Biotechs Tune Up for the Mating Dance

Is the biotech sector gearing up for a wave of merger mania?

Conditions seem ripe. After lining their pockets with record-breaking piles of investor cash in 2000, biotech firms are finding the pickings a bit slim this year. That's setting up a nice game of Survivor: Biotechs with bulging wallets are in a position to gobble up brethren with nothing but two nickels to rub together.

But don't expect a mass rush to the deal table. Slumping stock prices are forcing companies to tread lightly. And the underlying strength of the entire sector -- including an unprecedented number of drugs in the development pipeline -- means that mergers will be struck not as a survival tool, but to make already strong firms stronger.

"What you'll see in the next six to nine months is big biotech companies buying small biotechs to create a deeper and more diversified drug development pipeline," says John McCamant, editor of the Medical Technology Stock Letter. "These days, taking one or two shots on goal [with potential new drugs] is too risky."

Wall Street money flowing into biotech has slowed dramatically. In 2000, publicly held biotech firms raised $29 billion, shattering all previous records, according to Burrill, a biotech merchant bank. That figure included $10 billion raised in the first quarter of 2000 alone.

But in the first three months of this year, only $1.4 billion was raised, mainly from $711 million in secondary offerings, according to Burrill. While $1.4 billion is nothing to sneeze at, financing activity for the rest of the year is not expected to rise anywhere near last year's level, given the turmoil on Wall Street. The American Stock Exchange Biotechnology Index is off 23% from the start of the year, underperforming the S&P by 13%. And the three biotech IPOs launched this year are all trading below their offering prices.

It can cost anywhere from $50 million to $200 million to fund the late-stage testing and paperwork required to get a single drug through the approval process. Being able to fund this expensive drug development work -- and do it over and over again -- will fuel merger activity this year and determine whether a company ends up a buyer or a seller, biotech observers say.

So who are the likely buyers? The usual suspects: Big-cap biotechs. Amgen(AMGN Quote - Cramer on AMGN - Stock Picks) has more than $2 billion in cash and cash equivalents in its corporate coffers, according to figures compiled by Lehman Brothers. Celera(CRA Quote - Cramer on CRA - Stock Picks), Genentech(DNA Quote - Cramer on DNA - Stock Picks), Human Genome Sciences(HGSI Quote - Cramer on HGSI - Stock Picks), Immunex (IMNX Quote - Cramer on IMNX - Stock Picks) and Millennium Pharmaceuticals (MLNM Quote - Cramer on MLNM - Stock Picks) all have more than $1 billion in cash on hand. Other companies with healthy cash accounts include Abgenix(ABGX Quote - Cramer on ABGX - Stock Picks), Protein Design Labs (PDLI Quote - Cramer on PDLI - Stock Picks) and Biogen(BGEN Quote - Cramer on BGEN - Stock Picks).

Pharmaceutical giants could also jump into the market. Biotech companies typically ink drug development and marketing alliances with big drug makers, but as was the case with Johnson & Johnson (JNJ Quote - Cramer on JNJ - Stock Picks) buying Alza(AZA Quote - Cramer on AZA - Stock Picks) for $10 billion in stock at the end of March, mergers do happen.

The list of sellers is harder to pinpoint. McCamant of the Medical Technology Stock Letter says any biotech company with less than 18 months of cash left should be looking for a deal.

Stock prices are down, and they don't look like they're coming back anytime soon," he says. "If you're a company that's running out of cash, you'd be smart to be proactive about finding a merger partner," he says.

Scott Morrison, national director of the life sciences practice at Ernst & Young, paints with a slightly broader brush. Of the approximately 550 publicly held biotech firms in the world, only about 100 have the market capitalization and fund-raising chops to push ahead with a viable drug development effort. The rest -- 450 companies -- are vulnerable for a takeover, he says.

"Any biotech company with a market cap below $150 million could be a target in this market. It's that simple," Morrison adds.

Biotech observers say a representative sampler of possible merger targets -- companies with promising drugs but handicapped by small market valuations or a dearth of cash on hand -- might include Triangle Pharmaceuticals(VIRS Quote - Cramer on VIRS - Stock Picks), which has several promising HIV drugs in development; Corvas(CVAS Quote - Cramer on CVAS - Stock Picks), which is developing a drug to prevent life-threatening deep vein thrombosis (blood clots in the legs or groin caused by surgery); United Therapeutics(UTHR Quote - Cramer on UTHR - Stock Picks) and its roster of experimental drugs to combat vascular disease; and Ortec International(ORTC Quote - Cramer on ORTC - Stock Picks), which has developed a cultured skin product to treat wounds.

Again, it's not known whether any of these firms are actively seeking merger partners, but observers say their current profile could put them on the seller's side of the deal table.

But while an uptick in M&A activity is predicted, a huge wave of consolidation is unlikely. Most buyers still want to pay for deals with a mixture of stock and cash, so weak stock prices could keep some potential buyers on the sidelines. And buyers are going to be picky about their targets, looking for deals that fit their corporate strategies and augment existing drug development efforts.

Millennium is one biotech firm planning on acquisitions to bolster its roster of potential drugs. The company, with six experimental drugs already in various stages of testing, reiterated plans this week to acquire another four or five potential drugs, either through acquisition or licensing deals.

This is a strategy that's paid off for the company in the past. Its most advanced drug candidate, the lymphocytic leukemia drug Campath, is awaiting approval from U.S. drug regulators this quarter. Millennium acquired Campath when it purchased biotech firm LeukoSite in October 1999. "It's critical for biotech companies to have a diverse and high-quality drug pipeline. Having one or two drugs isn't enough," says Morrison. "This is difficult for even the biggest companies like Amgen to grapple with, so you will see companies using cash to buy pipeline, especially when the market is down and the opportunities are out there."