Brian Abrahams: The use of cutting edge technologies like CRISPR- Cas9 has really started to take center stage of late. And this is something that could be highly disruptive over time in terms of the way that we treat rare genetic diseases as well as infectious disease and cancer.
Joe Coletti: Welcome to another edition of Pathfinders in Biopharma, the podcast series from RBC Capital Markets that explores the fast moving world of biotech and pharma. I'm Joe Coletti, your host. Today we have a special guest, a returning guest to the program, Brian Abrahams, research analyst and head of our biotechnology research here at RBC Capital Markets. Brian's got over 18 years of experience covering the sector and companies in the sector, and part of the framework for our discussion today is actually his game changer series, which really focuses on the bigger disruptive forces across biotech that are impacting the sector now and will be far into the future. So Brian, thanks for joining us today.
Brian Abrahams: Thanks so much for having me.
Joe Coletti: Brian, before we sort of dive into the sector a little bit, I want to give our listeners more insight into your personal background but also your overall perspective on the biotech sector right now.
Brian Abrahams: Absolutely. So, just by way of my background, I'm a senior biotech analyst here at RBC Capital Markets, head of US Biotech research. I've been on the sell side for over 18 years, been at RBC for over five years. I have a science and medical background. I studied molecular biophysics and biochemistry in college, went to medical school, got a medical degree, and then during a residency in the field of neurology came over to do sell side equity research. And what I try to do in my research is to bring a clinical practical perspective based on my experiences, as well as some scientific background, and work with folks on my team as well who bring in areas of expertise within the sciences to best analyze life science companies in the biotech space.
Joe Coletti: It's a really fascinating background. I think it's also, it's so unique to this sector because the strength of your background is what I think makes your research and analysis so much stronger and necessary in this day and age. But shifting to the sector very quickly, you're obviously covering the sector every day. How are you thinking about things more broadly now? What's your perspective on the sector?
Brian Abrahams: We're generally constructive on the biotech space now, and I think to understand where we're going, one needs to understand where we've come from, because it's been a really interesting last few years for the space. In 2020 and 2021, there was quite a bit of excitement and exuberance, perhaps over exuberance in the group, where you had the COVID pandemic really highlighting the R& D prowess of biopharma companies and putting that in the spotlight, the defensiveness of the sector, the insulation against pandemic headwinds also helped get people excited. And overall the pendulum may have swung too far where we ended up having what we felt were somewhat inflated valuations for early stage companies, and perhaps a lack of appropriate discounting for drug development risks. But things have probably had swung too far in the other directions since then with the sector having come down quite a bit in the last year or so, until it started to show some signs of recovery. There's still a lot of innovation going on that we think is going to drive long- term revenue for drug companies in the space.
Biotech should be resilient in a high interest rate inflationary environment as well as in a recession. And I think third quarter earnings, which we just finished just this week, really showcase that. We're continuing to expect more M& A activity, and I think that's something that should help drive enthusiasm and valuation for SMID- Cap biotech companies. The FDA is really a key gatekeeper in this space, and the agency has shown more and more flexibility in approving drugs, especially for unmet need diseases. And then lastly, we've really started to see a lot of positive clinical data points over the last six months that I think have justifiably gotten people excited about NextGen medications in areas such as Alzheimer's disease, schizophrenia, and eye diseases. And we're starting to indeed see some hints of this improved sentiment, and a lot of rotation coming into the group of late. But we do expect the momentum to continue at least for the near term.
Joe Coletti: So, we just passed the U. S. midterm election recently, and so politics and policy seems like a great place to start. Your Game Changers report, Game Changers in Biotech, it's an incredible product. And you released one late summer to cover the second half of the year, and one of the risks that you cited was that risk of disruption from governmental drug pricing controls as really a key trend.
Brian Abrahams: Yeah, so our Game Changers report is a really unique biannual report that we do where we focus on the latest developments for the bigger picture, under the radar disruptive products, technologies, and even legal or epidemiological developments that could have a transformational impact on the biotech sector, and existing and emerging franchise from large and mid- cap companies within our coverage universe. Philosophically speaking, this is really the first time that Medicare was the biggest government payer would have the power to heavily discount medications very substantially over time, up to about 60%. Now, this hasn't really gotten immediate attention in part we think because the full effects of the negotiation really don't take effect until the latter part of the decade. So, we have some time before we feel its potential impact, but we do think it could be meaningful for the long term revenue tales of many companies. And we could even start to see some of these effects as early as next year with regards to some of the inflation caps on pricing and the Medicare Part D catastrophic coverage changes.
It's also going to be interesting to see what sorts of effects this might have on drug development strategy going forward. And there's also lots of different exceptions and exemptions within this IRA as well. There's the possibility this could artificially shift the value equation towards certain areas and away from others. So, towards the biologics which have longer exclusivity periods, where they're exempt from Medicare negotiation, as opposed to small molecules. We could see therapeutic area prioritization or deprioritization, boards, orphan diseases or diseases of younger patients, and perhaps away from diseases of older individuals who would be more affected by Medicare and these changes. And we're already starting to see companies less incentivized to start new trials of older drugs, where new indications might add revenue later in the development cycle when they'd be closer to potentially having their price negotiated. In our estimates, we've estimated about a 3% to 5% fair value impact, negative fair value impact, for most of the larger companies within our group.
So, it's material. That being said, it's also probably not Draconian, and I think what a lot of people are recognizing is that while this will be impactful, it could have been worse. The IRA is going to affect most drugs at the end of their life cycles when they will probably be getting close to a patent cliffs. Initial proposals for drug pricing reforms had proposals for price controls for commercial insurance as well, which would've been even more extensive and expansive. And we've seen, and will likely continue to see, companies either raise prices this year more than usual, or introduce higher starting prices when a drug is approved in order to counterbalance some of the potential effects here. But I do think it is a risk, and potentially disruptive risk to the group that needs to be considered, just in the way that it changes the overall pricing milieu, the overall environment here for drug pricing, which to date has been relatively free for companies in terms of picking the wrong price.
Joe Coletti: There's a lot in there, and it sounds like this is an issue that hasn't been talked about for a long time, but what will continue to be talked about for a long time. And when we think about these issues, these sort of external impacts if you will, this is certainly one of them. There's one other one that I wanted to quickly ask you about as I follow up on that, is really supply chains. Do you see this as still being a disruptive element at any level in the biopharma space, particularly post- COVID?
Brian Abrahams: So, yes and no. I think supply chains, and the war in Ukraine, and the interrelatedness there have certainly had an impact across the macro space in many sectors. For the most part, biotech as a whole I would say is much more insulated from these effects. Supply chains have been generally intact. Biotech are not that reliant on China, and they tend to have good redundancy in terms of their supply chains. The commentary we've heard of late from companies is that any pandemic related supply constraints are easing, and they're able to acquire the necessary inputs in order to make their products. Most of our companies have indicated they have strong procurement teams, and they would expect any cost increases related to some of the supply constraints out there to be relatively manageable. We believe likely a lot less than the current 7% or 8% year- over- year inflation rate would suggest.
That being said, overall costs have increased for our companies, which could have an impact on operating expenses going forward. And indeed, just coming out of third quarter earnings, we got the general sense companies were steering investors to expect higher than consensus OpEx going into next year. Additionally, the other thing we're seeing is some slowdowns in clinical trial conduct. Remember, clinical trials really form the backbone of the drug development cycle for the sector, and we've seen some delays in enrolment that multiple companies have announced recently. And when that happens it pushes out potential data catalysts, which tend to be value creation events, as well as visibility for approval and revenue generation timelines. Now, part of it is just that there's more competition, there's more companies out there vying for the same patient. Part of it is staffing shortages and turnover that have created bottlenecks in terms of site enrolment for clinical trials. And then, also the Ukraine is also impacting trial conduct.
That was a popular region for drug studies, and we are starting to still see pull- through from companies needing to pivot away from the Ukraine to other regions and restart site initiations for their clinical trials there. Although, I would say not as dramatic as for other spaces, but we are keeping an impact on expenses and clinical trial efficiency.
Joe Coletti: That's really fascinating, especially at your point about Ukraine and clinical trials. I think that that's really important and another factor in terms of some of these macro headwinds and impacts that are happening around the world. Let's zoom in a little bit on the sector just a bit more maybe. Your top disruptive trend for quite a while now in the space has really been around innovation, and we talk about innovation a lot on the show, and how it's really powering the sector. Where are you seeing the strongest innovation today?
Brian Abrahams: So, as we think about the biotech sector for the long term, there are a number of dynamics beginning to percolate today that we think have the potential to dramatically transform the way medicines are developed and delivered for years to come. And this has taken place on a lot of different fronts. Different therapeutic approaches, new mechanisms, new modalities. Alzheimer's is a great example of a space where we've seen a ton of recent innovation. This went from being viewed as a virtual graveyard for drug development, to being seen as one of the hottest most talked about areas in biotech. We had some positive results there. There's several more phase three's coming in the next few months that'll read out. We'll have an FDA decision on approval of a next generation medicine next year, and we'll learn about whether Medicare is going to be reimbursing it. We think that could potentially continue that momentum, and it's going to help us understand whether the clinical benefits shown in the studies are strong enough, and the delivery and management not overly burdensome here that these drugs can actually provide a really good return for these companies developing them.
Gene editing, another hot area. The use of cutting edge technologies like CRISPR-Cas9 has really started to take center stage of late, and this is something that could be highly disruptive over time in terms of the way that we treat rare genetic diseases as well as infectious disease and cancer. We recently saw the first evidence that a drug edits and fixes a genetic mutation, and that can be given directly to a patient. So, that was a really big breakthrough. Now, we still need to learn a lot more about how safe this technology's going to be over the longer term, and how broadly it can be utilized across different disease states. But again, big step forward there. The psychiatry space, another area of innovation. We're seeing a lot of changes in our approach to serious chronic mental health disorders. For years, the ways that we've treated depression and schizophrenia and related diseases has been predicated on this neurotransmitter hypothesis, where patients take drugs like SSRIs or antipsychotics that tone up or down chemical signals in the brain like serotonin and norepinephrine.
And while they work for some, a lot of people don't get great benefits from them and they often have side effects. But today companies are trying a new approach there. They look at novel therapies with different mechanisms in order to try to achieve better efficacy without as many tolerability issues, or even to try to change the brain circuitry more durably, sometimes even with really short courses of treatment. Treating depression as you would treat strep throat or pneumonia. So, really fascinating. Those are just a few of the different therapeutic areas and modalities where we're seeing a lot of innovation going on, and there's a lot more behind that as well.
Joe Coletti: That's really interesting, and we know investors are paying attention to this. And that's where I wanted to pivot next is we talk a lot about innovation and we've talked to some investors on the show. But as investors kind of make more calculated decisions in the biopharma space, particularly in this environment, what do you see companies changing about their funding and capital raising strategies right now?
Brian Abrahams: Well, we've seen this evolving a lot in the past year or so after a couple of years where we had roughly 100 companies per year going public and a ton of capital flow into the space. The number and size of deals in biotech has sharply declined across all financing channels in the first half of 2022. The total capital raised and the first half of this year was 10 billion dollars as compared to about 36 billion dollars in the first half of 2021. Over a quarter of the biotech universe, in our calculation, is trading below cash negative enterprise values. So, we're seeing smaller companies increasingly trim their programs in order to preserve capital, and companies finding creative ways to finance now. Monetization with royalty companies, debt agreements, creative partnerships, but high quality stories off of good data have still been able to successfully raise capital through more traditional means, and maintain their stock price even with some dilution.
So, I would say overall it's somewhat of a mixed bag, but we are still seeing some capital flow into the space even though there's fewer IPOs and secondaries these days. And companies with quality assets and platforms are finding ways to keep the lights on and finance their programs, and ultimately to get them over the line.
Joe Coletti: Now, what about M& A? Pivot to M&A for a second, which is always my favourite question to ask guests. What's your view on M& A in the sector right now?
Brian Abrahams: M& A is always a big driver for sentiment within biotech. We remain bullish on the prospects for M&A to pick up in the group as we get into the end of this year and into 2023, and a lot of things should drive deals in our opinion. We've seen strong balance sheets across larger biopharmas. As of mid- year 200 billion on the balance sheets, near record level. Larger companies have a need to continue to expand their pipelines. Many of them are facing patent cliffs. In fact, there is expected to be 225 billion dollars of lost revenue due to patent cliffs by the end of this decade across biopharma. And of course, COVID revenues are down. After many of these companies, through vaccines or treatments, had generated tens of billions of dollars in sales, a lot of that's likely not to be recurring and will need to be replaced.
Now, on the most recent earnings calls in third quarter, we have heard some mixed commentary on large company appetite for M&A. On one hand, many larger companies have cited their financial flexibility for significant business development when asked, but other large and important companies express more of a preference for smaller bolt- on deals and internal pipeline investment. Additionally, increasing interest rates could also reduce the appetite to take on leverage to do big deals. And there's still some lingering uncertainty around how the FTC would view deals. Now, it's been tough to predict what types of deals regulators could push back on. It's not necessarily super common in the biopharma space, but that could always play into companies minds as they think about the stage and size of companies they might look at acquiring. Overall though, the stage should be set for more M& A activity in the space, and we think that would be positive for SMID- Cap valuations. We usually start to see read- throughs there, as well as helping improve large cap fundamentals. So, effectively could be a win- win.
Joe Coletti: So, as we talk about innovation we have to mention the FDA, which plays a key role in this. So, how are you viewing the FDA and their role in innovation in the biopharma sector right now?
Brian Abrahams: Well, the FDA remains the key gatekeeper for drug approvals of course. In terms of their overall engagement, they remain highly engaged and communicative with companies, much better state than we were in say 10 to 15 years ago. And there's been some specific recent signals of their flexibility with recent approvals of ALS and Alzheimer's drugs. They understand that sometimes a disease is so severe, and there's no other options for patients, that one can't afford to wait to get it in the hands of patients. So, perhaps only one instead of two pivotal trials might be acceptable, or a drug might even qualify for accelerated approval. That's something that was traditionally reserved effectively for cancer drugs where the FDA might use progression- free survival or response rates as a surrogate for whether or not a drug might ultimately help a cancer patient live longer.
But now we're seeing the idea of getting a drug approved early based on a biomarker. We're seeing that extend out to other spaces as well. Now, the key is that companies don't abuse this privilege. In the past, a lot of companies have actually dragged their feet on completing trials in order to confirm that their drug works after they get an early approval. So, the FDA has been cracking down on that and forcing companies to be well along with their confirmatory study enrolment before they'll approve something on an accelerated basis. There's several areas that we're keeping our eye on in the coming 12 months, where we're going to have some key regulatory decisions. Alzheimer's disease, NASH, which is a liver disease, and Duchenne muscular dystrophy are three specific examples. And I would actually add hemophilia as well. Those are all going to be important litmus tests to see how amenable or flexible the FDA's going to be going forward, and how they view different modalities as well.
Its therapeutic areas are going to be important. Whether a drug is a traditional small molecule, or an antibody, or a gene therapy is also going to probably play into the FDA's views on safety and a benefit risk equation. And it's not all been permissive as of late. There have been some recent delays in clinical holds, which again shows that the FDA is still very, very focused on ensuring safety. So, I think overall it's going to be important with regards to the FDA for investors to keep in mind the individual merits of a company's program. Just because something is for a tough disease doesn't mean it's definitely going to sail through, but we are seeing more FDA amenability and engagement of late.
Joe Coletti: Thank you, Brian, for this really fascinating conversation today. Really happy to have you here.
Brian Abrahams: Thanks for having me.
Joe Coletti: Well, that's it for our conversation with Brian today. Thank you for listening to Pathfinders in Biopharma, brought to you by RBC Capital Markets. Remember to follow us for more great content and episodes in the future. This episode was recorded on November 11th, 2022. And if you'd like to learn more or continue the conversation, please visit rbccm. com/ biopharma.
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