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2016 BDO Life Sciences RiskFactor Report

28 August 2016

In the Life Sciences Industry, Innovation Challenged by Capital Markets Volatility and Public Controversy

The evolving life sciences landscape has experienced highs and lows over the past year.  Amid fluctuating market dynamics and political controversy, share prices took a turn for the worse in Q3 2015, and the downward trend continued through the first few months of 2016. High-profile concerns surrounding issues like drug pricing and overvaluation of biotech stocks have also been a significant drag on the sector, perhaps contributing to a weakened IPO market. Only eight companies priced during the first quarter of 2016—and just three of those eight posted first-day gains.

However, there is plenty of reason for cautious optimism. Despite the negative headlines, the life sciences sector remains poised for healthy global growth as the industry continues to pursue innovative solutions to worldwide problems. The Nasdaq Biotechnology Index demonstrated improved performance in March and April. The New York Times reports that, in April, $40 billion of healthcare deals were announced in a single day. In addition, our BDO IPO Halftime Report found that two-thirds (66 percent) of capital markets executives predict the healthcare sector, including life sciences, will generate the most offerings during the remainder of this year. Still, life sciences stocks hit some turbulence this Spring and, after a brief reprieve, face renewed volatility in the aftermath of the U.K.’s Brexit referendum. Brexit’s long-term impact on the life sciences industry remains to be seen.

As geopolitical turmoil and the drug pricing controversy linger, the road to growth may not be a straight one. According to our fourth annual Life Sciences RiskFactor Report, the top three risks this year for the largest 100 U.S. life sciences organizations are industry competition and consolidation, regulatory hurdles and intellectual property (IP) infringement. In addition, nearly 9 in 10 (89 percent) life sciences companies cite pricing pressure as a risk — the first time the report has tracked this risk factor separately.

What has become clear in recent months is that the drug pricing issue is nuanced, without an obvious solution to measuring value. Beyond the negative publicity from the actions of certain bad actors, the shift from fee-for-service to value-based care, set in motion by the Affordable Care Act (ACA), is also forcing companies to re-evaluate how they price their products in response to new reimbursement models. What it means to tie value to outcome is still being fleshed out—and in the interim, drug manufacturers will increasingly need to justify why they charge more than their competitors based on performance. In this environment, “me-too” innovations—such as a third-to-market compound with a new biomarker—and “obscure” products with small user bases may no longer warrant a pricing premium unless the manufacturer can effectively prove improved outcomes.

The business of innovation is inherently risky—and between unprecedented pricing pressure, regulatory scrutiny and market volatility, navigating today’s risk landscape is as challenging as it has ever been.

“Amid market turbulence and a difficult IPO environment, the life sciences sector has also experienced a few bright spots in M&A activity as well as promising research and product developments. While investors appear to be more risk-averse than they were during this time last year, breakthrough innovations almost always reap dividends. But, for the time being, drug pricing remains the elephant in the room.” Ryan Starkes, Assurance Partner and Leader of the Life Sciences Practice at BDO

Unpredictable Outcomes Meets Pricing Pressure

Life sciences companies frequently struggle to achieve profitability due to the high volume of capital deployed into research and development (R&D) efforts—which can take years before paying dividends. Consistent with prior years, 68 percent cite a history of operating losses as a risk, pointing to the industry’s significant investment in R&D, marketing and other necessary expenses, as well as the unpredictability of outcomes. Valuations are typically based not on profits but on sales potential. However, heightened scrutiny of drug pricing and macroeconomic factors have caused valuations to drop. But the life sciences sector may be somewhat shielded from Brexit-driven economic uncertainty—and from economic headwinds in general—since products are non-discretionary and, in many cases, lifesaving. Others worry that investors will move away from smaller companies with high clinical risk, pressured into safe-haven assets by Brexit-related volatility.  While the economic impact of Britain’s decision to leave the EU is hotly debated, one clear outcome is more uncertainty. Eighty-three percent of companies analyzed cite headwinds from general economic and financial market conditions as a risk.

The vast majority of life sciences organizations are also concerned about the tougher financing environment: 85 percent cite inadequate liquidity or capital as a risk factor in their annual filings. According to Bloomberg data, venture capital funding in 2016 is on pace to drop about 25 percent. Seventy-one percent of the 100 largest U.S. life sciences companies cite indebtedness as a risk, up 15 percentage points over last year.

Cyberattacks and Cyber Concerns on the Rise

Nearly 9 in 10 (89 percent) life sciences companies cite cyber risk in their annual filings, up by 19 percentage points from 2015 and 43 percentage points from 2013. Life sciences companies have access to extremely valuable data assets that can translate into big payouts for hackers. The biggest cyber threat in the life sciences industry is arguably to its intellectual property, which may fall victim to insider theft or corporate espionage. However, drug and device makers are targeted for more than their IP: Records on clinical and patient data can go for 10 times the value of credit card information in online black markets.

Cybersecurity in the life sciences industry has become increasingly urgent in recent years, with almost two-thirds of pharma companies reporting a security breach, according to a Crown Records Management survey. Cybersecurity of medical devices has also emerged as a realm of concern for regulators because of the potential impact on essential clinical performance and the extended risk to healthcare organizations in shared networks. In January, the FDA issued a new set of draft guidance outlining recommended steps medical device manufacturers should take to address cybersecurity vulnerabilities and minimize risk to patient safety.

The guidance on medical devices highlights the challenges of cybersecurity for the extended enterprise. Any entity in the network can be the weak link, and cybercriminals are increasingly taking advantage of weaknesses in third-party relationships to gain access to the targeted company’s network. Almost all companies analyzed in the RiskFactor Report (97 percent) cite supplier, vendor and manufacturer risk.

“Data—and finding ways to monetize that data—is at the heart of life science organizations’ business. While they may be a less obvious target than consumer-facing industries, sophisticated hackers are stealing critical business intelligence with larger but less straightforward financial rewards. Life sciences companies must put in place the right controls and detection mechanisms to adequately guard these critical data assets against both internal and external threats.”  - Shahryar Shaghaghi, National Leader, Technology Advisory Services and Head of International BDO Cybersecurity.