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Biotechnology is undergoing a transformation that should spell profits for companies and investors alike. William Davidson reports.

Investors in the biotechnology sector frequently witness odd events and peculiar business pursuits – as well as exciting financial developments.

In terms of events, nothing trumps the travails of a small Cambridge-based outfit which recently forced its way into the FTSE 250 on the back of massive smallpox vaccine orders from the US government. The shares then tumbled when a pharmaceutical rival stumbled across 20 million vaccine doses in an old freezer.

For unique business plans, check out Phytopharm. This company is using plant-based drugs to treat male pattern baldness (a popular cause in City broking circles) and, bizarrely, canine arthritis. Tranxenogen is meanwhile using genetic therapy to create flocks of transgenic chickens whose eggs contain proteins to treat human diseases.

Profits and developments

Amid all of this weird science, though, there are compelling investment opportunities. Indeed, after something of a fallow 2001, the next two years are set to be an exciting time for the sector.

One of the most noteworthy events of the year will be vaccine development business Acambis' move into profitability. Only a handful of biotechs have made into a profit, such as Celltech and Shire. According to Altium Capital's Sam Fazeli, Acambis's graduation should be followed in 2003 by that of stent coating business Biocompatibles and vaccine developer PowderJect.

In line with a move to profitability, several UK biotechs have drugs that are at a relatively late stage in their development. For a young companies, the completion of phase II clinical trials is often the most important stage of development because it is not until then that large pharma partners become involved.

Fundings and mergers

While these advances are welcome, there are still question marks over the funding of UK biotech companies. There were virtually no cash calls in the UK in 2001, and Fazeli predicts only two in 2002 – from Antisoma and Xenova. This could lead to a rush of fundraising efforts in 2003, as several companies are expected to run out of cash, including Alizyme, AorTech and Xenova.

A harsher funding environment is not necessarily a bad thing for investors. A recent study showed the venture capital industry has raised nearly $10 billion for investment in the biotech sector. Given the poor reception of biotech IPOs in recent years, this suggests investee companies will wait longer before attempting to float. They will subsequently be larger and more developed, which in turn could reduce investors' exposure to risk.

Takeover activity could also accelerate soon. Mergers are rare in the biotech world, not least because chief executives are notoriously self-confident and egos sometimes get in the way of otherwise sensible deals. Nevertheless, Fazeli believes 2002 will see several corporate takeovers, with Celltech, Acambis and Biocompatibles all potentially good targets.

Changes afoot

These changes are likely to occur against a backdrop of profound structural transformation within the sector as a whole. According to Simon Rogerson, manager of the BioScience VCT, there are 'massive changes taking place and smaller biotechs are starting to represent good value'.

His logic is based on the fact that big pharma companies are being forced to replace blockbuster drugs that have seen them through the past ten years or so. Rogerson explains: 'If I was considering investing in AstraZeneca or Glaxo-SmithKline, I would ask myself whether the next pound they spent would generate a higher return than the previous pound. The answer would be no. The only way that big pharma companies can become more efficient is either to merge, and strip out costs, or outsource the science to small biotechs'.

Hard facts and figures bear this out. Ten years ago 'big pharma' derived 23 per cent of its revenue from products licensed from small biotech or research organisations. Today the figure is close to 45 per cent, and rising.

The implications have some investors salivating. Even if a fledgling biotech firm is unlikely to post a profit in the near future (and most take at least ten years to do so), it is increasingly likely to license its research techniques and intellectual property to big operators. Sales, profits – and share price rises – could follow.

Fulcrum Pharma

Aim-listed Fulcrum designs and carries out drug development programmes for a wide range of large pharma and biotech customers. It sets up 'virtual teams' by recruiting people from contract manufacturers and contract research organisations, and hires a leader to oversee the project. Fulcrum can reduce the time and cost of a project by up to 30 per cent. 'We have a simple model, but it works', says managing director Jon Court.

Japan is providing the firm with compelling opportunities. The country still has the second highest GDP per capita in the world and a rapidly ageing population, meaning healthcare spending is set to increase. Yet, as Court points out, when it comes to outsourcing the Japanese pharma industry is 'six or seven years' behind its European and US counterparts.

The US also presents massive opportunities, and Fulcrum hopes to open an office in the Boston area shortly.

In the year to August, Fulcrum's turnover rose 234 per cent to £6m. Pre-exceptional and -tax profits came in at £546,000, compared with £24,000 last year. For the current year, Seymour Pierce is looking for profits of £1.25 million, which translates into 1p earnings. This puts Fulcrum on an undemanding p/e of 15.8.

Mkt cap: £9.7m Share price: 15.75p

BioFocus

The chemistry service business recently turned in a sparkling set of full-year results, easily beating analysts' predictions. In the year to December, sales nearly doubled to £10.9 million, while pre-tax profits rose 42 per cent to £2m. Earnings per share came in at 11.94p.

Since year-end, BioFocus has signed contracts with UCB and Quintiles. This year the focus will be on balancing the business between outsourcing services, a very profitable area of work, and 'pure' drug discovery, which is typically unprofitable.

According to the company, 2002 has started well. But it is too early to tell whether the past year's forecast-beating results will be repeated. Broker Nomura predicts earnings per share of 12p, rising to 32p in 2003. This puts the business on a forward p/e of 24, falling to less than 9.

Mkt cap: £46.7m Share price: 287.5p

GW Pharmaceuticals

GW Pharmaceuticals has a broad portfolio of products, all of which are based on cannabis extracts. It is chaired by Dr Geoffrey Guy, who, together with Dr Brian Whittle (who is also on GW's board), founded plant-based pharmaceuticals company Phytopharm.

Treatments under development include ones for cancer pain, migraine, multiple sclerosis (MS), rheumatoid arthritis and various psychotic disorders. Its most advanced product, for MS, is in Phase III trials. Analysts expect these to be completed by the third quarter of this year.

Several factors mark GW out from the biotech crowd. Possibly the most important is the fact that there is anecdotal evidence supporting the efficacy of cannabis-based drugs. This should speed up the process of submitting drugs for trials.

Making the treatments should also be simpler because GW has its own cannabis 'factory' in a secret UK location that is stuffed with 40,000 cannabis plants.

The Government is very supportive of GW's work, stating that it will allow cannabis-based medicines to go on general prescription. With profits not expected for some time, GW sits at the higher end of the risk scale – even by biotechs stanfards – but could reward the brave.

Mkt cap now: £116.7m Share price now: 121.5p

Alizyme

In a recent note, WestLB Panmure's Dr Nick Staples said Alizyme was 'considerably under-valued'. Recent results showed a loss of £6.6 million, and the shares fell 10 per cent as the market focused on this. However, there are compelling reasons why Staples is right and the market is wrong.

Alizyme has four products in clinical trials. This is unusual for a company of its size, and provides proof that its technology works. The most advanced treatment – for ulcerative colitis – is COLAL-PRED, which is in Phase III trials. It uses a proprietary coating to ensure that the active steroid is delivered at the right time, and in the right place (the colon). This technology is used with other products in the Alizyme stable.

Alizyme finds itself in a relatively strong position, thanks to a dearth of Phase III drugs ready for licensing. Significantly, Phase II trials of COLAL-PRED are about to start in the US, creating the possibility of marketing agreements in the colossal US market. All four brokers covering Alizyme rate it a Buy.

Mkt cap: £60.2m Share price: 76p