Jason Zhang, Ph.D. Analyst Prudential Equity Group, LLC

Our fearless prediction for biotechnology in 2007 is that more small- to mid-cap biotech companies will be acquired by either large pharmaceutical (pharma) or large biotech companies. We believe the recently announced acquisitions (Figure 1) are only the start of more acquisitions to come in 2007.

Biotech companies are being acquired by large pharma for several reasons. First, a huge disparity of market capitalization continues between large pharma and biotech companies, making the pharma-biotech purchase relatively easy on the books. Even after the recent market-cap shrinkage of large pharma and the incredible market-value growth of several biotech companies, the total market cap of the large pharma companies (14 largest) is still approximately 4 times the total market cap of all listed (about 430) biotechs. If we take out the top-10 biotech companies, the ratio is a stunning 10 times. The total market cap of biotech companies, excluding the top 10, is about $150 billion, which is about equivalent to GlaxoSmithKline plc, the second-largest pharma company in the world. As a result, the purchasing power of large pharma companies, either in paper money or hard cash, is enormous relative to the market valuation of biotechs.

Second, large pharma is starving for pipeline additions. Large pharma is realizing that its thirst for products, particularly in the late stage, can be quenched by biotechs. More often than not, large pharma companies prefer product licensing and collaboration over outright acquisition. This approach hedges the downside financial risk if a drug does not work out in clinical trials, and it provides meaningful upside potential if the drug is approved. As an increasing amount of large pharma companies jump into this game and the supply of attractive products decreases, the price tag for licensing and collaboration increases dramatically (Figure 2). Furthermore, more biotech companies want to hold on to the U.S. marketing rights or demand 50/50 profit split in the major markets. These developments force more large pharma companies to entertain the idea of outright acquisition, particularly if the target company has more than one attractive product or an attractive technology platform.

Finally, the strategic changes in many large pharma companies in the last few years have made them more acceptable to companies with products in specialty markets. Not long ago, the product licensing and acquisitions of many pharma companies were limited to $1-$2 billion. A product needed to have that kind of revenue potential to justify large pharma’s huge, predominantly primary-care sales force. However, once pharma companies realized that such products were hard to produce, they restructured their sales organization to be more aligned with specialty markets in which a small but highly focused sales organization could generate more profitable revenue. As these pharma companies’ R&D pipeline rarely had these “specialty” drugs, they eagerly turned to biotech companies, which happened to have plenty of such drug candidates in development.

It would be difficult for us to predict which company was going to be acquired, and by whom, because large pharma companies acquire biotechs for different reasons. In general, most of the deals that occurred in the last few years have involved biotech companies that have had active product collaborations with a pharma company; have held a product that was best-in-class or first-in-class or was a threat to a major drug within a pharma company; or had a technology platform that could be widely adopted to increase R&D output. When considering all of these criteria, we think the following companies in our coverage universe are the most likely to be acquired.

MedImmune, Inc.

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click the image to enlarge Select Pharma-biotech partnerships: valuations and numbers

Vertex Pharmaceuticals