Demystifying Biologics

By Michael Shulman

Simply put, generic competition among suppliers of final treatments will not hit the margins of proprietary component suppliers. The market is huge and growing rapidly, but remains fractured. Academic research institutions, government institutions like the National Institutes of Health (NIH), traditional drug companies, biotech outfits, diagnostic test companies, contract research organizations, large hospitals and even individual researchers are all potential customers.

The market is worldwide and growing the fastest overseas, with some U.S. enabling companies seeing as much as 60% of their business coming from overseas sales. At present, U.S. and European companies dominate the market because of their existing product lines and concern about the quality of products and their sources.

There are several kinds of enabling companies serving the biotech and life sciences industries:

• Genomics and genomic-infrastructure equipment companies. These companies have also begun to provide genomic screening services related to proprietary methods associated with their equipment.

• Measurement and sample preparation devices. These are pure hardware companies.

• Contract Research Organizations (CRO) and cost-plus businesses that use proprietary techniques as part of the pre-clinical services they offer to drug companies.

• Contract manufacturing of biologic products. This is a booming industry that includes some companies also providing components and consumables. These companies may manufacture small amounts of treatments for clinical trials or marketable products, and often receive royalties because their proprietary technology is used in the manufacturing process.

• Big Pharma and biotech outfits with subsidiaries selling internally developed components.

• Component and consumable providers that provide reagents, proteins and many kinds of other biologic products to enable research and the manufacturing of biologic treatments.

Finally, it's unfortunate that nearly every analyst and investment house categorizes component and consumable suppliers differently, but there is still no right, wrong or accepted way to categorize these companies. For investors, the real issue and important distinction are the "cost-plus" versus "profit margin" business models.

Cost-Plus Business Model

The cost-plus business model pertains to products and services that are highly competitive. They are purchased by the biotech or Big Pharma company because it doesn't want to bother making the product itself and/or finds it cheaper to use a third-party product or service.

They are called cost-plus because profits for the product or service are typically a certain percentage above the core cost of making the product or providing the service.

These products and services are typically not protected by patents.

Profit Margin Business Model

The profit margin business model applies to products, and occasionally services, that are reasonably unique. They are often protected by patents and have much less competition than cost-plus products and services.

Profit margin products and services are sold at prices that are related to the value of that product or service, so profit margins are directly related to the value the customer perceives -- not the cost of producing the product or service.

For this reason, a profit margin type product can have extreme profit margins -- as much as 90% or more -- and still be valued very highly by the customer.

I prefer the profit-margin business model for investment since higher profit margins fuel new product development and new sales capability, which are the two drivers of growth. Cost-plus businesses, especially CROs, are too competitive and face stiff competition from low-cost-structure environments like India and China.