Biotech's Small-Cap Sickness May Be Catching

The prognosis for small-cap biotechs isn't bright. Unfortunately for the sector, it could be contagious.
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SEATTLE -- Amid the fog of Internet wealth off Puget Sound, it's easy to lose sight of the true state of the biotechnology industry. At the

Biotechnology Industry Organization

meeting, here in the hometown of

Immunex

(IMNX)

(it of the fat $11 billion market cap), industry folk have brought their microcapitalizations hoping some of Seattle's magic mist will rub off.

But if they listen closely to the money people, they won't like what they hear. Investors aren't particularly interested in anything to do with start-up biotechs. This is, after all,

Amazon.com's

(AMZN) - Get Report

hometown, too. Amazon and its brethren among information technology companies have the power to cloud men's minds.

"It's hard to argue that it's not a crisis" in biotech, says Dennis Purcell,

Hambrecht & Quist's

head of health care banking. "There is nothing on the horizon that suggests the investment community will dramatically change its view" and start bidding up shares of small- and mid-cap biotech companies. Purcell, an industry veteran, says one-third of the public biotech companies have about one year of cash left and have few options to raise dough.

"The biotech industry needs to raise around $8 billion to $10 billion a year

to fund research and development," he says. "Big Pharma has been keeping up its end of the bargain, with about $3

billion to $4 billion a year. But in the first five months of the year, only half a billion has been raised in the public equity markets."

And Big Pharma can only do so much. Between 1994 and 1998, the pharmaceutical industry participated in about 200 investments per year on average with the biotech industry. "That leads us to believe that the pharmaceutical industry can only do so many deals a year," he says.

The IPO market is moribund and straight equity deals for already publicly traded early-stage biotechs are as scarce as Seattle millionaires are plentiful. In other words, Big Pharma isn't going to bail out biotech and neither is the stock market.

Things got bad because of countless unanticipated blow-ups -- drugs that didn't work in late clinical trials, drugs not approved by the

Food and Drug Administration

or drugs that didn't sell well. Considering all this, Purcell doesn't think this is simply a case of biotechs being out of fashion.

"Given what we've learned about the risks, it's probably unlikely that things will swing back" to where they were in the early '90s, when a company putting its first product into human trials might be worth several hundred million dollars. "Smart companies assume the equity markets won't bail them out," says Purcell.

Purcell says that over the last several years, the world changed while biotechs were in the lab.

For one thing, many mutual fund managers have more money these days, as investors have thrown cash at funds. So they have less interest in small-caps because they have little impact on the performances of their bigger funds. Small-caps are now defined as $500 million to $1.5 billion, when it used to go down to $250 million. This leaves most biotechs as "nano-cap" orphans.

Also, the pharmaceutical industry is consolidating, especially in Europe. That has distracted them and inhibited their ability to make deals with biotechs. And the strong stock performance and growth of big pharmaceuticals means they need bigger acquisitions and bigger drugs to make a financial impact. There aren't many biotech companies or products that fit that bill.

And then there has been consolidation on Wall Street. Many boutique emerging growth investment banks have been swallowed by big commercial banks. They've subsequently not covered smaller companies and need to do bigger deals to make an impact on the bottom line.

No one has an answer. But many companies will go out of business. The ones that remain will need to cut programs and spending. There are some imaginative solutions. Tracking stocks, private placements into public companies, convertible deals. Purcell has even mused about leveraged buyouts, but these haven't happened.

What's left is buying each other. "The lack of capital makes M&A inevitable," Purcell says. But he says there are problems -- sigh -- to overcome.

Big Pharma's not acquiring smaller companies; it has found it cheaper to "rent than buy," he says. The big companies hold much of the power in negotiating product deals. They get good terms on the products they want without having to buy the infrastructure.

The big biotechs feel intense pressure from Wall Street to deliver steadily growing earnings. That means they are unlikely to do dilutive deals for their early-stage colleagues, says Purcell. "They haven't figured out how to take the financial risk out of the equation," says Purcell. If the big biotechs buy another money-sucking biotech, they haven't solved any of their problems.

However, the old problem -- CEO ego -- is dissipating, say the bankers. "People are tired, the stocks aren't going up and they have to answer their boards," says John Rumsey, Purcell's West Coast deputy.

"We have a few guidelines for a CEO," says Purcell. "If you need to be the CEO, you probably shouldn't be in the

merger meeting. If you need all of your products, you shouldn't be in the meeting. If you need all of your infrastructure and overhead, you probably shouldn't be in the meeting."

Nevertheless, H&Q keeps the biotech faith. Purcell points out: "There are very few industries that if you are right, you can make 20 times your money."