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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Why Is It An Attractive Target? MedImmune manufactures and sells Synagis, an antibody used as a prophylaxis to prevent RSV infection in premature babies. Sales of the drug will be more than $1 billion for 2006, and we see no meaningful competition for the next five years. The company has shown that a second-generation antibody, Numax, could be slightly more effective than Synagis. If approved and launched, Numax, at a minimum, could extend the patent protection by more than 10 years and is more profitable than Synagis. At best, the drug may even expand beyond Synagis’s current market, to be used as a treatment of RSV infection. In short, the Synagis/Numax franchise should give the company a well-protected and very profitable stream of cash flows.

In addition, MedImmune is to receive royalties on two HPV vaccines, one from Merck and another from GlaxoSmithKline. With estimated combined sales of $4 billion at their peaks, MedImmune could receive up to $300 million per year.

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

Furthermore, we think the company’s flu franchise could turn around in 2007 with an expanded label to include children as young as one year old. Given that the vaccine has shown better efficacy than a traditional flu shot, sales of the vaccine could be substantial in the next few years as the government and the public get more serious about preventing flu infection in the U.S.

Who Are The Likely Acquirers? We think Merck is the most logical acquirer of MedImmune. Merck could do a better job of selling Synagis and save the royalty on its HPV vaccine it has to pay MedImmune. Merck would also find the flu vaccine business attractive. Given that MedImmune has a huge R&D budget, the deal could even be accretive to Merck if Merck cuts the R&D significantly.

What Are The Potential Acquirers Waiting For? We would argue MedImmune’s valuation is not particularly high given the assets the company has. What a potential acquirer may be waiting for is the FDA decision on the flu vaccine’s label, which should become available in late May 2007. A positive decision by the FDA would eliminate the last hurdle remaining before we see a very successful flu vaccine franchise.

Vertex Pharmaceuticals

Why Is It An Attractive Target? Vertex’s main drug is telapravir (VX-950) for the treatment of chronic hepatitis C. This is an oral drug that has shown unprecedented antiviral activity and could change the current paradigm of treatment by both shortening the treatment duration from one year to about three to six months and increasing the cure rate from about 45% to 75% or higher. We think the global HCV treatment market could be $8 billion, and telapravir’s peak sales could reach $3 billion.

Who Are The Likely Acquirers? Roche Holding AG and Schering-Plough are the leaders with drugs already sold for HCV. Novartis AG, Merck, Bristol-Myers Squibb (, Boehringer Ingelheim, Abbott Laboratories, and Johnson & Johnson, or J&J are all seriously developing drugs for this disease and could all be potential suitors of Vertex. J&J could be the front-runner considering its collaboration with Vertex for telapravir’s rights outside of the U.S. In addition, Novartis, Merck, and GSK all have had collaborations with Vertex on different projects. Outside of the traditional large pharma companies, a biotech giant such as Gilead Sciences could also be an acquirer because of its stronghold in the HIV drug market.

What Are The Potential Acquirers Waiting For? 2007 should be a very important one for the drug because a series of efficacy data from several ongoing Phase II trials will become available. In addition, safety data of the drug, first by the end of 2006 and more in 2007, from a total of 1,000 patients will also be available. With these two sets of data, the drug’s efficacy and safety should become a null question, even though the company may still have to run a Phase III. We think any acquirer would welcome that kind of assurance given the high valuation of this deal. On the other hand, an $8-billion acquisition (assuming a 50% premium over the current price) of a company with a drug that could achieve $3 billion worldwide sales, as well as several other drugs that are also promising, is not necessarily expensive.