The Internet Economy; Biotech Style

Euphoria reigned at the Chase H&Q annual health care conference. Biotechs that seemed unable to buy an audience last year presented to rooms so crowded that breathing itself was difficult. To some extent, the biotechs, particularly the genomics companies, were benefiting from the rotation of investors out of the Internet. But something else was afoot: the Internet way of valuing companies had come to biotech. In particular, the biotechs are no longer being valued according to some basic earnings model, but--like the Internet plays--on their potential to dominate their niches, and then use their financial power, as reflected in their share prices, to consolidate to themselves other and harder assets.

The January 1999 Hambrecht & Quist Healthcare conference was about as depressing as this benchmark industry event ever gets—granted you were in anything except e-health.

Twelve months later and euphoria reigned at the Westin St. Francis. Biotechs that seemed unable to buy an audience last year presented to rooms so crowded that breathing itself was difficult. Chase H&Q figures its attendance, about 3,400 last year, was at least 4,500 this year, stretching the seams of the Westin St. Francis to the bursting point.

To some extent, the biotechs, particularly the genomics companies, were benefiting from the rotation of investors out of the Internet and into "the next thing," says Dennis Purcell, Chase H&Q's global head of Life Sciences. The popular press had taken up the cause of genomics, pushing less sophisticated investors into a neighborhood that had largely been the home of biotech sophisticates. "The CFOs don't really know now who owns their stocks," says Purcell.

Nor does it take a lot of investors to move biotech stocks. Purcell points out that earlier this year, the average biotech traded about 100,000 shares a day; in the fourth quarter, they were trading 400,000 shares. The activity brought in the momentum players who cared less about where a stock was going to be in six months than where it would price at the end of the day—and usually it was up. In one December day of trading, Incyte Pharmaceuticals Inc. saw its stock go from $34 to $72 and settle at $47.

But something else was afoot: the Internet way of valuing companies had come to biotech. Said one VC: the Internet companies aren't valued on earnings, but on the potential to dominate a business. Such domination requires overwhelming financial power which would permit the collection, probably through acquisition, of enough assets to assure the domination, not just of an emerging niche, but of allied, traditional businesses, over the long term. In effect, shareholders are both picking dominators and helping to ensure their success by pushing their stock prices to levels which permit the domination. America Online's acquisition of Time Warner, announced on the Monday the conference began, seemed to symbolize the almost infinite new-economy possibilities in the strange alliances between shareholders and their asset-poor Internet corporate champions.

A parallel set of alliances seemed to be forming in the biotech industry. As economically vague as any Internet businesses, biotechs have nonetheless always been valued—when any quantitative methodology has been at all applied—by discounting back from some compound's theoretical earnings. Valuations have thus always been restricted to a fairly narrow band: it is the rare biotech company which burst the $500 million market valuation level, let alone $1 billion. Today, dozens of companies cavort in this stratospheric realm.

The more the investment world believes in a new economy—where dominant positions in emerging niches can be leveraged into domination of substantial traditional businesses—the more it affords favored new-style biotechs the opportunity to acquire similarly traditional sets of assets. By doing so, they not only construct long-term barriers to entry, they ensure a very different group of industry leaders (and given their anemic stocks, it appears that the market has indeed lost confidence in Big Pharma's management).

The biotech analogy to the AOL/Time Warner transaction is not lost on investors. Amgen Inc. 's market value is now greater than that of Schering-Plough Corp. , American Home Products Corp. , Eli Lilly & Co. , Abbott Laboratories Inc. , and SmithKline Beecham . Genentech Inc. is worth more than Pharmacia & Upjohn Inc. and Astra Zeneca PLC. "Is it a stretch," asked one financier at the conference "for Millennium [market cap: $5.8 billion] to buy Genzyme [market cap: $4.4 billion] or even for Alkermes [market cap: $2 billion] to think about buying Alza [market cap: $4 billion]? Adds Dennis Purcell: "Genomics companies need to move swiftly and cleverly to take advantage" of their stock to buy other assets. "They can even layer debt onto their balance sheets. Here's where the smart managers will distinguish themselves."