Disco(very) Dancing to a Slower Beat?

SARS. Iraq. Recession. Terrorists. Risk aversion is in the air, and it hardly seems surprising that leading suppliers of discovery tools for studying gene expression are warning that their own businesses may suffer going forward. Roche and Merck say it's discovery-business-as-usual in Big Pharma, despite the fact that capital spending in the biotech sector has slowed. But some Wall Street analysts contend that customers are moving away from gene expression as a discovery vehicle. And such a point of view creates disturbing implications for the still unprofitable Affymetrix, which has yet to demonstrate that selling gene-based microarrays and related instrument systems is a model for a sustainable business.

SARS. Iraq. Recession. Terrorists. Risk aversion is in the air.

And in the drug industry that largely means a sharper focus on later-stage products at the expense of discovery technology. Thus it seems hardly surprising that leading suppliers of discovery tools for studying gene expression, Applied Biosystems Group (ABI), a unit of Applera Corp. , and Affymetrix Inc. , are warning that their own businesses may suffer going forward. Investors reacted with a knee-jerk, cutting the companies' share prices 19% and 35%, respectively, on the news—levels from which the stocks have yet to recover.

But are companies investing less in high-risk genomics-oriented discovery research? Yes and no.

"I don't get a sense that we or other [large] companies are doing less," says Lee Babiss, PhD, VP, preclinical R&D, at Roche . "There are no budget restrictions; the spending is there." Tony Ford-Hutchinson, PhD, EVP, worldwide basic research for Merck & Co. Inc. , similarly rejects the proposition that external events have had a significant impact on his discovery programs. "You've got to completely separate biotech from Big Pharma in that respect," he points out, because share prices of pharma stocks didn't catapult during the genomics boom as did those of biotechs and didn't have to readjust as dramatically. Capital spending in the biotech sector has slowed, he acknowledges, but much less so, if at all, in pharma.

Indeed, the desperation of biotechs to find deep-pocketed partners in the absence of robust capital markets has created more opportunity for discovery collaboration at Merck: the company's commitment to external research is now 15% of the basic research budget—the highest percentage ever. The amount of pharma M&A has also worked to Merck's benefit in this respect. "It's affected the number of pharma companies biotechs can deal with," Ford-Hutchinson contends. And he strongly takes issue with those who say genomics has merely created "more rubbish to sift through." "At Merck, early-stage productivity is up," he claims, in large part due to the ability to apply genomics information.

Lee Babiss, however, suggests that indifferent capital markets may even be affecting large pharma companies, including Roche. "Throughout biotech and pharma, there's a greater emphasis on delivering now," he says. And to some extent the pressure that creates from the Street is troubling. It's unrealistic for analysts to judge Roche or any pharma company on a quarterly basis, he laments, given 10- to 15-year drug discovery/development timelines. In addition, he points out that 50-60% of Roche's growth will be based on the development of its current pipeline.

"The problem comes when analysts look at the shape of our portfolio and whether it's changing quarter to quarter," Babiss explains. "There's a poor understanding of attrition," he believes, especially when planning for high attrition early is part of a company's strategy. "It has an impact on supporting R&D and has impacted [the stock price of] Roche."

Of course, quarter-to-quarter trends are much more relevant for suppliers such as R&D toolkit providers like ABI and Affymetrix. ABI, for its part, made many of the same primary arguments about the effect of external events in January 2002, when it discussed the unpredictability of forecasting its sequencing business. As it did recently with respect to 2003, the firm then cited uncertainties in the release of government funds for capital equipment spending as a primary reason for its inability to predict 2002 revenues.

That the same situation exists this year suggests a pattern that's now part of the company's business cycle. Moreover, as company president Mike Hunkapillar, PhD, said when ABI's sequencing business noticeably slowed, the sales cycle is looking like it did before the explosion in high-throughput sequencing, with the focus less on Big Biology" Human Genome Project and more on applications—Small Biology. (See "Out of Sequence," IN VIVO, February 2002 (Also see "Out of Sequence" - In Vivo, 1 Feb, 2002.).) Some Wall Street analysts go further, contending that customers are moving away from gene expression as a discovery vehicle.

Such a point of view creates disturbing implications for the still unprofitable Affymetrix. Unlike ABI, which has a broad-based research products business, Affymetrix has yet to demonstrate that selling gene-based microarrays and related instrument systems is a model for a sustainable business.

Indeed, concern over Affymetrix's growth prospects predated the company's earnings warning, which may have accounted for the sharp reaction to its April 3 preannouncement after the close of stock trading. Roche's Lee Babiss says he must have gotten calls from fifteen analysts in the last six months asking about Affymetrix and whether providing chips is a sustainable core business for a growth company. Uncertainty over Affymetrix's prospects was also heightened when GlaxoSmithKline PLC liquidated its stake in Affymetrix--4.7 million shares--in the open market over two days in mid-March.

Affymetrix understandably declined to comment on its preannouncement beyond the wording of its press release, which suggested a revenue shortfall due to slower instrument sales, prior to its formal earnings conference call on April 23. But if one believes the razor/razor blade analogy for sales of instruments and chips--namely, that instrument sales rise first as a marketer builds an installed base--until Affymetrix demonstrates that it can continue to grow its market at an acceptable price point as that market matures, the same thing that's true on the upside may be true on the downside: once equipment sales begin to soften, the trajectory of chip sales may decline.

Pricing has been an issue in Affymetrix's ability to grow both the academic and commercial markets for gene chips. Merck, for example, mostly works through competitor Agilent Technologies Inc. , from whom it apparently gets chips at a lower unit cost. Affymetrix says chip sales to academics remain strong, but they are lower-volume users than industry clients.

On the other hand, to anyone with a glass-half-full attitude, the ABI and Affymetrix earnings announcements could signal a downstream move from basic discovery to those applications more directly related to specific drug development programs. Affymetrix will participate to some extent here, through its majority ownership position in its high-density chip spin-off, the pharmacogenomicist Perlegen Sciences Inc. A recent agreement with Roche in diagnostics also gives it the backbone for a push into clinical genomics [See Deal]. But although Affymetrix will receive an amortized $70 million fee over five years from Roche under that deal, the alliance is unlikely to generate significant product revenues for several years.