The buzz from day one of the J.P. Morgan Healthcare Conference in San Francisco earlier this week was the announcement on Sunday night by Roche that it was acquiring a majority interest in Foundation Medicine (NASDAQ: FMI) for a bit more than $1 billion in cash, which translates into $50 a share. Those were just the latest eye-popping numbers from Foundation, which went public in September 2013, amid warnings of a biotech bubble. From its initial offering price of $18, Foundation proceeded to enjoy a first-day jump all the way up to $35 a share, straining credulity for those investors focused on the fact that the company had not received meaningful reimbursement for its flagship cancer diagnostic product, FoundationOne.
It’s sixteen months later and Foundation still has not received the positive coverage decisions from Medicare or major private insurers that it would need in order to even dream of making money on its sequence-based diagnostic test. The stock had ridden down to $23 a share before the acquisition and there was plenty of short interest even at that level (pity those investors who did not cover those shorts on Friday!).
But Roche still went ahead and bought the majority of an unprofitable company for $1 billion in a transaction reminiscent of its purchase of a controlling stake in Genentech in 1990. Aside from the deal structures, which in both cases leave the U.S. management team intact—if now reporting to Roche headquarters in Basel, Switzerland—there would seem to be virtually no similarity. Roche has moved far beyond its early-90s status as a small molecule-heavy European pharma eager to transition into biologics. At the time of the initial Roche transaction, Genentech was already a powerful product engine, having developed early protein replacement therapeutics human insulin and human growth hormone with lots more in the pipeline and vibrant science to match. By contrast, Foundation has done little more than make losses on its diagnostics business.
But there is one big parallel between that deal and this one: In both cases, Roche believes that it has seen the future of the pharmaceutical industry. And it can only grasp that future by placing a large and risky bet on a U.S. innovator company. Roche’s thorough transformation into a company invested in targeted therapies driven by disease biology supports my thesis that it was the only pharmaceutical company in the world that had a rationale for acquiring a big stake in Foundation and that it is the one best positioned to make the deal a success.
In my view, the key reasons boil down to these:
• Roche was early and fervent in its embrace of diagnostics as drivers of drug development and sales. I know only one top executive in the pharmaceutical industry who cut his teeth in molecular diagnostics and he did so at Roche—Daniel O’Day, who was the CEO of Roche Molecular Diagnostics from 2006 to 2010 and is currently the chief operating officer of Roche Pharma. Once the Foundation transaction is completed, O’Day and two others chosen by Roche will join Foundation’s board of directors. Aside from the personal, Foundation also fell on fertile ground at Roche on the institutional level. Roche had already changed its drug-discovery focus to be more diagnostics-driven than most other pharmaceutical companies on virtually every level. As Roche CEO Severin Schwan declared in 2012: “More than 60% of our pharmaceutical pipeline projects are coupled with the development of companion diagnostics in order to make treatments more effective.” That number has almost certainly gone up.
• Roche was the pharma that had most thoroughly integrated clinical genomic sequencing into its trial protocols, long before it had figured out how best to use the data. In my work with biotech companies, I had been hearing for years how Roche had embraced sequencing data as a key success factor for the pharma industry of the future. As soon as the cost of sequencing became halfway affordable (maybe $5,000 to $10,000 per full sequence), Roche began to require genomic insights from every patient in every clinical trial. If there was any doubt about how highly Roche regarded sequencing, its $51-a-share Illumina (NASDAQ: ILMN) bid in 2012 dispelled it. (Illumina, whose CEO Jay Flatley said at the time that the bid seriously undervalued his company, now trades at $181 a share).
An executive speaking under condition of anonymity who knows Roche Ventures confirmed that Roche places high importance on genomic data—both that it has itself collected, as well as the data being collected by Foundation. As an aside, Roche Ventures had invested in Foundation two rounds before the IPO in 2012 and had no strings attached in the form of a promised acquisition or partnering deal. That investment is another indicator of the value Roche management placed on keeping up with the world of clinical sequencing. That executive told me on Monday that Roche was counting on Foundation’s data scientists to be able to make the most effective use of their own banks of both sequencing and outcomes data and that the prospect of joining forces was irresistible.
• Roche realized that it would face competition if another pharma company scooped up Foundation. Roche believes that in genomic profiling, it has identified a common theme for creating value in cancer drugs of whatever stripe—targeted therapies like kinase inhibitors; biologics like monoclonal antibodies; and even immuno-oncology approaches like checkpoint inhibitors. Having made this observation, it did not want anyone else to catch up. Combining Roche’s clinical sequencing data and its drug pipeline with Foundation’s gene-level and patient-level insights clearly would realize the most powerful synergy. But in the hands of another pharma, the Foundation team and data sets could have posed competition. Ergo, Roche decided to buy into Foundation now.
• Roche is counting on a shift from biochemical targets to genomic profile targets, especially in drugs for solid tumors. Foundation’s “poster child” cancer cases are those in which genetic profiling suggested—against all experience of oncologists and with no evidence from n-of-1,000 clinical trials—that cancer drug X, developed for, say, ovarian cancer, would work best in cancer indication Y (e.g. prostate cancer). Because the patient is desperate, the physician prescribes the drug and voila—there is a response or even a remission. This pattern echoes what has happened in blood cancers such as chronic lymphocytic leukemia (CLL), in which old-fashioned chemotherapeutic agents have been replaced by biologics like rituximab (Rituxan) and are being augmented or, eventually, replaced again by kinase inhibitors like ibrutinib (Imbruvica). This will likely happen in solid tumors as well: chemo as we know it will be scaled back (though, like that other blunt instrument, surgery, it will likely never completely disappear) and physicians will chase cancer cells through various waves of genetic mutations, each of which demands a different targeted therapeutic or biologic to hold it at bay. In that world, the company that is most on top of the mutation patterns and treatment patterns and can incorporate those into both its drug development efforts and its sales pitch wins (or at least has an edge).
Diagnostics will likely be an important part of immunotherapy as well, an area where Roche is currently weak. Right now companies like Juno Therapeutics (NASDAQ: JUNO), Kite Pharma (NASDAQ: KITE), Bellicum Pharmaceuticals (NASDAQ: BLCM), and Novartis are taking baby steps with a form of cellular immunotherapy known as CAR-T, in which a patient’s T cells are genetically modified to seek out and kill tumor cells. Most companies are focusing on surface antigens like CD19 that are widely expressed and therefore do not require molecular diagnostics. But to realize the full potential of these therapies, companies will need to match patient-specific tumor profiles with panels of off-the-shelf biologic reagents and cell engineering products. That’s where Foundation’s tests might come in.
• Foundation is setting new standards in cancer genome analysis. Foundation has raised the bar in the accuracy of genome-based tumor profiling (sensitivity, specificity) by something like a factor of three, and built robust and scalable informatics and analytics. Roche was already using the Foundation platform on a limited basis and realized that it was simpler to expand that use rather than to try to copy it.
Since the last few pharma mega-mergers, the industry’s biggest players have gone in wildly different directions. Novartis embraced gene therapy and gene editing. AstraZeneca doubled down on the biologics franchise it obtained with the acquisition of MedImmune. Bristol-Myers Squibb and Merck have raced ahead in checkpoint inhibitors. Merck, Sanofi, and to some extent Pfizer have rapidly expanded investment in “beyond the pill” and “digital interventions” (apps as drugs). And Roche took up diagnostics and genetics. For Roche, drug development, especially in oncology, is all about “genetics-driven medicine,” which in their view requires “genetics-driven drug development” and “genetics-driven marketing.” No one else has placed such a big bet on genetics, though all pharma companies are certainly exploring it (For example, AstraZeneca, Johnson & Johnson, and Sanofi recently announced a collaboration with Illumina to develop a “next-generation-sequencing based test system for oncology.”) In some sense, if Roche wins this one, others—e.g., those betting on checkpoint inhibitors and CAR-T cells—might lose out.
In CBT Advisors’ world of venture-backed biotech companies, this landscape poses significant challenges. Gone are the days when a biotech’s innovation would be appreciated by as many as five or ten pharma companies at the same time (there are barely fifteen left that regularly carry out M&A) and there could be a big bidding war. The biotechs’ leverage is not what it used to be. Counterbalancing that is the obvious productivity flop in pharma R&D. Biotech is the only place pharma can turn for real innovation. And turn they do, early and often.
This creates a bonanza for firms like mine that assist early, science-driven companies in managing their public positioning and their business development pitch from day one to create the largest possible exits. Now more than ever, the right story sells, just maybe to only one or two bidders. In Foundation’s case, the billion-dollar number was probably what it took to get the company’s pre-IPO investors (which included Google Ventures and Bill Gates, not to mention smart funds like Casdin Capital) to give up on at least some of their dreams of long-term returns in exchange for a sweet 10-12 times (I’m guessing) on their last pre-IPO investment from early 2013.
From Foundation’s point of view, the deal does three things, all of them good:
• Cashes out the early investors at a price they can accept.
• Delays, perhaps indefinitely, the need to break even on selling tests and shifts the focus to drug development and companion diagnostics
• Relieves the constant pressure to market the company’s analytic services to multiple pharma companies in deals that have been the main source of revenue for Foundation to this point. That pressure was undoubtedly going to become heavier as Foundation’s pharma partners realized that, quarter after quarter, there was no reimbursement coming from Medicare and little from other payers, leaving pharma to provide the vast majority of the company’s source of revenue. (A first small insurer in Grand Rapids, MI, announced coverage of FoundationOne and another Foundation test in October, 2014.)
Back to why the acquirer had to be Roche: remember that over the last 25 years, Roche has had the undoubtedly humbling—but ultimately very profitable—experience of owning Genentech. Revenues and product pipeline from that acquisition long ago overtook those products from Roche’s own drug development in volume and importance. In some sense, Genentech has come to own Roche. Since Roche is nowhere near as advanced in gene therapy as Novartis, nor as advanced in checkpoint inhibitors as Merck and Bristol, the move to own Foundation is an attempt to be the best it can be as a genetics-driven drug developer and marketer. No other pharma would have seen this deal that way. When and if Foundation’s investment bank called around looking for better offers, I bet no one called them back.
For Roche, the deal will either turn out to be a leapfrog or, maybe, a dead end. But if cancer therapies, especially for solid tumors, really do wind up getting developed and marketed in a genome-driven way—and many trends point in that direction—then this move will have turned out to be prescient indeed.