Making money in the biotech Gold Rush
Companies that sell the 'picks and shovels' can be more profitable than the biotechnology firms themselves.
NEW YORK (CNNMoney.com) - Prospectors during the California gold rush bet everything they had on the long odds of finding gold, while merchants got rich selling them picks and shovels.
The biotech business is similar, according to analysts who follow the industry. Biotechs, and the investors who back them, conduct expensive tests in pursuit of potential blockbuster drugs that may or may not come to market.
But many biotechs are young, money-losing start-ups, and investing in the companies that sell products and services to the biotech industry may be less risky, and more profitable, some of the analysts said.
"You may not find any gold in the river, but you need to buy the picks and shovels try and find the gold," said Dmitry Silversteyn, an analyst for Longbow Research who covers the biotech suppliers.
The "picks and shovels" make money by selling the tools and services that the biotechs need -- everything from beakers and razor blades to analysis services and technology for DNA research and cell cultures.
"Typically, they are faster to generate revenue and, hopefully, faster to profitability," said Edward Tenthoff, analyst for Piper Jaffray, comparing the suppliers to the biotechs.
Whether biotechs make money depends on clinical trials meant to see if their experimental drugs are safe and effective, and review by the Food and Drug Administration, which determines whether their drugs can be sold in the United States.
Unlike Big Pharma, many biotechs are small firms with little or no revenue, so a lot is at stake with potential new products, and investors can't predict the outcomes of studies and FDA decisions.
"The reason biotechs are risky is because it takes a lot of time and money to go through the FDA trials," said Silversteyn at Longbow Research. "[The pick and shovel suppliers] are more or less insensitive to the vagaries of FDA approval, so long as there's money being spent on R&D research."
The life science providers
Sigma-Aldrich Corp. (down $0.12 to $63.91, Research), a St. Louis-based maker of chemical products used in drug research, is one of the larger players in the industry with a stock market value of about $4.3 billion.
Other leaders include Fisher Scientific International (up $1.41 to $69.19, Research) of New Hampshire and Invitrogen (up $0.17 to $69.92, Research) of California, both suppliers of drug development tools to biotechs, big drugmakers and researchers at hospitals and universities.
James Gale, managing partner of LifeScience Fund, which invests in privately held biotech suppliers and sells them to publicly traded companies, said the pressure to come up with top-selling blockbusters has prompted biotechs and Big Pharma to buy more services from outside suppliers.
"They've got to come up with a new product, a billion-dollar product, and it's not like they grow on trees," said Gale.
But analysts are divided about whether spending on drug research is going to pick up or cool off, and so investment ratings for the biotech suppliers can vary widely.
That's partly because the suppliers' business is so difficult to gauge. Unlike Big Pharma revenue, which is tracked by prescription volume, the biotech suppliers sell thousands of different products to different clients in different industries.
While the companies may appear to have stable prices and strong order flows, the variety of products and customers can make results hard to forecast, said Richard Watson, an analyst at William Blair & Co.
That in turn calls for greater trust in management, and that could very well be the riskiest aspect to the business. "Transparency into the business is definitely a challenge with these kinds of companies," said Watson.
Still, if the California Gold Rush of more than 150 years ago is any guide, history may end up being kinder to the suppliers than the miners.
"When we look back on it, the people who actually made money were the ones selling the picks and shovels," said Quintin Lei, analyst at Robert W. Baird.
The analysts interviewed for this story do not own shares in the companies mentioned here, though Robert W. Baird has received compensation for non-investment research related to some of them.
To read about the future of the biotech industry, click here.