet

The assumptions for the spreadsheet

What you do with the numbers

Financial modeling – create the numbers

The first step is creating the numbers, no matter what method is going to be used to analyze them

  Create a large spreadsheet or a series of linked spreadsheets

  Horizontal – number of periods over which cash flows will occur (months, quarters, years)

  Vertical – all cash flow categories, both expenses and revenues

  Fill in all of the boxes

Valuation Tools – How To Analyze The Numbers

  Net Present Value (NPV)   The preferred valuation tool

  Risk-Adjusted NPV   Risk adjustments can be done here or at the

portfolio level   Internal Rate of Return (IRR)

  Uses the same spreadsheet and assumptions   Payback Period

  Very useful in manufacturing projects   Monte Carlo Simulation

  A structured sensitivity analysis

Net Present Value (NPV)

A project or product cash flow analysis that takes into account the fact that $1 received or spent in 2010 is worth more than $1 received or spent in the future

 NPV = C0 + C1/(1+R)1 + C2/(1+R)2 + … Cn/(1+R)n   C = cash flow in the specified financial period   R = cost of capital (risk free or risk adjusted)

NPV – $100 received in the future

What is the value today of $100 received in future years (risk-free discount rate of 5%)?

Year NPV 2010 $100.00 2013 $86.38 2018 $67.68 2023 $53.03 2028 $41.55

NPV – effect of risk-adjusted discount rates

What is the value today of $1 billion received in 8 years using risk-adjusted discount rates?

Rate NPV 10% $466.5 M 15% $326.9 M 20% $232.6 M 25% $167.8 M 30% $122.6 M 35% $90.6 M

Using financial models   These models are usually based on little information

and many assumptions   The quality of your financial model will depend

upon the quality of your assumptions   Better assumptions result from asking the right

questions   They are generally not useful for absolute valuations,

unless they are based on historical sales data   What can you do with the financial models?

  Compare NPVs for different deal structures for the same product

  Compare NPVs and risk profiles for different products

The hard part –

assessing risks

and

potential rewards

Risks & Rewards

  ‘only about 10% of the drugs which enter human clinical trials will eventually be approved’

  The development of novel healthcare products is a high risk business

  Neither big pharma nor stock analysts are good at picking winners

  Risk cannot be eliminated

  Risk can be mitigated by larger companies through portfolio management

  Risks can be assessed

Risks & Rewards: A Balancing Act

  Assessment of risks is much more important at the earlier stages of the development process

  Assessment of potential rewards, based on product sales, becomes more important as the product progresses through clinical development

  The only justification for taking these high risks is the potential large reward from successful product development

  Risks and potential rewards change with time and must be continuously assessed and balanced

Risks & Rewards: Three Stage Process

  Approval Risks

 What are the risks which could impact the approval of this product?

  Market Potential

 What is the market potential for this product?

  Market Risks

 What are the risks which could impact the market potential for this product?

  Financial: Capital Markets, Partnerships

  Regulatory

  Manufacturing

  Clinical

  Scientific

Approval Risks

Money is the scarcest asset

  Money has been, and is likely to remain, the scarcest asset for Canadian healthcare companies

  Funding must be continuously obtained from two primary sources

  Capital markets

  Partners

  Supplementary funding is also available from other sources

 Governments

  Disease associations

Show me the money!

  Canadian healthcare companies have historically been able to get sufficient funding from private and public capital market sources

  Liquidity was also available from periodic IPO windows

  In this context, companies preferred to periodically get financing in the public markets and continue development without a partner as long as possible

Show me the money, PLEASE!

  The markets and financing strategies changed dramatically starting in the fall of 2007

  Financing was more difficult

  Valuations plummeted

  IPOs were almost impossible

  Companies have been forced to consider all strategic and financing options

  For many small biotechnology companies, the focus became survival

Venture Capital Investment in Canadian Life Sciences Companies

Source: www.cvca.ca

Year Amount Financings

2004 $463 M 120

2005 $438 M 100

2006 $493 M 89

2007 $633 M 82

2008 $359 M 86

2009 $215 M 70

2010 (H1) $156 M

Investment in Public Development Stage Canadian Healthcare Companies

Source: Equicom Healthcare Reviews

Quarter 2005-2007 (average) 2009 2010

Q1 $378.4 $64.5 $115.2

Q2 $270.6 $177.5 $72.7

Q3 $97.3 $103.4 $65.5

Q4 $292.2 $152.8  

Total $1,038.5 $498.2 $253.4

Critical Questions

  Does the company have the financial resources to get to the next critical value-creation event, with a little breathing room?

  If the answer is no, can the company obtain that financing?

  If the answer is yes, and the event is positive, can the company then obtain additional funding either from the capital markets or a partner?

  Information sources   www.sedar.com

  http://www.sec.gov/edgar.shtml

Partnering

  Big pharma:

  Has cash and infrastructure

  Needs products

  Small biotech:

  Needs cash and infrastructure

  Has products

  Partnerships will continue to be signed

Risks: Partnering Deal Hurdles

  Buyer’s perspective:

  Buyers see thousands of opportunities every year

  Buyers are risk averse

  NIH (not invented here) syndrome by internal R&D teams

  Detailed due diligence is expensive

  Valuation and deal terms

  Seller’s perspective:

  Loss of control

  Valuation and deal terms

Risks: Partner or Buy? (1)

  When partnership discussions start, an acquisition is always on the table

  If the junior partner is a private company:

  VCs historically have preferred an IPO

  Sale of the company is now the preferred option

  The sale price can be split into up front cash and success payments

  If the junior partner is a public company, it is potentially for sale every day to other SMEs, larger biotechs and big pharmas

Risks: Partner or Buy? (2)

  From the potential partner’s (buyer’s) perspective, partnering is preferred because:

  There is a lower initial financial risk

  There is the same level of control over product development

  There are no HR or other problems when shutting down local operations

Regulatory Risks: The Critical Question

The critical event prior to generating revenues from sales is regulatory approval.

“Is there is a pathway to regulatory approval?”

The starting point in assessing regulatory risk is the end of the process – regulatory approval.

Basic Approval Requirements

  Two adequately controlled clinical studies which have been designed to prove the safety and efficacy of the new drug for a specific therapeutic indication

  A single trial is acceptable for certain diseases such as cancer

Regulatory Approval Risks (1)   Therapeutic indication

  Is this the first product which the FDA will assess for this therapeutic indication? If yes, is there a scientific or medical consensus on how to assess the product?

  If there have been unsuccessful pivotal studies, was it the product, therapeutic indication or the clinical design?

  Is the proposed indication a new monotherapy, an addition to the current therapy or a therapy to be used only when there is no response to current therapies?

Regulatory Approval Risks (2)

  Clinical Design

  Are there any differences in clinical design for this new product versus clinical trials conducted for approved products?

  Are there any differences in clinical design for the Phase 3 study and the preceding Phase 2 study?

  If there are differences, what are the justifications for these changes?

Regulatory Approval Risks (3)

  Standard of Care

  Is there a single FDA-approved standard of care for the chosen therapeutic indication?

  Is there more than one FDA-approved standard of care for the chosen therapeutic indication?

  If there is not an FDA-approved standard of care, is there a standard of care accepted or approved by the relevant medical groups?

  Are there products currently under regulatory review or in pivotal trials which, if approved, would result in a new standard of care?

Regulatory Approval Risks (4)   Primary clinical endpoint

  Is there a clinical endpoint accepted by the FDA for proving efficacy in this therapeutic indication?

  If not, are there clinical endpoints accepted or approved by the relevant medical groups?

  Are there any difficulties in the acquisition or interpretation of these endpoints?

  Is the primary clinical objective a superior safety profile and non-inferior efficacy?

Regulatory Approval Risks (5)

  Statistical analysis

 What are the statistical assumptions used in the design of the clinical trial?

  How are patient withdrawals handled?

  Is there any history of large placebo effects in this type of clinical trial?

Regulatory Approval Risks (6)   Statistical versus clinical significance

  A result can be statistically significant but the clinical benefit can be so small that it may not be clinically significant

  For example, is a statistically significant 2-week increase in survival also clinically significant when survival on the current standard of care is about 6 months?

  This result may previously have only impacted potential sales but clinical significance is now being discussed at FDA advisory committee meetings

Regulatory Approval Risks (7)   Safety profile

  The safety hurdle has been raised at the FDA

  The safety concern is highest for drugs which are intended for chronic use and for drugs to treat patients with medical conditions which are not immediately life-threatening

Manufacturing Approval Risk (1)

  Manufacturing is a critical regulatory component

  The manufacturing process has to meet GMPs

  The facility has to meet GMPs and be inspected

  Companies may face the following situation   If the process or facility used for Phase 3 / approval is

not commercially viable, changes need to be made before significant sales can be developed

  However, the cost of getting to a commercially viable process and facility prior to Phase 3 can require substantial scarce resources before knowing whether the product can be approved

Manufacturing Approval Risk (2)

  GMP processes must be reproducible and validated

  Chemical synthesis of small molecules is usually not a problem

  Isolation of natural products from a biomass can usually be controlled

  Recombinant manufacturing of proteins is complicated but controllable

  Upstream production

  Downstream purification

  Finished dosage form

Manufacturing Approval Risk (3)

  Manufacturing facilities are expensive

  Small molecules

  API – contract manufacturing

  Finished dose – contract manufacturing

  Biologics

  Capital cost of fermentation or cell culture facilities is enormous

  Contract manufacturing is available

  Changes in manufacturing scale and facilities can change the clinical activity of a biologic

Scientific Risk If the answers to the following five questions are

yes, there is probably an acceptable level of scientific risk.

  Do we know how the drug works?

  Do we know what causes the disease and how the disease progresses?

  Is the drug’s target a key factor in disease progression?

  Are the animal models predictive of human results?

  Does the preclinical data show that the drug is as effective as or superior to currently approved drugs or drugs currently in clinical development?

Manufacturing costs

  COGS (cost of goods sold) are an important component of due diligence conducted by potential partners and investors

  Rough guideline for COGS at commercial scale:

  COGS for biologics should be less than 10% of the selling price and preferably below 5%

  COGS for small molecule products should be less than 5% of the selling price and preferably less than 2%

Market Potential: Two Approaches

  There are two basic approaches to estimating the market potential for a new product

  The starting point for one approach is the number of patients with the medical condition, which is further refined by considering factors such as the number who are diagnosed, the number who are treated, success of current therapies and disease progression

  The starting point for another approach is the sales of drugs currently used to treat patients with this specific or similar medical conditions

Patient-Based Approach (1)   Estimated incidence of a specific medical

condition in the general population

  Number of patients diagnosed   Unless a patient is diagnosed, they cannot be treated

  Diagnosis by disease severity

  Treatments for Stage 1 through 4 cancers are dramatically different

  Treatment for a specific disease stage   How many patients receive first-line therapy?

  How many are cured, how many die and how many relapse and receive second-line therapy?

Patient-Based Approach (2)

  To go from an estimate of the number of patients treated annually to a market potential, you need to multiply by the annual drug cost

  Information on drug costs can be obtained from various free sources   Some companies do publish an approximate cost per

month or course of therapy

  Drug benefit formularies (e.g. ODB Formulary)

  Government studies (e.g. http://www.nice.org.uk)

  Purchased information   http://www.micromedex.com/products/redbook

Sales-Based Approach

  Some information is available for free

  Financial reports by public companies

  Analyst reports

  The most detailed information must be purchased and can be very expensive

  http://www.imshealth.com/portal/site/imshealth

  http://www.decisionresources.com/

  http://thomsonreuters.com/products_services/healthcare/healthcare_products/

  Canadian data - http://www.broganinc.com/ GWS-BIO

  Approval Timing: First-In-Class

  Clinical Data: Best-In-Class

  Competition

  Reimbursement

  Patents

Market Risks

Market Risks: First-In-Class

  Where several new drugs are structurally related, have the same biological target and similar safety and efficacy profiles, first-in-class (first approved) should have a market advantage

  If the new drug is going to be a second or later market entrant, how is it going to take market share?

Market Risks: Best-In-Class

  Where several new drugs are structurally related and have the same biological target, best-in-class (superior safety and/or efficacy) should become the class sales leader even when it is not first-in-class

  If a new drug is not going to be best-in-class and it will reach the market after the superior product, should product development be terminated?

Market Risks: Three Levels of Competition

  There are three levels of competition:

  Currently approved drugs

  Drug candidates at the same stage of development

  Drug candidates at an earlier stage of development

Competition: Currently Approved Drugs (1)

  Currently approved drugs are competition only if the new drug is attempting to replace one of the currently approved drugs

  Currently approved drugs are not competition if the new drug is going to be used in combination with the currently approved drugs or will be used only after the currently approved drugs no longer provide the desired clinical benefit

Competition: Currently Approved Drugs (2)

  Information sources

  Drugs@FDA http://www.accessdata.fda.gov/scripts/cder/drugsatfda/index.cfm

  Physicians’ Desk Reference http://www.pdr.net/home/pdrHome.aspx

  Compendium of Pharmaceuticals & Specialties http://www.pharmacists.ca/content/products/ecps_english.cfm

  Textbooks

  Courses

  Purchased reports

Competition: Drug Candidates (1)

  Information sources:

 www.clinicaltrials.gov

  Analyst reports

  Purchased reports

Competition: Drug Candidates (2)

  Drug candidates at a similar stage of development can be categorized and the competitive threat assessed with respect to:

  The biological target

  Drug of the same chemical class, different chemical class or biologic

  Comparative safety and efficacy in similar clinical trials

  Drug candidates at an earlier stage of development are less important from a risk perspective but their development should be monitored

Market Risks: Reimbursement

  Obtaining reimbursement for new drugs and medical procedures used to be a simple case of submitting paperwork

  The pharmaceutical industry is fighting constantly to prevent restrictive formularies and comparative therapeutic testing

  Launching new medical devises and diagnostics is much easier if the new products can be covered by existing payment codes

Market Exclusivity: Patents

  The basic patent life is 20 years from date of filing

  Patent life extension is available in the U.S. to account for regulatory delays and compensate for pediatric testing

  Data exclusivity now provides periods of exclusivity during which a generic product submission cannot be filed or approved if it relies in any way on the regulatory filings of the originator product

Patent Risks: Critical Questions

  Are there issued or filed patents which will provide a period of market exclusivity?

  Would the product infringe on other patents (freedom-to-operate)?

  Assuming product approval in year 20xy, how much market exclusivity is provided by both patents, patent extensions and data exclusivity?

Conclusion

Valuation and financial modeling is a qualitative and numerical assessment of

risks and potential rewards

 Anybody can crunch the numbers

 Better assumptions lead to better numbers

 Better assumptions come from asking the right questions