Valuation Analysis in Pharmaceutical Licensing and M&A

Valuation Analysis in Pharmaceutical Licensing and M&A Transactions A Tutorial By Tim Opler, Benj Garrett and Susan Langer January 2014

• Discuss role of valuation and project assessment • Introduce valuation tools

• Show how to use the tools in business development • Go over a variety of cases

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AGENDA

Agenda

Table of Contents 1. 2. 3. 4. 5. 6. 7. 8.

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Value Creation and Business Development Valuation of Pharmaceutical Projects Revenue Forecasting Cost Estimation Risk Estimation The Discount Rate Valuation Considerations in Licensing Valuation Considerations in M&A

VALUE CREATION AND BUSINESS DEVELOPMENT

Revenues and Costs Over Time ($ millions) 350 300

250 200 150 100 50

0 -50

1

2

3

4

5

6

7

8

9

10

11

-100

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Acquisition Cost

R&D

Launch Cost

Selling Cost

Other Cost

Revenue

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VALUE IS CREATED BY INVESTMENT FOR FUTURE PROFIT

Typical Value Creating Profile

PROCESS

Value Creation Process

Assessing the projects Finding projects that fit

Negotiating deals for the projects in the face of competition

Delivering on the potential of the projects

Realizing the value

Assessment and negotiation calls for strong valuation and analysis work. This is our focus today. 6

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Evaluation Criteria

Financial Analysis • What is the time horizon to peak revenues for each product? • What will sales and marketing costs be? • What are the total cash requirements? • What is the value of each product opportunity?

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Ability to Execute / Risks • How achievable are the returns and how significant are the risks? • Do we have the competencies to succeed? • Can we control the key success factors?

Fit with Future Strategy

Perception of Wall Street / Shareholders?

• How does each product fit with our long-term vision? • Are there other products in the pipeline to realize our goals? • What is the opportunity cost of pursuing these initiatives?

• Is Wall Street likely to invest in a company pursuing these products? • How has Wall Street responded to other companies that have adopted this strategy?

HOW FINANCIAL ANALYSIS FITS INTO STRATEGY

Where Financial Analysis Fits into Business Development Strategy

Example: Licensing Process at Bristol-Myers Squibb

Identify the Opportunity

Initial Technical Evaluation

Detailed Technical Evaluation

Detailed Commercial Evaluation

Technical Due Diligence Commercial Due Diligence

Final Approval

Contract Negotiations

Source: Talk by BMS: “The Role of Licensing / Business Development in the Pharma Industry”, 2004.

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Product Profile / Pricing / Competition Sales Forecast P&L Assumption (COGS, S&M, R&D)

Deal Terms Manufacturing / Tax Considerations PTRS

Risk Adjusted NPVs & IRRs

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BRISTOL-MYERS SQUIBB VALUATION PROCESS

Bristol-Myers Squibb Deal Valuation Process

Illustrative Table by Kazuo Edaza of BMS Assets Opportunity ID 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

PTRS 92% 78% 20% 80% 74% 58% 30% 85% 27% 53% 81% 26% 59% 72% 62% 36% 40% 24% 26% 89% 55% 7% 24% 64%

ENPV 370 120 250 182 80 80 250 80 90 18 23 214 582 87 1,400 77 27 371 102 1,538 633 100 152 272

EIRR 535% 345% 318% 301% 230% 230% 210% 90% 83% 83% 76% 59% 58% 54% 48% 42% 41% 40% 40% 35% 34% 33% 31% 30%

Assets Opportunity ID 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48

PTRS 6% 48% 25% 10% 82% 63% 40% 14% 21% 21% 43% 14% 35% 45% 35% 46% 19% 60% 42% 8% 31% 7% 18% 38%

ENPV 3 411 129 71 837 288 12 116 137 132 183 80 151 12 8 230 28 3 123 15 52 22 7 6

EIRR 29% 29% 27% 27% 26% 26% 26% 24% 24% 24% 24% 23% 22% 20% 19% 19% 19% 19% 19% 18% 18% 17% 15% 13%

PTRS = probability of technical and regulatory success eNPV = expected NPV eIRR = risk-adjusted internal rate of return 10

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Source: Talk by Kazuo Ezawa, Bristol-Myers Squibb, “Pharmaceutical Portfolio Management”, DAAG, February 2004.

PROJECT RANKING

Bristol-Myers Squibb Ranking of Potential Licensing Deals

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

The approach that we will discuss today is very similar to that used by Bristol-Myers Squibb.



In fact, almost every large pharmaceutical company uses the same approach to deal valuation.



Consulting firms like BCG, Campbell Alliance, LEK, Mattson Jack and McKinsey have standardized the industry in this way.



A key area of emphasis from us is to keep an eye on risk-adjusted returns in transactions.



There are numerous fine points and ways in which firms differ in approach.



We will discuss many of these but the key focus will be on the “hands on” – how to approach to valuation.

TODAY’S DISCUSSION

Our Approach

ROI (IRR)

Examples in Specialty Pharma

Small Project Big Payoff

Big Project Big Payoff (The zone of shareholder bliss)

Small Project Low Payoff

Allergan – Botox Biovail – Wellbutrin XL Cephalon - Provigil ENDO – lidoderm patch Forest – Lexapro Gilead - Truvada King – Altace Reliant - Lovaza Salix – Rifaximin Viropharma - Vancomycin

Big Project Low Payoff

Scale of Project

The key to creating lasting value is to bet big and win. 12

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VALUE IS CREATED BY INVESTMENT FOR FUTURE PROFIT

General View: Go Big and Go for IRR / ROI to Create Value

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Big Pharma A, B, C

Sometimes employ real options tools in project assessment. The idea is to look at a drug development project as a sequence of choices or options. The most important insight is the “option to abandon” a project is valuable. A further insight involves the value of the option to expand indications.

Biotech A

Focuses largely on “pie splitting” – the sharing of the rNPV of a project. Other inputs like IRR are not looked at all. Have historically used higher discount rates for risky projects but without risk-adjustment.

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Some Key Differences Across Pharmaceutical Firms - Method

Big Pharma An organization called that carries out financial analysis of licensing and M&A projects. They have prepared an internal manual on how to value D every aspect of a project which standardizes their approach. Tends to do careful valuation work with reasonable discount rates. Always have at least three scenarios. Organization tends to be intelligent but financially conservative in looking at opportunities. Will occasionally look at real options and offer option deals to biotechs. Has created a management science group that engages in sophisticated Big Pharma predictive modeling of pharma product performance. Their view is that good forecasts are the most important and most difficult aspect of E pharma licensing. This group has been driving real options work but hard for organization to grasp. The focus is much more on simplicity, insight and medical soundness Big Pharma than say Big Pharma E. Every projects gets summarized on two pages (and not more ever) for either the head of commercial or the head of F R&D. Once there is a preliminary approval an AIF (autorissation investiment financiere) is prepared (30 to 50 pages). This document does not skimp on commercial analysis but uses basic rNPV models. 14

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Differences Across Firms - Process

VALUATION OF PHARMACEUTICAL PROJECTS

A: Profit = - $50 + $60 = $10

$10

Added Value $50

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Initial Investment

NET PRESENT VALUE

Q: Suppose we can invest $50 today & receive $60 later today. What is our increase in value?

This is the definition of NPV 60 Profit = -50 +  $4.55 1.10 $4.55 The idea of an expected rate of return or discount rate reflect the time value of money, otherwise known as the underlying cost of capital in society.

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$50

Added Value Initial Investment

NET PRESENT VALUE

Q: Now suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return?

Ct NPV C  0 (1 r)t

For two periods

With multiple periods

C1 C2 Ct NPV  C0    ...  1 2 t (1  r ) (1  r ) (1  r ) N

or

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Ct NPV   t t 1 (1  r )

Where N=Number of years t = year C = cash flow r = discount rate Sigma = Summation Symbol

NET PRESENT VALUE

NPV = PV - required investment

Net Present Value Rule

If the net present value of a project is positive then it creates value and should be carried out. If resources are finite and there are more positive NPV projects than time, money or other constraints would allow then the group of projects that maximize NPV should be implemented.

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Risk Adjusted NPV

Pharmaceutical cash flows are risky and the risk can be characterized based upon stage of development. Risk-Adjusted NPV or rNPV is a risk weighted NPV and should be used in assessing risky project.

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Revenues Total Market Prescriptions Written X Penetration of Product = Units Sold X Price = Revenue

-

Costs COGS

+ Research and Development Expense

+ Selling Costs

-

Other Cash Outflows

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Net Cash Flow

Capital Expenditures + Change in Working Capital Cash Taxes

+ G&A / Other Costs

+ Acquisition Costs

Risk Adjustment at Each Stage 21

=

rNPV

INPUTS TO RNPV MODEL

Elements of Risk Adjusted NPV Model

RNPV FORMULA

The rNPV Formula

N

R1Ct rNPV   t t 1 (1  r )

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Where N=Number of years t = year t=1 (now) C = cash flow R1 = Probability of cash flow now r = discount rate Sigma = Summation Symbol

The risk-adjusted IRR is the discount rate that would give an rNPV equal to zero. In other words, it is the expected rate of return on a project. We refer to the rIRR as the risk-adjusted IRR.

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IRR ANALYSIS

rIRR

Issue Equity

vs.

Partner Drug

Both of the choices shown at left involve bringing cash today by causing current equityholders to give up future cash flow (either by sharing the cash flow through issuance of more equity) or instead by giving away product cash flows to a partner. There is an embedded opportunity cost which is computed in the rate of return given up in future cash flows for cash today. This is the internal rate of return or IRR. When derived from a probabilized model we refer to this as a rIRR (risk-adjusted IRR). 

Cash Received by Licensor t   t 1

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Cash Flow Given Up to Licensee t (1  r )t

The internal rate of return is the discount rate that is impounded in the equation comparing cash received to cash flow given up.

APPLICATION OF IRR TO LOOK AT TRADE-OFFS

An Example Trade-Off

ACCOUN TING

TREATM

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Accounting Considerations – EPS Impact  How will the expense be amortized?

– Straight-line amortization • Negative EPS impact in later years due to smaller profit share payments • Acquisition price set standard treatment – Amortize based on profit share payments • EPS accretive each year • What happens if we don’t achieve projections? Write-down – Amortize in full each until asset is gone, then recognize full benefit • Most conservative approach • Not EPS accretive in the beginning years  Many pharma companies are highly focused on EPS management • Will prefer to use investment dollars over R&D dollars whenever possible • Will prefer to push out spending into the future 25

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EPS

Example of EPS Impact in a Transaction to Restructure an Alliance 2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

$0.02

$0.03

$0.05

$0.06

$0.07

$0.08

$0.04

$0.04

$0.01

$0.01

$0.01

Assumptions Discount Rate: 10%

Amortization: Based on projected profit share payments Tax rate: ~35%

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Revenue Forecasting

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Cost Assumptions

Tax and Working Capital

Risk

ACCOUN TING

TREATM

ENT

Building an rNPV Analysis of a Project

Cash Flow Estimates

Discount Rate Selection

rNPV Computation

REVENUE FORECASTING

Estimating Product Revenue Trajectory

Analyst Bottom Up Looking at Reports and Market Similar Research Analysis Products Reports We believe the best approach is to have a good bottom up model and check the thinking by looking at external reports and similar product revenues. 29

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THREE WIDELY USED METHODS FOR REVENUE FORECASTS

Approaches to Developing Market Sizes

Market / Valuation Analysis

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Full Service Analysis / Consulting / Support

VENDORS ARE OFTEN USED FOR MARKET ANALYSIS

Commonly Used Research Vendors

Total Population, Population in Target Markets

Incidence/Prevalence

Potential Market Size

Use 10 year planning horizon: 2012-2022. Assume 2012 launch

% Diagnosed Addressable Market Size % Treated for Disease

% Prescription of Drug

Price per Day of Drug

Actual Ave Days Used

It is very common to build several scenarios (good, poor, expected)

Penetration, Pricing Studies, Competitive Analysis, Compliance Analysis, Reimbursement Analysis and Utilization Patterns Revenue Estimates over the Planning Horizon

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BUILDING A BOTTOM’S UP REVENUE FORECAST

Going from Market Size to Revenue Estimates (Bottom Up)

2000

2025

U.S. Patients are Not Controlled with ACE’s, ARBs and Beta Blockers

Trends in awareness, treatment, and control of high blood pressure in adults ages 18–74

800 700 600 500 400 300 200 100 0

National Health and Nutrition Examination Survey Percent

Developed Market Economies

China

India

1976–80

1988–91

1991–94

1999–2000

Awareness

51

73

68

70

Treatment

31

55

54

59

Control

10

29

27

34

Other Economies Source: JNC 7

Source: Kearney et.al., Lancet, 2005, 365: 217-223

Many Patients Poorly Controlled with Existing Treatments ALLHAT Study: Distribution of Patients by SBP Before and After Treatment with HCTs, CCBs and ACEi’s 40 Baseline

36 Months

30

Thin Pipeline of New Treatments

The only major recent innovation in anti-hypertensive therapy on the horizon is the direct renin inhibitor class (e.g., aliskiren/Tekturn) from Novartis.

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Direct Renin Inhibitors

ACEs, ARBs

10 0 <100 100- 110- 120- 130- 140- 150- 160- 170- 180+ 109 119 129 139 149 159 169 179

SBP (mm hg) Source: Cushman, et al. J Clin Hypertens 2002, 4:393.

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Diuretics, Beta blockers, Calcium Channel Blockers *Source: Sealey and Laragh, American Journal of Hypertension, May 2007

Renin inhibitors are not more effective than ACEs and ARBs and may be unsafe.*

EXAMPLE: NOVEL HYPERTENSION DRUG

Global Burden of Hypertension, Millions of Persons with Hypertension

Rationale for a Synergistic Effect with Current Treatments

There are four important ways in which the novel drug can take share in the hypertension market: 1. Better efficacy and/or safety than current treatments 2. Synergistic with existing treatments (e.g., consider a triple ARB, HCT, novel combo) 3. Better outcomes in certain patient subgroups 4. Better marketing in the face of generics

 The Novel drug is a vasodilator that operates  

Opportunity for Segmentation / Differentiation by Patient Subgroups

Better outcomes in patients on Cox-2’s and NSAIDs

Better outcomes in patients at risk of nephropathy

Better outcomes in nonresponders to existing antihypertensives Better outcomes in salt sensitive hypertensives

Novel Antihypertensive

Better outcomes by genetic biomarker

Better outcomes in obese patients Better outcomes in cardiac patients

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Better outcomes in patients with inflammation



independently of the RAAS cascade and is likely to be synergistic with RAAS inhibitors. It is likely that a many uncontrolled hypertensive persons would be controlled with the novel drug given its mechanism. Likely to be synergistic in salt-sensitive hypertension • The drug appears more effective than other meds in animals that are salt sensitive. • Salt sensitive patients are some of the poorest responders to existing medications. Likely to be synergistic in obese patients • The drug appears to be effective in the presence of obesity. • Obese patients are some of the poorest responders to existing medications.

DIFFERENTIATION OPPORTUNITY

Taking Share by Differentiation

Key Assumptions Daily Cost of Therapy ROW as % of US Market

$4 80.0%

2010

2012

2014

2015

2016

2018

2019

2023

2028

2031

Begin Year Patient No. Growth in Patients

80,000,000

84,872,000 3%

90,040,705 3%

92,741,926 3%

95,524,184 101,341,607 104,381,855 117,482,697 136,194,645 148,823,566 3% 3% 3% 3% 3% 3%

Diagnosis Rate Treatment Rate # of Patients Treated Compliance Rate

50.0% 70.0% 28,000,000 50.0%

50.0% 70.0% 29,705,200 50.0%

50.0% 70.0% 31,514,247 50.0%

50.0% 70.0% 32,459,674 50.0%

50.0% 70.0% 33,433,464 50.0%

50.0% 70.0% 35,469,562 50.0%

50.0% 70.0% 36,533,649 50.0%

50.0% 70.0% 41,118,944 50.0%

50.0% 70.0% 47,668,126 50.0%

50.0% 70.0% 52,088,248 50.0%

0.0%

0.0%

0.0%

0.0%

0.0%

6.0%

8.0%

12.0%

12.0%

12.0%

0 250 4.00 $ 1,000 $0.0 0.0

0 250 4.20 $ 1,050 $0.0 0.0

0 250 4.41 $ 1,103 $0.0 $ 0.0

Hypertension - US

Penetration Rate Patients on drug Average Days of Therapy Cost Per Day Cost per Day * Days of Therapy Total Revenues Probabil. Adj Revenues

0 250 0 0 $0.0 0.0

5.0%

0 250 0$ 0 $0.0 0.0

2,128,174 250 4.86 $ 1,216 2,586.81 $ 129.3

2,922,692 250 5.11 $ 1,276 3,730.18 $ 186.5

4,934,273 5,720,175 6,250,590 250 250 250 6.21 $ 7.92 $ 8.73 1,551 1,980 2,183 7,654.68 $ 11,325.56 $ 13,644.25 382.7 566.3 682.2

Hypertension - ROW Begin Year Patient No. Growth in Patients

64,000,000

67,897,600 3%

72,032,564 3%

74,193,541 3%

76,419,347 3%

81,073,285 3%

83,505,484 3%

93,986,158 108,955,716 119,058,853 3% 3% 3%

Diagnosis Rate Treatment Rate # of Patients Treated Compliance Rate

50.0% 70.0% 22,400,000 50.0%

50.0% 70.0% 23,764,160 50.0%

50.0% 70.0% 25,211,397 50.0%

50.0% 70.0% 25,967,739 50.0%

50.0% 70.0% 26,746,771 50.0%

50.0% 70.0% 28,375,650 50.0%

50.0% 70.0% 29,226,919 50.0%

50.0% 70.0% 32,895,155 50.0%

50.0% 70.0% 38,134,501 50.0%

50.0% 70.0% 41,670,598 50.0%

0.0%

0.0%

0.0%

0.0%

0.0%

6.0%

8.0%

12.0%

12.0%

12.0%

0 250 0$ 0 $0.0 $ 0.0 $

0 250 4.00 $ 1,000 - $ - $

0 250 4.20 $ 1,050 - $ - $

0 250 4.41 $ 1,103 - $ - $

1,702,539 250 4.86 $ 1,216 2,069.45 $ 103.47 $

2,338,154 250 5.11 $ 1,276 2,984.14 $ 149.21 $

3,947,419 250 6.21 $ 1,551 6,123.74 $ 306.19 $

- $

- $

- $

- $

4,656 $

6,714 $

13,778 $

Penetration Rate Patients on drug Average Days of Therapy Cost Per Day Cost per Day * Days of Therapy Total Revenues Probabil. Adj Revenues Total Worldwide Revenue

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0 250 0 0 $0.0 0.0

5.0% $

- $

4,576,140 5,000,472 250 250 7.92 $ 8.73 1,980 2,183 9,060.44 $ 10,915.40 453.02 $ 545.77 20,386 $

24,560

LARGE REVENUE FOR NOVEL HYPERTENSION DRUG

Revenue Forecast for Novel Hypertension Drug

• Prevalence: • Total number of potential customers at any one point in time • Best for products purchased by same customer on a recurring basis (chronic Rx) • Incidence: • Number of new potential customers each year • Best for products treating onetime acute event (heart attack)

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ACCOUN TING

Estimate Incidence and Prevalence

TREATM

ENT

Defining the Market

Identify Segments

Change Over Time

• All potential customers are not alike • Segmentation helps refine penetration and share forecasts • It also allows you to refine estimates and focus efforts by identifying “early adopters” • Example in RA • Severely affected patients (25% of the market) • Moderately affected • Mildly affected

• Customer base and segmentation are influenced by factors that change over time • Growth driver analysis provides insight into changing and/or emerging markets

Penetration is usually the main driver of revenue forecasts. There are a few different means to estimate the peak penetration that a new product can be expected to achieve: 1. Historical penetration of comparable products 2. Objective comparisons versus currently available treatments (efficacy, safety, convenience) 3. Physician interviews to gauge acceptance and potential use versus competing treatments (preference share analysis) 4. Analysis of likely reimbursement and factors related to achieving reimbursement from key payor groups 5. Mapping of commercial effort into physician prescribing behavior (companies often use IMS analysis) 6. Almost all “bottoms up” approaches to penetration analysis tend to overestimate penetration in practice. Preference analysis tends to do a poor job of predicting actual prescribing behavior in the face of detailing and sampling 7. Comparison versus pipeline products and relative timing to market

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Can then build low, expected and high penetration scenarios (important to understand limitation of forecasts in practice)

IMPORTANCE OF MARKET PENETRATION SCENARIOS

Building Penetration Scenarios

Primary Market Research (Structured Interviews)

Historical Analysis of Impact of Order of Entry Expected Product Market Share By Order of Entry

P&T Committees

Physicians by Segment

Payor Research

Estimates of usage and dependence on pricing

By Physician Segment

By Disease State (e.g., first line, second line)

Build demand curve, make pricing estimates 37

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Total Products on Market

1st

1

100

2

58

42

3

43

31

26

4

35

26

21

18

5

30

22

18

16

6

26

19

16

14

2nd

3rd

4th

5th

6th

13

12

Research Sources: G. Kalyanaram,”The order of entry effect in prescription (Rx) and over-thecounter (OTC) pharmaceutical drugs,” International Journal of Pharmaceutical and Healthcare Marketing, 2008, pp. 35-46. Hans Bauer and Marc Fischer, “Product life cycle patterns for pharmaceuticals and their impact on R&D profitability of late mover products,” International Business Review, 2000, 703-725.

IT IS POSSIBLE TO TAKE AN EVIDENCE-BASED APPROACH

Research Methods for Market and Penetration Analysis

t uc od Pr w Ne ed a t al tim rci Es me m Co s ve

Li

T3 T3 T2 NF T3 NF T2 T2 T3 T3 NF T3 T3 NF T2 T3 T2 T2

ia

e

id iz

T2 T2 T2 NF T3 NF T2 T3 T3 T3 NF T3 T3 NF T2 T3 T2 T3

d an Av

lip G

T2 T2 T2 F T2 NF T2 T3 T2 T2 T2 T2 T2 T2 T3 T2 T2 T3

in rm

fo et

T3 T3 T3 T3 T3 NF T3 T3 T3 T3 T3 T3 T3 T3 T3 T3 T3 T3

M

24,900,000 12,020,000 10,960,000 9,000,000 8,990,000 7,290,000 3,340,000 2,730,000 2,520,000 2,290,000 69,000,000 49,000,000 49,000,000 6,000,000 5,000,000 3,300,000 8,900,000 1,200,000 275,440,000

ia

National National National Internal PBM National Regional Internal PBM Regional Regional National PBM PBM PBM PBM PBM PBM PBM PBM PBM

v nu Ja

I

Target Payers*

WellPoint/Anthem Aetna/US Healthcare United Healthcare Prime Therapeutics Cigna Kaiser RxSol / PacifiCare Coventry HealthNet Humana Caremark ExpressScripts Medco PharmaCare MemberHealth Rx Anthem NMHCRx Coventry

pe Ty

38

an Pl

Leads to suggested sales force sizing and territory coverage with a managed care strategy in light of a launch budget. This facilitates building a penetration forecast that is market based. Typically such forecasts are much lower than those derived from physician preference share analysis.

T3 T3 T2 NF T2 F T2 T2 T2 T3 NF T3 T3 NF T2 T3 T2 T2

COMMERCIAL ANALYSIS AND PENETRATION

Penetration Analysis Should Understand Prescriber Concentration, Sales Force Design, Prescribing Behavior and Reimbursement Positioning

Historical Ramp Speed Analysis Bauer and Fischer (2000) show that Early Movers Ramp Slowly

Source: H.H. Bauer, M. Fischer, International Business Review 9, 2000, pp 703–725

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COST ESTIMATION

ACCOUN TING

TREATM

ENT

Estimating Costs

Research Costs / Clinical Development Costs • Identify remaining steps to IND (Toxicology, PK, etc.) • Estimate cost of remaining steps • Evaluate anticipated time and numbers of patients per phase • Examine patient enrollment issues, treatment length and cost, ease of establishing endpoints, long-term safety, regulatory complexity, etc.

COGS • Look at COGS estimates on comparable products • Use expected dosing and treatment length to generate unit sales. Estimate COGS at that sales volume • Important to be aware of fixed / variable elements of COGS • Review status and current data on scale-up issues

Sales and Marketing Costs • Examine concentration of customer base: hospital or office based physicians, etc. • Use IMS sales force sizing / penetration studies. • Evaluate potential market issues: requirements for physician training and education, patient education, direction to consumer marketing, etc.

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Estimating Costs Pre-Clinical Costs

Clinical Development Costs

From lead to IND: $5 to $15mm

Number of Patients in Trials

From target to lead: $5mm to $50mm

Complexity and Length of Protocol

Pre-Clinical Cost Drivers

Time in Trial

Difficult of chemically reaching target Existence of pool of potential targets Existence of predictive animal models

Demand for Patients / U.S. vs. ROW

Cost and complexity of pharmacology work Need for extensive animal toxicity work

Drug supply costs

Need for formulation / scale-up work

A good rough benchmark is to assume $25,000 per patient and count the number of patients. 42

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• Raw materials • Inventories • Small molecular versus biologic

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ACCOUN TING

Input Costs

TREATM

ENT

COGS Factors

… and production costs • Batch size • Production process (complexity, steps) • Storage and inventories • Delivery to customers

Estimating COGS can be based on a number of factors • Similarity to other drug profiles • Complexity • Economies of scale

ACCOUN TING

TREATM

ENT

Sales Force Costs: Example of Costing Grid

Number of Personnel

Fully Loaded Cost

Total Annual Costs

Senior Management

2

$380,000

$760,000

Regional Managers

5

$260,000

$1,300,000

MSLs

8

$250,00

$4,000,000

Sales Reps

120

$180,000

$21,600,000

Support Staff

12

$80,000

$960,000

Total

$28.6 million

Level

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ACCOUN TING

TREATM

ENT

SG&A Typically is Typically Much Higher than Direct Sales Force Cost

Company Pfizer GlaxoSmithKline Sanofi-Aventis Novartis AstraZeneca Merck Wyeth Bristol-Myers Squibb Eli Lilly Schering-Plough King Pharmaceuticals Sepracor Reliant Pharmaceuticals Sciele

Revenues 2006 ($mil) $ 48,371 $ 45,500 $ 38,934 $ 36,749 $ 26,475 $ 22,636 $ 20,351 $ 17,914 $ 15,691 $ 10,594 $ 1,998 $ 1,196 $ 800 $ 293

SG&A Expense ($mil) $ 15,589 $ 14,268 $ 10,641 $ 13,157 $ 9,464 $ 8,165 $ 6,501 $ 6,270 $ 4,890 $ 4,718 $ 714 $ 764 $ 550 $ 145

SG&A Margin 32% 31% 27% 36% 36% 36% 32% 35% 31% 45% 36% 64% 69% 49%

Salesforce Cost ($mil) Revenue / Rep $ 4,140 $ 1,389,971 $ 4,375 $ 1,229,730 $ 3,342 $ 1,364,191 $ 1,940 $ 2,370,903 $ 1,950 $ 1,765,000 $ 1,900 $ 1,741,231 $ 1,575 $ 1,695,917 $ 1,348 $ 1,628,545 $ 2,175 $ 950,970 $ 1,618 $ 827,656 $ 193 $ 1,816,364 $ 333 $ 629,474 $ 126 $ 1,111,111 $ 114 $ 450,769

U.S. Reps 8,800 9,000 6,500 5,200 6,000 8,000 5,000 3,300 7,000 4,500 1,100 1,900 720 650

Worldwide Reps 34,800 37,000 28,540 15,500 15,000 13,000 12,000 11,000 16,500 12,800 1,100 1,900 720 650

Source: Cowen Pharma, Jan 2007 and Torreya Partners Analysis

It is important to estimate variable cost components of a new drug introduction beyond direct sales force costs.

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ACCOUN TING

TREATM

ENT

Illustration of a Launch Budget for a Primary Care Product New Drug Launch Costs Marketing Travel Advertorial Media Patient Starter Kit Launch Sales Aid Launch Campaign Art Small Science Flash Card Patient Ed Booklet & Holder Direct to Patient Concepts Printing Sales Aids Testing Media to PCPs and GI docs Launch Journal Advertising Launch Media Launch Convention Panels MDAlert PharmAlert Pharmacy Sell Sheet Managed Care Sales Aid Formulary Stickers Shelf Talker Web site Direct Mail Product Website Development Premium Item Give-Aw ays Launch Meeting (does not include hotel and flight arrangements) Marketing Plan -Consulting Sales Training Modules Promo Items Rebate Trade Show Booths RCW Account service fee Drug Med Ed Sample packaging Marketing Total

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2011 1,000,000 6,000,000 30,000 86,500 100,000 43,000 98,750 58,000 250,000 12,000 1,500,000 2,000,000 40,000 37,000 32,000 27,000 37,000 15,000 20,000 250,000 205,000 60,000 107,000 1,000,000 120,000 20,000 150,000 630,500 3,000,000 568,000 17,496,750

Regulatory & Prod Developm ent Surveillance system 800 number Orange book costs PDUFA establishment Total Personnel Representatives (1500) including salary, benefits & fleet Recruiting, Travel and Misc Personnel Expenses Managed care organization (100) Sales Management, MSLs, Outcomes Grp (80) Total Sam ples Manufacturing, Packaging

250,000 20,000 100,000 50,000 420,000

262,500,000 75,000,000 15,000,000 20,000,000 372,500,000

50,000,000

Sales Sales Incentive (trip/other) Training Inventory sample cost Total Shipping costs

3,000,000 1,500,000 1,000,000 5500000 1,000,000

Total $ 446,916,750

RISK ESTIMATION

Phase 1: Done Q3 2008

Phase 1b: Done Q2 2009

Phase 2: Done 2010

Phase 3: Done 2012

Opportunity to show range of doses

Opportunity to find clear efficacy and start to see safety profile. Hopefully, primate tox is complete and we have a backup compound in Phase 1.

Critical to get the dose right, establish a safety profile and begin to write the label. Animal carcinogenicity done.

Write the label, confirm the safety profile and dose. Consider head to head trials vs. standard of care, noting points of differentiation. Get QT study done.

Phase 3: Large safety confirmation trial / write label

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48 48

Drug Safe and Superior to existing meds Drug Safe, not Superior but adds to existing meds

Phase 3: Not Safe

Terminate / Consider Other Indications

Phase 1b: Not Safe



Terminate Development



Phase 1b: Initial Proof of Concept

Phase 1: Not safe

If we can beat on efficacy and match safety we have a giant drug.

Drug approvable but inferior to existing meds

Phase 2: Dose and Safety Confirmed

AR9281 Phase 1a Safety Trial

Drug Approval / Label: 2013

KEY CLINICAL EVENTS AND POTENTIAL OUTCOMES

Important to Diagram Key Development Steps and Risks

100%

80%

100%

60%

80%

Cumulative probability of success (percent) 40%

52%

20%

26% 18%

15%

0% Pre-Clinical

Successful IND Submission

Phase I/IIa Successful

Phase IIb Successful

Stage of Development 49

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Phase III Successful

NDA Successful

MOST DRUG CANDIDATES FAIL TO BE APPROVED

Using Industry Average Failure Rates to Handicap Risk (PTRS)

Probability of FDA Approval Probability of FDA Approval for Products Entering (%) STUDY

Lehman Brothers (1997) Myers / Howe (1997)(1) DiMasi / Manocchia (1997) (1)

Kaitin (1995) DiMasi / Hansen / Grabowski / Lasagna (1997, 1995) Struck (1994 biotech) Struck (1994 conventional NCE) DiMasi / Seibring / Lasagna (1994) Wenzel (1993) Grabowski (1991) Tucker / Blozan / Coppinger (1988) Sheck / Cox / Davis et al. (1984) Hansen (1979) Recombinant Capital (o.D.) Bienz-Tadmor / DiCerbo / Lasagna (1992) Grosse / DiMasi / Nelson (1996) Average Average (excl. high and low)

Preclinical

Phase I

Phase II

Phase III

FDA

4 22 – – – 38 11 – – – ? – – 19 – –

10 24 – 20 23 69 25 –

63 64 – 62 64 92 66 – 63 64 ? – – 60 – –

90 75 90 75 – 100 100 83 –

29 21

30 32 – 30 31 79 33 – 30 31 ? – 50 30 – –

19 18

25 23

38 34

66 64

87 87

23 ? 17 19

? – – – – –

Notes

(2)

(3) (4)

Source: "Real Option Valuation in R&D Decision-Making in Pharmaceuticals" by Dr. Gunnar Pritsch, Associate Principal, McKinsey & Co. (1) No empirical study, but “conclusion estimates”. (2) Gastrointestinal: 79%; anti-infective: 84%; cardio: 90%; oncology: 92%; antiviral: 93%; endocrine: 94%; neuropharmacologic + radiologic: 100%. (3) Peptide hormone analogous: 24%; antiviral 29%; antineoplastics: 33%; cardiovascular: 34%. (4) Data 1980-89; number reflects average expected success for all recombiment protein and monoclonal antibody drugs; all recombinants: 19-43%; new recombinants: 15-39%; therapeutic MAbs: 4-29%.

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WIDE RANGE OF SUCCESS RATE ESTIMATES

Studies of Drug Approval Risk

Avance published a study in November 2009 of over 200 companies listed on public stock exchanges, tracking their clinical drug candidates from 2003-2009.

Cost ($ million)

Success Rate / Transition Probability (%)

Duration (Months)

Phase I

5

71%

12

Phase II

12

44%

26

Phase III

68

69%

34

NDA

3

NA

18

Total

88

21%

90

Stage

In biotech the success rate was even lower, averaging 9% for NCEs and 15% for biologicals.

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OVERALL SUCCESS RATE OF DRUG APPROVAL: 21%

Success Rates from a Recent Study

Another Updated Study: DiMasi – March 2010

Source: JA DiMasi, L Feldman, A Seckler and A Wilson, “Trends in Risks Associated With New Drug Development: Success Rates for Investigational Drugs,” Clinical Pharmacology and Therapeutics, March 2010, pp. 272-277.

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Success Rates Depend on Therapeutic Indication

Source: DiMasi, J.A., 2001, “Risks in New Drug Development: Approval Success Rates for Investigational Drugs”, Clin Pharmacol Ther, vol. 69, p. 297-307.

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Transition Probabilities by Therapeutic Class


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Small versus Large Molecule


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THE DISCOUNT RATE

ACCOUN TING

Nominal / Real

TREATM

ENT

Discount Rates Used in Industry

Discount Rate

Company Actelion

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Source Nominal

13.2%

HY Report 2009

Large Pharma A

Real

10%

2010 Interview

Spec Pharma A

Nominal

12%

2010 Interview

Large Biotech A

Nominal

10%

2009 Interview

Spec Pharma B

Nominal

14%

2009 Interview

Large Pharma B

Nominal

12%

2009 Interview

AstraZeneca

Nominal

11%

Annual Rpt 2008

Range

10 to 14%

ACCOUN TING

TREATM

ENT

Nominal Versus Real Discount Rates

Nominal rates include the effects of inflation. Real rates have been adjusted for inflation. It is important to match cash flows in the forecast to the type of rate used: Nominal cash flows with nominal rates and real cash flows with real rates. It’s an important distinction because many pharma revenue forecasts are real whether stated or not. Price increases that are modeled in are above and beyond normal inflation.

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Discount Rate Should Reflect the Cost of Capital What is the Cost of Capital?  The cost of capital is a measure of the opportunity cost of capital in an economy.

A company’s cost of capital should equal the marginal return available to investors in the next best investment opportunity of similar risk available in the capital markets  The cost of capital should reflect: 

The return available to investors in the economy on risk-free instruments



The return that investors require for taking systematic risk over and above the risk-free rate



Systematic risk is that which cannot be diversified away.



Traditionally measured as the weighted average of the cost of equity and debt. Known as the Weighted Average Cost of Capital (WACC).

The Cost of Capital is the opportunity cost of money in a competitive market economy and is a guide to the right discount rate. 59

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Weighted Average Cost of Capital (WACC)

Cost of Equity

Cost of Debt

Risk-Free Rate

Credit Spread

Country/ Political Risk Premium

Tax Shield

Risk-Free Rate

Equity Market Risk Premium

Equity Beta

Business Risk

Country/ Political Risk Premium

Financial Risk

WACC is a weighted average of cost of equity and debt, where the weights for cost of debt and cost of equity are determined by market values of equity and debt. Because a number of inputs to WACC are of statistical nature, WACC is a range rather than a point estimate. 60

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THE TRADITIONAL APPROACH TO WACC

Estimating The Cost of Capital using WACC Approach

Because equity is a long-term investment, a risk-free rate representing a long-term horizon is most appropriate. Consequently, we utilize the 30-year U.S. Treasury as the risk-free rate in the CAPM.

EQUITY MARKET RISK PREMIUM

The equity market risk premium is the excess return expected for the equity market relative to the long-term bond market. The figure that is used normally ranges between 4 and 8%.

EQUITY BETA(1)

The beta is a risk measure which represents the non-diversifiable risk associated with an equity investment measured relative to the overall equity market. It is a function of asset risk and financial risk. POLITICAL RISK PREMIUM

The political risk premium represents the incremental return investors require for use of their funds in international investments and represents nonsystematic risks such as expropriation.

(1) When calculating the asset beta for high-levered, non-investment grade companies, it is important to utilize a “debt beta” in the calculation.

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TRADITIONAL APPROACH TO WACC (CONT’D)

RISK-FREE RATE

Discount Rates in Practice

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CAPM near useless (betas on risky pharma companies often very low)

Industry betas are better if you must use beta

We prefer to pick a fixed rate that reflects the leveraged opportunity cost of equity

Another approach is to look at industry wide implied cost of equity from actual market prices.

VALUATION CONSIDERATIONS IN LICENSING

Illustrative

Value to Original Developer

Total Program Value

NPV= $30 License

Milestones Royalties

NPV= $80 R&D

Sales

COGs R&D

NPV= $50 Sales

S&M License

Value to Partner

COGs Milestones

S&M R&D

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Royalties

PARTNERSHIP AND NPV

Partnering a Program Splits the NPV Between the Original Developer and the Partner

Negotiating and Valuing Licensing Deals

NPV Split • • • •

What percent of the rNPV goes to the licensor and licensee? Generally the licensor can get more than 50% of the value Generally the split is more favorable to the licensor on earlier deals Generally the split is more favorable to the licensor when the licensee is small or in financial difficulty

rIRR to the Licensee • A key benchmark is what return on investment goes to the licensee (risk-adjusted internal rate of return) • A smart licensee avoids putting his capital to work in order to boost the rIRR • A smart licensor tries to get the lowest rIRR deal possible • Surprisingly, many counterparties in pharma negotiations pay less attention to this metric than they should.

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PARTNERSHIP DASHBOARD

Partnership Economics in a Recent Torreya Advised Transaction

1. Pick deals with large scale and high rIRRs 2. Know your rIRR limit – generally in the 20 to 30% range. 3. Focus on putting largest payments after key risk points have been passed 4. Focus discussion on precedent transactions (example at right) 5. Focus discussion on key issues (e.g., reimbursement, compliance, other related product revenues) 6. Focus discussion on fit and good job that can be done 7. Include equity as consideration if licensor is cash-strapped (often is misvalued) 8. Understand liquidation preferences of licensor / seller 67

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BARGAINING TACTICS WHEN IN-LICENSING

Bargaining Tactics when In-Licensing

1. Ask licensor to show what they can do for you. Get financial forecasts if possible. Ask for a capabilities presentation. 2. Figure out the licensor’s financial modeling approach and assumptions as best as possible. 3. Figure out the licensor’s hurdle rate on rIRR. 4. Solve for the licensor’s model and the rIRR as terms change. 5. Focus less on deal comparables. 6. Try to get payments made early in the collaboration. 7. Avoid including equity as consideration.

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BARGAINING TACTICS WHEN OUT-LICENSING

Bargaining Tactics when Out-Licensing

Assume $20 million upfront, $160 million in milestones and a 22% royalty. Cash Flows to BigPharma from Partnership Transaction - US Items Forecast Revenue Cost of Goods Sold Royalty payment to Biotech BigPharma development expense SG&A and launch cost Milestone payments to Biotech BigPharma Pre-tax cash flows After-Tax Cash Flow Probability of Success in Year Probability of Payment if Deal in 2008 Probability Adjusted Cash Flow

EPS Impact with success

2008 0 0 0 5 0 20 (25) (25) 10% 100% (25) $ (0.00)

BigPharma Tax Rate

22%

BigPharma Rate of Return on Partnership

36%

Value created at BigPharma by deal:

2009 0 0 0 10 0 0 (10) (10) 20% 50% (5) $ (0.00)

2010 0 0 0 20 0 40 (60) (60) 40% 25% (15) $ (0.01)

2011 0 0 0 20 0 0 (20) (20) 40% 25% (5) $ (0.00)

$6,104 million for an investment of

2012 0 0 0 50 (30) 60 (140) (140) 70% 20% (28) $ (0.02)

$

2013 0 0 0 50 (30) 60 (140) (140) 70% 20% (28) $ (0.02)

2014 0 0 0 10 0 0 (10) (10) 85% 15% (2) $ (0.00)

$

2015 624 62 137 0 (156) 200 68 53 100% 10% 5

2016 1,686 169 371 0 (422) 0 725 565 100% 10% 57

2017 2,918 292 642 0 (642) 0 1,342 1,047 100% 10% 105

2018 4,339 434 954 0 (954) 0 1,996 1,557 100% 10% 156

0.01 $

0.08 $

0.15 $

0.22 $

(78) million in expected terms.

The deal on the table here is for a Phase 1b cardiometabolic drug. The proposal made of 20mm upfront gives the licensor (big pharma company) a generous return of 36%. However, the project is highly risky. The licensee should keep bargaining to try to get the pharma’s return down to a sub 25% area. This will require getting the upfront to be higher.

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2019 5,972 597 1,314 0 (1,314) 0 2,747 2,143 100% 10% 214

0.31 $

2024 8,836 884 1,944 0 (1,944) 0 4,064 3,170 100% 10% 317

0.45 $

2029 12,450 1,245 2,739 0 (2,739) 0 5,727 4,467 100% 10% 447

0.64

ONE SHOULD ALWAYS TRY TO GUESS THE OTHER SIDES VALUE

Solving for the Other Side’s Model

THE M&A SETTING

M&A and Licensing Valuation Analysis are Conceptually Similar Same exercise but now we are valuing a company rather than a drug. Sum the rNPVs of the projects of the target company with adjustment for overhead costs or model the company as a whole (will shown an example for Eli Lilly). This gives the target company intrinsic valuation. Try not to overpay. Valuation is treacherous, particularly with terminal value assumptions. Problem is that most M&A deals involving later stage and marketed assets are NPV negative. Two ways to think about this:

1. Look at the IRR on your own company – what is your cost of cash? 2. Look at missing elements – particularly the target’s pipeline. 71

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OUR UNDE RSTAN DING OF

LILLY’S VALUA

TION APPRO ACH

M&A Analysis Approach at One Pharma •

•

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The Pharma has a well developed approach – Step 1. Identify cash flows from identifiable products – Step 2. Discount the cash flows at a rate in the low teens to get the DCF value – Step 3. Compute the target purchase price as the equity value plus a premium of 30 to 50% (typically 40%) plus debt less cash – Step 4. Compare the DCF to purchase price of the target • The difference between enterprise value and DCF is known as pipeline or science value • If pipeline value is negative then the valuation test suggests acquire • If pipeline value is greater than 50% then the valuation test suggests avoid • If pipeline value is between 0 and 50% then study further and make a business judgment This approach leaves significant room for quantitative and qualitative judgment. It is intelligent and designed to avoid situations where the pharma overpays for targets.

Consequences of a Hypothetical 2004 Acquisition of a Specialty Pharma Operating Income (ex-Synergies) Operating Income (ex-syergies)

Revenues $3,966 $3,549 $3,163

Revenues

$3,072 $2,777

$2,725 $2,373

$2,199

$526

2005

$699

$772

$803

2006

2007

2008

Warner Chilcott

$996

$726 $625

$351

$377

2007

2008

$270

$216

2006

28.4% 41.1% 30.7%

30.6% 38.9% 32.5%

Allergan

Pro Forma

Source: Wall Street projections

$1,000 $856

$841

2005 Operating Margin

Allergan

$1,377 $1,207

30.8% 45.4% 33.9%

Warner Chilcott

31.6% 46.9% 34.5%

Pro Forma


EPS

2003-2008 CAGR 19.9% accretive

18.8% accretive

14.1% accretive

$5.54 $4.62

$4.42 $3.28

$3.55

2005

$5.48

$3.87

2006 Allergan

2007 Pro Forma


2008

2005-2008 CAGR

8.4% accretive

21.4% 22.4%

20.5%

$6.51 17.0% 15.2% 12.9%

17.9%

18.7%

13.3%

Revenue

Operating Income (ex-synergies)

Allergan

Warner Chilcott

Pro Forma

EPS

Factors to Consider in NPV Models of Pharmaceutical Companies

Model each drug in an additive manner. • Revenues and cost curves for each drug. • Use reasonable estimates to the curves for the models.

Take drugs out at least 10 to 15 years – past patent expiration dates • Analyst reports generally stop too soon • Pay careful attention to patent issues and associated cliffs • Use analyst reports to get the estimates started Carefully think about the role of R&D in the model. • If you keep R&D in then you need a terminal value • If you leave it out or scale it down then no terminal value required

Be aware of how your own company looks through the same lens • For the purpose of a stock for stock merger it’s important to look at each party with the same analytical approach • If you ignore their pipeline, you should ignore yours etc.

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DISCLAIMER These materials have been provided to you by Torreya Partners LLC or Torreya Partners (Europe) LLP together with their respective affiliates and the members, directors, officers, employees, advisers or agents of each of them (together “Torreya Partners”) and may not be used or relied upon for any purpose other than as specifically contemplated by a written agreement with Torreya Partners. t The information used in preparing these materials was obtained from public sources and is intended only for educational and illustrative purposes. The material herein was prepared by the authors and may not represent the opinions or methods employed by Torreya Partners. Torreya Partners assumes no responsibility for independent verification of the validity of the content herein nor can it indicate that the content is complete and accurate in all material respects. No representation, warranty or undertaking, express or implied, is made and no responsibility is accepted by Torreya Partners as to or in relation to the accuracy or completeness or otherwise of these materials or as to the reasonableness of any other information made available in connection with these materials (whether in writing or orally) to any interested party (or its advisers). Torreya Partners will not be liable for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on any statement contained in these materials or any such other information. None of these materials, the information contained in them or any other information supplied in connection with these materials will form the basis of any contract. To the extent such information includes estimates and forecasts of future financial performance (including estimates of potential cost savings and synergies) prepared by or reviewed and discussed with the managements of your company and/or other potential transaction participants or obtained from public sources, we have assumed that such estimates and forecasts have been reasonably prepared on bases reflecting the best currently available estimates and judgments of such managements (or, with respect to estimates and forecast obtained from public sources, represent reasonable estimates). These materials were designed for us by specific persons familiar with the business and the affairs of your company and Torreya Partners assumes no obligation to update or otherwise review these materials. These materials have been prepared by Torreya Partners and its affiliates and accordingly information reflected or incorporated into these materials may be shared with employees of Torreya Partners and its affiliates and agents regardless of location. This presentation speaks only as of the date it is given, and the views expressed are subject to change based upon a number of factors, including market conditions and the Company’s business and prospects. Nothing contained herein should be construed as tax, legal or accounting advice. You (and each of your employees, representatives or other agents) may disclose to any and all persons, without limitation of any kind the tax treatment and structure of the transactions contemplated by these materials and all materials of any kind (including opinions or other tax analyses) that are provided to you relating to such tax treatment and structure. For this purpose, the tax treatment of a transaction is the purported or claimed US federal income tax treatment of the transaction and tax structure of a transaction is any fact that may be relevant to understand the purported or claimed US federal income tax treatment of the transaction. Torreya Partners (Europe) LLP, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority, is not acting for you in connection with any potential transaction(s) described in these materials and thus will not be responsible for providing you the protections afforded to clients of Torreya Partners (Europe) LLP or for advising you in connection with any potential transaction(s) as described in these materials except and unless subject to a subsequent specific written agreement relating to such potential transaction(s) between you and Torreya Partners (Europe) LLP. Authorised and regulated by the Financial Conduct Authority

Valuation Analysis in Pharmaceutical Licensing and M&A

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