Value creation in the biotechnology industry

As a recent study demonstrates, it’s non-financial disclosures that are key to value creation in this and other growing industries. Understand an industry’s value drivers and you’ll better understand the potential of individual firms

By Bruce McConomy and Bixia Xu

The identification of important non-financial performance indicators is essential when assessing value creation in emerging industries. Identification of such performance indicators helps managers within these industries determine what should be communicated internally and externally, and to manage and communicate in a cost-efficient and benefit-maximizing way. The identification of the key non-financial performance indicators in a particular industry could also help investors and potential investors decide which emerging  companies are the most promising investments.

Non-financial performance indicators are certainly critical in valuation for the fast growing biotechnology sector. The Globe and Mail recently reported that “biotech financings are flying off the shelf in Canada and the United States.” U.S. biotech firms raised more than $11 billion (U.S.) in the first 10 months of 2003, and more than $1 billion (Cdn) was raised in Canada. Earnings are not generally seen as being the reason for the resurgence in the biotech industry, but rather “positive clinical data, upbeat medical conferences and drug approvals by the U.S. Food and Drug Administration” are cited.

Better signals

A firm’s disclosure strategy plays an important role in its survival and growth. Therefore, managers have great incentives to manage disclosure. Traditionally, financial statement disclosures such as earnings and book value have been considered the most important disclosures. However, such financial information may not be the best summary of a firm’s value creation activities, and may appear to be unrelated to stock prices for companies in emerging industries.

In today’s business environment, characterized by factors such as global competition, decentralization, and off-balance sheet intangible assets, financial statement information has lost much of its ability to summarize value creation activities — particularly for emerging industries, including biotechnology and certain high technology sectors. In these industries, non-financial statement performance information that captures improvements in products, operating processes or strategic alliances may better signal future earnings trends and firm value.

Increasingly, disclosure strategy and disclosure management in emerging industries must take into account information such as market penetration, floor space for retailers, R&D, and the number of Web site hits. Depending on the industry, such information may be considered quite relevant to valuation. By providing disclosure of non-financial performance information, firms are able to complement their more traditional financial statement disclosures. Non-financial disclosure outlets include annual report disclosures such as the MD&A and “Report to Shareholders,” press releases, Web site disclosures, regulatory filings and conference call guidance provided to financial analysts.

Firms can manage their disclosures in a variety of ways. For example, some firms tend to manage the timing of public disclosures — releasing good news as soon as possible, and delaying the release of bad news. They might release poor results on a Friday afternoon after the stock markets have closed, in the hope that it will not generate bad press and an adverse impact on stock prices. Similarly they might highlight pro forma earnings in their press releases, rather than traditional earnings per share.

However, there are limits to the ability of firms to manage disclosure. Public companies are subject to securities laws regarding their disclosures, and increasingly boards of directors are becoming involved to ensure firms follow good corporate governance practices. Unethical behaviour by executives at public companies in North America is increasingly frowned upon, and companies with accounting and related scandals are often severely punished in the capital markets. Therefore firms benefit from a well thought out disclosure strategy, particularly a strategy that highlights the essential value drivers of the company, in a responsive (and ethical) manner.

Biotech basics

Biotechnology is a complex, knowledge-based industry in which many companies emerge and fail, and where strategic alliances are very important. In general terms, biotech firms make use of biological processes to solve problems or make new products. Firms in the biotech industry operate in various sectors including healthcare, agricultural production (including forest, animal and aquaculture biotechnology), food, environmental and defence segments. There are in excess of 1,450 biotech firms in the U.S., of which more than 300 are publicly held, with a market capitalization of more than $200 billion. The industry is growing rapidly, with revenues increasing from $8 billion in 1992 to $35 billion in 2001 (see www.bio.org for further details).

In this discussion we focus on biotech healthcare firms. Biotech healthcare firms differ from typical pharmaceutical companies, in that they generally don’t have products for sale in the consumer market — their products are under development. The typical healthcare biotech firm limits its research pursuits to a few drug treatments with commercial potential. Alliances often form between biotechnology firms and other firms, such as pharmaceutical companies. These companies can provide complementary resources including marketing, production and distribution, which are critical to the successful development and commercialization of new products. Biotech firms use disclosures such as news releases to differentiate themselves from similar firms, and to inform investors of potential (high risk/high reward) opportunities.

Biotech value creation

The main business line of biotech healthcare firms is to discover and produce drugs. Three unique attributes of this industry influence value creation. R&D is the most fundamental value creator in the biotech industry. Having quality drugs under development (in the “pipeline”) is an essential first step in value creation (see chart).

Clinical trials begin with animals, and, if successful, move in stages that test an increasing number of human subjects at each stage. Each step forward must be built on positive results from previous phases. Therefore, the drug development process is characterized by phases that are linked to each other. However, due to the high failure rates at each stage, caused in large part by subjects having a negative reaction or side effects to drugs under development value can either be created or “destroyed” as drugs move through the pipeline.

To prevent the biotech industry (and consumers) from unethical behaviour, governments carefully regulate the drug development process. Each movement from one phase to the next must be approved by governmental agencies and, similarly, obtaining government approval leads to value creation as such approval is necessary before the drug is launched on the consumer market.

Lastly, establishing business networks via strategic alliances, which help firms obtain competitive advantage through patents, serves as a third significant value creator. Access to significant financial and human resources are required for drug development. These strategic alliances may include initiatives for marketing drugs, R&D and/or manufacturing. Given the massive number of animal and human trials, the high inherent risk of drug development, and the intense competition in the drug marketplace, forming alliances to facilitate access to resources to speed up the “lab to market” process is essential to value creation.

In summary, similar to other industries, the value creation process in the biotechnology industry starts with inputs (resources) and ends up with outputs (earnings from approved drugs). However, as illustrated above, the unique value creation process for biotech firms is characterized by a focus on R&D (the “pipeline”), compliance with government regulation, and effective use of strategic alliances.

Non-financial disclosures and biotech value

In finance, firm value is often based on the present value of the firm’s future cash flows. From an accounting perspective, earnings are generally considered a better indicator of the firm’s prospects, as they are derived from successful use of the resources available to the firm. When earnings are an adequate, timely reflection of the value creation process, other non-financial statement disclosures may be considered redundant.

But drug development is a long process, and its success is subject to positive trial results and government approval, so value creation in the biotech industry can take a very long time to be captured in realized earnings. Financial statement disclosures are often complemented by other disclosures, such as the progression of drugs in the company’s pipeline.

The market value of biotech firms is mainly driven by hope — the hope of realized earnings potential stemming from approved drugs. Managers of biotech firms often employ a disclosure strategy to communicate their drug development status, to either strengthen or clarify that hope. Non-financial disclosure fills the information lag between capital markets (stock price) and the accounting system. Based on the value creation process, in a recent study we identified and categorized the major non-financial disclosures of healthcare biotech firms as follows:

• Commencement and completion of clinical trials including Phase I, Phase II and Phase III trials;
• Successful (positive) and unsuccessful (negative) results from clinical trials at different phases;
• Government approval of investigational new drugs and final approval of drugs, including government granting of drug patents;
• Strategic alliances including marketing alliances, R&D alliances and manufacturing alliances;
• Product launch.

Table 1 provides a brief summary of the stages of drug development. We focus on the drug approval process in the U.S., as FDA approval is often the key to success for biotech firms, even if they are based in Canada.

Positive reactions

In our study, we tested the stock market’s reaction to earnings announcements and the non-financial disclosures identified above to assess the ability, and relative importance, of these disclosures in signalling a firm’s future prospects.

The study demonstrated that capital markets react to non-financial disclosures more strongly than to earnings announcements, suggesting that those non-financial disclosures contain information not otherwise captured by financial statements. In this industry, non-financial disclosures appear to spread information on a timelier basis than financial statement information.

In comparing the various categories of non-financial disclosures, capital markets react strongly to the commencement of Phase III clinical trials, positive (negative) results of Phase II and Phase III clinical trials, FDA approval, and R&D alliances. These findings are consistent with our understanding of the most important value drivers in the healthcare biotechnology industry. Value creation is progressive for biotechnology firms. R&D success in previous early phases is transferred into the launch of Phase III trials, and the success of Phase III trials leads directly to success in terms of final government approval. Thus, among the three clinical trial phases, Phase III appears to be the most critical one. Its commencement and results (positive/negative) can have a great impact on a firm’s prospects.

Government approval is the final determinant of the realization of the “hope” that drives the market value of biotechnology firms. It’s quite possible that a drug may fail in the final government approval process. If a drug doesn’t obtain government approval, all the previous value creating activities fail along with it, extinguishing many a firm’s bright future. Thus, it’s not surprising that we observe a strong market reaction to final government approval.

Among the three types of strategic alliances, the capital market focuses most significantly on R&D alliances. This may be because R&D funds and activities are seen as the foundation of drug development, and the drug pipeline.

In terms of driving market value for biotech firms, non-financial disclosures may be more important than financial disclosures. But the importance of non-financial disclosures isn’t limited to biotech healthcare firms. Prior research suggests that industry specific disclosures can be very important in firm valuation. Non-financial information such as load factors in airlines, licences granted in the wireless communications industry, Web traffic and customer experience in Internet-based firms, and the number of patents obtained by pharmaceutical companies all help to explain stock prices. To better understand emerging industries, a good first step is to obtain an understanding of what drives value. Value drivers are often industry specific, and if you wait for the value to appear in the form of earnings on the income statement, you may have waited too long. 

Bruce McConomy, Ph.D., CA is an associate professor and Bixia Xu, Ph.D., is an assistant professor, both at the School of Business and Economics, Wilfrid Laurier University.

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